Granger-causality between islamic banks and conventional banks: evidence from Malaysia

This paper explores the Granger-causal relationship between Islamic banks’ non-performing financing (NPF) and conventional banks’ non-performing loans (NPL) for the banking industry in Malaysia. To further understand these asset quality variables, we added domestic macroeconomic variables namely domestic credit, real lending rate and exchange rate for the period January 2007 to January 2017. All variables are I(1) in nature on the basis Augmented Dicker Fuller (ADF) and Philips-Perron (PP) unit root test. Using time series cointegrating VAR models, coupled with the Long Run Structural Modelling (LRSM), Vector Error Correction Model (VECM) and Variance Decomposition (VDC), the results tend to suggest that NPF leads NPL. Contrary to expectation, the VDC results suggest that NPF and NPL variables are exogenous and endogenous respectively. This unexpected result gave rise to many interesting arguments especially within the Islamic banking perspectives. Apart from providing important insights into the causality between NPF and NPL, our results contribute to the policy implications. Interest rate variable being the most exogenous variable can affect both NPFs and NPLs. The CUSUM and CUSUMSQ tests substantiate the stability of the functions.