Efficiency in Islamic Banking
Dr Khaled A. Hussein
Islamic Research and Training Institute
Islamic Development Bank
PO Box 9201, Jeddah 21413
Saudi Arabia
1
Why is banking efficiency important?
Banking efficiency is important at the
macro and micro levels.
2
Financial sector as a whole plays a key
role in allocating the economy’s
financial resources.
In order to allocate resources
effectively, banks should be sound and
efficient.
3
• Efficient banking system helps to
increase the effectiveness of the
macroeconomic policies.
4
Bank efficiency is a socially optimal
target since it reduces the average cost
of financial transactions and therefore
enhance the society’s welfare.
5
Financial institutions used to enjoy local
oligopolies and therefore make rewarding
profits, but such advantages are shrinking
due to growth in competition.
Due to the growth of competition, bank
management is interested in enhancing
efficiency.
Regulatory authority has to assess the
efficiency of the banking sector before going
global.
6
Methods to measure banking efficiency
Financial ratios approach
Examine financial ratios such as
ROE, ROA, capital asset ratio, growth
rate of total revenue, cost/income ratio
7
Econometric Procedure
The efficiency in financial institutions can be
estimated using either:
• Parametric methods (such as the stochastic
frontier analysis, the thick frontier approach,
and the distribution-free approach)
• Non-parametric techniques (such as data
envelopment analysis and free disposable
hull analysis).
8
• Berger and Humphrey (1997) argue that it is
not possible to determine which of the two
major approaches dominates the other
• Berger, A. and D. Humphrey, (1997),
“Efficiency of Financial Institutions:
International Survey and Directions for Future
Research”, European Journal of
Operational Research, 98, 175-212.
9
The Efficiency Concepts
Cost and profit efficiency are the most
important economic efficiency concepts.
10
The cost efficiency
Cost efficiency gives a measure of how
close a bank’s cost to the best practice
bank’s cost that produces the same
bundle of output under the same
conditions.
11
Costs, C, depend upon prices of inputs,
P, the quantities of outputs, Q, random
error, v, and cost inefficiency, u.
The cost function can be specified as
following:
C = f (Q, P, v, u)
12
Profit Efficiency
Efficiency is measured by how close a
bank comes to earning maximum profit
given its output level.
13
The profit function employs bank’s
profits as the dependent variable and
the same explanatory variables as in
the cost function.
The profit efficiency function is specified
as following:
π = f (Q, P, v, u)
14
The translog model is the most popular
form in the literature.
The translog model of the profit
efficiency in can be written as following:
15
Variables
Dependent variable:
Profit before taxes
16
The explanatory variables
Input prices:
P1 is the price of labour and is
calculated as total salaries and staff
expenses over full time number of staff;
17
P2 is the price of fund which is
measured as interest expenses over
time and saving deposits,
Note that in case of Islamic banks
interest expenses are replaced with
profits distributed to depositors.
18
P3 is the price of physical capital which is
equal to depreciation over fixed capital and
investment in leasing.
In case of Islamic banks the depreciation
value should include the depreciation in
physical capital that bought for leasing.
Failure to take into account this fact will lead
to bias in the efficiency estimates.
19
One of the main challenges is to
identify banks’ level of outputs
The products of the Islamic banks are
different from their conventional
counterparts.
20
In case of conventional banks, products can be
grouped as following:
• short term debt (treasury bills, trading bonds, short
term loans and advances, and deposits at other
financial institutions that mature within one year);
• long term debt (non trading bonds, and medium &
long term loans),
• investments (securities and other investments).
21
Following the same criteria, Islamic banking
products can be classified into:
• short term debt includes murabaha, salam,
and qard fund.
• Long term debt includes sukuk, leasing, and
istisna.
• Investments consist of securities, mudaraba,
musharaka, and investment in properties and
managed funds.
22
The inclusion of the off-balance sheet
items as an output is of great
importance particularly to Islamic
investment banks where restricted
investment accounts are not recorded in
the balance sheet and considered as
off-balance sheet items.
23
Empirical Findings
Al-Shammari (2003) uses the translog
stochastic cost and alternative profit
frontier approaches to estimate bank
efficiency in GCC countries and
compare Islamic bank efficiency with
other types of banks.
See Tables 6.1 , 6.2 , 6.3 {pp. 13-15}
24
Al-Jarrah and Molyneux (2003) use the
stochastic frontier approach, and estimate
bank cost and profit efficiency estimates for
banks operating in Bahrain, Jordan, Egypt
and Saudi Arabia.
Table 6.4 shows that the average cost
efficiency for different types of banks ranged
from 93% for investment banks to 98% for
Islamic banks.
25
Al-Jarrah and Molyneux (2003) extend
their analysis by also estimating both
standard and alternative profit efficiency
for their sample of banks.
See Table 6.5 and 6.6
26
El-Gamal and Inanoglu (2002) used the
stochastic cost frontier approach to estimate
the cost efficiency of Turkish banks over the
period 1990 to 2000.
The study compared the cost efficiencies of
49 conventional banks with four Islamic
special finance houses (SFH’s).
27
Conclusions
Islamic banking is more efficient organisation
form than other types of banking
organisations. WHY?
The consensus of opinion seems to reveal
substantial efficiency advantages, it is not
absolutely clear why these exist – some put it
down to lower funding costs and others to
lower loan-losses.
28