Interest Rate Risk in Interest-free Banks: An Empirical Research on Turkish Participation Banks

Participation banks, which are globally called Islamic Banks or interest-free banks, basically receive funds based on profit-loss sharing principle and make loans via purchasing a commodity or a service and selling it to customers for a higher price (murabaha method) or profit-loss sharing investment contracts (mudarabah or musharakah method). In literature, most of theoretical studies suggest that interest-free banks' business model is based on profit-lost sharing principles and therefore unlike conventional banks these institutions are not exposed to interest rate risk. Conversely some empirical studies suggest that Islamic banks' profitability is affected by market interest rates and these institutions are exposed to interest rate risk. In this study, with reference to Basel Committee's definition of interest rate risk, effects of market interest rate fluctuation on the profitability of Turkish Participation Banks has been analyzed with Seemingly Unrelated Regression method for the period between June 2005 and June 2016. It is found that there is a significant relationship between the profitability of the participation banks and interest rate changes and therefore each institution is exposed to the interest rate risk at different levels.