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Sources of TFP growth in the Malaysian Islamic banking sector

Fadzlan Sufian
a a

Khazanah Research and Investment Strategy, Khazanah Nasional Berhad, Level 35, Tower 2, Petronas Twin Towers Kuala Lumpur City Centre, 50088, Kuala Lumpur, Malaysia Version of record first published: 04 Feb 2010

To cite this article: Fadzlan Sufian (2009): Sources of TFP growth in the Malaysian Islamic banking sector, The Service Industries Journal, 29:9, 1273-1291 To link to this article: http://dx.doi.org/10.1080/02642060801911128

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The Service Industries Journal Vol. 29, No. 9, September 2009, 12731291

Sources of TFP growth in the Malaysian Islamic banking sector

Fadzlan Suan
Khazanah Research and Investment Strategy, Khazanah Nasional Berhad, Level 35, Tower 2, Petronas Twin Towers Kuala Lumpur City Centre, 50088 Kuala Lumpur, Malaysia (Received 8 January 2008; nal version received 11 January 2008) This paper attempts to empirically analyse productivity changes of the Malaysian Islamic banking sector during the period of 2001 2004 by applying the nonparametric Malmquist productivity index method. During the period of study, the empirical ndings suggest that the Malaysian Islamic banking sector has exhibited productivity progress during the earlier years before declining during the latter years. The results suggest that foreign banks have exhibited higher productivity levels compared with their domestic counterparts during the earlier years, while the domestic banks productivity levels were relatively higher compared with the foreign banks during the latter years. Keywords: Islamic bank productivity; Malmquist total factor productivity index (MPI); Malaysia

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Introduction In recent years, nancial institutions have experienced a dynamic, fast-paced, and competitive environment at a cross-border scale. One of the most productive areas is the new paradigm of Islamic banking, which has remarkably captured the interest of both Islamic and contemporary economists. A recent survey states that there are more than 160 Islamic nancial institutions around the world (Dar, 2003). Even though most of the Islamic banks are within developing or Middle-East countries, many conventional banks in developed countries have begun to valve the massive demand for Islamic nancial products. The main difference between the 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 and prot and loss sharing (PLS) in performing their business as intermediaries (Ariff, 1988). Many Islamic economic studies have discussed in depth about the rationale behind the prohibition of interest (Chapra, 2000) and the importance of PLS in Islamic banking (Dar & Presley, 2000). Furthermore, under the term of Islamic PLS, the relationship between borrower, lender, and intermediary is rooted on nancial trust and partnership. The importance of the interest-free principle in Islamic banking has created an innovative environment among practitioners in which the alternative of interest is explored extensively. Dar (2003) classies four types of nancing that act as alternatives to interest: investment-based, sale-based, rent-based, and service-based. The existing research in Islamic banking and nance has focused primarily on the conceptual issues underlying interest-free nancing (Ahmed, 1981; Karsen, 1982).

Email: fadzlan.suan@khazanah.com.my

ISSN 0264-2069 print/ISSN 1743-9507 online # 2009 Taylor & Francis DOI: 10.1080/02642060801911128 http://www.informaworld.com

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These issues include the viability of Islamic banks and their ability to mobilise saving, pool risks, and facilitate transactions. On the other hand, few studies have focused on the policy implications of a nancial system without interest payments (Khan & Mirakhor, 1987). What is noteworthy is that empirical work on the performance evaluation of Islamic banks is sparse. The lack of complete data impeded any comprehensive analysis of the experience of the last three decades. To date, empirical works done in this area of research have yielded inconclusive results (Bashir, 1999; Bashir, Darrat, & Suliman, 1993). The Malaysian banking system has a unique setting, where conventional banks are allowed to offer Islamic banking and nance products along with the conventional products. This dual banking system provides an interesting ground to investigate the efciency of domestic and foreign banks. As Malaysia is among the rst countries in the world that implement a dual banking system, this study would be among the rst empirical investigation to examine the productivity of domestic versus foreign banks that provide Islamic banking services alongside the traditional conventional banking services. By applying the non-parametric Malmquist productivity index (MPI) methodology, we attempt to investigate the sources of productivity change of Malaysian Islamic banks during the period of 2001 2004. The preferred methodology has allowed us to isolate efforts to catch up to the frontier (efciency change) from shifts in the frontier (technological change (TECHCH)). Also, the Malmquist index enables us to explore the main sources of efciency change: either improvements in management practices (pure technical efciency change) or improvements towards optimal size (scale efciency change). Finally, we performed a series of parametric and non-parametric tests to examine whether the domestic and foreign banks were drawn from the same population. The remainder of the paper is organised as follows. The second section provides some background on the Islamic banking system in Malaysia, while the third section reviews the related studies with respect to the Islamic banking industry. The fourth section describes the data, sources, and model specication, which are employed in the study, and the empirical results are presented in the following section. The conclusion is given in the nal section. Background In Malaysia, Islamic nancing traces its root back to 1963, with the establishment of the Pilgrims Fund Board or Lembaga Tabung Haji (LTH). The LTH introduced a savings mechanism that enables Malaysian Muslims to save money to cover their costs of performing the annual pilgrimage. Money from the savings are invested in productive sectors of the economy, which yield returns uncontaminated by riba.1 Malaysia, as a country dominated by Muslims, was 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 of an Islamic bank in Malaysia, such as 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 operations and prots point of views. The conclusion was the establishment of the rst Islamic bank in Malaysia known as Bank Islam Malaysia Berhad (BIMB) in July 1983, with an initial paid-up capital of RM80 million.

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The establishment of BIMB marked a new milestone for the development of the Islamic nancial system in Malaysia. BIMB carries out banking business similar to other commercial banks, but along the principles of Syariah. The bank offers deposittaking 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 (prot-sharing). The bank grants nancing facilities such as working capital nancing under Al-Murabahah (cost-plus), house nancing under Bai Bithaman Ajil (deferred payment sale), leasing under Al-Ijarah (leasing), and project nancing under Al-Musyarakah (PLS). It has been the aspiration of the government to create a vibrant and comprehensive Islamic banking and nance system operating side-by-side with the conventional system. A single Islamic bank does not t the denition of a system. An Islamic banking and nance 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 rst 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 an Islamic Banking Scheme (IBS) or Skim Perbankan Islam (SPI) in March 1993. The 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, nance companies, and merchant banks to operate the scheme in July 1993 subject to the specic guidelines issued by the central bank. From only three banks offering Islamic nancing in March 1993, the number of commercial banks that offered Islamic nancing has increased to 15 (of which four are foreign banks). The Islamic banking system, which forms the backbone of the Islamic nancial system, plays an important role in mobilising deposits and providing nancing to facilitate economic growth. The Malaysian Islamic banking system is currently represented by 15 banking institutions comprising nine domestic commercial banks, four foreign commercial banks, and two Islamic banks that offer Islamic banking products and services under the IBS. These Islamic banking institutions offer a broad range of Islamic nancial products and services such as savings, current and investment deposits, and nancing products such as property nancing, working capital nancing, project nancing, plant and machinery nancing, 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. This reects that the Islamic banking system, with its extensive distribution networks (numbering 152 full-edged Islamic banking branches and over 2000 Islamic banking counters), is effective as a nancial intermediator. Islamic banking has also spurred the efforts by other non-bank nancial intermediaries such as the development nancial 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 among the rst few nations to have a full-edged Islamic banking system operating side-by-side with the conventional banking system. Throughout the years, Islamic banking has gained signicance and has been on a progressive upward trend. Since the year 2000, the Islamic banking industry has been growing at an average

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rate of 19% 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% of the total assets in the banking system. The market share of Islamic deposits and nancing increased to 11.2% and 11.3% of the total banking sector deposits and nancing, respectively. The rapid progress of the domestic Islamic banking system, accentuated by the signicant expansion and development of Islamic banking and nance, has become increasingly more important in meeting the changing requirements of the new economy (BNM, 2004). Related studies Although there has been extensive literature examining the efciency features of US and European banking markets over recent years, the work on Islamic banking is still in its infancy. Typically, studies on Islamic bank efciency have focused on theoretical issues and the empirical work has relied mainly on the analysis of descriptive statistics rather than rigorous statistical estimation (El-Gamal & Inanoglu, 2005). However, this is gradually changing as a number of recent studies have sought to apply the approaches outlined above to estimate bank efciency using various frontier techniques. Hussein (2003) provides an analysis of the cost-efciency features of Islamic banks in Sudan between 1990 and 2000. Using the stochastic cost frontier approach, he estimates the cost efciency for a sample of 17 banks over the period. The interesting contribution of this paper is that specic denitions of Islamic nancial products are used as outputs. In addition, the analysis is also novel as Sudan has a banking system based entirely on Islamic banking principles. The results show large variations in the cost efciency of Sudanese banks with the foreign-owned banks being the most efcient. State-owned banks are the most cost inefcient. The analysis is extended to examine the determinants of bank efciency. Here, he nds that smaller banks are more efcient than their larger counterparts. In addition, banks that have higher proportion of musharakah and mudharabah nance relative to total assets also have efciency advantages. Overall, the substantial variability in efciency estimates is put down to various factors, not least the highly volatile economic environment under which Sudanese banks have had to operate over the last decade or so. Hassan and Hussein (2003) examined the efciency of the Sudanese banking system during the period of 1992 and 2000. They applied a variety of parametric (cost and prot efciencies) and non-parametric DEA techniques to a panel of 17 Sudanese banks. They found that the average cost and prot efciencies under the parametric approach were 55% and 50%, respectively, while it was 23% under the non-parametric approach. During the period of study, they found that the Sudanese banking system have exhibited 37% allocative efciency and 60% technical efciency, suggesting that the overall cost inefciency of the Sudanese Islamic banks were mainly due to technical (managerially related) rather than allocative (regulatory). El-Gamal and Inanoglu (2005) used the stochastic frontier approach to estimate the cost efciency of Turkish banks over the period 1990 2000. The study compared the cost efciencies of 49 conventional banks with four Islamic special nance houses (SFHs). The Islamic rms comprised around 3% of the Turkish banking market. Overall, they found that the Islamic nancial institutions to be the most efcient and this was explained by their emphasis on Islamic asset-based nancing, which led to lower non-performing loans ratios. It is worth mentioning that SFHs achieved high

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levels of efciency despite being subjected to branching and other self-imposed constraints such as the inability to hold government bonds. Despite the considerable development of the Islamic banking sector, studies focusing on the efciency of Islamic banks, particularly on the Malaysian Islamic banking industry are still very limited. Several studies that have been devoted to assess the performance of Islamic banks have generally examined the relationship between protability and banking characteristics. Samad and Hassan (1999) applied nancial ratio analysis to investigate the performance of a Malaysian Islamic bank over the period 1984 1997. Their results suggest that, in general, the managements lack of knowledge was the main reason for the slow growth of loans under the prot-sharing system. Despite that, the bank was found to perform better compared with its conventional counterparts in terms of liquidity and risk measurement (lower risks).
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Methodology Three different indices are frequently used to evaluate TECHCHs: the Fisher (1922), Tornqvist (1936), and Malmquist (1953) indexes. According to Grifell-Tatje and Lovell (1996), the Malmquist index has three main advantages relative to the Fischer and Tornqvist indices.2 First, it does not require the prot maximisation, or the cost minimisation, assumption. Secondly, it does not require information on the input and output prices. Finally, if the researcher has panel data, it allows the decomposition of productivity changes into two components (technical efciency change or catching up and technical change or changes in the best practice). Its main disadvantage is the necessity to compute the distance functions. However, the data envelopment analysis (DEA) technique can be used to solve this problem. Following Fare, Grosskopf, Norris, and Zhang (1994) among others, the output-oriented Malmquist productivity change index will be adopted for this study. Output orientation refers to the emphasis on the equi-proportionate increase of outputs, within the context of a given level of input. The output-based Malmquist productivity change index may be formulated as: Mjt1
t 1 t1

;x

" #1=2 Dtj yt1 ; xt1 Dtj1 yt1 ; xt1 ;y ;x Dtj yt ; xt Dtj1 yt ; xt
t t

(1)

where M is the productivity of the most recent production point (xt 1, yt 1) relative to the earlier production point (xt, yt) and Ds the output distance functions. Thus, a value greater than unity will indicate a positive factor productivity growth between two periods. Following Fare et al. (1994), an equivalent way of writing this index is: Mjt1 yt1 ; xt1 ; yt ; xt " #1=2 Dtj yt1 ; xt1 Dtj yt ; xt Dtj1 yt1 ; xt1 Dtj yt ; xt Dtj1 yt1 ; xt1 Dtj1 yt ; xt

(2)

In Equation (2), the ratio outside the brackets is equal to the change of technical efciency between time t and t 1. In other words, it represents the change in the relative distance of the observed production from the maximum potential production. The component inside the brackets of Equation (2) is the geometric mean of the two productivity indexes and represents the shift in production technologies (technical change) between time t and t 1.

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Dtj1 yt1 ; xt1 Technical efficiency (TE) Dtj yt ; xt " Technological change (TECHCH) Dtj yt1 ; xt1 Dtj1 yt1 ; xt1 Dtj yt ; xt Dtj1 yt ; xt #1=2

(3)

(4)

Technical efciency change (TE) in Equation (3) can be further decomposed as the product of two components PTE change and scale efciency change as follows (Fare et al., 1994):
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" # t 1 t1 Dtj yt ; xt Dt1 yt1 ; xt1 Dj yt1 ; xt1 Dj yt1 ; xt1 t1 t1 t1 D t yt ; xt Dtj yt ; xt Dtj yt ; xt D j y ; x

(5)

The ratio outside the brackets in Equation (5) represents the pure technical efciency change, subject to a distance function (Dj) with variable returns to scale, between time t and t 1 and is denoted by PECH hereafter. In other words, Dt1 yt1 ; xt1 Pure technical efficiency change (PEFFCH) D t yt ; xt (6)

The component inside the brackets of Equation (6) represents the effects of economies of scale on productivity and is expressed as SECH which can be readily derived by dividing TE of Equation (3) by PEFFCH of Equation (6) and would not involve its own computations of additional distance functions. That is, scale efciency change (SECH) Scale efficiency change (SECH) TE PEFFCH (7)

After incorporating Equations (5) (7) into Equation (2), we obtain the complete decomposition of the MPI as follows: MPI TE TECHCH TECHCH PEFFCH SECH (8)

Another merit of dening the MPI using the output distance functions Dt is that the MPI and its corresponding components (TE, TECHCH, PEFFCH, and SECH) are all calculated in an index form and have a threshold value of one. In other words, if a derived value is equal to one, it indicates that a banks performance remains unchanged in that performance measure. A value of greater than one represents an improvement and a value of less than one indicate a decline. The product of the index components of TECHCH, PEFFCH, and SECH then amounts to the nal MPI. To determine the nal MPI, a close examination of Equations (2) and (5) reveal that we have to compute TECHCH, TE, and PEFFCH and then derive SECH by dividing

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TE by PEFFCH. Each output distance function corresponds to one particular output-oriented DEA linear programme. Among TECHCH, TE, and PEFFCH, there are six output distance functions, and thus, a total of six different DEA models have to be formulated and solved: Dt1 yt1 ; xt1 ; Dt1 yt ; xt ; Dt yt ; xt ; Dt yt1 ; xt1 ; Dtj1 yt1 ; xt1 ; Dtj yt ; xt (9)

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To illustrate, assume that there are N nancial institutions and that each varying amounts of K different inputs to produce M different outputs. The jth nancial institutions is therefore represented by the vectors xj yj and the K N input matrix X and the M N output matrix Y represent the data of all nancial institutions in the sample. In other words, xj is the input combinations for bank j, whereas yj is the output combinations for bank j.3 The purpose is to construct a non-parametric envelopment frontier over the data points such that all observed points lie on or below the production frontier. The calculations exploit the fact that the input distance functions, D, used to construct the Malmquist index are the reciprocals of Farrell (1957) output orientation technical efciency measures. The convexity constraint Ni l = 1 is introduced in Equations (10) (13) to assume variable returns to scale. By solving the equations with the same data under constant returns to scale and variable returns to scale, measures of overall technical efciency, TE, and pure technical efciency, PTE, are obtained. Hence, dividing the overall technical efciency, TE, by pure technical efciency, PTE, yields a measure of scale efciency, SE Dtj yt ; xt 1 maxu;l u s.t. yjt Yt l  0 uxjt Xt l  0 10

l0
Dtj1 yt1 ; xt1 1 maxu;l u s.t. yjt1 Yt1 l  0 uxjt1 Xt1 l  0 11

l0
Dtj1 yt ; xt 1 maxu;l u s.t. yjt Yt1 l  0 12

uxjt Xt1 l  0 l0

Dtj yt1 ; xt1 1 maxu;l u s.t. yjt1 Yt l  0 uxjt1 Xt l  0 13

l0

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Data sample, inputs outputs denition, and the choice of variables For the empirical analysis, all Malaysian conventional banks that offered Islamic banking window services were incorporated in the study. The annual balance sheets and income statements used to construct the variables for the empirical analysis were taken from published balance sheet information in annual reports of each individual bank. The denition and measurement of inputs and outputs in the banking function remains a contentious issue among researchers. To determine what constitutes inputs and outputs of banks, one should rst decide on the nature of banking technology. In the banking theory literature, there are two main approaches competing with each other in this regard: the production and intermediation approaches (Sealey & Lindley, 1977). Under the production approach, a nancial institution is dened as a producer of services for account holders; that is, they perform transactions on deposit accounts and process documents such as loans. Hence, according to this approach, the number of accounts or its related transactions is the best measure for output, while the number of employees and physical capital is considered as inputs. Previous studies that adopted this approach are by Sherman and Gold (1985), Ferrier and Lovell (1990), and Fried, Lovell, and Eeckaut (1993) among others. The intermediation approach on the other hand assumes that nancial rms act as an intermediary between savers and borrowers and posits total loans and securities as outputs, whereas deposits along with labour and physical capital are dened as inputs. Previous banking efciency studies that adopted this approach are, among others, Charnes, Cooper, Huang, and Sun (1990), Bhattacharya, Lovell, and Sahay (1997), and Sathye (2001). For the purpose of this study, a variation of the intermediation approach or asset approach originally developed by Sealey and Lindley (1977) will be adopted in the denition of inputs and outputs used.4 According to Berger and Humphrey (1997), the production approach may be more suitable for branch efciency studies, as at most times bank branches basically process customer documents and bank funding, while investment decisions are mostly not under the control of branches. 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 multi-product rms producing two outputs by employing three inputs. Accordingly, we assume Malaysian Islamic banks produce total loans ( y1) and income ( y2) by employing total deposits (x1), labour (x2), and xed assets (x3). Data for the empirical analysis are sourced from individual banks IBS annual balance sheet and income statements.5 Table 1 presents the summary of statistics for the outputs and inputs for Malaysian Islamic banking operations. A few conclusions can be drawn. First, over the 4-year period, total assets of Malaysian Islamic banking operations grew by about 71% to RM4.82 trillion in 2004 from RM2.82 trillion in 2001. Secondly, it is apparent that there has been increasing awareness among the Malaysian public about Islamic banking and nance during this period, substantiated by the growth in total loans (nancing) to the domestic economy and deposits from the Malaysian public in the same period. During the years (2001 2004), total loans and deposits grew by about 115% and by about 79%, respectively. Thirdly, conclusion could also be made about employment in the Islamic banking industry during this period. It is clear from Table 1 that the Malaysian Islamic banking and nance industry has created signicant employment for the period. As data on the number of employees are not readily made available, we use personnel expenses as a proxy measure. From Table 1 it is apparent that personnel expenses have

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Table 1. Descriptive statistics for inputs and outputs. 2001 (RMb) Outputs Total loans ( y1) Minimum Mean Maximum Standard deviation Income ( y2) Minimum Mean Maximum Standard deviation 2002 (RMb) 2003 (RMb)

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2004 (RMb)

26,377 1,441,734.71 6,409,411 1,937,174.37 3407 87,122.43 431,401 127,206.77

20,796 1,873,301 8,253,532 2,442,768.01 3961 107,506.93 490,847 153,407.31

17,096 2,499,915.20 11,703,438 3,263,292.70 5917 159,752.20 571,711 166,571.12

12,023 3,094,485.80 14,581,517 3,868,114.68 10,802 193,769.33 611,655 193,355.08

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Inputs Total deposits ( x1) Minimum Mean Maximum Standard deviation Labour ( x2) Minimum Mean Maximum Standard deviation Assets ( x3) Minimum Mean Maximum Standard deviation

79,679 2,384,403.93 9,064,966 3,019,347.63 389 7737.71 72,398 18,798.22 140,156 2,817,694.50 10,358,576 3,415,938.21

62,266 3,117,977.21 12,166,584 3,833,396.16 743 8703.93 75,172 19,579.20 93,056 3,512,071.79 13,204,458 4,222,744.81

97,797 3,726,400.40 12,577,435 4,094,701.14 895 14,726.2 88,137 26,396.60 150,511 4,381,516.13 15,578,265 4,757,408.56

627,564 4,269,593.13 15,965,833 4,510,658.40 653 16,115.47 93,865 27,972.43 834,447 4,821,954.73 15,578,265 4,570,657.78

expanded by  108% during the 4-year period. Finally, the Islamic banking and nance industry has increasingly generated awesome returns to Malaysian Islamic banks. During the period of study, we have witnessed more than 122% increase in the mean income of Malaysian Islamic banks, from a mere RM87, 122.43 billion in 2001 to RM193,769.33 billion in 2004.

Results In this section, we will discuss the productivity change of the Malaysian Islamic banking industry, measured by the MPI, and assign the changes in total factor productivity change (TFPCH) to technological change (TECHCH) and efciency change (EFFCH). We also attempt to attribute any change in EFFCH to changes in pure technical efciency (PEFFCH) and/or scale efciency (SECH). The summary of annual means of TFPCH, TECHCH, EFFCH, and its decomposition into PEFFCH and SECH for the years 2001 2004 is presented in Table 2. Because 2001 is the reference year, the Malmquist TFPCH index and its components take an initial score of 1.000 for 2001. Hence, any score greater (lower) than 1.000 in subsequent years indicates an improvement (worsening) in the relevant measures. Annual values of the indices for the industry and each Malaysian Islamic banks sub-group are provided in Tables 2 5.

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Table 2. TFPCH of Malaysian Islamic banking sector all banks. EFFCH Panel A (20012002) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Standard Chartered Bank Berhad Hong Kong Bank Berhad OCBC Bank Berhad Citibank Berhad Bank Islam Malaysia Berhad Geometric mean Maximum Minimum Standard deviation Panel B (20022003) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Standard Chartered Bank Berhad Hong Kong Bank Berhad OCBC Bank Berhad Citibank Berhad Bank Islam Malaysia Berhad Geometric mean Maximum Minimum Standard deviation Panel C (20032004) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Standard Chartered Bank Berhad 0.978 0.677 0.600 0.893 1.067 1.000 0.842 0.886 1.222 1.443 1.000 0.623 1.000 0.750 0.901 1.443 0.600 0.231 TECHCH 1.348 1.227 1.219 1.151 1.438 1.122 1.286 1.018 1.129 1.296 1.040 1.136 1.211 1.301 1.203 1.438 1.018 0.118 PEFFCH 1.000 0.717 0.689 0.922 1.051 1.000 1.000 0.929 1.290 1.000 1.000 0.586 1.000 1.000 0.925 1.290 0.586 0.175 SECH 0.978 0.944 0.871 0.968 1.015 1.000 0.842 0.953 0.947 1.443 1.000 1.062 1.000 0.750 0.974 1.443 0.750 0.155 TFPCH 1.319 0.831 0.732 1.027 1.535 1.122 1.082 0.901 1.380 1.870 1.040 0.708 1.211 0.976 1.084 1.870 0.708 0.321

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1.022 0.831 1.448 1.228 1.000 1.000 1.156 0.996 1.080 0.741 0.946 0.973 1.000 1.106 1.025 1.448 0.741 0.170

1.138 1.341 0.947 1.096 1.236 1.229 0.962 1.216 0.941 0.939 0.992 1.330 1.029 0.926 1.085 1.341 0.926 0.152

1.000 0.819 1.267 1.084 1.000 1.000 1.000 1.141 0.919 0.576 0.970 1.356 1.000 1.000 0.992 1.356 0.576 0.185

1.022 1.015 1.142 1.133 1.000 1.000 1.156 0.873 1.175 1.285 0.975 0.717 1.000 1.106 1.033 1.285 0.717 0.141

1.164 1.114 1.371 1.346 1.236 1.229 1.111 1.211 1.017 0.695 0.938 1.293 1.029 1.025 1.112 1.371 0.695 0.180

0.911 2.537 0.926 1.000 1.000 1.000 0.963 1.451 1.015 0.512

0.793 0.994 0.947 0.984 0.858 1.111 0.878 0.974 0.915 0.913

0.989 3.910 1.199 1.000 1.000 1.000 1.000 1.178 1.249 1.735

0.921 0.649 0.772 1.000 1.000 1.000 0.963 1.232 0.813 0.295

0.722 2.521 0.877 0.984 0.858 1.111 0.845 1.413 0.928 0.468
(Continued )

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Table 2. Continued. EFFCH Hong Kong Bank Berhad OCBC Bank Berhad Citibank Berhad Bank Islam Malaysia Berhad Geometric mean Maximum Minimum Standard deviation 1.026 2.065 0.329 1.266 1.023 2.537 0.329 0.568 TECHCH 0.967 1.016 0.856 0.896 0.933 1.111 0.793 0.080 PEFFCH 1.031 2.039 1.000 1.000 1.258 3.910 0.989 0.794 SECH 0.995 1.013 0.329 1.266 0.813 1.266 0.295 0.287

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TFPCH 0.992 2.098 0.282 1.134 0.954 2.521 0.282 0.592

Note: EFFCH, efciency change; TECHCH, technological change; PEFFCH, pure technical efciency change; SECH, scale efciency change; TFPCH, total factor productivity change.

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Total factor productivity growth of Malaysian Islamic banks As depicted in Panels A C of Table 2, the Malmquist results suggest that during the period of 2001 2004, Malaysian Islamic banks have exhibited TFPCH progress in years 2002 and 2003 before declining in year 2004. With respect to year 2001, the average TFPCH increase was 8.4% in year 2002, increasing to 11.2% in year 2003 before exhibiting 4.6% TFPCH regress in year 2004. During the years 2002 and 2003, TFPCH progress of the Malaysian Islamic banks was mainly due to TECHCH, which increased by 20.3% and 8.5%, respectively. On the other hand, the decline in the Malaysian Islamic banks TFPCH during the year 2004 was mainly due to the decline in TECHCH of 6.7% during that year. The empirical evidence seems to suggest that the Malaysian Islamic banks have exhibited 9.9% EFFCH decrease in 2002 before increasing by 2.5% in 2003. From Table 2 it is apparent that the Malaysian Islamic banks TECHCH declined by 6.7% in 2004; however, they have continued to record positive EFFCH of 2.3% during the year, albeit lower compared with the level recorded in 2003. The decomposition of the EFFCH index into its PEFFCH and SECH components suggest that the dominant source of the decrease in Malaysian Islamic banks EFFCH during the year 2002 was managerially related rather than scale-related, implying that the Malaysian Islamic banks were less efcient in controlling their costs during the years, rather than operating at the wrong scale of operations. Similarly, the results suggest that SECH has largely led to the increase in Malaysian Islamic banks efciency during the year 2003. During the year, the SECH of Malaysian Islamic banks increased by 3.3% while the PEFFCH declined by 0.8%. In contrast, during the year 2004 the results suggest that Malaysian Islamic banks have exhibited 22.0% decline in the SECH, which was offset by the 26.6% increase in PEFFCH during the year. Panels A C of Table 3 present the results for the Malaysian domestic Islamic banks (DOM_BNKS). As observed, the DOM_BNKS have exhibited TFPCH progress during all years, 7.5% in 2002 relative to 2001, increasing strongly to exhibit 18.5% TFPCH progress in 2003 relative to 2002 before declining markedly to record 6.6% increase in TFPCH in 2004 relative to 2003. The decomposition of the TFPCH index into its TECHCH and EFFCH components suggest that the decline in the DOM_BNKS TFPCH in 2004 was largely a result of the decline in TECHCH of 6.3% during the year. In contrast, the strong increase in the DOM_BNKS TFPCH in 2003 was also a result of the strong increase in TECHCH, which increased by 24.7%. The results thus suggest that like the TFPCH index, the DOM_BNKS TECHCH index also follow an inverted U-shaped behaviour during the period of our study. The decomposition of the EFFCH index into its

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Table 3. TFPCH of Malaysian Islamic banking sector domestic banks. EFFCH Panel A (20012002) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Bank Islam Malaysia Berhad 0.978 0.730 0.717 0.936 1.064 1.000 1.000 0.930 1.225 0.921 0.939 1.225 0.717 0.149 TECHCH 1.333 1.104 1.069 1.089 1.416 1.110 1.181 0.997 1.150 1.059 1.145 1.416 0.997 0.129 PEFFCH 1.000 1.000 0.745 0.955 1.000 1.000 1.000 0.901 1.006 1.000 0.957 1.006 0.745 0.083 SECH 0.978 0.730 0.963 0.980 1.064 1.000 1.000 1.032 1.219 0.921 0.982 1.219 0.730 0.122 TFPCH 1.304 0.805 0.767 1.019 1.506 1.110 1.181 0.928 1.409 0.975 1.075 1.506 0.767 0.249

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Geometric mean Maximum Minimum Standard deviation Panel B (20022003) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Bank Islam Malaysia Berhad Geometric mean Maximum Minimum Standard deviation Panel C (20032004) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Bank Islam Malaysia Berhad Geometric mean Maximum Minimum Standard deviation

1.022 0.725 1.223 1.069 1.000 1.000 1.000 0.916 0.854 0.791 0.950 1.223 0.725 0.144

1.138 1.521 1.138 1.282 1.244 1.233 1.165 1.320 1.177 1.302 1.247 1.521 1.138 0.115

1.000 1.000 1.340 1.047 1.000 1.000 1.000 1.120 1.000 1.000 1.046 1.340 1.000 0.109

1.022 0.725 0.913 1.021 1.000 1.000 1.000 0.818 0.854 0.791 0.908 1.022 0.725 0.110

1.164 1.103 1.392 1.370 1.244 1.233 1.165 1.209 1.006 1.030 1.185 1.392 1.006 0.128

0.911 2.537 0.916 1.000 1.000 1.000 0.937 1.451 1.002 1.266 1.138 2.537 0.911 0.500

0.793 0.995 0.957 0.985 0.858 1.111 0.910 0.974 0.924 0.896 0.937 1.111 0.793 0.086

1.000 1.000 1.001 1.000 1.000 1.000 1.000 1.178 1.000 1.000 1.017 1.178 1.000 0.056

0.911 2.537 0.914 1.000 1.000 1.000 0.937 1.232 1.002 1.266 1.120 2.537 0.911 0.492

0.722 2.525 0.877 0.985 0.858 1.111 0.852 1.413 0.926 1.134 1.066 2.525 0.722 0.524

Note: EFFCH, efciency change; TECHCH, technological change; PEFFCH, pure technical efciency change; SECH, scale efciency change; TFPCH, total factor productivity change.

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Table 4. TFPCH of Malaysian Islamic banking sector domestic banks (ex-full-edged Islamic banks. EFFCH Panel A (20012002) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad 0.978 0.730 0.717 0.936 1.064 1.000 1.000 0.930 1.223 0.941 1.223 0.717 0.157 1.022 0.725 1.223 1.069 1.000 1.000 1.000 0.916 0.854 0.970 1.223 0.725 0.139 0.911 2.537 0.916 1.000 1.000 1.000 0.937 1.451 1.002 1.125 2.537 0.911 0.529 TECHCH 1.333 1.104 1.069 1.089 1.416 1.110 1.189 0.997 1.151 1.156 1.416 0.997 0.133 1.138 1.521 1.138 1.282 1.244 1.233 1.165 1.320 1.177 1.242 1.521 1.138 0.121 0.793 0.995 0.957 0.985 0.858 1.111 0.910 0.974 0.924 0.941 1.111 0.793 0.090 PEFFCH 1.000 1.000 0.745 0.955 1.000 1.000 1.000 0.901 1.006 0.952 1.006 0.745 0.086 1.000 1.000 1.340 1.047 1.000 1.000 1.000 1.132 1.000 1.053 1.340 1.000 0.115 1.000 1.000 1.001 1.000 1.000 1.000 1.000 1.165 1.000 1.017 1.165 1.000 0.055 SECH 0.978 0.730 0.963 0.980 1.064 1.000 1.000 1.032 1.216 0.988 1.216 0.730 0.126 1.022 0.725 0.913 1.021 1.000 1.000 1.000 0.809 0.854 0.921 1.022 0.725 0.108 0.911 2.537 0.914 1.000 1.000 1.000 0.937 1.246 1.002 1.106 2.537 0.911 0.522 TFPCH 1.304 0.805 0.767 1.019 1.506 1.110 1.189 0.928 1.407 1.088 1.506 0.767 0.260 1.164 1.103 1.392 1.370 1.244 1.233 1.165 1.209 1.006 1.204 1.392 1.006 0.121 0.722 2.525 0.877 0.985 0.858 1.111 0.852 1.413 0.926 1.059 2.525 0.722 0.556

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Geometric mean Maximum Minimum Standard deviation Panel B (20022003) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Geometric mean Maximum Minimum Standard deviation Panel C (20032004) Afn Bank Berhad Alliance Bank Berhad Arab-Malaysian Bank Berhad EON Bank Berhad Hong Leong Bank Berhad Maybank Berhad Public Bank Berhad RHB Bank Berhad Southern Bank Berhad Geometric mean Maximum Minimum Standard deviation

Note: EFFCH, efciency change; TECHCH, technological change; PEFFCH, pure technical efciency change; SECH, scale efciency change; TFPCH, total factor productivity change.

PEFFCH and SECH components suggest that the dominant source of the decrease in the DOM_BNKS EFFCH in 2002 was purely technically related, whereas on the other hand the decline in the DOM_BNKS efciency in 2003 was scale-related rather than managerially related. Similarly, the results suggest that SECH has largely resulted in the increase

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in the DOM_BNKS EFFCH during the year 2004. In the same year, the DOM_BNKS SECH increased by 12.0% and the PEFFCH increased by 1.7%. To further check for the robustness of our results, we have also examined the results of domestic Malaysian Islamic banks (DOM_BNKS) excluding the full-edged Islamic banks (DOM_X_BNKS). The results are presented in Panels A C of Table 4. Similar to the results for the DOM_BNKS, during the period of study, the results suggest that DOM_X_BNKS have exhibited TFPCH progress during all years albeit higher. The results from Panels A C of Table 4 suggest that the DOM_X_BANKS have exhibited 8.8% TFPCH growth in 2002 relative to 2001, 20.4% progress in 2003 relative to 2002 and 5.9% growth in 2004 relative to 2003. Again, similar to the results for the domestic Malaysian Islamic banks, the decomposition of the TFPCH index into its TECHCH and EFFCH components suggest that the DOM_X_BNKS TFPCH growth during the years 2002 and 2003 was largely attributed to TECHCH, while EFFCH, which increased by 12.5%, has resulted in the TFPCH progress in 2004. It is apparent that the exclusion of the full-edged Malaysian Islamic banks has resulted in higher TECHCH during the years 2002 and 2004. The results of the decomposition of the DOM_X_BNKS EFFCH
Table 5. TFPCH of Malaysian Islamic banking sector foreign banks. EFFCH Panel A (20012002) Standard Chartered Bank Berhad Hong Kong Bank Berhad OCBC Bank Berhad Citibank Berhad Geometric mean Maximum Minimum Standard deviation Panel B (20022003) Standard Chartered Bank Berhad Hong Kong Bank Berhad OCBC Bank Berhad Citibank Berhad Geometric mean Maximum Minimum Standard deviation Panel C (20032004) Standard Chartered Bank Berhad Hong Kong Bank Berhad OCBC Bank Berhad Citibank Berhad Geometric mean Maximum Minimum Standard deviation 1.443 1.000 0.905 1.000 1.069 1.443 0.905 0.242 TECHCH 1.296 1.040 1.168 1.211 1.175 1.296 1.040 0.107 PEFFCH 1.000 1.000 1.000 1.000 1.000 1.000 1.000 0.000 SECH 1.443 1.000 0.905 1.000 1.069 1.443 0.905 0.242 TFPCH 1.870 1.040 1.057 1.211 1.256 1.870 1.040 0.391

0.823 1.000 1.105 1.000 0.977 1.105 0.823 0.117

0.887 0.890 1.418 1.011 1.031 1.418 0.887 0.251

0.695 1.000 1.000 1.000 0.913 1.000 0.695 0.153

1.184 1.000 1.105 1.000 1.069 1.184 1.000 0.089

0.730 0.890 1.567 1.011 1.007 1.567 0.730 0.364

0.578 1.000 1.000 0.470 0.722 1.000 0.470 0.278

0.994 1.279 1.696 1.041 1.224 1.696 0.994 0.321

1.438 1.000 1.000 1.000 1.095 1.438 1.000 0.219

0.402 1.000 1.000 0.470 0.659 1.000 0.402 0.327

0.574 1.279 1.696 0.489 0.883 1.696 0.489 0.579

Note: EFFCH, efciency change; TECHCH, technological change; PEFFCH, pure technical efciency change; SECH, scale efciency change; TFPCH, total factor productivity change.

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into its PEFFCH and SECH components suggest that the exclusion of the full-edged Malaysian Islamic banks has resulted in higher SECH during the years 2002 and 2003. On the other hand, PEFFCH seems to have declined in 2002, increased in 2003, and remained the same in 2004. The results for the foreign Islamic banks (FOR_BNKS) are presented in Panels A C of Table 5. As observed, during the period of study the FOR_BNKS TFPCH was on a declining trend, exhibiting TFPCH progress of 25.6% in 2002 before declining substantially to exhibit TFPCH increase of only 0.7% in 2003 relative to 2002. It is also apparent from Panel C of Table 5 that the FOR_BNKS have exhibited 11.6% TFPCH regress in 2004. The decomposition of the TFPCH index into its TECHCH and EFFCH components suggest that the decline in the FOR_BNKS TFPCH in 2004 was largely attributed to the decline in EFFCH of 27.8% during the year. Unlike the DOM_BNKS, the results suggest that EFFCH has largely resulted in the increase in the FOR_BNKS TFPCH in 2002 and 2003. The FOR_BNKS TFPCH regress during the year 2004 was also the result of the decline in EFFCH. The decomposition of the EFFCH index into its PEFFCH and SECH components suggest that the dominant source of the decrease in the FOR_BNKS EFFCH in 2003 was managerially related, whereas on the other hand the decline in the FOR_BNKS efciency in 2004 was scale-related rather than managerially related. Similarly, the results suggest that SECH has largely resulted in the increase in the FOR_BNKS EFFCH during the year 2002. During the year 2002, the FOR_BNKS SECH increased by 6.9% while the PEFFCH was stagnant. Univariate tests After examining the Malmquist results, the issue of interest now is whether the two samples were drawn from the same population and whether the domestic and foreign banks possess the same technology. The null hypothesis tested was that the domestic banks and foreign banks were drawn from the same population or environment. We tested the null hypothesis that the domestic and foreign banks were drawn from the same population and have identical technologies by using a series of parametric (ANOVA and t-test) and non-parametric (KolmogorovSmirnov, MannWhitney (Wilcoxon Rank-Sum), and KruskallWallis) tests. Based on most of the results presented in Table 6, we failed to reject the null hypothesis at the 0.05 levels of signicance that the domestic banks and foreign banks were drawn from the same population and have identical technologies. This implies that there is no signicant difference between the domestic and foreign banks technologies (frontiers) and that it is appropriate to construct a combined frontier. Furthermore, the results from Levenes test for equality of variances do not reject the null hypothesis that the variances among domestic banks and foreign banks were equal, implying that we could assume the variances among domestic and foreign banks to be equal. Our ndings corroborate with those by, among others, Sathye (2001) and Isik and Hassan (2002). Conclusion and directions for future research This paper attempts to investigate the productivity changes of Malaysian Islamic banks during the period of 20012004, by applying a non-parametric MPI method. The preferred methodology has allowed us to isolate efforts to catch up to the frontier (efciency change) from shifts in the frontier (technological change). Also, the Malmquist index enables us to explore the main sources of efciency change: either improvements in management practices (PTE change) or improvements towards optimal size (scale efciency change). Additionally,

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Table 6. Summary of parametric and non-parametric tests for the null hypothesis that domestic banks (db) and foreign banks (fb) possess identical technologies (frontiers). Test groups Parametric test Individual tests Hypotheses Test statistics Productivity change (TFPCH) Technological change (TECHCH) Efciency change (EFFCH) Pure technical efciency change (PEFFCH) Scale efciency change (SECH) Analysis of variance (ANOVA) test Meandb = meanfb F ( p . F) 0.101 (0.752) 0.598 (0.282) 0.820 (0.053) 0.533 (0.395) 0.590 (0.295) t-test Kolmogorov Smirnov (K S) test Distributiondb = distributionfb K S ( p . KS) 0.342 (1.000) 0.586 (0.883) 0.488 (0.971) 0.537 (0.936) 0.683 (0.739) Non-parametric test MannWhitney (Wilcoxon Rank-Sum) test Mediandb = medianfb z ( p . z) 2 0.168 (0.867) 2 0.445 (0.656) 2 0.088 (0.930) 2 0.084 (0.933) 2 0.571 (0.568) Kruskall Wallis equality of populations test

T ( p . t) 0.318 (0.752) 0.531 (0.598) 0.229 (0.820) 0.628 (0.533) 0.543 (0.526)

x2 ( p . x2)
0.028 (0.867) 0.198 (0.656) 0.008 (0.930) 0.007 (0.933) 0.326 (0.568)

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Note: Test methodology follows among others, Aly, Grabowski, Pasurka, and Rangan (1990), Elyasiani and Mehdian (1992), and Isik and Hassan (2002). Parametric (ANOVA and ttest) and non-parametric (KolmogorovSmirnov, MannWhitney, and Kruskall Wallis) tests test the null hypothesis that the domestic and foreign banks were drawn from the same efciency population (environment). The numbers in parentheses are the p-values associated with the relative test.

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we have also performed a series of parametric and non-parametric tests to examine whether the domestic and foreign banks were drawn from the same set of population. Our results suggest that Malaysian Islamic banks productivity have exhibited an inverted U-shaped behaviour during the period of our study. The Malaysian Islamic banks have exhibited 8.4% productivity progress in year 2002, increasing to record the highest productivity change of 11.2% in 2003, before declining to record 4.6% productivity regress in 2004. Our results suggest that the domestic banks have exhibited higher productivity growth compared with their foreign counterparts. The decomposition of the productivity change index suggests that Malaysian Islamic banks productivity progress was mainly attributable to technological change rather than efciency change during the years 2002 and 2003, whereas the opposite was true during the year 2004 when the results suggest that Malaysian Islamic banks have exhibited higher efciency change. Further decomposition of the efciency change index into its pure technical and scale efciency components suggests that during the period of study pure technical efciency has largely resulted in an increase in the Malaysian Islamic banks efciency. However, the results may have to be interpreted with caution as Malaysian Islamic banks were found to have exhibited pure technical efciency decline in 2000 and 2003 before increasing strongly in 2004, which has eliminated the negative effects of 2002 and 2003. Further, to address the issue whether the domestic and foreign banks were drawn from the same sample of population or environment, or whether the domestic and foreign banks have the same technological (frontiers) attribution, we have performed a series of parametric and non-parametric tests. Our results from the parametric and non-parametric tests could not reject the null hypotheses at the 0.05 levels of signicance that the domestic and foreign banks were drawn from the same population or environment, suggesting that it is appropriate to construct a single frontier for both the domestic and foreign banks. The general conclusion that can be drawn from the ndings is that, in recent years, the full-edged Islamic banks seems to have under-performed their window-based Islamic banking peers, due to sub-optimal scale of operations. The principal ndings for the period under study indicate that technical efciency scores are improving more for the conventional banks offering Islamic banking products and services than for the fulledged Islamic banks. Thus, the results suggest that for the full-edged Islamic bank to be efcient, they need to reduce their size. The results are generally consistent with earlier studies, which have found that the larger banks tend to be less efcient. The emergence of two foreign banks, i.e. Citibank and Hong Kong Bank, as the global leaders may be mainly explained by (1) advantages gained from their long-term involvement in the Malaysian banking sector, (2) their ability to mobilise Islamic banking funds from the Middle East (due to their wide international presence), and (3) their dynamism and innovativeness in introducing and promoting new Islamic banking and nance products, to meet domestic needs. Foreign banks are also considered to possess inherent economies of scale, as a direct extension of their other international operations and so are capable of competing with the incumbent domestic banks. From the policy-making perspective, the results may imply that the opening up of the Islamic banking sector to the entry of foreign banks as an important measure in the on-going process of efciency improvement and innovation, as well as increasing globalisation of the Malaysian nancial system. Due to its limitations, the paper could be extended in a variety of ways. Further analysis into the investigation of Malaysian Islamic banks productivity is suggested to consider the risk exposure factors. To establish overall Islamic banks performance, risk exposure factors should be taken into consideration along with the productive efciency measures. The best banks may not necessarily be the most efcient producer of loans, but also ones

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that balances high efciency with low risk assumptions. Investigation of changes in the efciency changes over time by employing the DEA method could yet be another extension to the paper. Future research into the efciency and productivity of Malaysian Islamic banks could also consider the production function along with the intermediation function. Despite these limitations, the ndings of this study are expected to contribute signicantly to the existing knowledge on the operating performance of the Malaysian Islamic banking industry. Nevertheless, the study has also provided further insight into the banks specic management style as well as the policymakers in regard to attaining optimal utilisation of capacities, improvement in managerial expertise, efcient allocation of scarce resources, and most productive scale of operation of the banks in the industry. This may facilitate directions for sustainable competitiveness of future Islamic banking operations in Malaysia.
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Notes
1. Riba, the English translation of which is usury, is prohibited in Islam and is acknowledged by all Muslims. The prohibition of riba is clearly mentioned in the Quran, the Islams holy book and the traditions of Prophet Muhammad (sunnah). The Quran states: Believers! Do not consume riba, doubling and redoubling. . . (3.130); God has made buying and selling lawful and riba unlawful. . . (2:274). 2. The Malmquist total factor productivity index was not invented by Malmquist. In his paper (Malmquist, 1953), he brought input functions of distance into an analysis of consumption, developing a method for the empirical measurement of standard of living. The change in living standards is dened as the ratio of two input functions of distance. Before the Malmquist paper, the input function of distance was brought into a paper by Debreu (1951), and the output function of distance was introduced by Shephard in his book (Shephard, 1953). The natural development of their papers was the denition of the index of change of total factor productivity as the ratio of two input or output functions of distance. Some 31 years had to pass before it arrived. The Malmquist index of change in total factor productivity was proposed in a paper for the rst time in Caves, Christensen, and Diewert (1982) Today, these indices are entitled partially oriented indices of change in total factor productivity. In the case of production technology that satises the constant yields axiom, the indices are the same. 3. For easy understanding, the study denotes by j, y, and x to represents a particular bank j, outputs and inputs, respectively. In other words, it denotes the possible combinations of outputs and inputs for a particular bank j at time t and t 1. 4. Humphrey (1985) presents an extended discussion of the alternative approaches of what a bank produces. 5. Only data from IBS accounts are used. Malaysian conventional banks offering Islamic banking window services are required to maintain a separate IBS account. Hence, the data used are not contaminated with the conventional banking operations.

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