Abstract
In theory, the cornerstones of Islamic finance are interest avoidance and risk-sharing. In practice, however, Islamic banks seem to be lacking both, particularly the latter. We investigate the interest rate impact on Islamic banks' three most-widely used types of financing instruments – i.e. sale-based, lease-based and risk-sharing – by employing the system GMM estimators on a unique panel data set of 77 Islamic banks from 13 countries over the period 2003–2017. We find that sale- and lease-based financing instruments are negatively correlated with the interest rate and that their exposure is amplified in more developed Islamic banking jurisdictions. Risk-sharing instruments, however, appear to be out of the interest rate domain of influence except in less developed Islamic banking jurisdictions, where the impact is positive. Additionally, the above effects on sale-based and risk-sharing instruments hold true only in the case of full-fledged Islamic banks and Islamic bank subsidiaries, respectively; the impact on lease-based instruments hold under all specifications. The findings imply that predominant use of sale- and lease-based financing instruments in their current form undermines the interest-free and risk-sharing essence of Islamic banking and runs the risk of converging with its conventional counterpart.
•Islamic banks’ financing is predominantly sale- and lease-based•Sale- and lease-based financing instruments of Islamic banks are negatively affected by interest rates•The above effects appear to be amplified in more developed Islamic banking jurisdictions•Risk-sharing financing appears to be free from interest rate influence only in more developed Islamic banking jurisdictions.•Full-fledged Islamic banks appear to be more susceptible to interest rate risk than Islamic bank subsidiaries.