Efficiency in Islamic Banking

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Efficiency in Islamic Banking

• Dr Khaled A. Hussein
• Islamic Research and Training Institute
• Islamic Development Bank
• PO Box 9201, Jeddah 21413
• Saudi Arabia

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Why is banking efficiency important?

• Banking efficiency is important at the macro
  and micro levels.

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• Financial sector as a whole plays a key role in
  allocating the economys financial resources.
• In order to allocate resources effectively,
  banks should be sound and efficient.

4

• Efficient banking system helps to increase the
  effectiveness of the macroeconomic policies.

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• Bank efficiency is a socially optimal target
  since it reduces the average cost of financial
  transactions and therefore enhance the societys
  welfare.

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• 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.

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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

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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).

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• 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.

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The Efficiency Concepts

• Cost and profit efficiency are the most
  important economic efficiency concepts.

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The cost efficiency

• Cost efficiency gives a measure of how close a
  banks cost to the best practice banks cost that
  produces the same bundle of output under the same
  conditions.

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• 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)

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Profit Efficiency

• Efficiency is measured by how close a bank comes
  to earning maximum profit given its output level.

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• The profit function employs banks profits as
  the dependent variable and the same explanatory
  variables as in the cost function.
• The profit efficiency function is specified as
  following
• p f (Q, P, v, u)

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• The translog model is the most popular form in
  the literature.
• The translog model of the profit efficiency in
  can be written as following

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Variables

• Dependent variable
• Profit before taxes

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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

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• 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.

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• 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.

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• One of the main challenges is to identify banks
  level of outputs
• The products of the Islamic banks are different
  from their conventional counterparts.

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• 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).

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• 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.

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• 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.

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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

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• 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.

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• 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

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• 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 (SFHs).

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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.