Model Example of Research Proposal

INSANIAH UNIVERSITY COLLEGE

MASTER IN FINANCE & ISLAMIC BANKING

RESEARCH TOPIC:

EFFICIENCY OF ISLAMIC BANKING IN MALAYSIA
FROM YEAR 2000 - 2009

PREPARED BY:

AHMAD TAKIUDDIN BIN SHUAIB (M0911689M04)

PREPARED FOR:

PROF. DATO’ DR. JAMIL BIN OSMAN
TUAN HAJI SHAYA’A BIN OTHMAN

CONTENTS

CHAPTER 1: INTRODUCTION
 Background of Study …2
 Islamic Banking in Malaysia …6
 Problem Statement …8
 Objective of Study …11
 Research Questions …11
 Research Hypothesis …12
 Significance of Study …12
 Operational Definition …14

CHAPTER 2: LITERATURE REVIEW …27

CHAPTER 3: RESEARCH METODOLOGY
 Introduction …33
 Data Envelopment Analysis (DEA) …34
 Input And Output Variables And The Data …37

REFERENCES …41
APPENDIX

1.0 Introduction
1.1 .Background of Study

The Islamic financial services industry has been growing rapidly in this recent
decades. Financial institutions have experienced a dynamic, fast-paced, and
competitive environment at a cross-border scale. One of the most growing parts is
the new paradigm of Islamic Banking, which has remarkably captured the interest of
both Islamic and contemporary economists. This is evidenced by the greater
participation of players and wider product offerings encompassing all sectors of
banking, takaful and the capital market. Innovations of products and services are
taking place swiftly in providing competitive product offerings to meet the more
diverse and differentiated requirements of consumers and businesses.

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.

The robustness of the growth of the Islamic financial system is supported by the
Shariah wisdom and dynamism in facilitating the ever changing requirements and
the expanding horizon of the Islamic finance industry. Shariah deliberation on
financial products has evolved from classical contracts surrounding murabahah and
deferred sales to a more advanced and sophisticated product structures. It is indeed
undeniable that Shariah is the pivotal element of the Islamic financial system as
Shariah compliance is the distinctive characteristic of Islamic finance compared to
the conventional system.

The main difference between Islamic banks and the contemporary banks is that,
while the latter is based on the conventional interest-based principle, the former
follows a principle of interest free financing and profit and loss sharing (PLS) in
performing their business as intermediaries (Ariff, 1988). Many Islamic economics

studies have discussed in depth about the rationale behind the prohibition of interest
(Chapra, 2000) and the importance of PLS in Islamic banking (Dar and Presley,
2000).

Furthermore, under the term of Islamic PLS, the relationship between borrower,
lender and intermediary are rooted in financial trust and partnership. The importance
of the interest-free financing in Islamic Banking has created an innovative
environment among practitioners in which the alternative of interest is anticipated.
Dar (2003) classified four types of financing acting as alternatives of interest;
investment-based, sale-based, rent-based and service-based.

The existing research in Islamic banking and finance has focused primarily on the
conceptual issues underlying interest-free financing (Ahmed, 1981; Karsen, 1982).
These issues include the viability of Islamic banks and their ability to mobilise saving,
pool risks and facilitate transactions. Few studies have focused on the policy
implications of a financial system without interest payments (Khan, 1986; Khan and
Mirakhor, 1987).

Muhammad Taqi Usmani (2005) added ―It seems that the size of Islamic banking will
be at least multiplied during the next decade and the operation of Islamic banks are
expected to cover a large area of financial transactions of the world. But before the
Islamic financial institutions expand their business they should evaluate their
performance during the last two decades because every new system has to learn
from the experience of the past, to revise its activities and to analyze its deficiencies
in a realistic manner. Unless we analyze our merits and demerits we cannot expect
to advance towards our success. It is in this perspective that we should seek to
analyze the operation of Islamic banks and financial institutions in the light of Shariah
and to highlight what they have achieved and what they have missed‖.

The literature on bank efficiency and the role of foreign banks is dominated by
studies about the US, and to a smaller degree European, banking industries (Berger
and Humphrey, 1997). Efficiency studies found that foreign banks in developed
countries exhibited lower efficiency in comparison with domestic banks. However,
banks from certain countries were able to operate more efficiently than domestic

banks in other developed countries (Berger et al., 2000). Even though the research
on transition and developing markets lags far behind, the findings support the
conclusion that foreign banks in these countries succeeded in exploiting their
comparative advantages and show higher efficiency than their domestically owned
counterparts (Isik and Hassan, 2002; Grigorian and Manole, 2002; Hasan and
Marton, 2003; Bhattacharyya et al., 1997). One of the proposed explanations is that
foreign banks enter developing and developed countries for different reasons. In
particular, foreign banks do not just follow their customers into developing markets,
but seem genuinely interested in exploiting local opportunities (Clarke et al., 2001).

Several studies that have been devoted to assess the performance of Islamic banks
generally examine the relationship between profitability and banking characteristics.
Bashir (1999) and Bashir (2001) perform regression analyses to determine the
underlying determinants of Islamic performance by employing bank level data in the
Middle East. His results indicate that the performance of banks, in terms of profits, is
mostly generated from overhead, customer short term funding, and non-interest
earning assets. Furthermore, Bashir (2001) claims that since deposits in Islamic
banks are treated as shares, reserves held by banks exert negative impacts such as
reducing the amount of funds available for investment.

Samad and Hassan (1999) apply financial ratio analysis to see the performance of a
Malaysian Islamic bank over the period 1984-1997 and generally find that bankers‘
lack of knowledge was the main reason for slow growth of loans under profit sharing.
The Islamic bank was found to perform better than conventional banks in terms of
liquidity and risk measurement (less risky). Although this study is based only upon
one Islamic bank in Malaysia, the result has given some insight on the example from
outside the Middle East area. Similarly, utilizing Banking Efficiency Model, Sarker
(1999) claims that Islamic banks can survive even within a conventional banking
architecture in which PLS modes of financing is less dominated. Using Bangladesh
as a case study, Sarker (1999) argues further that Islamic products have different
risk characteristics and consequently different prudential regulation should be
applied.

1.2..Islamic Banking in Malaysia

In Malaysia, Islamic finance traces its root back to 1963, with the establishment of
the Pilgrims Fund Board or Lembaga Tabung Haji (LTH). This was a savings
mechanism under which, devout Malaysian Muslim set aside regular funds to cover
the costs of performing the annual pilgrimage. These funds were in turn invested in
productive sectors of the economy, aimed at yielding return uncontaminated by riba‘.

As a country with a population dominated by Muslims, Malaysia was also affected by
the resurgence that had taken place in the Middle East. Many parties were calling for
the establishment of an Islamic bank in Malaysia. For example, in 1980, the
Bumiputera Economic Congress had proposed to the Malaysian Government to
allow the setting up of an Islamic bank in the country. Another effort was the setting
up of the National Steering Committee in 1981 to undertake a study and make
recommendations to the Government on all aspects of the setting up and operations
of an Islamic bank in Malaysia, including the legal, religious and operational aspects.
The study concluded that the establishment of an Islamic bank in Malaysia would be
a viable project from the operation and profits point of views. The conclusion marked
the establishment of the first Islamic bank in Malaysia, Bank Islam Malaysia Berhad
(BIMB) in July 1983, with an initial paid up capital of RM80 million. The
establishment of BIMB has marked a new milestone for the development of the
Islamic financial system in Malaysia. BIMB carries out banking business similar to
other commercial banks, but along the principles of Syari‘ah. The bank offers deposit
taking products such as current and savings deposit under the concept of Al-Wadiah
Yad Dhamanah (guaranteed custody) and investment deposits under the concept of
Al-Mudharabah (profit-sharing). The bank grants financing facilities such as working
capital financing under Al-Murabahah (cost-plus), house financing under Bai‘
Bithaman Ajil (deferred payment sale), leasing under Al-Ijarah (leasing) and project
financing under Al-Musyarakah (profit and loss sharing).

It has been the aspiration of the Government to create a vibrant and comprehensive
Islamic banking and finance system operating side-by-side with the conventional
system. A single Islamic bank does not fit the definition of a system. An Islamic
banking and finance system requires a large number of dynamic and pro-active
players, a wide range of products and innovative instruments, and a vibrant Islamic
money market. The first step in realising the vision was to disseminate Islamic

banking on a nationwide basis with as many players as possible and within the
shortest period possible. This was achieved through the introduction of Skim
Perbankan Islam (SPI) in March 1993. SPI allows conventional banking institutions
to offer Islamic banking products and services using their existing infrastructure,
including staff and branches. The scheme was launched on 4 March 1993 on a pilot
basis involving three banks. Following the successful implementation of the pilot-run,
Bank Negara Malaysia (BNM) has allowed other commercial banks, finance
companies and merchant banks to operate the scheme in July 1993 subject to the
specific guidelines issued by the central bank. From only three banks offering Islamic
financing in March 1993, the number of commercial banks that offered Islamic
financing has increased to 15 (of which four are foreign banks).

The Islamic banking system, which forms the backbone of the Islamic financial
system, plays an important role in mobilising deposits and providing financing to
facilitate economic growth. The Malaysian Islamic banking system is currently
represented by 21 banking institutions comprised of nine domestic commercial
banks, four foreign commercial banks and two Islamic banks offering Islamic banking
products and services under the Islamic Banking Scheme (IBS). These Islamic
banking institutions offer a comprehensive and broad range of Islamic financial
products and services ranging from savings, current and investment deposit
products to financing products such as property financing, working capital financing,
project financing, plant and machinery financing, etc. The ability of the Islamic
banking institutions to arrange and offer products with attractive and innovative
features at prices that are competitive with conventional products, has appealed to
both Muslim and non-Muslim customers, reflecting the capacity of the Islamic
banking system as an effective means of financial intermediation, with extensive
distribution networks of Islamic banking institutions, comprising 152-full-fledged
Islamic banking branches and more than 2,000 Islamic banking counters. Islamic
banking has also spurred the efforts by other non-bank financial intermediaries such
as the development financial institutions, savings institutions and housing credit
institutions to introduce Islamic schemes and instruments to meet their customer
demands.

Today, Malaysia has succeeded in implementing a dual banking system and has
emerged as the first nation to have a full-fledged Islamic system operating side-by
side with the conventional banking system. Throughout the years, Islamic banking
has gained significance, and has been on a progressive upward trend. Since 2000,
the Islamic banking industry has been growing at an average rate of 19 per cent per
annum in terms of assets. As at end-2004, total assets of the Islamic banking sector
increased to RM94.6 billion, which accounted for 10.5 per cent of the total assets in
the banking system. The market share of Islamic deposits and financing increased to
11.2 per cent and 11.3 per cent of total banking sector deposits and financing
respectively. The rapid progress of the domestic Islamic banking system,
accentuated by the significant expansion and developments in Islamic banking and
finance has become increasingly more important in meeting the changing
requirements of the new economy (Bank NegaraMalaysia, 2004).

1.3 .Problem Statement
Despite the growing interest and the rapid growth of the Islamic banking and finance
industry, analysis of Islamic banking at a cross-country level is still at its infancy. This
could partly be due to the unavailability of data, as most of the Islamic financial
institutions, particularly in the Asian region, are not publicly traded.

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
bank‘s 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 bank‘s 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
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.

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).

In a rapidly changing financial market worldwide, bank regulators, managers, and
investors are concerned about how efficiently banks transform their expensive inputs
into various financial products and services. According to Berger et al. (1993),
although rapid changes in the financial services industry have been taking place all
around the globe, the efficiency research has not kept pace with these changes, in
terms of both maturity and breadth. In their recent excellent international survey
paper, Berger and Humphrey (1997) also underscored the imbalance of the focus in

the literature after reviewing 130 frontier (X-) efficiency studies from 21 countries and
various types of financial institutions. They reported that the vast majority of the
studies on banking efficiency focus on the banks of developed countries in general
(about 95%) and of the US in particular (about 70%). While giving possible directions
for future research, both survey studies suggest that more research is needed in
measuring and comparing the efficiency of banks and other financial institutions from
different countries. The economic and political environments surrounding financial
institutions differ substantially across countries. For research and policy purposes,
results from banking markets that are more national in scope with much higher levels
of concentrations may shed some light on the efficiency impact of various regulatory
policies.

Carvallo and Kasman (2005) noted that the liberalisation of financial markets at a
global scale, the increasing use of advanced technology, and the information
revolution have put competitive pressure on banking firms, both domestically and
internationally. This competitive pressure is particularly important for banks in the
emerging markets as they constitute the main financial intermediaries to channel
savings and investment. In this context, the competitive advantage is enhanced if
banks can function efficiently.

In this regard, conventional banks enjoy several advantages over Islamic banks. For
example, conventional banks have a very long history and experience, accept
interest which is a major source of bank revenues, do not share loss with clients, ask
for guaranteed collaterals in most transactions, enjoy very huge capital, spread very
widely, have much more developed technologies, can enter Islamic banking market
(e.g. Citibank, Bank of America, Deutsche Bank, ABN, AMRO, USB, HSBC, and
ANZ Grindlays) and are proved to benefit from theoretical and empirical research. In
light of the above advantages, it is interesting to examine the efficiency of both
banking streams. Further, some important (both positive and negative) changes
have taken place in recent years. For example, many large international
conventional banks have started to compete by offering Islamic banking services,
and the number of Islamic banks has increased causing competition among Islamic
banks themselves. Knowledge and practice of Islamic banking is spreading quickly

and as more Islamic banking entities are established, new regulations, policies, and
accounting standards are designed to accommodate these changes.

Despite the above-discussed advantages and challenges, the literature (Hassan and
Bashir, 2003; Sarker, 1999; Bashir, 1999; Samad andHassan, 1999;Yudistira,
2003;Hussein, 2004) suggests that Islamic banks are more efficient than
conventional banks. However, there is no conclusive evidence in this regard. To
further substantiate this controversial issue, this study uses a new set of international
data in the Middle-East countries over the period 1990-2005 and applies data
envelopment analysis (DEA) to test the comparative cost, revenue, and profit
efficiency of the conventional and Islamic banking.

1.4..Objectives Of The Study
This study could be an initial effort to analyse the performance of the Malaysian full
fledged Islamic bank and further make comparison with foreign Islamic bank , Islamic
Windows and conventional bank.
Therefore, the objectives of this study are:

1. To analyze the performance of the overall Islamic banking in Malaysia
2. To compare the performance of the overall Islamic banking full fledged
companies inclusive of foreign Islamic bank and Islamic windows and
conventional banks in Malaysia
3. To measure the efficiency of Islamic banking in Malaysia for the year 2000 –
2009 by using the Data Envelopment Analysis (DEA)

1.5..Research Question

1. Is Islamic Banking in Malaysia operate efficiently?

2. What are the elements of efficiency to achieve?

3. How to measure efficiency in Islamic banking?

4. Why must Islamic Banks operate efficiently?

5. Is Islamic Banking operate more efficient compared to Conventional Banking?

6. Is it true that due to new regulations and liberalisation implemented by
Malaysian Government in Islamic Banking, create more competition among
the banks and drive the Islamic banks to operate more efficient?

1.6..Research Hyphothesis

1. The local full fledged Islamic banks operate more relatively efficient compared
with other Islamic banks.

2. Increased market competition brought about by deregulation and liberalisation
at national level drive local full fledged Islamic banks to operate more
efficiently and increase their performance and competition.

3. The efficient-structure suggests that banks that are able to operate more
efficiently than their competitors, incur lower costs and achieve higher profits
and increased market shares that may result in increased concentration.

1.7..Significance Of The Study
There are many studies that tackle various aspects of the efficiency features of the
financial system. These studies have many objectives; although, generally speaking,
it is rare to find a single study that examines all the efficiency features of a financial
system.

Studies on bank efficiency have gained more attention from financial system policy
makers and regulators, researchers, managers, and owners of financial institutions
in recent years. Policy-makers and regulators can benefit from a further
understanding of the efficiency of banks as the performance of the banking can
impact on certain policies implemented in the financial system. For example, bank
efficiency studies are helpful in judging the extent to which changes in the regulatory
environment impact on efficiency. For instance, the removal of restrictions (e.g entry
barriers) should stimulate industry performance and create social benefits by
reducing waste in resources. Deregulation should foster competition and reduces the
market prices of financial services (Burger and Humphrey 1997). The study of

banking sector efficiency can therefore help identify whether policy action are
effective.

Regulators can also use efficiency studies to investigate market structure and
performance issues, especially in examining whether bank profitability is driven by
market power factors or efficient operations (see Berger,1995; Molyneux, Altunbas
and Gardener,1996,Ch.4).Concentrated banking sectors may make banks operating
in the same industries earn high profits through settings prices of financial products
and services at levels unfavourable to customers. This situation is known as the
market-power hypothesis. An alternative view, known as the efficient-structure
hypothesis, suggests that more efficient banks are able to generate higher market
shares and earn high profits that are mostly induced by competitive prices enabled
by efficient operations rather than market power practices. Hence, testing whether
the efficient-structure or market-power hypothesis prevails can provide regulators
with information about the appropriate conduct of the banking industry.

Studies on efficiency can also provide signals as to the health of the financial sector.
They can help to identify efficiency sources that could either strengthen or harm the
performance of the banking industry. For example, many studies have found that
strong capital levels are connected to efficient bank performance, because banks
that perform well are able to generate higher profits that strengthen their solvency
base. On the other hand, the level of problem loans is found to be negatively related
to bank efficiency (Berger and Humphrey, 1992; Hermalin and Wallace, 1994;
Mester,1996). Studies that link bank efficiency to financial soundness help to provide
regulators with information about the source of inefficiency and how this may be
related to banking sector risk.

Efficiency studies are important for managers, since, from the point of view of
business strategy, managers need to take the steps or find the reasons and the
determinants for why and how they cam improve their efficient performance from
both the input side (by improving cost efficiency using better information technology,
managerial practices, and enhancing capital) and the output side (by improving profit
efficiency through their marketing and pricing strategies). Efficiency studies can also
help managers benchmark the performance of their banks with their main

competitors (they can also be used to compare the efficiency of their own branch
networks).

Studies on bank efficiency may also be important from a shareholders‘ perspective
because they appoint managers and expect them to run their financial firms
efficiently. Having a wider range of best-practice benchmark indicators may help
shareholders monitor their managers more effectively. It is clearly in shareholders‘
interest that managers maintain efficient performance that ensures stable profits and
soundness for the bank or banks in question.

Overall, bank efficiency studies can provide results that are of interest to financial
policy-markers, financial institution managers and owners. The study of banking
sector efficiency can provide useful added information institutions‘ profitability,
market power, and the overall safety and soundness of the financial system.

1.8..Operational Definition

1.8.1..Defining Financial System Efficiency
In economics, the word efficiency is always linked to the allocation of resources. Its
narrow definition usually refers to resources being employed in a way that gives the
maximum production of goods and services. When this is achieved then allocation is
said to be optimal. Generally the concept of economic efficiency means that the
economy produces goods and services that fully reflect the preferences of
consumers, given that the production of these goods and services is made with
minimum costs. In addition to this, economists may also include environmental and
social aspects in the calculus of economic efficiency.

Financial system efficiency is measured in term of efficiency achieved in mobilizing
savings from the saving-surplus units in the economy and in allocating this funds
among saving-deficits units in the economy. Efficiency measurement is one aspect
of investigating a firm‘s 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).

1.8.2..Types of Efficiency as Applied to the Financial System
In Islam, all Muslim have the ultimate objective to ensure all activities in life in
accordance with Sha‘riah i.e meeting Redha Allah SWT. ―Today must be better than
yesterday in all aspect of life‖

i)..Informational Efficiency
Informational efficiency refers to the extent to which a financial system is able to
provide information that helps allocate financial resources to their most productive
uses. Indeed, information is one of the most important factors affecting the process
of funds allocation. This is because the acquisition of information by both lenders
and borrowers may be the most determinant for financing activities. In addition, the
more information available on the quality of borrowers (i.e their success in loans
repayment and their projects‘ feasibility) the more funds the lenders are willing to
provide the borrowers. If the lenders lack information, the risk of non-payment of the
debt will increase, and risk averse lenders will be less willing to finance borrowers. In
this case, informational inefficiency leads to more market imperfections, which
reduces the supply of funds available for economic growth.

Informational efficiency could be viewed as how parties deal with asymmetric
information problems and the ability of the financial markets to reflect the financial
assets prices according to market fundamentals.

ii)..Symmetric Information Efficiency
Symmetric Information Efficiency deals with how the financial system is able to
provide all relevant information for parties engaged in financial deals. When the
distribution of information between these parties is uneven, then this is known as an
asymmetric information problem. That is, when the less informed party deals in a
transaction with the more informed party, it s difficult for the less informed party to
make accurate decisions.

Asymmetric information in the financial system can appear before and/or after the
transaction. Pre-transaction asymmetric information problems relate to adverse
selection; while morald hazard comes after the transaction. Adverse selection occurs
when the lack of information makes it difficult for the financier to make successful
selections. In the case of banking, adverse selection exists when a bank is not able
to distinguish between borrowers with low or high default probabilities. In this case,
the quality of borrowers would be indistinguishable to the bank. By applying Akerlof‘s
(1970) lemons model, the credit market will suffer fro market imperfections in which
the lack of information will induce lenders to raise the interest rate.

The second sort of asymmetric information is called moral hazard. It appears after
the parties agree to make a transaction. The hazard in the transaction exists when
one of the parties engages in behaviour that is undesirable to the other party. In
banking, morald hazard arises when the borrower uses funds in activities that
increase the probability of default. In financial markets, since a firm has no obligation
to repay the nominal value of the stock, the incentive of firms‘ managers to
undertake risky investments is more likely.

When funds allocation to risky uses becomes a norm for getting high returns,
instability in the economy will become more likely. If borrowers fail to repay their
loans and firm failure increase, it would be difficult for banks to meet savers
withdrawals, and this could make banks insolvent. Moreover as the likelihood of

firms‘ failures increase, stock holders will still rush to sell shares of these firms, and
the stock market might crash.

Therefore, in the absence of an efficient market, asymmetric information problems
will increase market imperfections that may destabilize the financial system and the
economy. In order to overcome asymmetric information problems, these
informational efficiencies (obviously) have to be improved. The literature explains
several methods that the financier might use to increase information about the
quality of funds‘ applicants. Among theses are screening, credit rationing, monitoring
and commitment (Stiglitz,1989;Mishkin,1998).The first two, screening and credit
rationing, are used to alleviate the adverse selection problem. The others, monitoring
and commitment, are used to reduce moral hazard.

The importance of informational efficiency aspects in alleviating asymmetric
information problems is that they contribute to real economy efficiency by deriving
process allows the financial system to achieve socially beneficial projects by
reducing or eliminating inferior projects and diverting resources to more productive
projects. Moreover, the collection of information about investors‘ creditworthiness
creates a valuables database for intermediaries and a network of information that
facilitates information transmission (Greenwood and Jovanovic,1990).For example,
the existence of private firms (such as Moody‘s and Standard and Poor‘s in the US
and London-based Fitch IBCA credit rating agencies)specializing in collecting
information and evaluating the performance of firms will guide financiers who
purchase such information to determine which firms are worthy of receiving funds.
These agencies typically rate relatively large companies. However, banks may use
consumer credit rating firms (like Experian in the UK) to credit score retail customers
as well as using their own extensive internal databases.

iii)..Operational Efficiency
Operational efficiency in the financial system relates to the system‘s ability to
organise the channelling of funds with minimum cost. As we will show below, when
the cost of intermediation is at a minimum, this means that fewer resources are
utilized to channel a greater volume of funds. Operational efficiency has mostly been
studied in the context of financial institutions, such as banks (although it can also

relate to the operational characteristics of capital market organizations and
exchanges).

Before talking about the operational efficiency elements of financial intermediaries, it
is essential that we explain the bank production process. Namely, we need to define
what a bank or financial firm produces before we can say whether it is relatively
efficient or not. The measurement of what a bank produces (its outputs) is a
controversial issue in financial studies since the production of financial institutions is
characterized by its non-physical (services) nature.

In banking studies, there are however two views of measuring outputs; the
production and the intermediation approaches. The production approach, banks are
viewed as firms that use labour and capital to produce loans, deposits and other
earning assets. In addition, this approach measures outputs as the number of loans
and deposits accounts. The intermediation approach views banks as firms that use
labour, capital and deposits to produce loans and other earning assets. The
intermediation approach measures outputs in terms of their values, but not number
of accounts. Therefore, the difference between both approaches lies mainly in
whether deposits should be considered among inputs or outputs: and whether banks‘
input and output are measured according to the number of value of accounts. Most
of the banking efficiency study adopt the intermediation approach because it is
easier in term of data availability, and it is at the heart of measuring the cost of
intermediating deposits to the receivers of loans (Berger and Mester, 1997)

Returning to operational efficiency, most of the work undertaken in the financial area
focuses on modelling the efficiency of banks. In particular, substantial emphasis in
recent years has been made attempting to measure X-inefficiency (a term initially
coined b Leibenstein, 1966) that refers to deviations from the cost-efficient frontier
that depicts the lowest production cost for a given level of output. X-efficiency stems
from technical efficiency, which gauges the degree of friction and waste in the
production processes, and allocative efficiency, which measures the levels of various
inputs. These two are neither scale nor scope dependent and thus X-efficiency is a
measure of how well management is aligning technology, human resources
management, and other resources to produce a given level of output.

X-efficiency is defined as the distance of the actual performance of banks from their
efficiency frontier. It could come from both the cost and revenue sides. The cost X-
efficiency refers to how close the actual cost performance is to the cost frontier while
the revenue X-efficiency measures the distance of the actual revenue from its
frontier. Following Berger et al. (1993), we also decompose Xinefficiency into
allocative X-inefficiency and technical X-inefficiency. Allocative X-inefficiency is
defined as the effects of basing production decisions on shadow prices that deviate
from the actual ones. Technical X-inefficiency measures losses from failing to meet
this defective production plan by using more inputs to produce fewer products. Gains
of X-efficiency from consolidations refer to whether the actual performance of banks
moves closer to the optimal frontier or not after consolidations.

The literature on X-efficiency obtains consistent results. There is significant X-
inefficiency in the banking industry from the perspectives of both cost and revenue,
although quantitative conclusions vary greatly across estimate methods. On the cost
side, X-efficiency refers to how close the actual cost performance is to the optimal
cost frontier, which is defined as the minimum cost operation given prices and
output bundle. In the early studies on cost Xefficiency, estimating X-efficiency is
defined as distinguishing systematic management inefficiency from random errors
that might temporarily impose relatively high costs on certain institutions. This
concept of X-efficiency also has the potential to be extended into studies of X-
efficiency on the revenue side. The four approaches employed in evaluating U.S.
banking data are reviewed in detail in Berger et al. (1993).

X-efficiency is usually decomposed into technical and allocative efficiency. In
welfare economics, allocative efficiency is used to show the situation in which the
prices of goods and services produced in the economy reflect the minimum cost of
supplying them. Thus in perfect competition, consumers pay prices that reflect the
minimum cost of production at which producers receive normal profits that are
adequate to make their business continue supplying the products. In a market with a
sole producer, the price is set above the minimum cost, where the price consumer
pay deviates from being allocatively efficient. In financial studies, specifically
banking, allocative efficiency denotes the ability of a bank to use inputs in optimal

propotions with respects to their prices (Farrell, 1957). In banking studies most
authors, including Berger et al (1993a), find that banks‘ inefficiencies are technical in
nature rather than allocative. Therefore, many authors, such as Mester (1993) and
Altunbas et al (2000) do not decompose the X-efficiency measurements. In general,
the empirical banking literature provides more attention to technical rather than
allocative efficiency.

Technical efficiency relates to the avoidance of excessive use of inputs, i.e. more
than that is optimal for the given level of output (Berger et al. , 1993). In banking, the
measurement of the optimal use of inputs, once technical efficiency is achieved,
involves the analysis of the cost or price of inputs. From society‘s point of view,
society is better off if a cost-inefficient bank improved its operational efficiency
towards reducing inefficient and unproductive usage of its inputs. There are many
reason why technical inefficiency might exists. A managerial element might have an
influence on a firm‘s operation s through mistakes in choosing the optimal size of
inputs. However, if sub-optimal level of deposits are obtained using this strategy then
the bank may not be able to fulfil its output obligations, resulting in a misuse of
inputs.

iv)..Scale Efficiency
Scale economies exist when a bank operates on its decreasing long-run total
average cost curve. The concept of scale efficiency was first introduced by Farrell
(1957), which can be simply defined as the relationship between a bank‘s per unit
average production cost and volume, and thus a bank is said to have economies of
scale when the increase in outputs is accompanied by a lower unit cost of
production. The concept of scale efficiency was first introduced by Farrell (1957),
which can be simply defined as the relationship between a bank‘s per unit average
production cost and volume, and thus a bank is said to have economies of scale
when the increase in outputs is accompanied by a lower unit cost of production.

Scale efficiency measures banking operations across sizes. Its specifies the
movement of profit frontiers as banking scale grows following bank consolidations.
Such movement comes from both the cost and the revenue sides. Given fixed
prices, the cost side scale efficiency occurs when large banks are able to produce

identical services at lower cost than small banks. The revenue side scale efficiency
occurs when large banks are able to provide more services at the same cost as
small banks. Higher scale associated with consolidations is therefore potentially able
to increase profit efficiency.

Earlier studies on banking scale efficiency focus on the cost side of production and
then later extend into the revenue side. Some recent studies also analyze scale
efficiency of banks from the perspective of profit. The results of the studies on the
cost side consistently show that scale efficiency depends on individual bank‘s scale
level before consolidations although some recent studies find growing trend in scale
efficiency overtime.

On the revenue side, the literature shows mild revenue scale efficiency. Finally, from
the perspective of profit, the literature shows mixed results. On the cost side, the
literature finds that there is an optimal scale in terms of saving cost. This result
suggests that banks that are below the optimal scale reduce their unit cost by
increasing scale until the optimal scale is obtained. In contrast, banks that above the
optimal scale would raise their unit cost by increasing scale.

Earlier studies of cost efficiency on scale rely on Cobb-Douglas production function,
mainly because of its tractability, and use data on small size banks, because of lack
of available data for large banks. The works of Benston (1972) and Bell and Murphy
(1968) are representative of this literature. Using different data mainly from the
1960s, these studies suggest that the scale elasticity of operating cost is somewhere
around 0.95 and statistically significant. In other words, according to these studies,
with one percent growth in banking scale, operating costs will rise by only 0.95
percent. Therefore, for these small banks, scale efficiency in terms of scale elasticity
of operating cost is slight but statistically significant.

The scale efficiency studies in the late 1980s and early 1990s use translog functional
forms and focus on average cost. The use of these forms supersedes the Cobb-
Douglas functions by accommodating more flexible functional forms (Berger et al.,
1999 gives a comprehensive review of this literature). Using the data on U.S. banks
from the 1980s, studies in this period suggest that the average cost curve of banks

has a relatively flat U-shape form with median sized10 banks being slightly more
scale efficient than others. According to these results, large banks cannot gain any
scale efficiency and may even lose some of it by increasing their size. Unfortunately,
these analyses do not agree on the location of the bottom of the average cost U —
the optimal scale point. Studies using various data that contain diversified banking
sizes usually identify greatly different optimal scale points. This incongruence leads
to failure in fitting large and small banks on the same parametric cost function.
Further studies confirm this failure and attribute it to the limited flexibility of the
translog functional form when data are located far from the mean values of
themselves (McAllister and McManus, 1993, Mitchell and Onvural, 1996).

Later studies continue to search for more flexible functional forms. McAllister and
McManus (1993), Berger et al. (1997), and Berger and DeYoung (1997) suggest that
the Fourier-flexible functional form should be used for U.S. financial institution
studies instead of the translog. In addition, Mester (1992) estimates a hybrid translog
function. Berger et al. (1993), Berger (1995, 2000), and Akhavein et al. (1997a,
1997b) estimate a Fuss normalized quadratic variable profit function. Most of these
studies argue for the result that scale Some studies find efficient scale assets to be
at a range of $75 million and $300 million (Berger et al. 1987, Berger and Humphrey
1991, Bauer et al. 1993).

On the revenue side, there is evidence of mild revenue scale efficiency (Berger et al.
1996). Other studies in this literature use the profit function to jointly evaluate the
combined effects of scale changes on the cost and the revenue sides. In some
studies (Berger et al. 1993, Clark and Siems 1997), profit efficiency is measured as
being highest for large institutions. While Berger (1995) argues that large and small
institutions are equal in terms of scale efficiency.

v)..Scope And Product Mix Efficiencies
Scope economies exist when it costs the same or less if one or more output are
added (to the available output set) than if different firms produce each output
separately. Scope economies may be realized when mergers or acquisitions take
place between firms producing different outputs. Individual banks producing a variety
of services may also be enjoying scope economies. As an example, one bank may

provide loans and another bank may engage in portfolio investments. If these two
banks join together and produce both loans and investments, scope economies may
be achieved when joints production of these two outputs are less costly than the
total cost of these output being produced separately by individual banks.

The majority of empirical studies on scope economies in banking have been
undertaken in US banking industry. Evidence to support the hyphotesis that multi-
product banks have lower costs than specialists has been put forward in studies
such as by Gilligan and Smirlock (1984) and Lawrence and Shay (1986). However,
others including Hunter, Timme and Yang (1990) and Mester (1987) find no strong
support for the existence of scope economies in banking.

Changes in business scope and product mix are capable of improving bank
efficiency as well. Scope efficiency occurs when it is more efficient for multiple
financial services to be provided by a single institution instead of separate
specialized ones. In empirical studies, scope efficiency is often difficult to estimate
for the banking industry because there are very few specialized banks in the data
sample. Studies of product mix efficiency solve this problem by evaluating somewhat
different output combinations. Other studies use the concept of expansion-path sub-
additivity to measure a combination of scope and product mix efficiencies
simultaneously. The empirical results in the literature are mixed on the cost side; but
show no efficiency gains on the revenue side.

On the cost side, improvement in business scope and product mix may reduce
operating cost in two ways: one is by the sharing of fixed costs over multiple
products; the other is by the cost complementarities in providing different products.
Fixed costs are shared when the fixed capital of an institution is more fully utilized by
providing multiple services (issuing transaction accounts, savings accounts,
consumer loans, and trust services, etc.).

Cost complementarities occur when there is some benefit in providing one service as
a result of producing another one. For example, the payment flow information
developed in providing deposit services can be employed to reduce the cost of
acquiring credit information in monitoring loans to the same customers. Using these

concepts, Pulley and Humphrey (1993) analyze the effects of changing scopes on
bank operating cost with data of large U.S. banks between 1978 and 1990. Their
estimates of scope efficiency in a five-output model (real estate, commercial and
industrial, and consumer installment and credit card loans) average at 20% of those
banks‘ total cost. Moreover, they conclude that this efficiency gain is not due to cost
complementarities between deposits and loans but rather due to 13 sharing of fixed
costs.

However, Ferrier et al. (1993) suggest otherwise by using the concept of expansion-
path with data of U.S. banks operating in 1984. They exam the cost effects of
product line expansion, and find slight inefficiency. In addition, Berger et al. (1987)
and Hunter et al. (1990) draw qualitatively similar conclusions using U.S. banking
data in the 1980s: very few cost savings are found from consolidating outputs of
different banks.

On the revenue side, improvements in scope and product mix can raise banking
efficiency by enhancing their revenue. However, no empirical studies show evidence
supporting such enhancement. Pulley et al. (1993) study this from the perspective
that consumers are generally willing to pay higher prices for multiple financial
services in one location to save on transportation and time costs. They define scope
in terms of deposits and loans and find no efficiency gains from combining them. In
another study, Berger et al. (1996) find no evidence of significant scope efficiency
gains on the revenue side using data from 1978 through 1990.

From the perspective of both cost and revenue, Berger et al. (1993) construct a two-
output profit function of banks and conclude that banks would be better off by
producing either one of these two goods instead of both. Clark and Siems (1997)
also arrive at a similar conclusion that change in product mix yields no profit
advantages.

vi)..Other Aspects Of Operational Efficiency
Risk-pooling comes from the role of diversification and spread of assets being
invested in the financial system (Tobin, 1984). Banks can spread risk across large
numbers of borrowers with different risk types different projects and different sectors

of an economy. Also, financial markets allow investors to make their portfolios more
efficient by choosing well-diversified assets. The general idea behind risk spreading
is to avoid non-systematic risk; that is the fall in the return of investment will be
recovered by the rise of return of another.

Uncertainty reduction has been explained by Tobin as an aspect of efficiency, which
he calls, ‗full insurance efficiency’. Insurance efficiency implies that the financial
system enables its participants to have their financial assets delivered and obtained
with insurance against all future contingencies. In other words, this is called ‗hedging‘
against uncertainty. Since the volatility of stocks and exchange rates impede the
trade of financial assets, financial derivatives (such as forward contracts, financial
futures, options, swaps and so on) are tools that allow individuals and companies to
engage in contracts that contain the delivery of a specified amount and quantity of
assets on a certain date. Therefore, future financial instruments are, in general
important for financial system efficiency because they reduce the risk associated
with the volatility of assets prices and provide confidence and stability in the
transactions within the financial system.

Funds-pooling refers to the law of aggregation as an important efficiency feature of
the financial system, which helps maximize the level of funds intermediated in the
economy. Banks are the main financial system institutions able to aggregate and
pool small savings I order to make large loans. Financial markets can also aggregate
small funds from the new issues of society‘s wealth classes to participate with their
funds in a way that matches their wealth capacities.

2.0..Literature Review

Efficiency measurement is one aspect of investigating a firm‘s 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).

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.

Meanwhile, depending on the types of ownership, the empirical results of the impact
of deregulation on banking efficiency and productivity in developing countries are

varied (Bhattacharya et al., 1997; Burki and Niazi, 2003). Bhattacharya et al. (1997)
focused their study on the efficiency of three different kinds of ownership (private,
public and foreign) of Indian commercial banks. Public-owned banks were found to
be the most efficient but somehow demonstrated temporal decline in efficiency. This
was followed by foreign banks, which had temporal increase in efficiency. Privately
owned banks were the least efficient banks and the pattern did not significantly
change over the 1986-1991 period.

A study conducted by Burki and Niazi (2003) on the banking industry in Pakistan
showed that state-owned bank was the most inefficient followed by private banks.
Foreign banks were the least inefficient over the period of 1991 to 2000. Noulas
(2001) study on the efficiency of Greek banks for the period 1993 to 1998 concluded
that the private banks were more efficient than state-controlled banks.

The comparison of efficiency between foreign and domestic banks provides
evidence that foreign banks in developing and transition countries have succeeded
in capitalizing on their advantages and show a higher level of efficiency than their
domestic peers (Bonin et al., 2005; Isik and Hassan, 2002; Hasan and Marton, 2003;
Bhattacharyya et al., 1997). Furthermore, several papers tested whether foreign and
domestic banks came from the same population, in other words whether they
operated in the same environment. These tests are especially important for
efficiency studies in order to determine whether to construct separate or common
frontiers for domestic and foreign banks. Parametric and non-parametric tests
usually failed to reject the null hypothesis that foreign and domestic banks came
from the same population (Isik and Hassan, 2002; Sathye, 2001).

Notwithstanding, a few studies had shown a good impact of deregulation on
efficiency and productivity. Specifically, deregulation has resulted in improvement in
productivity in Norwegian Banks (Berg et al., 1992). Shyu (1998) also reported
improved efficiency of the Taiwanese banking industry after deregulation. The
efficiency of the Turkish commercial banks had also increased as a result of
deregulation (Zaim, 1995). A recent study by Isik and Hassan (2003) on Turkish
banks also showed an increase in their efficiency. They attributed the increase in
efficiency to improved resources management practices. In addition, the finding

showed that the efficiency gaps between private banks and public banks have also
been narrowed. Perhaps, the successful story of banking deregulation in Turkey,
which triggered better efficiency, could be due to the support of small and medium
industry, and commercial businesses to the Turkish banking industry.

From the empirical studies mentioned above, there is strong evidence to believe that
efficiency gains can be secured through competition. In other words, regulation, if
properly implemented, will enhance competition and make it more effective in the
market place.

Samad (1999) was among the first to investigate the efficiency of the Malaysian
Islamic banking sector. In his paper, he investigates the relative performance of the
fully fledged Malaysian Islamic bank compared to its conventional bank peers.
During the period of 1992-1996 he found that the managerial efficiency of the
conventional banks was higher than that of the fully fledged Islamic bank. On the
other hand, the measures of productive efficiency revealed mixed results. He
suggests that the average utilization rate of the Islamic bank is lower than that of the
conventional banks.

Donsyah Yudistira (2004) conducted research on technical, pure technical, and scale
efficiency and measures are calculated by utilizing the non-parametric technique,
DEA. The inefficiency across 18 Islamic banks is small at just over 10 percent, which
is quite low compared to many conventional counterparts. Similarly, Islamic banks in
the sample suffered from the global crisis in 1998-1999 but performed very well after
the difficult periods. This would suggest that the interdependence of Islamic banks
on other financial system is significant and any regulator, especially in which the
bank operates, should consider Islamic banking in the search of global financial
stability.

There are finding on diseconomies of scale for small-to-medium Islamic banks which
suggests that Merger &Acquisition should be encouraged. Supported by the non-
parametric technique and regression analysis, Islamic banks within the Middle East
region are less efficient than their counterparts outside the region. Additionally,
market power, which is common in the Middle East, does not significantly impact on

efficiency. The reason is that Islamic banks from outside the Middle East region are
relatively new and very much supported by their regulators. Furthermore, publicly
listed Islamic banks are less efficient than their non-listed counterparts.

More recently, Sufian (2006) examined the efficiency of the Malaysian Islamic
banking sector during the period 2001-2004 by using the non-parametric DEA
method. He found that scale efficiency (SE) outweighs pure technical efficiency
(PTE) in the Malaysian Islamic banking sector, implying that Malaysian Islamic banks
have been operating at the non-optimal level of operations. He suggests that the
domestic Islamic Banking Scheme banks have exhibited a higher technical efficiency
compared to their foreign Islamic Banking Scheme bank peers. He suggests that
during the period of study the foreign Islamic Banking Scheme banks‘ inefficiency
was mainly owing to scale rather than pure technical.

He found that larger Malaysian Islamic banks tend to disburse more loans and are
more efficient compared to its smaller counterparts. His results suggest that market
share has a positive and significant effect on Malaysian Islamic banks efficiency.
Finally, the results also suggest that the more efficient banks tend to be more
profitable.

Fadzlan Sufian and Mohamad Akbar Noor Mohamad Noor ( 2009 ) examine the
performance of the MENA and Asian Islamic banks during the period 2001-2006.
The efficiency estimates of individual banks are evaluated using the non-parametric
DEA approach. The empirical findings suggest that pure technical inefficiency
outweighs scale inefficiency in the Islamic banking sector, implying that the Islamic
banks have been managerially inefficient in exploiting their resources to the fullest
extent. The empirical findings seem to suggest that the MENA Islamic banks have
exhibited higher technical efficiency compared to their Asian Islamic bank
counterparts. During the period of study we find that pure technical inefficiency has
greater influence in determining the total technical inefficiency of the MENA and the
Asian Islamic banking sectors.

The findings contribute significantly to the existing knowledge of the operating
performance of the Islamic banking industry in the MENA and Asian countries.

Nevertheless, the study has also provided further insight into the banks‘ specific
management as well as the policymakers with regard to attaining optimal utilization
of capacities, improvement in managerial expertise, efficient allocation of scarce
resources and the most productive scale of operation of the banks in the industry.
This may also facilitate directions for sustainable competitiveness of Islamic banking
operations in the future.

The study conducted by Hamim S. Ahmad Mokhtar et al (2008) has established
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. 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.

Similarly, he found that profits earned by the fully fledged Islamic bank, either
through the use of deposit or loanable funds, or used funds, are also lower than the
conventional banks, reflecting the weaker efficiency position of the fully fledged
Islamic bank. In contrast, the productivity test by loan recovery criterion indicates that
the efficiency position of the fully fledged Islamic bank seems to be higher and that

bad debts as a percentage of equity, loans, and deposits also show a clear
superiority over the conventional bank peers.

Hassan Taufiq et al 2009 conducted on efficiency study of conventional versus
Islamic banks in the Middle East One of the main and important findings suggests
that there is no significant difference between the overall efficiency results of
conventional versus Islamic banks. Given the advantages that the conventional
banks enjoy over the Islamic banks, the results in this paper are in favour of the later
banking system. Taken together, these findings suggest that there is substantial
room for more cost minimisation, and revenue and profit maximisation in both
banking systems. To some extent, conventional banks behave similarly to Islamic
banks in respect of efficiency. On average, unlike age, the size differences do not
contribute towards efficiency differences between both streams.

3.0 Research Methodology
3.1 Introduction
Conceptually, there are two general methodologies to measure frontier efficiency;
the parametric approach using econometric techniques, and the non-parametric
approach utilising the linear programming method. Both approaches differ mainly in
how they handle the random error and the assumptions made on the shape of the
efficient frontier. However, each of the techniques has its own strengths and
weaknesses. The most widely employed parametric methods are stochastic frontier
approach (SFA), thick frontier approach (TFA) and distribution-free approach (DFA).
On the other hand, the commonly used non-parametric techniques are free disposal
hull analysis (FDH) and Data Envelopment Analysis (DEA).

This paper follows the DEA nonparametric approach. In this regard, Farrell (1957)
originally developed this non-parametric efficiency approach. The DEA is non-
parametric in the sense that it simply constructs the frontier of the observed input-
output ratios by linear programming techniques (Iqbal and Molyneux, 2005). For an
introduction to DEA methodology, see for instance Coelli et al. (1998) and
Thanassoulis (2001).

Technical efficiency reflects the ability of a firm to obtain maximum output from a
given set of inputs (Farrell, 1957). There is an increasing concern to measure and
compare efficiency of firms under different environments and activities. If a firm
produces only one output, using one input this could be done easily. However, this
method is often inadequate as firms normally produce multiple outputs by using
various inputs related to different resources.

The parametric approach has the advantage of allowing noise in the measurement of
inefficiency. However, the approach requires us to specify the functional form for the
production, cost or profit function. On the other side of the coin, the non-parametric
approach is simple and easy to use since it does not require any specification of the
functional form (Coelli, 2004). However, it suffers from the drawback that all
deviations from the best-practice frontier are attributed to inefficiency as it did not
allow for noise to be taken into account.

3.2..Data Envelopment Analysis (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 multi output variables.

The term Data Envelopment Analysis (DEA) was first introduced by Charnes,
Cooper and Rhodes (1978), (hereafter CCR), to measure the efficiency of each
Decision Making Units (DMUs), that is obtained as a maximum of a ratio of weighted
outputs to weighted inputs. This denotes that the more the output produced from
given inputs, the more efficient is the production. The weights for the ratio are
determined by a restriction that the similar ratios for every DMU have to be less than
or equal to unity.

This definition of efficiency measure allows multiple outputs and inputs without
requiring pre-assigned weights. Multiple inputs and outputs are reduced to single
‗‗virtual‘‘ input and single ‗‗virtual‘‘ output by optimal weights. The efficiency measure
is then a function of multipliers of the ‗‗virtual‘‘ input-output combination.

The CCR model presupposes that there is no significant relationship between the
scale of operations and efficiency by assuming constant returns to scale (CRS), and
it delivers the overall technical efficiency (OTE). The CRS assumption is only
justifiable when all DMUs are operating at an optimal scale. However, firms or DMUs
in practice might face either economies or diseconomies of scale. Thus, if one
makes the CRS assumption when not all DMUs are operating at the optimal scale,
the computed measures of technical efficiency will be contaminated with scale
efficiencies.

Banker et al. (1984) extended the CCR model by relaxing the CRS assumption. The
resulting ‗‗BCC‘‘ model was used to assess the efficiency of DMUs characterised by
variable returns to scale (VRS). The VRS assumption provides the measurement of
pure technical efficiency (PTE), which is the measurement of technical efficiency
devoid of the scale efficiency effects. If there appears to be a difference between the
TE and PTE scores of a particular DMU, then it indicates the existence of scale
inefficiency.

Amongst the strengths of the DEA is that, DEA is less data demanding as it works
fine with small sample size. The small sample size is among other reasons, which
leads us to DEA as the tool of choice for evaluating Malaysian Islamic banks X-
efficiency. Furthermore, DEA does not require a preconceived structure or specific
functional form to be imposed on the data in identifying and determining the efficient
frontier, error and inefficiency structures of the DMUs[1] (Evanoff and Israelvich,
1991; Grifell- Tatje and Lovell, 1997; Bauer et al., 1998). Hababou (2002) adds that it
is better to adopt the DEA technique when it has been shown that a commonly
agreed functional form relating inputs to outputs is difficult to prove or find. Such
specific functional form is truly difficult to show for financial services entities. Avkiran
(1999) acknowledges the edge of the DEA by stating that this technique allows the
researchers to choose any kind of input and output of managerial interest, regardless

of different measurement units. There is no need for standardisation. Three useful
features of DEA are first, each DMU is assigned a single efficiency score, hence
allowing ranking amongst the DMUs in the sample. Second, it highlights the areas of
improvement for each single DMU. For example, since a DMU is compared to a set
of efficient DMUs with similar input–output configurations, the DMU in question is
able to identify whether it has used input excessively or its output has been under-
produced. Finally, there is possibility of making inferences on the DMUs general
profile. We should be aware that the technique used here is a comparison between
the production performances of each DMU to a set of efficiency DMUs.

The set of efficiency DMUs is called the reference set. The owners of the DMUs may
be interested to know which DMU frequently appears in this set. A DMU that appears
more than others in this set is called the global leader. Clearly, this information gives
huge benefits to the DMU owner, especially in positioning its entity in the market.

The main weakness of the DEA is that it assumes data that are free from
measurement errors. Furthermore, since efficiency is measured in a relative way, its
analysis is confined to the sample set used. This means that an efficient DMU found
in the analysis cannot be compared with other DMUs outside of the sample. The
reason is simple. Each sample, separated, let us say, by year, represents a single
frontier, which is constructed on the assumption of same technology. Therefore,
comparing the efficiency measures of a DMU across time cannot be interpreted as
technical progress but rather has to be taken as changes in efficiency (Canhoto and
Dermine, 2003).

DEA can be used to derive measures of scale efficiency by using the variable returns
to scale (VRS), or the BCC model, alongside the constant returns to scale (CRS), or
the CCR model. Coelli et al. (1998) noted that the BCC model have been most
commonly used since the beginning of the 1990s. A DEA model can be constructed
either to minimise inputs or to maximise outputs. An input orientation aims at
reducing the input amounts as much as possible while keeping at least the present
output levels, while an output orientation aims at maximising output levels without
increasing use of inputs (Cooper et al., 2000). The focus on costs in banking and the

fact that outputs are inclined to be demand determined means that input-oriented
models are most commonly used (Kumbhakar and Lozano Vivas, 2005).

There Envelopment Model in DEA having two alternative approaches to determine
the efficient frontier characterized that is input-oriented, and the other output-
oriented. Input-oriented model where the inputs are minimized and the outputs are
kept at their current levels (Banker, Charnes and Cooper, 1984) 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 input based 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 Envelopment Models in Spreadsheets using Excel
Solver for Input-oriented VRS Envelopment Spreadsheet Model DEA is indicated in
Appendix 1. Chapter 1 Envelopment DEA Models (Joe Zhu 2002:Quantitative
Models for Performance Evaluation and Benchmarking Data Envelopment Analysis
with Spreadsheets Second Edition,)

DEA allows us to compute overall cost, technical, allocative, pure technical, and
scale efficiency. Technical efficiency (TE) refers to the ability to produce the
maximum outputs at a given level of inputs, or ability to use the minimum level of
inputs at a given level of outputs. Allocative efficiency (AE) refers to the ability to
select the optimal mix of inputs in light of given prices in order to produce a given
level of outputs.

The measure of overall cost efficiency (CA) is the product of technical and
allocative efficiency. The TE measure can be further decomposed into pure
technical efficiency (PTE) and scale efficiency (SE).

3.3 Input and output variables and the data
(Data sample, inputs–outputs definition and the choice of variables)
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).

Under the production approach, pioneered by Benston (1965), banks are primarily
viewed as providers of services to customers. The input set under this approach
includes physical variables (e.g. labour and material) or their associated costs, since
only physical inputs are needed to perform transactions, process financial
documents, or provide counselling and advisory services to customers. The output
under this approach represents the services provided to customers and is best
measured by the number and type of transactions, documents processed or
specialized services provided over a given time period. This approach has primarily
been employed in studying the efficiency of bank branches.

Under the intermediation approach, financial institutions are viewed as
intermediating funds between savers and investors. In our case, Islamic banks
produce intermediation services through the collection of deposits and other liabilities
and in turn these funds are invested in productive sectors of the economy, yielding
returns uncontaminated by usury (riba‘). This approach regard deposits, labour and
physical capital as inputs, while loans and investments are treated as output
variables. Following among others, Hassan and Hussein (2003), Hassan (2005) and
Sufian (2006), a variation of the intermediation approach or asset approach originally
developed by Sealey and Lindley (1977) will be adopted in the definition of inputs
and outputs used in this study. Furthermore, as at most times bank branches are
engaged in the processing of customer documents and bank funding, the production
approach might be more suitable for branch efficiency studies (Berger and
Humphrey, 1997).

This study employs the intermediation approach for three reasons: First, it will be
evaluating the bank‘s 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 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.

For the empirical analysis, all Malaysian conventional banks that offered Islamic
banking window services and their Islamic windows, 2 full-fledged Islamic banks
from 2000 to 2009. will be incorporated in the study (see Table I). The annual
balance sheet and income statement used to construct the variables for the empirical
analysis were taken from published balance sheet information in annual reports of
each individual bank.

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.

The aim in the choice of variables for this study is to provide a parsimonious model
and to avoid the use of unnecessary variables that may reduce the degree of
freedom. All variables are measured in millions of Ringgit (RM). We model Malaysian
Islamic banks as a multi-product firms producing one output by employing two
inputs.

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APPENDIX 2

Banks that offered Islamic banking services in Malaysia is as follows:
1) Domestic banks offering window Islamic banking services
 Affin Bank
 Alliance Bank
 Arab-Malaysian Bank
 EON Bank
 Hong Leong Bank
 Maybank
 Public Bank
 RHB Bank
 Southern Bank

2) Foreign banks offering window Islamic banking services
 Standard Chartered Bank
 Hong Kong Bank
 OCBC
 Citibank

3) Domestic full fledged Islamic banks
 Bank Islam Malaysia
 Bank Muamalat

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