Efficiency in Islamic Banking

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

2. Why is banking efficiency important? Banking efficiency is important at the macro and micro levels.

3. 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.

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

5. Bank efficiency is a socially optimal target since it reduces the average cost of financial transactions and therefore enhance the society’s welfare.

6. 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.

7. 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

8. 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).

9. 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.

10. The Efficiency Concepts Cost and profit efficiency are the most important economic efficiency concepts.

11. 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.

12. 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)

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

14. 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)

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

16. Variables Dependent variable: Profit before taxes

17. 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;

18. 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.

19. 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.

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

21. 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).

22. 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.

23. 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.

24. 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}

25. 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.

26. 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

27. 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).

28. 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.