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24,1
28
Naziruddin Abdullah
AlHosn University, Abu Dhabi, United Arab Emirates, and
Syed M. Alhabshi
Universiti Tun Abdul Razak (UNITAR), Kelana Jaya, Malaysia
Downloaded by Universiti Utara Malaysia At 21:14 02 January 2016 (PT)
Abstract
Purpose In an attempt to enrich the literature of the efficiency of Islamic banks, this study aims to
empirically investigate the efficiency of the fully fledged Islamic banks as well as Islamic windows in
Malaysia.
Design/methodology/approach This study measures the technical and cost-efficiencies of these
banks using the non-parametric frontier method, data envelopment analysis (DEA).
Findings The findings show that, on average, the efficiency of the overall Islamic banking
industry has increased during the period of study. The study also revealed that, although the fully
fledged Islamic banks were more efficient than the Islamic windows, they were still less efficient than
the conventional banks. Finally, Islamic windows of the foreign banks were found to be more efficient
than Islamic windows of the domestic banks.
Originality/value The findings of this study will provide some empirical insights as to how these
two modes of Islamic banks had fared in the competitive environment from 1997 to 2003.
Keywords Banking, Banks, Islam, Malaysia
Paper type Research paper
Introduction
Islamic banking has been in existence since the 1970s, and it has shown tremendous
growth over the last 30 years. The practise of Islamic banking now spreads all over the
world from the East to the West, all the way from Malaysia, Bahrain to Europe and the
US. As of 2004, the size of the banking industry assets has reached hundreds of billions
of dollars from merely hundreds of thousands of dollars in the 1970s.
Since early 1990s, studies that were focused on the efficiency of financial institutions
have become an important part of banking literature (Berger and Humphrey, 1997).
Perhaps, one of the reasons is, efficiency can be used as an indicator to measure a
banks success. Specifically, using the efficiency criterion, the performance of
individual banks as well as the industry can be gauged. Another reason is that the
efficiency can also be used to investigate the potential impact of government policies on
a banks efficiency. Indeed, it is of regulators interest to know the impact of their policy
decisions on the performance and efficiency of the banks, as they will enormously
affect the economy.
While there has been extensive literature examining the efficiency of the US and
European conventional banking industries over the recent years (Berger and
Humanomics
Vol. 24 No. 1, 2008
pp. 28-48
# Emerald Group Publishing Limited
0828-8666
DOI 10.1108/08288660810851450
The authors would like to thank Associate Professor Dr R. Ravindran, Professor Tim Coelli, the
Editor of this journal, and anonymous referees for useful comments on previous drafts of this
paper. The authors also acknowledge the financial support of Central Bank of Malaysia. The
usual caveats apply.
Humphrey, 1997; Goddard et al., 2001), the empirical work on Islamic Banking
efficiency, particularly in Malaysia, is still in its infancy. Typically, the studies on
Islamic banks have focused on theoretical issues, and empirical work has relied mainly
on the analysis of descriptive statistics rather than rigorous statistical estimation
(El-Gamal and Inanoglu, 2003).
In Malaysia, the first Islamic bank, Bank Islam Malaysia Berhad (BIMB), operated as
the only Islamic bank for 10 years since July 1983 before the government allowed other
conventional banks to offer Islamic banking services using their existing infrastructure
and branches in 1993 (Bank Negara Malaysia, 1994, 1999). The government decided to
allow the conventional banking institutions to offer Islamic banking services or Islamic
windows, because this was thought to be the most effective and efficient mode of
increasing the number of institutions offering Islamic banking services at the lowest cost
and within the shortest time frame (Bank Negara Malaysia, 1994, 1999). By so doing, it
would also forge the Malaysian banking industry to be more competitive, which would
then drive an improved performance and leading to enhanced efficiency of the Islamic
banking industry (Alias et al., 1994; Kaleem, 2000). However, with the facilities and
incentives extended, most especially by the Central Bank, to both the full-fledged Islamic
banks and Islamic windows, one wonders whether they had over the two-decade period
(from 1980s to 1990s) performed efficiently? Although this issue is very pertinent, only a
few studies have been undertaken to investigate it.
This study examines the efficiency of the Islamic banking industry in Malaysia
from 1997 to 2003. The results would provide us with explicit indications whether the
decision to allow Islamic windows to operate side-by-side with full-fledged Islamic
banks commensurate with the ultimate objective of creating a conducive environment
for them to compete in an efficient manner.
The efficiency measurement would also give an indication whether current Islamic
banks in Malaysia are ready to face financial liberation. This being the case because
under the Phase Three of the Financial Sector Master Plan, the Central Bank of
Malaysia had issued full-fledged Islamic bank licenses to foreign banks as part of the
financial liberalisation of Islamic banking in Malaysia (Bank Negara Malaysia, 2004).
Following this introduction, the developments of Islamic banking in Malaysia is
discussed. Subsequently, the previous studies on bank efficiency and its definition are
reviewed briefly in related literature. The (data envelopment analysis) DEA
methodology and input and output used to carry out the efficiency analysis are detailed
in methodology. Interpretation of results is presented in the empirical findings. The
final section concludes the paper.
Development of Islamic banking in Malaysia
Malaysia has emerged as the first country to implement a dual banking system where
Islamic banking system operates side-by-side with the conventional banking system.
The Malaysian model has been recognised by many Islamic countries as the model of
the future and many countries have shown interest in adopting the Malaysian system
in their respective countries. In fact, delegates from various countries, mainly Muslim
countries, have come to Malaysia, particularly to the Central Bank and Bank Islam
Malaysia Berhad (BIMB), to study how the dual banking systems work.
Islamic banking system comprises full-fledged Islamic banks and Islamic windows,
which operated within the conventional banking institutions (commercial banks,
finance companies and merchant banks). There are currently two domestic full-fledged
domestic Islamic banks operating in Malaysia. The first is Bank Islam Malaysia
Islamic banking
in Malaysia
29
H
24,1
30
Berhad (Bank Islam), established in 1983, while the second Islamic bank is Bank
Muamalat Malaysia Berhad (Bank Muamalat), established in 1999[1].
The Malaysian Islamic banking industry, in terms of assets, deposits and financing
base has grown very rapidly over the seven-year period, as illustrated in Table I. For
example, the total assets accumulated by the industry (comprising of Bank Islam, Bank
Muamalat and Islamic windows) rose sharply from RM17.8 billion in 1997 to RM77.4
billion at the end of 2003. Total deposits mobilised by this industry increased
tremendously from RM9.9 billion in December 1997 to RM55.9 billion in December 2003.
On the financing side, the Islamic banking system has shown an impressive growth from
RM10.7 billion to RM48.6 billion during the same period. However, it would be intriguing
to investigate whether the growth achieved was corresponding to higher efficiency level.
1997
Table I.
Total assets, deposits
and financing of islamic
banking system
1998
1999
As at end of
2000
2001
2002
2003
5,153.2
1,170.2
348.4
Total financing RM million 10,749.4 10,461.1 13,723.7 20,816.1 28,317.6 36,717.7 48,615.4
Full-fledged Islamic bank
3,350.7 3,471.4 5,029.5 6,423.4 7,671.0 9,158.2 9,764.5
Islamic windows:
Commercial bank
4,705.8 4,702.8 4,920.5 8,533.6 12,257.6 16,706.4 22,324.3
Finance company
2,189.9 1,878.4 2,995.5 5,089.8 7,617.4 10,049.6 15,745.8
Merchant bank
503.0
408.5
778.2
769.3
771.6
803.5
780.8
The second phase, from 1993-2003, was aimed at creating a more conducive
environment for competition among the banks. At the same time, it was to give banks
ample time to try to capture a larger market share. Lastly, while the intention was to
create awareness among the public, especially the Muslim, about the benefits of Islamic
banking system, this was also the period where conventional banks were allowed to
offer Islamic banking services by setting up Islamic windows in 1993.
The third phase that commenced from 2004 was the period of further financial
liberalisation (Bank Negara Malaysia, 2004). During this period, the Central Bank
paved the way for new foreign Islamic banks to operate in Malaysia by means of
issuing licenses to them.
First phase (1983-1992): the establishment of the first Islamic bank
It can be said that the Central Bank was instrumental in the development of the Islamic
banking system in Malaysia. In 1981, the government formed a National Steering
Committee on the establishment of an Islamic bank. The Central Bank was given the
task to prepare a paper on the possibility of instituting the first Islamic bank in this
country.
After two years of hard work, BIMB was established in Malaysia. It commenced
operations on 1 July 1983. The legal basis for the setting-up of BIMB was the Islamic
Banking Act (IBA) 1983 where BIMB was permitted to carry out banking business as
prescribed in Syariah (Islamic laws). From 1983 to 1993, BIMB had enjoyed ten years of
monopoly as the sole provider of banking services based on Islamic principles. This
exclusive right given to BIMB was to allow the bank to develop as many Islamic
products as possible and to get them tested in the market. It was also intended, in a
way, to protect the bank from having to compete with other conventional banks whose
experience was far richer than BIMB. As a result, BIMB, in terms of total assets, has
grown tremendously. Backing with total assets of RM325.5 million in 1984, the amount
rose to RM13.7 billion in 2003, indicating an average growth rate of 216.3 per cent per
annum throughout the period (BIMB Annual report). BIMB also proved to be a viable
banking institution with its activity expanding rapidly throughout the country. As of
2003, BIMB has 84 branches nationwide and 2,022 employees compared with 6
branches and 272 employees in 1984 (BIMB Annual Report).
Second phase (1993-2003): the emergence of Islamic windows
Following a splendid achievement in the first phase, the banks long term objectives
have been mapped out for the subsequent phase (Khalid, 1996). Specifically, in this
phase, is envisaged by the Malaysian government to set-up a comprehensive, viable
and sound Islamic banking system serving all Malaysians, both Muslims and nonMuslims. In other words, it is aimed at creating an Islamic banking system, which does
not involve interest or riba to operate side by side with conventional banking system.
To meet these objectives, the Central Bank decided to undertake a gradual and stepby-step approach. The first step was to introduce the Skim Perbankan Tanpa Faedah
(SPTF) or interest-free banking scheme in 1993 whereby the conventional banks were
allowed to offer similar Islamic banking facilities as the full-fledged Islamic bank did.
Figure 1 highlights some of the reasons for allowing the conventional banks to set-up
Islamic windows.
In December 1998, the term interest-free banking scheme used for Islamic windows
was replaced by Islamic Banking Scheme (IBS) or Skim Perbankan Islam (Bank
Negara Malaysia, 1998). In that year, all banking institutions that have Islamic
Islamic banking
in Malaysia
31
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32
Figure 1.
Reasons for setting up of
Islamic windows
windows were also required to upgrade the Islamic banking unit to Islamic banking
division so as to further expand the Islamic banking industry.
The second phase also saw the setting-up of the second full-fledged Islamic bank,
the Bank Muamalat Malaysia Berhad (BMMB). The establishment of BMMB was the
result of merger arrangements between Bank Bumiputra Malaysia Berhad (BBMB)
and Bank of Commerce Malaysia Berhad (BOCB). The arrangement was made in such
a way that the Islamic banking operations of these two banks were transferred to this
newly established bank. With the merger, Bank Islam stands to lose its monopoly
status as the only full-fledged Islamic bank. The creation of BMMB will ensure healthy
competition for Bank Islam, which comes under constant criticism from the press over
recent years for its over-cautious and bureaucratic approach (Hashim, 2002).
Third phase (2004 onwards): towards financial liberalisation of Islamic banks
The distinctive feature of this phase is that the government had brought forward the
financial liberalisation of the Islamic banking industry from 2007 to 2004. What came
out from the liberalisation was the instant emergence of three new foreign full-fledged
Islamic banks, all of them from the Middle-east, in the Malaysian banking market
(Bank Negara Malaysia, 2004). The strategy was to create more competition and to tap
new growth opportunity as well as raise the performance of the Islamic banking
industry as a whole.
The first full-fledged foreign Islamic bank issued with license to operate in Malaysia
was Kuwait Finance House, while the second and third were Al Rajhi Banking &
Investment Corporation, and a consortium led by Qatar Islamic Bank (Sidhu, 2004b;
Bank Negara Malaysia, 2004). Besides that, all the Islamic windows or IBS were
encouraged to be set up into Islamic subsidiary (IS), which will be licensed as fullfledged Islamic banks (Bank Negara Malaysia, 2004). The intention was to strengthen
and spur the growth of the local-based Islamic banks as well as to encourage them to
expand offshore (Sidhu, 2004a). However, the move was not well-received. Some argued
that it leads to duplication of resources, which in turn will raise the costs. Others see it
as turning back the clock. This is the case because with the issuance of licenses to the
new full-fledged Islamic banks (foreign and local-based) it means more banks are
competing in a small unchanging banking market (Fernandez and Shamsudin, 2004).
The first local-based banking group that launched Islamic subsidiary was RHB
Group, which opened RHB Islamic Bank Berhad. The second was Commerce group
when it launched the Commerce Tijari Bank Berhad (Bernama, 2005; Dhesi, 2005), and
the third banking group was Hong Leong Group, which established the Hong Leong
Islamic Bank (Hamsawi, 2005).
Related literature
Efficiency definition
Efficiency measurement is one aspect of investigating a firms performance. Efficiency
can be measured in three ways; maximisation of output, minimisation of cost, and
maximisation of profits. In general, efficiency is divided into two components
(Kumbhakar and Lovell, 2003). A firm is regarded as technically efficient if it is able to
obtain maximum outputs from given inputs or minimise inputs used in producing
given outputs. The objective of producers here is to avoid waste. According to
Koopmans (1951) a producer is considered technically efficient if, and only if, it is
impossible to produce more of any output without producing less of some other output
or using more of some inputs. On the other hand, allocative efficiency relates to the
optimal combination of inputs and outputs at a given price. The objective of producers
might entail the following: to produce given outputs at minimum costs; to utilise given
inputs so as to maximise revenue; and to allocate inputs and outputs so as to maximise
profit. This technique of production is widely known as economic efficiency where the
objective of producers becomes one of attaining a high degree of economic efficiency
(cost, revenue or profit efficiency).
Study on bank competition and efficiency
Theoretically, competition is good because it ensures that the costs of production are
minimised and at the same time it promotes efficiency (Nickell, 1996). Increased
competition could force banks to operate more efficiently in order to survive. It forces
the banks to produce products and provide services that are most demanded by the
customers. If they can provide services demanded efficiently and with the least cost,
there is no reason why they cannot make more profits. Otherwise, they will make losses
and possibly go out of business.
A few studies had been conducted to investigate the impact of bank deregulation on
competition, efficiency and performance. The issues addressed were centred on
whether deregulation had increased competition, improved efficiency and performance.
There is a consensus view that deregulation had enhanced competition. But a mixed
result was found on efficiency and performance. In the case of the US banking industry,
for example, there was evidence that deregulation did not change efficiency (Elyasiani
and Mehdian, 1995). A study by Bauer et al. (1993) found little change in average
inefficiency, but productivity over the period had deteriorated, which they attributed to
deregulation and increases in competition. They, however, did not examine the
differences in efficiency and productivity among banks of different sizes and they had
excluded the very small banks.
A number of studies on Spanish banks also focused on efficiency and performance
during the deregulation period. Among others are Grifell-Tatje and Lovell (1996, 1997),
and Lozano (1997, 1998). The most important finding that is worth highlighting is that
the efficiency and productivity of Spanish banks have not improved during the
deregulated phase. Worse still, after the deregulation phase, the studies showed a
reduced efficiency among Spanish savings banks (Khumbakar et al., 2001). The
findings tend to suggest that the Spanish banks performed badly in terms of efficiency
because the banks found it difficult to adjust themselves to the increased competition
as a result of the deregulation.
Islamic banking
in Malaysia
33
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34
DEA
To measure efficiency, the DEA will be this study choice because it does not require us
to specify the functional form or distributional forms for errors. In essence, it is more
flexible than the parametric approach. Furthermore, the reason for using DEA is that it
has been extensively used in measuring the efficiency of banks in many countries by
many researchers like Aly et al. (1990), Elyasiani and Mehdian (1992), English et al.
(1993), Favero and Papi (1995), Bhattacharya et al. (1997) and Katib (1999). Apart from
the above reasons, DEA is chosen because it can be applied to multi-input and multioutput variables.
Perhaps, the only drawback of the DEA approach is that it does not allow for any
error in the data. As Mester (1994) correctly pointed out, the bank that has been lucky
or whose costs have been under-measured would be labelled as the most efficient while
any unfavourable influence beyond a banks control would be attributed to
inefficiency. Despite this drawback, Seiford and Thrall (1990) argued that that DEA is
a more robust approach for efficiency estimation because it measures the relative
efficiency of each firm with respect to the efficient frontier that is constructed from the
actual data.
On the return to scale assumption, this study uses the variable returns to scale
(VRS) assumptions to define the best practice frontier, which guarantees that a bank is
only compared with another bank of similar size. Finally, this study uses the inputbased orientation. This method of measuring efficiency has been employed by many
studies, among others, Aly et al. (1990), Ferrier and Lovell (1990), Furukawa (1995),
Elyasiani and Mehdian (1995), Zaim (1995), Miller and Noulas (1996), Resti (1997),
Bauer et al. (1998), and Casu and Molyneux (2000). The mathematical formulation for
DEA technique is indicated in Appendix 1.
Input and output variables and the data
Despite the large body of literature on bank efficiency, there is no general consensus on
how to define inputs and outputs as variables in analysing the efficiency. In general, the
literature on bank efficiency has two prominent approaches, they are: production; and,
intermediation approach (Elyasani, 1990; Aly et al., 1990; Ferrier and Lovell, 1990;
Mester, 1997).
The production approach defines the bank activity as production of services. In
other words, it views the banks as using physical inputs such as labor and capital, to
provide deposit and loan accounts, viewed as the banks outputs[3]. On the other hand,
the intermediation approach views banks as the intermediator of financial services. It
assumes that banks collect deposits, using labor and capital then convert those sources
of funds into loans and other earning assets (Sealey and Lindley, 1977). The latter
approach is argued to be particularly appropriate for banks where most activities
consist of turning large deposits and funds purchased from other financial institutions
into loans or financing and investments (Favero and Papi, 1995).
In practice, the intermediation approach is the most widely used technique to
measure efficiency (Kwan, 2002). In choosing the appropriate approach, Berger and
Humphrey (1997) suggested that the intermediation approach is the best for evaluating
the entire bank because it is inclusive of interest expense (income paid to depositors),
which often accounts for one-half to two-third of total costs. However, he recommended
that the production approach is more appropriate for evaluating the efficiency of the
banks branches because branches process customer documents for the banks as a
whole.
Islamic banking
in Malaysia
35
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36
Table II.
Statistics of banks input
and output variables of
Islamic banking
Table III.
Statistics of banks input
and output variables of
conventional banks
This study employs the intermediation approach for three reasons: First, it will be
evaluating the banks efficiency as a whole; two, this approach is widely used (Kwan,
2002), and three, the principle of Islamic financial system is based on participation in
enterprise or equity-based where the business participants may end up with profit or
loss. This, by no means, implies the importance of intermediary activities.
For the choice of input and output, this study uses two inputs and one output
variables. The first input, denoted by X1 (i.e. the quantity of input X1), is total deposits,
which includes both Al-Wadiah Savings Deposits and Mudharabah Investment
Deposits from customers and other banks. The second input, denoted by X2 (i.e. the
quantity of input X2), is total overhead expenses, which includes the personnel
expenses and other operating expenses. This represents the resources expended, which
converted deposits into financing[4] and other earning assets. The output is total
earning assets, denoted by Y1 (i.e. the quantity of output Y), which includes financing,
dealing securities, investment securities and placements with other banks.
In the calculation of CE, apart from quantity of input and output, two input prices
are also required. They are prices of deposits, denoted by P1; and prices of labor and
capital, denoted by P2. While P1 is defined as the income paid to depositors[5] divided
by total deposits, P2 is calculated using personnel and other overhead expenses
divided by the total assets. Tables II and III summarise the descriptive statistics of the
banks input and output variables from 1997 to 2003 for the Malaysian Islamic and
conventional banks.
Tables II and III indicates that average deposits, overhead expenses and earning
assets for conventional banking were higher than for Islamic banking. It also appears
that the average price of deposits for Islamic banking were much lower than
conventional banking. This may suggest that they either obtained cheaper funds or
Variables
Description
X1
X2
Y1
P1
P2
Total deposits
Total overhead expenses
Total earning assets
Price of deposits (%)
Price of labor and capital (%)
SD (RM million)
1,485.691
12.264
1,465.189
3.647
0.501
2,250.944
33.097
2,336.291
2.447
0.530
Source: Authors calculation based on financial reports of Malaysian banks, central bank annual
reports (1997-2003)
Variables
Description
X1
X2
Y1
P1
P2
Total deposits
Total overhead expenses
Total earning assets
Price of deposits (%)
Price of labor and capital (%)
SD (RM million)
17,807.215
304.865
18,254.799
4.784
1.363
16,766.796
283.253
17,589.748
2.219
0.489
Source: Authors calculation based on financial reports of Malaysian banks, central bank annual
reports (1997-2003)
paying much lower income to the depositors. With regards to the average prices of
labor and physical capital, the results shows that conventional banking has higher
prices than Islamic banking. This may suggest that they investing more in human
resources and new technology than Islamic banking.
The study used 288 panel data from the banks financial statement[6] of 20 Islamic
Windows, 2 full-fledged Islamic banks and 20 conventional banks from 1997 to 2003.
The financial statements were individually obtained from each bank. Some of the
information was also obtained from the Bank Negara Malaysia reports. The samples
are selected on the basis that the bank had Islamic banking operations within the study
period and data availability. The conventional banks included are the parent banks of
Islamic windows. Table AI in Appendix 2 shows the list of the banks.
Islamic banking
in Malaysia
37
Empirical findings
This section summarises the findings of technical efficiency (TE) and cost efficiency
(CE) of Islamic banking in Malaysia using the DEA, from, which the efficiency scores
are obtained for all the 288 banks from 1997 to 2003. The DEA efficiency analysis for
this study was carried out using DEAP version 2.1, a DEA computing software
developed by Coelli (1996). A brief description about DEAP computer program is
provided in Appendix 3.
Robustness of the data and results was checked by taking the following procedures.
First, we deleted the efficient banks (banks on the frontier), and then second, we reestimated the efficiency scores and correlated the new efficiency ranking with the
ranking prior to deleting any observations. The results in Table IV show that the
correlation between the efficiency that was calculated before and after removing all
efficient banks are significant at 0.01 levels, and the associated p-value for correlation
is 0.0001. The Spearman correlation coefficient of 0.957 suggests that the efficiencies
obtained using all panel data amounting to 288 banks was reasonably robust, at least
on ordinal scale of the banks ranking.
Estimates levels of TE and CE
TE measures reflect the degree to which a bank could minimise its inputs used in
the production of given outputs (input oriented measures). A value of 1 or 100 per
cent indicates full efficiency and the operations are made on the production
frontier. A value of less than 1 (or less than 100 per cent) reflects operations below
the frontier. The wedge between 1 and the value observed measures the technical
inefficiency.
CE measures the distance of a banks cost from the best practice banks cost, if both
were to produce the same output bundle under the same market conditions (Berger and
Mester, 1997; Vander, 2002). Thus, if the measured CE of a bank is 0.80, it implies that it
is about 80 per cent cost efficient or it has wasted 20 per cent of its cost relative to a best
Category
Pearson correlation
Spearman correlation
TE
0.956* (0.0001)
0.957* (0.0001)
Table IV.
Notes: The associated p-values are shown in parentheses. *Correlation is significant at 0.01 levels
(two-tailed)
DEA efficiency
correlation analysis
H
24,1
38
practice bank[7]. In this case, the bank should use its inputs more efficiently in order to
gain a reduction of 20 per cent in their costs so that it could reach the minimum cost of
the best practice bank.
Overall efficiency
The TE and CE estimates, derived from the DEA model, are summarised in
Tables V-XII. Table V shows the TE and CE trend of Islamic banks and conventional
banks in Malaysia from 1997 to 2003. The average TE and CE scores for Islamic
Banking were 57.2 and 45.6 per cent, respectively. However, that level of efficiency is
still lower than the TE and CE scores of conventional banks, which were 78.8 and 77.8
per cent, respectively. The TE results of the conventional banks that are computed here
are similar to that of Katib (1999). They range between 68 and 80 per cent[8]. Whilst,
the CE levels of the conventional banks are found to be similar to the levels of
inefficiency in the US (Ferrier and Lovell, 1990) and in Italy (Resti, 1997) where the
mean cost inefficiency recorded was 21 to 25 per cent.
N 288
Cost efficiency
Mean
SD
No. of banks
Year
Islamic banking
19
21
22
21
22
22
22
149
1997
1998
1999
2000
2001
2002
2003
Overall mean
0.513
0.597
0.550
0.550
0.591
0.540
0.657
0.572
0.236
0.232
0.206
0.212
0.227
0.137
0.214
0.211
0.407
0.469
0.386
0.423
0.490
0.472
0.545
0.456
0.139
0.153
0.136
0.130
0.177
0.139
0.198
0.160
Conventional banking
20
20
20
19
20
20
20
139
1997
1998
1999
2000
2001
2002
2003
Overall mean
0.745
0.793
0.764
0.782
0.805
0.819
0.806
0.788
0.096
0.098
0.124
0.139
0.129
0.132
0.140
0.123
0.734
0.784
0.746
0.772
0.800
0.814
0.799
0.778
0.091
0.097
0.106
0.132
0.129
0.133
0.139
0.120
Table V.
Overall technical and
cost efficiency, 1997-2003
Table VI.
TE scores by bank type,
1997-2003
Technical
efficiency
Mean
SD
N 288
Mean
SD
0.709
0.067
Islamic windows
Commercial banks
Finance company
Merchant banks
0.564
0.564
0.532
0.214
0.213
0.180
Conventional bank
Commercial banks
Finance company
Merchant banks
0.820
0.744
0.678
0.094
0.101
0.221
Islamic banking
in Malaysia
N 288
Mean
SD
0.708
0.068
Islamic windows
Commercial banks
Finance company
Merchant banks
0.445
0.413
0.430
0.165
0.100
0.118
39
Conventional bank
Commercial banks
Finance company
Merchant banks
0.811
0.740
0.658
0.090
0.101
0.208
CE by bank type,
1997-2003
Sum of squares
df
Mean square
Significance
TE
Between groups
Within groups
Total
3.602
8.437
12.039
2
285
287
1.801
0.030
60.841
0.0001
CE
Between groups
Within groups
Total
8.278
4.942
13.219
2
285
287
4.139
0.017
238.700
0.0001
TE
Full-fledged IBa
Conventional banks
CE
Table VIII.
Islamic windows
Full-fledged IBa
Islamic windows
Conventional banks
Table VII.
SE
Significance
Islamic windows
Conventional banks
Full-fledged IBa
Conventional banks
Full-fledged IBa
Islamic windows
0.155a
0.073 a
0.155a
0.228a
0.073 a
0.228a
0.027
0.022
0.027
0.021
0.022
0.021
0.0001
0.012
0.0001
0.0001
0.012
0.0001
Islamic windows
Conventional banks
Full-fledged IBa
Conventional banks
Full-fledged IBa
Islamic windows
0.279a
0.065 a
0.279a
0.344a
0.065a
0.344a
0.023
0.022
0.023
0.016
0.022
0.016
0.0001
0.025
0.0001
0.0001
0.025
0.0001
Notes: aThe mean difference is significant at the 0.05 level. IB refers to Islamic banks
For comparison sake, although the efficiency results of the Islamic banking were
somewhat smaller than that of the conventional banking, they are still acceptable
considering the fact that the banks had been in the market for less than two decades.
By any standard, 20 years of Islamic banking existence in the Malaysian banking
industry is too short a period compared with conventional banking, which has the
history of more than 100 year existence in this country.
Table IX.
Results of Tamhane T2,
multiple comparisons
between the bank types
H
24,1
40
Table X.
TE scores by ownership
status, 1997-2003
Table XI.
CE by ownership status,
1997-2003
Table XII.
Results of t-test
(ownership status of
Islamic banking)
N 178
Mean
SD
Islamic windows
Domestic commercial banks
Foreign commercial banks
0.533
0.628
0.202
0.229
Conventional banks
Domestic commercial banks
Foreign commercial banks
0.813
0.835
0.096
0.092
N 178
Mean
SD
Islamic windows
Domestic commercial banks
Foreign commercial banks
0.406
0.530
0.143
0.182
Conventional banks
Domestic commercial banks
Foreign commercial banks
0.804
0.828
0.090
0.090
Ownership status
df
p-value
TE
Domestic banks
Foreign banks
61
27
2.060
86
0.042
CE
Domestic banks
Foreign banks
61
27
3.395
86
0.010
that the full-fledged Islamic banks were more efficient than Islamic windows. However,
if a comparison is made between the full-fledged Islamic banks and conventional
banks, the former banks are still less efficient than the latter banks (i.e. commercial
banks and finance houses). Perhaps, one possible reason for this is because much of the
full-fledged Islamic banks funding still remains idle. This finding is consistent with
that of Samad (1999) where it was shown that Bank Islam Malaysia Berhad has more
surplus liquidity compared to conventional banks.
The CE results in Table VII also show that the full-fledged Islamic banks were more
efficient than Islamic windows. However if the result is compared with the
conventional banks performance, the full-fledged Islamic banks were found to be less
efficient than commercial banks and finance houses. From this result one can conclude
that the conventional banks experienced higher CE compared to full-fledged Islamic
banks.
In order to test whether the bank type implies different levels of efficiency, we
perform ANOVA statistical test as shown in Table VIII. Three categories of bank type
are Islamic windows, full-fledged Islamic banks and conventional banks. A statistical
test of ANOVA in Table VIII shows that there was a significantly different level of TE
(F 60.841, df 2,285, p 0.0001) and CE (F 238.700, df 2,285, p 0.001) for all
types of banks. The strength of relationship between efficiency and bank types as
measured by Eta square is 0.30 for TE and 0.63 for CE.
In order to examine further the relationship between the bank types and efficiency,
we run post hoc comparison. The Tamhanes T2 test, as shown in Table IX, indicates
that the full-fledged Islamic Banks have higher TE than Islamic windows (mean
difference 0.155, se 0.027) but lower than conventional banks (mean difference
0.073, se 0.022). For CE, Tamhanes T2 test also indicates the same findings that
full-fledged Islamic banks have higher CE than Islamic windows (mean diffrence
0.279, se 0.232) but lower than conventional banks (mean difference 0.065,
se 0.022).
Average bank efficiency by ownership status
One distinctive feature of this study is that the efficiency analysis is extended to the
extent that it allows us to make comparisons between the foreign and the domestic
banks performance. Generally, it is noticed that the efficiency of foreign banks in
developing countries tend to be higher than domestic banks while the findings in
developed countries were opposite. However, the evidence available to inform us about
the efficiency comparison between foreign and domestic bank in developing countries
is still limited apart from the studies by Zaim (1995), Bhattacharya (1997), Burki and
Niazi (2003), and Hassan and Marton (2003).
The comparisons results between the foreign and the domestic banks efficiency in
Malaysia are shown in Tables X and XI. Only commercial banks have different
ownership status, while all other types of banks are domestic banks. As evident from
the tables, Islamic windows of the foreign banks turned out to be more efficient than
Islamic windows of the domestic banks. For the conventional banking, the findings
also indicate that foreign banks are generally more efficient than domestic banks. The
finding is consistent with the previous studies, including that of Zaim (1995) and
Hussein (2003) who found that foreign banks were the most efficient banks.
The findings observed in Tables X and XI must be tested for statistical significance.
The results of t-test in Table XII seemed to indicate that there were significant
differences, in terms of technical and CE, between the two different ownerships status.
Islamic banking
in Malaysia
41
H
24,1
The mean technical and CE for domestic and foreign Islamic windows are significantly
different at p 0.042 and p 0.010, respectively. Islamic windows of the foreign
banks were found to have experienced higher technical and CE than Islamic windows
of domestic banks[10]. The finding is line with the arguments that foreign banks are
more superior as they normally has advance technology and skills; sophisticated
services and broader international networks (Levine, 1996; Unite and Sullivan, 2003).
42
Conclusions
Although there are several studies that have been conducted to measure the efficiency
of banks particularly in the US, the study on Islamic banking efficiency is still lacking;
let alone using the frontier technique. This study is intended mainly to fill that gap.
This study is set out to provide empirical evidence of Islamic banks efficiency in
Malaysia for the years 1997-2003. This was the period where Islamic windows were
introduced and further financial liberalisation of the Islamic banking industry was
promulgated. For analysis purpose, the annual report of two full-fledged Islamic
banks, 20 Islamic windows and 20 conventional banks were used. The findings showed
that the average efficiency of the overall Islamic banking industry has increased during
the survey period. The study also revealed that the full-fledged Islamic banks were
more efficient that the Islamic windows. However, the efficiency level of Islamic
banking was still less efficient than the conventional banks. On the other hand, foreign
banks were found to be more efficient than domestic banks.
Islamic banks in Malaysia are now facing ever-increasing competition, particularly
with the issuance of three new licenses to three foreign full-fledged Islamic banks. The
competition from conventional banks is also expected to increase further in the near
future due to globalisation. The findings of this study revealed that the technical and
cost efficiencies of Malaysian Islamic banks could be improved further. In this regard,
it requires a concerted effort from the management and policy-makers to try to
optimise the utilisation of scarce resources owned by the banking industry in Malaysia.
This finding would also facilitate them to set the directions for future improvement of
Islamic banking operations in Malaysia. Finally, this study would open a fruitful
avenue for future research in the area of Islamic banking efficiency and competition in
other Muslim countries.
Notes
1. There are also three new full-fledged foreign Islamic banks, which were given licence to
operate in Malaysia from the year 2004: Kuwait Finance House, Al-Rajhi Banking &
Investment Corporation and consortium led by Qatar Islamic Bank.
2. In Turkey, the banks are the main source of funding for the industrial and commercial
businesses and most of the business in Turkey is controlled by small and medium
companies (Kasman, 2002).
3. Cobb and Douglas (1928) explained about the theory of production.
4. The term financing is for Islamic banks, which is equivalent to the loans for
conventional banks.
5. Income paid to depositors is equivalent to interest expense for conventional banks.
6. Financial statements comprised of balance sheets, income statement and notes to the
accounts.
7. The score one refers to best practice bank while the score of zero refers to worst practice
bank.
8. Katib (1999) studied the TE of commercial banks in Malaysia from 1989 to 1995.
9. TE estimates for conventional banks have marginally increased from 74.5 per cent in
1997 to 80.6 per cent in 2003 while the CE of conventional banks trend has slightly
improved from 73.4 to 79.9 per cent.
10. However, t-test for different ownership status for conventional banks was found to be
statistically insignificant.
11. For detail explanation of the inputs and output together with the notations used, refer
to the section on inputs and output variables and data.
12. The researcher put the letter (i) for each Islamic window in order to differentiate
between Islamic windows and their parent banks, i.e. the conventional banks.
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Further reading
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Lumpur.
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frontier approach, Applied Economics, Vol. 22, pp. 539-51.
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Islamic Banking and Finance: Current Development and Latest Instruments in Islamic
Banking Industry, Kuala Lumpur, 10-11 June.
Appendix 1. Summary of DEA mathematical formulation
Technical efficiency (TE)
Following Coelli et al. (1998) and Coelli (2004), we assume there are N banks operating in the
Malaysian banking industry, and each has K inputs and M outputs. For the ith banks, xi and yi
represent the column vectors of input and output, respectively. For N banks, X represents the
K N input matrix and Y is the M N output matrix. The VRS input-oriented TE of each bank
is estimated by solving a linear programming problem. The mathematical formulation is as
follows:
min; subject to yi Y 0; xi X 0; N10 1; 0
where Pi is a vector of input prices for the ith bank and Xi* is the cost-minimising vector of input
quantities for the ith bank, given the input price (Pi) and the output quantities (yi). CE for bank i is
calculated as the ratio of Pi0 xi*/Pi0 xi, where Pi0 is the transpose of bank i s input price vector.
Thus, CE is the ratio of the frontier costs of bank i s output vector, given the set of its input
prices, to its actual cost, where 0 CE 1, and CE 1 for fully efficient banks.
Islamic banking
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47
Table AI.
Affin Merchant Berhad
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48
All of the three principal options mentioned are available in either in input or output orientation
except for CE calculation. The program is written in Fotran (Lahey F77LEM/32) for IBM
compatible PCs. It is a DOS program but can be run easily from WINDOWS using FILE
MANAGER. Further information on how to run the program is discussed in Coelli (1996) and
Coelli et al. (1998).