Dependency of Islamic bank rates on the conventional bank rate not only violates the religiosity principle, but also the fundamentals of an efficient market due to possibility of arbitrage profit from the rate differences. This study tests such dependency in a dual banking system by considering monthly data from January 2009 to April 2018 on Malaysia banks using a 12-month rolling standard deviation, and several ARDL and causality models based on Toda-Yamamoto approach are employed to investigate the short- and long-run dependency of rates. The study finds that the Islamic bank deposit and financing rates in Malaysia are influenced by both the conventional rates and the Bank Negara Malaysia’s policy rate. Results imply that Islamic banks do serve profitdriven
customers. We suggest that Islamic banks are forced to benchmark their rates
to conventional rates as a result of the trade-off between religious and economic
fundamentals by profit-driven customers. The study demonstrates that the question of Islamic legitimacy of Islamic banks needs to be addressed considering the correct profiling of the customer-base and the regulatory environment in which Islamic banks operate in. We discuss implications for Islamic rate setting behaviour in the presence of monetary shocks in a dual banking system.