The Competitiveness Comparison Between

Islamic Banks and Conventional Banks :

Case of Indonesian Banking System
Presenter: Cupian (G1211025)
Supervisor : Dr. Muhammad Abduh
Ph.D Colloquium
Institute of Islamic Banking and Finance
International Islamic University Malaysia
November 2nd-3rd, 2014

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Outline
Introduction
Problem Statement
Research Objective

Theoretical Framework
Methodology
Expected results/findings

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Significance of the Study

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INTRODUCTION
Banking competition has escalated over the past couple decades.
Large financial institutions are strategically penetrating new markets
and try to offer a diverse spectrum of products and services to
strengthen their existence and boost their profitability. Among such
developments is the expansion of Islamic banking since seventies,
and its growing recognition as a viable mode of financing.

The competitive environment of the banking system in Indonesia has

experienced several changes in recent decades. The deregulation of
financial services in Indonesia allows banks to freely establish
branches and provide financial services throughout this country.

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The recent global financial crisis severely hits the banking system of
several countries in the world and forces government to intervene in
the financial sector. All these events can bring a change in
concentration and competition in the banking systems.

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Problem Statement

the recent global financial crisis has severely hit the

Indonesian banking system forces government to
intervene in the financial sector and it could have an
impact on the competitiveness of the system

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The deregulation of financial services in Indonesia

allowing banks to freely establish branches and provide
financial services can bring a change in concentration and
competition in the banking systems.

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Research Objectives
Empirically assessment of the competitive structure of the
Indonesia banking system, both Islamic and conventional.

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Investigation on an implication of the deregulation of

financial services in Indonesia and the recent global financial
crisis on the competitiveness of Indonesian banking system.

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Research Questions
Q1:
What are the competitive structure of the Indonesia banking
system both conventional and Islamic over the period 20062013?

What are the impact of input prices of deposit, physical

capital and labor on the revenue of Islamic and conventional
banks?

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Q2:

Q3:

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Research Questions
What are the impact of total asset and equity ratio on the
revenue of Islamic and conventional banks?

Q4:

Q5:
What are the impact of total asset and equity ratio on the
revenue of Islamic and conventional banks?

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What are the impact of efficiency on performance increases

as the market becomes more competitive?

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Significance of the study

Knowledge gained from the study will provide

government with information about how to make a
financial policy which can create a competitive
market in the banking sector.

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the results of this study may help bank managers

determine the key success (or failure) factors of
Islamic and conventional banks in the competitive
market .

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1

Financial Deregulation and Financial

Crisis and Technological advance

Market Structure

Market concentration and competition

Monopoly
Oligopoly
Monopolistic Competition and
Perfect Competition.

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The overall Research Framework

Efficiency
Profitability
Performance

Dual Banking Sector

Conventional Banks

The empirical analysis of the link between competition

and profitability of the banking system
Assessment the competitive structure of the
Indonesia banking system
the impact of input prices of deposit, physical
capital and labor on the revenue of Islamic
and conventional banks

The deregulation of financial services in Indonesia, technological

advancement and the recent global financial crisis on the
competitiveness of the system.
the estimation of the Boone indicator pre and post financial
crisis
identify a change in the degree of competition

Boone indicator
translog total cost function
seemingly unrelated regression

1.
2.

H statistic of the Panzar-Rosse model

ordinary least square (OLS) and fixed effects(FE)
estimators

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Islamic Banks

Banking System Stability

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Literature Review
Differences between Islamic and conventional bank
SCP and ES Theory
Studies on banking using Panzar Rosse Model

Studies on banking in Indonesian Banking System

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Studies on banking using Boone Indicator Model

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The conventional bank operation is to purchase transactions

deposits from the depositors at a low interest rate, then allocate
those funds to the households and firms at a higher interest rate,
earning an interest spread based on its competitive advantage.
Meanwhile, Islamic banking considered as a different banking
stream as it prohibits interest and replaces with a profit share.
Moreover, another principle of an Islamic bank is the avoidance
of economic activities involving oppression.
2000)

(Santos

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Differences between Islamic and

Conventional Bank

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The structure-conduct-performance (SCP) hypothesis and

the efficient-structure (ES) hypothesis

Under the ES hypothesis the positive statistical relation between

profitability and industry concentration could be explained by efficiency
gains of banks. Empirical evidences support both hypotheses. Smirlock
(1985) finds evidence in favour of the ES hypothesis using U.S. banks.
Berger (1995) also finds that the ES hypothesis holds in the U.S.
banking system. In contrast, Goddard et al. (2001) find evidence in
favour of the SCP paradigm for European banking systems.

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The SCP paradigm assumes that in concentrated markets, banks can

easily arrange collusive agreement and exercise market power.
Empirically, a positive relationship between profitability and market
concentration indicates that the market is less competitive. The ES
hypothesis on the other hand asserts that the positive relationship
between profit and concentration in concentrated markets could result
from the banks efficiency gains (cost advantage) contrary to the
collusive behavior.
(Demsetz, 1974)

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Studies on banking using Panzar Rosse Model

Authors
Shaffer (1982)

Countries
New York (USA)

Periods

Results
monopolistic competition

Casu and Girardone (2006)

European Union countries

1997-2003.

monopolistic competition

Molyneux et al. (1994)

EU countries

1986-1989

Nathan and Neave (1989)

Canada

1982-1984

Banks in France,
Germany, Spain and the
UK operate under
monopolistic competition
and the monopoly for
Italy.
perfect competition for
1982 and monopolistic
competition for 1983 and
1984

Vesala (1995)

Finland

1985-1992

monopolistic competition
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Studies on banking using Boone Indicator Model

Authors

Leuvensteijn et al.
(2007)

Countries

France, Germany, Italy,

the Netherlands, Spain,
the UK, the U.S. and
Japan.

Periods

1994-2004

Results

Tabak et al. (2011)

Schaeck and Cihak

(2008, 2010)
Leuvensteijn et al.
(2008)

U.S. has the most

competitive loan
market.
In the EU, German and
Spain were found to
have a competitive loan
market.
commercial banks to
operate under a more
competitive
environment than
savings banks.

10 Latin American
countries banking
systems
European countries and
rural U.S. banks
eight European countries
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Periods

Method

Results
The Islamic banks in
general have a lower
degree of stability
compared to
conventional ones the

Gamaginta, Rokhim, (2010)

2004 - 2009

Z-score
indicator. Using
the parametric
statistical t-test,

Widyastuti,
Armanto, (2012)

2001 - 2006

Panzar and
Rosse

The competition in
banking
decreased after the
introduction of API,
with a large tendency to
monopoly or collusive
oligopoly

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Authors

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Studies on banking in Indonesian Banking System

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Scope and Limitation Study

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This study focuses on the Islamic and Conventional banking

sector in Indonesia with the observation period of 2006 2013. The number of commercial banks was 88 commercial
banks including 75 conventional banks and 13 Islamic banks
which are treated equally as individual bank separated from
their holding.

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Methodology
The non-structural approach
The Panzar-Rosse Model

Data analysis
variables

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Relative Profit Differences

(The Boone Indicator)

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The Panzer-Rosse model

the sum of the elasticities ofbank revenue function

with respect to input prices

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The method attempts to infer the competitive

The method
inferthe
the
competitive
structureattempts
of a market by to
observing
response
of a
banks
revenues
to changes in cost
of response of
structure
ofequilibrium
a market
by observing
the
banks production.
equilibrium revenues to changes in cost of
The PR approach introduces H-Statistic, which is the
production.
sum of the elasticities ofbank revenue function with
to input prices
The PRrespect
approach
introduces H-Statistic, which is

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The rejection of the null hypothesis H < 0 rules out

the monopoly market structure

the rejection of both H < 0 and H = 1 the (but not

the H < 1 ) hypothesis indicates monopolistic
competition.

the rejection the H < 1 hypothesis, it indicates

perfect competition.
This interpretation is valid under the assumption that the
observations are in the long-run equilibrium (Nathan & Neave,
1989).

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Empirical Application

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In the econometric analysis this paper estimates

the H-statistic from the following log-linear reducedform bank revenue equation for a panel dataset:

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Price of labor (W3)

Ratio of personnel expenses to total assets. Personnel expenses include wages and salaries, and other
staff-related expenses. It is used as a proxy for the unit price of labor.

Marginal cost (MC)

It is the cost of producing one more unit of output. It is calculated by estimating a separate cost
function (7).
Ratio of net loans to total assets. Net loan is calculated as gross loans minus provision for nonperforming loans. The variable is used to capture risk preference.
It is the sum of the value of equity and liability. The variable is used to capture possible scale
economy.
Ratio of equity to total assets. It captures the impact of leverage.
It is the total earning assets. It includes loans, securities, insurance assets and investments in property.
The variable is used as a proxy for bank level output

Loans ratio (Z1)

Total assets (Z2)

Equity ratio (Z3)

Output (q)

*) For Islamic banks, the category of loans is substituted by financing activities

and interest revenues are called financing revenues. Similarly, the interest expense
item is labeled financing expenses.

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Definition
Total interest and dividend income plus non-interest operating income.
Total operating expenses. It includes interest expenses, personnel expenses, and other operating
expenses.
Gross Interest Income (GII) * Interest income on loans, other interest income, and dividend income.
)
Return on Assets (ROA)
The ratio of before-tax profit to total assets. It captures all sources of income.
Price of deposits (W1)
Ratio of interest expenses to total deposit and short-term funding (Current accounts, saving accounts,
time deposits, interbank deposits and alternative funding sources such as securities). It is a proxy for
the unit price of borrowing funds.
Price of physical capital (W2) Ratio of depreciation expenses and administrative expenses to total assets. Administrative expenses
include such as advertisement, security, information technology, and insurance expenses. The
variable is used as a proxy for the unit price of physical capital.

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Variable
Total Revenue (TR)
Total Cost (TC)

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The research methodology will be started by collecting the required

data from Central Bank of Indonesia database. The data are publicly
available in the quartally published Balance Sheet accounts and
Income Statements of individual banks. The sample consists of 88
commercial banks including 75 conventional banks and 13 Islamic
banks operating in Indonesia and they are treated equally as
individual bank separated from their holding.

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Data Analysis

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Collecting
Secondary Data

Data of Islamic Banks

and Conventional Banks
being separated

Process by
Regression Model

Summary

the Boone
indicator
model

analyzed using the

Panzar-Rosse (PR)
model and

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Procedure

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Leuvensteijn, M., Bikker, J.A., van Rixtel, A. & Kok-Sorensen, C. (2007): A new
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Working Paper No. 0768.

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References

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