Islamic banking is a worldwide phenomenon involving a variety of institutions and instruments. Islamic institutions and instruments have developed in many countries during the past few decades. In countries such as Iran, Sudan, and Pakistan, all or most financial inter-mediation conforms to Islamic Shari[ah as defined by local authorities. These countries also have banking authorities that govern the general level of charges and returns in the system. In most other countries, Islamic transactions and institutions make up a small part of the total and must compete with conventional financial institutions. Islamic instruments are simply a narrow group of familiar financing instruments.
During the last two decades, Islamic banks have significantly expanded their network, and have been able to amass large amounts of deposits as well as promote many economic ventures. In addition, they play a major role in rendering banking services to poverty stricken households, who historically have been treated apathetically. Given the differential behavior of Islamic banks compared to traditional commercial banks, and their involvement in both social and economic activities, there has always been the question of long run sustainability of these banks. The diverse involvement of Islamic banks in social and economic activities indeed increases their operational costs, which many critics consider to be the major constraint for the long run sustainability of this newly introduced profit sharing banking system.
This paper employs both parametric (cost and profit efficiency) and nonparametric methods (DEA analysis and Malmquist productivity index) to study cost, profit and X-efficiency of 43 Islamic banks in 21 Muslim countries over the 1995-2001 period. First, it employs a stochastic cost frontier approach to compute the cost efficiency. Second, it employs alternative profit efficiency which considers both cost and revenue simultaneously to examine profit efficiency. Third, it employs a nonparametric data envelopment analysis (DEA), to calculate the overall, technical, pure technical, allocation and scale efficiencies. While technical inefficiency is caused and correctable by management, allocation inefficiency is caused by regulation and may not be controlled by management. Finally, by applying a Malmquist DEA method to the panel data over time, Malmquist total factor productivity (TFP) indices are calculated. These indices will help us to examine the productivity improvement of Islamic banks over time in these countries. The results of this study will allow us to examine what factors are important in improving the cost-efficiency of Islamic banks, and under what conditions such institutions are sustainable.
Regardless of a bank’s underlying philosophy, its long run sustainability depends on economic efficiency. A bank is economically efficient if it operates with both technical efficiency and price efficiency. A firm is said to be more technically efficient than another if it produces relatively larger output from the same set of inputs. A firm is price efficient if it maximizes profits. That is, if it equates the marginal value of product of each factor to its price. Such a study is important both from an operational as well as an academic point of view. First, such a study will exhibit the expansion potentials of Islamic bands in a mixed banking system. Second, it will have policy implications for Islamic banks and the banking system as to how to improve cost efficiency. Third, it will suggest policy measures to improve price efficiency within the banking system. Finally, much less research has been done in the area of Islamic banking compared to the traditional commercial banking industry. Since Islamic banks differ from conventional banks in their cost, profit and revenue structures, it is important for these banks to be studied independently.
The frontiers are constructed using cost, output, and input data for each bank. Linear programming techniques allow for the construction of best practice cost and production frontiers from these data. The performance of a particular branch is then judged relative to this frontier. The specific efficiency measures calculated can be given fairly simple interpretations. The technical efficiency measure gives the proportional reduction in input usage, which could have been achieved if the firm operated on the production frontier. The technical efficiency can be decomposed into the proportional reduction in input usage if inputs were not wasted (pure technical efficiency) and that reduction if there existed constant returns to scale (scale efficiency). As such, pure technical inefficiency reflects excess input levels for a given level of output. This inefficiency may be sustainable if competitive forces are weak. This inefficiency is unique in that it is caused by and correctable by management. From a societal standpoint, firms that operate at constant returns to scale represent the socially efficient level of operation. Therefore, choosing a non-constant scale of operation also constitutes inefficiency.
The allocative efficiency measure gives the proportional reduction in costs if the optimal combination of inputs had been utilized. As such, allocative inefficiency reflects suboptimal proportions of factor inputs. Management cannot correct this inefficiency to the extent that it is due to regulation, such as the need to substitute service for interest payments on demand deposits. Overall efficiency measures the proportional reduction in costs which could have been achieved if firms had been both allocatively and technically efficient. The Malmquist-DEA technique allows us to decompose total factor productivity into changes in technical efficiency over time and shifts in technology over time. Improvements in technical efficiency change are considered to be evidence of moving close to the efficient frontier over time, whereas improvements in technological change are considered to be evidence of innovation.
During the last two decades, Islamic banks have significantly expanded their network, and have been able to amass large amounts of deposits as well as promote many economic ventures. In addition, they play a major role in rendering banking services to poverty stricken households, who historically have been treated apathetically. Given the differential behavior of Islamic banks compared to traditional commercial banks, and their involvement in both social and economic activities, there has always been the question of long run sustainability of these banks. The diverse involvement of Islamic banks in social and economic activities indeed increases their operational costs, which many critics consider to be the major constraint for the long run sustainability of this newly introduced profit sharing banking system.
This paper employs both parametric (cost and profit efficiency) and nonparametric methods (DEA analysis and Malmquist productivity index) to study cost, profit and X-efficiency of 43 Islamic banks in 21 Muslim countries over the 1995-2001 period. First, it employs a stochastic cost frontier approach to compute the cost efficiency. Second, it employs alternative profit efficiency which considers both cost and revenue simultaneously to examine profit efficiency. Third, it employs a nonparametric data envelopment analysis (DEA), to calculate the overall, technical, pure technical, allocation and scale efficiencies. While technical inefficiency is caused and correctable by management, allocation inefficiency is caused by regulation and may not be controlled by management. Finally, by applying a Malmquist DEA method to the panel data over time, Malmquist total factor productivity (TFP) indices are calculated. These indices will help us to examine the productivity improvement of Islamic banks over time in these countries. The results of this study will allow us to examine what factors are important in improving the cost-efficiency of Islamic banks, and under what conditions such institutions are sustainable.
Regardless of a bank’s underlying philosophy, its long run sustainability depends on economic efficiency. A bank is economically efficient if it operates with both technical efficiency and price efficiency. A firm is said to be more technically efficient than another if it produces relatively larger output from the same set of inputs. A firm is price efficient if it maximizes profits. That is, if it equates the marginal value of product of each factor to its price. Such a study is important both from an operational as well as an academic point of view. First, such a study will exhibit the expansion potentials of Islamic bands in a mixed banking system. Second, it will have policy implications for Islamic banks and the banking system as to how to improve cost efficiency. Third, it will suggest policy measures to improve price efficiency within the banking system. Finally, much less research has been done in the area of Islamic banking compared to the traditional commercial banking industry. Since Islamic banks differ from conventional banks in their cost, profit and revenue structures, it is important for these banks to be studied independently.
The frontiers are constructed using cost, output, and input data for each bank. Linear programming techniques allow for the construction of best practice cost and production frontiers from these data. The performance of a particular branch is then judged relative to this frontier. The specific efficiency measures calculated can be given fairly simple interpretations. The technical efficiency measure gives the proportional reduction in input usage, which could have been achieved if the firm operated on the production frontier. The technical efficiency can be decomposed into the proportional reduction in input usage if inputs were not wasted (pure technical efficiency) and that reduction if there existed constant returns to scale (scale efficiency). As such, pure technical inefficiency reflects excess input levels for a given level of output. This inefficiency may be sustainable if competitive forces are weak. This inefficiency is unique in that it is caused by and correctable by management. From a societal standpoint, firms that operate at constant returns to scale represent the socially efficient level of operation. Therefore, choosing a non-constant scale of operation also constitutes inefficiency.
The allocative efficiency measure gives the proportional reduction in costs if the optimal combination of inputs had been utilized. As such, allocative inefficiency reflects suboptimal proportions of factor inputs. Management cannot correct this inefficiency to the extent that it is due to regulation, such as the need to substitute service for interest payments on demand deposits. Overall efficiency measures the proportional reduction in costs which could have been achieved if firms had been both allocatively and technically efficient. The Malmquist-DEA technique allows us to decompose total factor productivity into changes in technical efficiency over time and shifts in technology over time. Improvements in technical efficiency change are considered to be evidence of moving close to the efficient frontier over time, whereas improvements in technological change are considered to be evidence of innovation.
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