What attracts conventional investors to Islamic financial instruments? We answer this question by comparing Malaysian Islamic and conventional security prices and their response to macro-financial factors. Our analysis suggests that Islamic and conventional bond and equity prices are driven by common factors. Likewise, especially in recent years, Islamic banks have responded to economic and financial shocks in the same way as conventional banks, suggesting that the gap between Islamic and conventional financial practices is shrinking. Malaysia has progressively developed its Shariah-compliant Islamic finance industry.2 Launched with a small Islamic savings sector fund in 1963, Malaysia’s Islamic finance has grown steadily to become the third largest in the global Islamic finance industry (Figure 1) and one of the most developed Islamic banking markets in the world. Presently, Malaysia is the world’s largest issuer of Islamic bonds (Sukuk) (Khan, 2011).3 Islamic banking assets and assets under management are worth US$ 1,200 billion with an average growth rate of about 20 percent annually (BMB Islamic, 2011).

Malaysia has a dual financial system with Islamic and conventional markets operating in parallel. Both systems offer a full range of financial products and services; often use the same infrastructure (Yakcop, 2003); and compete for overlapping groups of customers in all segments of the financial system, including banking, insurance, fund management, and capital markets.4 The Islamic banking sector positions itself as a “complement, if not alternative, to conventional finance” (Brown, 2009). Its market share has systematically increased: as of September 2011, Islamic banking assets accounted for 21.6 percent of total banking assets in Malaysia, rising from 12 percent in December 2006 (Figure 2),5 meeting the government’s goal of 20 percent. On Bursa Malaysia, about two-thirds of the listed securities (by stock market capitalization) are Shariah-compliant. The Islamic private debt securities market is the largest in the world, with US$ 34 billion of domestic corporate bonds outstanding.