Humanomics

Efficiency analysis of Islamic banks in Pakistan

Muhammad Tariq Majeed Abida Zanib
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Humanomics, Vol. 32 Iss 1 pp. 19 - 32

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Efficiency analysis of Islamic Efficiency

analysis of
banks in Pakistan Islamic banks
Muhammad Tariq Majeed and Abida Zanib
School of Economics, Quaid-i-Azam University, Islamabad, Pakistan
19
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Abstract
Purpose – This paper aims to empirically analyze the efficiency of full-fledged Islamic banks, Islamic
branches of conventional banks and conventional banks in Pakistan.
Design/methodology/approach – The paper uses data envelopment analysis to measure and
compare the efficiency of banks. Three measures of efficiencies such as total technical efficiency, pure
technical efficiency and scale efficiency are computed to achieve the objective of the paper.
Findings – Overall, full-fledged Islamic banks are less efficient in terms of total technical efficiency
and pure technical efficiency than conventional banks. However, Islamic branches of conventional
banks are highly scale-efficient than their counterparts.
Research limitations/implications – The findings need to be supported by considering production
function and risk exposure factors.
Originality/value – This paper evaluates and compares the efficiency of Islamic and conventional
banks by utilizing the largest available data set during 2007-2014.
Keywords Islamic banking, Efficiency analysis, Data envelopment analysis
Paper type Research paper

1. Introduction
Conventional financial tactics have landed humanity into an abyss of problems,
including financial crisis. As a feasible alternative financial setup, Islamic financial
industry has become an attention-grabbing area in the wake of the recent global
financial crisis (Khan, 2009). Sharia’h-based values of the Islamic financial system have
attracted investors across the world, who are frustrated with the conventional banking
setup (Arthur, 2009). Today, Islamic banks are not only increasing their involvement in
social and economic activities but also wrapping large amount of deposits. According to
WIBC report (2014), the global annual growth of Islamic banking assets is 17.4 per cent.
Indeed, Islamic banks are growing fast because they are based on the foundation and
properties of the unity of knowledge which stem from the divine concept of Tawhid.
This concept represents believing in the oneness of God as comprehensive knowledge.
Thus, the unity of knowledge promotes a learning system to analyze the issues of world
economy, including financial institutions. Particularly, the explanation of Tawhid in
relation to zakat[1] is that Islamic banks emphasize on the wealth circulation with the
objective of well-being of the entire society. Indeed, zakat is mobilized by Islamic banks
as an important form of development financing instrument, for instance, Qard Hasan
that is completely an interest-free loan and Mudarabah that enables poor to contribute Humanomics
as a shareholder by utilizing the amount of money received as zakat. Moreover, trade Vol. 32 No. 1, 2016
pp. 19-32
financing allows to revolve zakat to facilitate the zakat recipient. In this way, Islamic © Emerald Group Publishing Limited
0828-8666
financial instruments lead to well-being (Choudhury and Harahap, 2008). DOI 10.1108/H-07-2015-0054
 H This study focuses on Pakistan that is among those Muslim majority countries that
32,1 operate a dual banking system. Indeed, recently, the State Bank of Pakistan has allowed
conventional banks to offer Islamic banking services and financial contracts at separate
branches. According to the Islamic Banking Bulletin[2] (SBP, 2014) report, 5 full-fledged
Islamic banks and 15 conventional banks are offering separate Islamic branches. Most
of the Islamic banks started operation in 2006. The number of Islamic bank branches has
20 reached 1,314 in 2014 as compared to 150 in 2007. The Islamic banking industry in
Pakistan has recorded impressive growth in terms of deposits, assets and investment
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during the past eight years. For example, the total assets of the Islamic banking industry
have elevated sharply up to Rs 1,016 billion in 2014 from Rs 118 billion in 2007. The total
deposits accumulated by the Islamic banking industry increased tremendously to
Rs 872 billion in 2014 from Rs 83 billion in 2007. The total investment rose rapidly up to
Rs 354 billion in 2014 from Rs 72 billion in 2007. Islamic banks are wrapping 11.4 per
cent market share of the financial sector in 2014 as compared to 0.5 per cent market share
in 2003. Thus, it is interesting to scrutinize whether the growth is the result of a higher
efficiency level. Findings of the paper provide useful information to bank management
and policymakers.
The literature shows that the global recognition of Islamic banks cannot be denied in
a macroeconomic context. However, in terms of microeconomic environment, various
studies such as Mokhtar et al. (2008), Saeed et al. (2013) and Johnes et al. (2013) conclude
that Islamic banks are less efficient than convention bank. Chapra (2007) mentions that
the reason behind the less efficiency of Islamic banks is threefold: First, the core features
of Islamic financial contracts, particularly in terms of collateral, maturity and
repayment, are unique for different clients and thereby increase management cost.
Second, Islamic banks are relatively smaller than conventional banks. Researchers
conclude that larger banks are technically more efficient than smaller banks (Miller and
Noulas (1996), Drake et al. (2006)). Third, almost all Islamic banks are domestically
owned. Studies by Matthews and Ismail (2006) and Rahim et al. (2013) determine that
foreign banks are technically more efficient than domestic banks.
The rapid growth of Islamic banking, particularly in Muslim economies such as
Saudi Arabia, Qatar, Malaysia, Pakistan, Turkey, Indonesia and United Arab Emirates,
has generated a debate among researchers about the efficiency and its derivers. Indeed,
a study comparing the efficiency of Islamic and conventional banks is an
attention-grabbing area. Many previous studies (Yusdistira, 2004; Hassan, 2006; Noor
et al., 2010; Ahmad and Noor, 2011; Rahim et al., 2013; Rosman et al., 2014) have
concentrated on the efficiency performance of only Islamic banks. Some studies
(Mokhtar et al., 2008; Saeed et al., 2013; Johnes et al., 2013) have compared the efficiency
of Islamic and conventional banks, and just few studies by Kamaruddin et al. (2008) and
Siddique and Rahim (2013) have comparatively analyzed the efficiency of Islamic banks
and Islamic branches of conventional banks.
In spite of the availability of latest data, the literature discloses the apparent lack of
efficiency evaluation of Islamic banks by using a large sample of time frame. Therefore,
this paper attempts to contribute in the literature by comparatively evaluating the
efficiency performance of three types of banks that are full-fledged Islamic banks,
Islamic branches of conventional banks and conventional banks in Pakistan by
extending the time frame from 2007 to 2014. This paper addresses the following
research question:
 RQ1. Which type of banks is more efficient in terms of technical, allocative and scale Efficiency
efficiency in Pakistan? analysis of
The remainder of the paper is planned as follows. Section 2 illustrates brief literature Islamic banks
review. Data and methodology are described in Section 3. Section 4 discusses results.
Finally, conclusion and policy implications are presented in Section 5.

2. Literature review 21
Efficiency measurements are utilized to analyze banks’ performance. Three major
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methods are used to analyze efficiency. First two are maximization of profit and output.
The third is minimization of cost. Efficiency comprises two components like technical
efficiency and allocative efficiency. A bank is considered technically efficient if it
obtains maximum output with a given set of input. In contrast, allocative efficiency
reflects the ability of a bank in minimizing the input to achieve the same level of output
(Fare et al., 1985).
Literature reveals that various studies focused on the efficiency of Islamic banks
either alone or in comparison with conventional banks conducted in different countries
(for detail see Table I). Previous comparative studies provide mixed evidence. Two
studies (Muharrami, 2008; Johnes et al., 2013) claim the higher efficiency of Islamic
banks than conventional banks. However, Muharrami (2008) utilizes a small sample of
banks and does not conduct a test of significance. Some studies by Bader et al. (2008),
Abdelkader and Salem (2013), Rozzani and Rahman (2013) and Sillah et al. (2014) reveal
no difference between the efficiency of Islamic and conventional banks. Other studies by
Hassan (2006), Srairi (2010) and Saeed et al. (2013) disclose the low efficiency of Islamic
banks than conventional banks. Hassan (2006) and Saeed et al. (2013) do not mention
whether the reason of the low efficiency of Islamic banks is a small sample size.
In contrast, some studies measure the efficiency of Islamic banks in isolation, such as
Yusdistira (2004) finds that the overall inefficiency of Islamic banks is small at about 10
per cent and small to medium banks are facing diseconomies of scale. He further
suggests that the problem of diseconomies of scale can be overcome by merging small
Islamic banks with large financial institutions. Ahmad and Noor (2011) describe that
world Islamic banks prove to be highly pure and technically efficient. It attributes to
their less operating expenses relative to size, assets, equity and the level of national
income. They also reveal a positive association between the technical efficiency and
profitability of Islamic banks. While focusing on the efficiency performance of
Malaysian Islamic banks, Rahim et al. (2013) find that foreign-owned Islamic banks are
more efficient than domestically owned Islamic bank in terms of pure technical and
allocative efficiency. However, they do not explore further the reason for this finding.
Rosman et al. (2014) disclose that operation at Asian and Middle Eastern Islamic banks
sustained during crisis and most of the Islamic banks exhibited scale inefficiency due to
diseconomies of scale.
Another group of studies compare the efficiency of full-fledged Islamic banks and
Islamic windows of conventional banks. Mokhtar et al. (2008) conclude that the overall
efficiency of Islamic banks boosts in Malaysia over the period 1997 to 2003. They
disclose that the efficiency level at full-fledged Islamic banks is higher than Islamic
windows, but lower than conventional banks. Furthermore, they find that Islamic
windows at foreign banks unveil higher efficiency than Islamic windows at domestic
banks. To some extent differently, while scrutinizing cost and profit efficiency,
 H Studies Sample countries Methods
32,1
Comparative studies
Islamic banks are more efficient than conventional banks
Muharrami (2008) GCC; Saudi Arabia, UAE, Kuwait, Qatar, Oman, Bahrain DEA
Johnes et al. (2013) Bahrain, Bangladesh, Yamen, Bahrain, UAE, Turkey, MFA
22 Egypt, Sudan, Palestine, Indonesia, Tunisia, Jordan, DEA
Saudi Arabia, Kuwait, Qatar, Malaysia, Pakistan
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Islamic banks are less efficient than conventional banks

Srairi (2010) GCC: Saudi Arabia, UAE, Kuwait, Qatar, Oman, Bahrain SFA
Saeed et al. (2013) Pakistan DEAFRA
Hassan (2006) World DEA
No significant difference between efficiency of Islamic and conventional banks
Bader et al. (2008) OIC: DEA
Africa; Algeria, Tunisia, Senegal, Gambia and Sudan
Asia; Malaysia, Bangladesh, Brunei, Pakistan and
Indonesia
Middle East; UAE, Bahrain, Kuwait, Lebanon, Iran,
Jordan, Turkey, Saudi Arabia and Yamen
Abdelkader and MENA countries DEA
Salem (2013)
Sillah et al. (2014) Saudi Arabia SFA
Rozzani and Malaysia SFA
Rahman (2013)
Studies comparing efficiency at full-fledged Islamic banks and Islamic branches of conventional banks
Mokhtar (2008) Malaysia DEA
Siddique and Pakistan DEA
Rahim (2013)
Kamaruddin et al. Malaysia DEA
(2008)
Studies measuring efficiency of Islamic banks only
Rosman et al. Bahrain, Yemen, Iraq, Iran, Lebanon, Philippine, DEA
(2014) Indonesia, Palestine, Malaysia, Jordan, Turkey, Kuwait,
Sudan, Brunei Darussalam, Saudi Arabia, Pakistan,
United Arab Emirates, Singapore, Syria and Qatar
Rahim et al. (2013) MENA and Asian countries DEA
Ahmad and Noor World DEA
(2011)
Rahim et al. (2013) Malaysia DEA
Table I. Yusdistira (2004) World DEA
Studies measuring
efficiency of Islamic Notes: DEA⫽ data envelopment analysis; SFA⫽ stochastic frontier approach; MFA⫽ meta frontier
banks analysis

Kamaruddin et al. (2008) find that instruments at Islamic banks are more competent in
controlling cost than earning profit. The cost efficiency attributes to allocative efficiency
and economies of scale. Another study by Siddique and Rahim (2013) discloses that
stand-alone Islamic branches of conventional banks exhibit higher technical efficiency,
 but lower allocative and cost efficiency than full-fledged Islamic banks. However, they Efficiency
do not support the results with logical reasoning. These studies are fascinating and pave analysis of
the way forward to investigate the underlying reasons of different efficiency
performance of Islamic and conventional banks.
Islamic banks
Annual efficiency assessment of banking sectors is required in every country. Such
evaluation provides useful information to various parties such as debtors, depositors
and financial regulators. Despite extensive research, existing literature pertaining to 23
latest efficiency evaluation in particular is insufficient. To get a clear picture, there is a
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need to compare the efficiency level among full-fledged Islamic banks, Islamic windows
and conventional banks. It is also essential to explore the reasons of higher and lower
efficiency. The paper aims to provide the information about higher and lower
efficiencies of banks and their reasons.

3. Data and methodology

This study focuses on Muslim majority country Pakistan where the financial industry is
dealing with dual banking system. The sample of study considers 15 banks: 5
full-fledged Islamic banks, 5 Islamic branches of conventional banks and 5 conventional
banks[3]. Three types of banks included in the sample are bound to follow national and
international financial regulations under the supervision of the State Bank of Pakistan.
The data are extracted from financial statements, profit–loss accounts of each bank for
the period 2007-2014. We select this period because almost all Islamic banks started
operation in 2006. Thus, this time frame provides us an opportunity to investigate and
compare the efficiency of Islamic and conventional banks. Data are consistent within the
types of banks; however, some discrepancy in operation is allowed for analysis, such as
Islamic banks fulfill the requirements of Sharia’h Supervisory Board.
In literature, the banking efficiency is often measured by using parametric approach
financial ratios analysis (FRA) or non-parametric approach data envelopment analysis
(DEA). Hasan (2005) mentions that the FRA has certain disadvantages, such as it
assumes cost minimization and profit maximization; this assumption does not hold in
the framework of Islamic banking. In contrast, non-parametric approach DEA does not
assume any particular optimization objective with respect to the firm, and it is
commonly used in measuring the efficiency of firms. Therefore, the study uses DEA to
conduct a comparative analysis of the input-oriented efficiency of Islamic banks in
Pakistan from 2007 to 2014.
Critics argue that the objective of both Islamic and conventional banks differ; thus,
direct comparison is void. For instance, the operation at conventional banks is driven
with the object of profit. In contrast, Choudhury (2008) states that Islamic banks help to
attain the well-being of social and economic system by involving zakat and other
sharia’h-based spending variables to direct resource mobilization. Moreover,
Choudhury (2014) describes that principles of Islamic financial contracts and
transactions are derived from Quran and Sunnah (teaching of Prophet Muhammad).
These principles ensure the social well-being by focusing on:
• interest free services;
• joint venture instruments like Musharakah and Mudarabah;
• avoidance of waste in resource allocation, consumption and production; and
• zakat (wealth tax) to ensure justice, circulation and redistribution of wealth.
 H On the other hand, the conventional banking does not ensure the well-being of all, as it
32,1 excludes those who want Riba-free finance. Islam promotes the well-being of all. In a
recent study, Choudhury et al. (2011) critically evaluate the conventional concepts of
well-being described by different indicators, such as Human Development Index (HDI).
He argued that while constructing HDI, “no causal relationships are studied between the
given variables”. Furthermore, he emphasizes that:
24 […] wellbeing is both an outlook of sustainable development with the central place of the
ethical and social factors that bring about institutional and value dimensions into the selection
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of commodities-type variables, the discursive institutional dynamics, and an explanatory form

that extends ideas beyond the above-mentioned approaches.
In the present study, our main focus is on the efficiency of Islamic banking which is
based on the divine principals to ensure the real well-being of humanity.
However, objection on direct comparison is rejected because Islamic banks are
competing with conventional banks in similar financial market that comprises religious
customers and unconstrained customers (Warde, 2010). Moreover, Islamic banks as an
alternative of conventional banks reflect direct competition. Therefore, direct
competition allows direct comparison. Furthermore, estimation methods such as
parametric stochastic frontier approach and non-parametric DEA are available to
measure the difference between both types of banks. Both of these methods assume that
input and output are comparable (Coelli et al., 2005). However, this study utilizes DEA,
which compares banks having identical input and output although their objective is
different.
Contrary to this, SFA can also compare firms having divergent objectives.
Nonetheless, its requirement of a large degree of freedom is rarely fulfilled in the real
world. Therefore, DEA is preferred over stochastic frontier analysis for various reasons.
For instance, it is flexible, works with small sample size and does not entail specification
of the functional form in determining the error, efficiency and inefficiency generated
from DMU (Bauer et al., 1998; Coelli, 2004). However, DEA has a disadvantage like it
does not allow considering noise while measuring inefficiencies. Despite its
disadvantage, the paper used DEA because it is a robust approach to measure efficiency,
as it estimates the relative efficiency of each bank by using actual data (Seiford and
Thrall, 1990). Moreover, it has been excessively used in literature to examine the
efficiency of banks in different countries by many scholars (Table I).

3.1 A non-parametric approach DEA

DEA is a linear programming procedure, initiated by Charnes et al. (1978). It assumes
variable return to scale and helps to analyze efficiency of each decision-making unit
(DMU). This designates higher efficiency of production if more output is produced with
given input. The CCR[4] model assumes constant return to scale (CRS) by considering no
association between scale of operation and efficiency, and it is used to estimate overall
technical efficiency (OTE). The assumption of CRS is applicable only when all DMU
operate at an optimal level. Practically, banks or DMU might face increasing or
decreasing return to scale. Therefore, when banks operate beyond the optimal scale with
the assumption of CRS, the results of technical efficiency would be contaminated with
scale efficiencies. Banker et al. (1984) presents BCC[5] model that is an extension of CCR
model and assumes variable return to scale (VRS) rather than CRS to determine the
efficiency of DMU. It also provides the estimation of pure technical efficiency that is not
 contaminated with scale efficiency effects. The variance between technical and pure Efficiency
technical efficiency score of a bank or DMU is an indication of the presence of scale analysis of
inefficiency. Thus, BCC model and CCR mode can be utilized to estimate scale
efficiencies.
Islamic banks
A DEA model is constructed using either an input or output orientation. An output
orientation represents maximization of the output with a given level of input. On the
other side, input orientation provides the same level of output with minimum number of 25
input. As a standard approach, DEA uses both CRS and VRS assumptions to estimate
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scale effects. The estimated score of the VRS model will be higher due to the tight
envelopment of data points and score of scale efficiency will fall between 0 and 1. A
distinguished feature of the VRS model is that it reports whether a bank is operating at
increasing or decreasing or constant return to scale. CRS is applicable only when the
slope of efficiency is similar to the ratio of inputs to outputs (Cooper et al., 2000).
Isik and Hassan (2002) suggest that estimating efficiency for each year is more
appropriate than constructing multi-year analysis for the target banks. Keeping in mind
all studies in literature, this study prefers to measure the annual efficiency frontier for
each type of bank separately. Indeed, the business environment is changing
continuously; for instance, a bank that is technically more efficient in one year may not
be efficient the next year.

3.2 Input and output specification

Despite extensive research on bank efficiency, the input and output variables are not
specified. To select input and output variables, production approach and intermediation
approach have been utilized by Aly et al. (1990) and Mester (1997). Kwan (2002)
mentions that the intermediation approach includes interest expense that wrap the
two-third of total cost, and this approach is widely used to evaluate the entire bank.
However, the production approach is appropriate to evaluate each branch of the bank.
Keeping in mind the evidence mentioned above, this paper utilizes the intermediation
approach by using STATA 13. The reason behind the selection of this approach is
twofold. First, it considers a bank as an intermediator that collects deposits and uses
them in lending and investment (Sealey and Lindley, 1977; Favero and Papi, 1995).
Second, it is frequently used and evaluates the efficiency of the entire bank (Kwan, 2002).
Banks accept deposits and utilize these deposits in advancing loans; thus, banks are
recognized as an intermediary between borrower and lenders (Pasiouras, 2008). Banks
use deposits, fixed assets and capital as input and produce output in terms of total
assets, investment and advances. The description of variables is given in Table II.

4. Empirical results
This section presents details of estimated results. We explain the technical efficiency of
Islamic and conventional banks in Pakistan, using the DEA technique that further
divides technical efficiency into pure technical efficiency and scale efficiency. In case of
the scale inefficiency, this study attempts to provide evidence by considering return to
scale for each type of banks. Table III provides descriptive statistics of variables used in
DEA.
Over the tenure of research (2007-2014), total deposits (X1), fixed assets (X2) and
share capital (X3) for typical conventional banks are Rs 370,580 million, Rs 10,129
million and Rs 8,980 million, respectively. These are approximately 4.5, 5 and 0.5 times
 H higher than the values for full-fledged Islamic banks, respectively, and much higher
32,1 than the values for Islamic branches of conventional banks. Similarly, output variables
investment (Y1), advances (Y2) and total assets (Y3) are typically higher for
conventional banks as compared to full-fledged Islamic banks and Islamic branches of
conventional banks. It is because the number of conventional bank branches is much
higher as compared to full-fledged Islamic banks and Islamic branches of conventional
26 banks. According to Islamic Banking Bulletin (SBP, 2014), the number of full-fledged
Islamic bank branches and Islamic branches of conventional banks are 767 and 451,
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respectively, that are significantly smaller than about 9,000 branches of conventional
banks in Pakistan.

4.1 Efficiency analysis of the banking industry in Pakistan

Results in Table IV suggest that the efficiency of three types of banks: full-fledged
Islamic banks, Islamic branches and conventional banks show declining trend during
2007-2010. Efficiency of Islamic as well as conventional banks decreased during 2008
and 2009 due to the global economic meltdown. During the study period, full-fledged
Islamic banks unveil lower mean technical efficiency of 81 per cent as compared to 94
and 96 per cent for Islamic branches of conventional banks and conventional banks,

Variables Notation Description

Deposits X1 Deposits of customers

Fixed assets X2 Operating fixed assets
Capital X3 Share capital
Investment Y1 Investment
Advances Y2 Financing and other related assets
Assets Y3 Total assets (cash and balance with treasury and other banks,
Table II. due from financial institutions, investment, financing and
Description of other related assets, operating fixed assets, deferred taxed
variables assets and other assets)

Input Output
Variables X1 X2 X3 Y1 Y2 Y3

Full-fledged Islamic banks

Mean 66,270 2,079 6,449 25,820 32,425 287,600
SD 77,072 1,309 1,893 36,944 33,183 1,321,747
Islamic branches of conventional banks
Mean 21,072 551 823 11,949 8,230 28,021
SD 26,147 633 567 14,334 9,401 34,201
Conventional banks
Table III. Mean 370,580 10,129 8,980 170,772 199,155 443,266
Statistics of input SD 356,701 6,912 3,422 211,990 157,976 446,186
and output variables
used in DEA Notes: Authors’ calculations based on annual reports of 15 banks in Pakistan during 2007-2014; all
(Rs million) variables are reported in Pakistan Rs million
 Efficiency scale 2007 2008 2009 2010 2011 2012 2013 2014 Mean SD
Efficiency
analysis of
Ful -fledged Islamic banks Islamic banks
Technical efficiency 0.89 0.77 0.51 0.87 0.76 0.9 0.92 0.89 0.8137 0.124
Pure technical efficiency 0.92 0.92 0.86 0.9 0.83 0.91 0.93 0.9 0.8962 0.045
Scale efficiency 0.96 0.83 0.6 0.96 0.91 0.99 0.99 0.98 0.9025 0.12
Islamic branches of conventional banks 27
Technical efficiency 0.97 0.97 0.9 0.95 0.95 0.97 0.93 0.95 0.9487 0.027
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Pure technical efficiency 0.97 0.98 0.95 0.96 0.97 0.97 0.97 0.96 0.9662 0.014
Scale efficiency 1 0.99 0.94 1 0.98 0.99 0.96 0.98 0.98 0.019
Table IV.
Conventional banks Descriptive statistics
Technical efficiency 1 0.99 0.95 0.97 0.95 0.96 0.94 0.93 0.9612 0.022 of efficiency
Pure technical efficiency 1 0.99 0.97 0.98 0.99 0.97 0.98 0.99 0.9837 0.009 estimates
Scale efficiency 1 0.99 0.97 1 0.83 0.99 0.96 0.93 0.9587 0.053 (Rs millions)

respectively. It implies that conventional banks work well in maximizing output with
the given number of input.
While examining total technical inefficiency, Table IV also clearly indicates that pure
technical inefficiency is higher than scale inefficiency for full-fledged Islamic banks and
Islamic branches of conventional banks. However, an adverse situation is found in the
case of conventional banks. These empirical results imply that although Islamic
branches of conventional banks and full-fledged Islamic banks are operating at the
optimal scale of operation, they are managerially inefficient in controlling the cost and
full utilization of resources. However, conventional banks are found to be highly pure
and technically efficient. It attributes to their decreasing cost due to economies of scale.
These results are inconsistent with the findings of the study by Ahmad and Noor (2011).
The reason may be that they utilized a large sample of banks across the world, whereas
our study is just focusing on the banking industry in Pakistan.
The results expose that full-fledged Islamic banks reveal the highest technical
efficiency only during 2012 and 2013. It is noted that full-fledged Islamic banks
overcome pure technical inefficiencies during the same period. Certainly, this proposes
that total technical efficiency is influenced by pure technical efficiency of Islamic banks.
Moreover, scale inefficiencies are lower than technical inefficiencies for full-fledged
Islamic banks and Islamic branches of conventional banks. It represents that these two
types of banks are operating relatively at the optimal scale of operation as compared to
their conventional counterparts. It is suggested that being an emerging industry,
Islamic banks are not wasting their resources, rather choosing the correct combination
of input that minimize their cost. However, certain scale inefficiencies for Islamic banks
are attributed to their diseconomies of scale.
Overall results reveal that conventional banks are most efficient in Pakistan,
recording a mean efficiency score of 97 per cent followed by Islamic branches of
conventional banks with a mean efficiency score of 96 per cent. In contrast, it is found
that full-fledged Islamic banks are less efficient with mean efficiency score of 87 per cent.
This implies that conventional banks are highly efficient in minimizing cost by
decreasing input. These findings are in line with results found by Hassan (2006), Srairi
(2010) and Saeed et al. (2013).
 H 4.2 Estimation of efficiency frontier
32,1 The aforementioned evidence mentions the reasons of technical inefficiency of
full-fledged Islamic banks. Now, we elaborate the reasons of scale inefficiency. Banks
operate either at CRS or VRS, where CRS represents that the output increases
proportionally with an increase in input. Contrary to this, VRS signifies that the output
would increase or decrease disproportionally with the increase in input. If the bank is
28 operating at VRS, then the bank has an increasing return to scale (IRS) or a decreasing
return to scale (DRS). IRS represents that the output increases more than an increase in
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input. On the other hand, DRS signifies that the output increases less than the increase
in input.
Table V indicates that during most of the study period, being small, full-fledged
Islamic banks operate at DRS and Islamic branches of conventional banks operate at
CRS. In contrast, being large, conventional banks operate at CRS in earlier period of the
study. Later on, they tend to operate on DRS. These results are inconsistence with other
studies in literature by Noulas et al. (1990) and McAllister and McManus (1993). One
implication is that as an emerging industry, the cost of spreading and managing Islamic
banking business is high that leads to decreasing returns to scale or constant returns to
scale. However, Islamic banks gained increasing return to scale (IRS) in 2010 and 2012
by minimizing the cost with the help of atomization of banking operation. This suggests
that there was an incentive for Islamic banks to control the cost and gain efficiency by
boosting their business operation. In short, it was possible for Islamic banks to achieve
substantial gains by changing the operating scale through internal growth of the sector.
Nonetheless, severe energy shortage increased the cost of operation; it became difficult
for Islamic banks to maintain IRS. On the other hand, conventional banks do not exhibit
IRS throughout the tenure of research, rather they operate at CRS and DRS. In fact, with
an increase in the size of a large bank, the output would increase in a small ratio with an
increase in the input; thus, large bank exhibit DRS. Hence, it is suggested that to enjoy
efficiency gains, policymakers must avoid the promoting mergers of conventional
banks.

5. Conclusion
This study analyzes the efficiency of Islamic and conventional banks in Pakistan during
2007-2014. The efficiency is estimated for three types of banks by utilizing DEA. The
empirical evidence suggests that conventional banks are the most efficient in terms of
total technical efficiency and pure technical efficiency than both types of Islamic banks.
It implies that Islamic banks are managerially inefficient due to the misallocation of
resources. However, results show that scale inefficiency is lowest for Islamic branches of
conventional banks. It represents that Islamic branches of conventional banks operate

Type of banks 2007 2008 2009 2010 2011 2012 2013 2014

Full-fledged Islamic banks CRS DRS DRS IRS DRS IRS DRS DRS
Islamic branches of conventional banks CRS CRS CRS CRS CRS IRS CRS CRS
Conventional banks CRS CRS CRS CRS DRS CRS DRS DRS
Table V.
Estimation of Note: IRS⫽ increasing return to scale; CRS⫽ constant return to scale; DRS⫽ decreasing return to
efficiency frontier scale
 at the optimal scale of operation. In sum, it is concluded that conventional banks are Efficiency
most efficient in technical and pure technical efficiency than fully fledged Islamic banks, analysis of
while Islamic branches of conventional banks proved better in terms of scale efficiency.
The findings of our study provide insights to bank management and policymakers
Islamic banks
by suggesting the best allocation of resources, better management techniques and
optimal use of capacity. Within the limitations of this study, it can be extended in
various ways such as further research can consider the production function to measure 29
the efficiency of banks. Change in cost and allocative efficiencies can be addressed.
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Furthermore, risk exposure factors can be taken into consideration to analyze the
efficiency of Islamic banks in Pakistan.

Notes
1. “Zakat is a levy of 2.5 per cent on the net wealth and asset value existing in liquid form”
(Choudhury and Harahap, 2008).
2. Islamic banking Bulletin is issued by Central Bank of Pakistan.
3. Names of the sample banks are given in Appendix.
4. It is named after Charnes, Cooper and Rhodes. They initiated this model in 1978.
5. It is named after Banker, Charnes and Cooper. They initiated this model in 1984.

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 H Appendix
32,1

Full-fledged Islamic banks Islamic branches of conventional bank Conventional bank

Meezan Bank Limited Bank Alfalah Bank Alfalah

32 Bank Islami Fysal Bank Fysal Bank
Dubai Islamic Bank Bank of Khyber Bank of Khyber
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Table AI. Burj Bank Askari Bank Askari Bank

List of sample banks AL Baraka Bank Habib Bank Limited Habib Bank Limited

Corresponding author
Abida Zanib can be contacted at: abidazainab99@gmail.com

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