INSANIAH UNIVERSITY COLLEGE

MASTER IN FINANCE & ISLAMIC BANKING

RESEARCH TOPIC:

EFFICIENCY OF ISLAMIC BANKING IN MALAYSIA FROM YEAR 2000 - 2009

PREPARED BY:

AHMAD TAKIUDDIN BIN SHUAIB (M0911689M04)

PREPARED FOR:

PROF. DATO DR. JAMIL BIN OSMAN TUAN HAJI SHAYAA BIN OTHMAN

CONTENTS

CHAPTER 1: INTRODUCTION Background of Study Islamic Banking in Malaysia Problem Statement Objective of Study Research Questions Research Hypothesis Significance of Study Operational Definition 2 6 8 11 11 12 12 14

CHAPTER 2: LITERATURE REVIEW

27

CHAPTER 3: RESEARCH METODOLOGY

Introduction Data Envelopment Analysis (DEA) Input And Output Variables And The Data 33 34 37

REFERENCES APPENDIX

41

1.0 Introduction 1.1 .Background of Study

The Islamic financial services industry has been growing rapidly in this recent decades. Financial institutions have experienced a dynamic, fast-paced, and competitive environment at a cross-border scale. One of the most growing parts is the new paradigm of Islamic Banking, which has remarkably captured the interest of both Islamic and contemporary economists. This is evidenced by the greater participation of players and wider product offerings encompassing all sectors of banking, takaful and the capital market. Innovations of products and services are taking place swiftly in providing competitive product offerings to meet the more diverse and differentiated requirements of consumers and businesses.

Islamic banking has been in existence since the 1970s, and it has shown tremendous growth over the last 30 years. The practise of Islamic banking now spreads all over the world from the East to the West, all the way from Malaysia, Bahrain to Europe and the US. As of 2004, the size of the banking industry assets has reached hundreds of billions of dollars from merely hundreds of thousands of dollars in the 1970s.

The robustness of the growth of the Islamic financial system is supported by the Shariah wisdom and dynamism in facilitating the ever changing requirements and the expanding horizon of the Islamic finance industry. Shariah deliberation on financial products has evolved from classical contracts surrounding murabahah and deferred sales to a more advanced and sophisticated product structures. It is indeed undeniable that Shariah is the pivotal element of the Islamic financial system as Shariah compliance is the distinctive characteristic of Islamic finance compared to the conventional system.

The main difference between 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 financing and profit and loss sharing (PLS) in performing their business as intermediaries (Ariff, 1988). Many Islamic economics

studies have discussed in depth about the rationale behind the prohibition of interest (Chapra, 2000) and the importance of PLS in Islamic banking (Dar and Presley, 2000).

Furthermore, under the term of Islamic PLS, the relationship between borrower, lender and intermediary are rooted in financial trust and partnership. The importance of the interest-free financing in Islamic Banking has created an innovative environment among practitioners in which the alternative of interest is anticipated. Dar (2003) classified four types of financing acting as alternatives of interest; investment-based, sale-based, rent-based and service-based.

The existing research in Islamic banking and finance has focused primarily on the conceptual issues underlying interest-free financing (Ahmed, 1981; Karsen, 1982). These issues include the viability of Islamic banks and their ability to mobilise saving, pool risks and facilitate transactions. Few studies have focused on the policy implications of a financial system without interest payments (Khan, 1986; Khan and Mirakhor, 1987). Muhammad Taqi Usmani (2005) added It seems that the size of Islamic banking will be at least multiplied during the next decade and the operation of Islamic banks are expected to cover a large area of financial transactions of the world. But before the Islamic financial institutions expand their business they should evaluate their performance during the last two decades because every new system has to learn from the experience of the past, to revise its activities and to analyze its deficiencies in a realistic manner. Unless we analyze our merits and demerits we cannot expect to advance towards our success. It is in this perspective that we should seek to analyze the operation of Islamic banks and financial institutions in the light of Shariah and to highlight what they have achieved and what they have missed.

The literature on bank efficiency and the role of foreign banks is dominated by studies about the US, and to a smaller degree European, banking industries (Berger and Humphrey, 1997). Efficiency studies found that foreign banks in developed countries exhibited lower efficiency in comparison with domestic banks. However, banks from certain countries were able to operate more efficiently than domestic

banks in other developed countries (Berger et al., 2000). Even though the research on transition and developing markets lags far behind, the findings support the conclusion that foreign banks in these countries succeeded in exploiting their comparative advantages and show higher efficiency than their domestically owned counterparts (Isik and Hassan, 2002; Grigorian and Manole, 2002; Hasan and Marton, 2003; Bhattacharyya et al., 1997). One of the proposed explanations is that foreign banks enter developing and developed countries for different reasons. In particular, foreign banks do not just follow their customers into developing markets, but seem genuinely interested in exploiting local opportunities (Clarke et al., 2001).

Several studies that have been devoted to assess the performance of Islamic banks generally examine the relationship between profitability and banking characteristics. Bashir (1999) and Bashir (2001) perform regression analyses to determine the underlying determinants of Islamic performance by employing bank level data in the Middle East. His results indicate that the performance of banks, in terms of profits, is mostly generated from overhead, customer short term funding, and non-interest earning assets. Furthermore, Bashir (2001) claims that since deposits in Islamic banks are treated as shares, reserves held by banks exert negative impacts such as reducing the amount of funds available for investment.

Samad and Hassan (1999) apply financial ratio analysis to see the performance of a Malaysian Islamic bank over the period 1984-1997 and generally find that bankers lack of knowledge was the main reason for slow growth of loans under profit sharing. The Islamic bank was found to perform better than conventional banks in terms of liquidity and risk measurement (less risky). Although this study is based only upon one Islamic bank in Malaysia, the result has given some insight on the example from outside the Middle East area. Similarly, utilizing Banking Efficiency Model, Sarker (1999) claims that Islamic banks can survive even within a conventional banking architecture in which PLS modes of financing is less dominated. Using Bangladesh as a case study, Sarker (1999) argues further that Islamic products have different risk characteristics and consequently different prudential regulation should be applied.

1.2..Islamic Banking in Malaysia

In Malaysia, Islamic finance traces its root back to 1963, with the establishment of the Pilgrims Fund Board or Lembaga Tabung Haji (LTH). This was a savings mechanism under which, devout Malaysian Muslim set aside regular funds to cover the costs of performing the annual pilgrimage. These funds were in turn invested in productive sectors of the economy, aimed at yielding return uncontaminated by riba.

As a country with a population dominated by Muslims, Malaysia was also 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 and operations of an Islamic bank in Malaysia, including 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 operation and profits point of views. The conclusion marked the establishment of the first Islamic bank in Malaysia, Bank Islam Malaysia Berhad (BIMB) in July 1983, with an initial paid up capital of RM80 million. The establishment of BIMB has marked a new milestone for the development of the Islamic financial system in Malaysia. BIMB carries out banking business similar to other commercial banks, but along the principles of Syariah. The bank offers deposit taking 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 (profit-sharing). The bank grants financing facilities such as working capital financing under Al-Murabahah (cost-plus), house financing under Bai Bithaman Ajil (deferred payment sale), leasing under Al-Ijarah (leasing) and project financing under Al-Musyarakah (profit and loss sharing).

It has been the aspiration of the Government to create a vibrant and comprehensive Islamic banking and finance system operating side-by-side with the conventional system. A single Islamic bank does not fit the definition of a system. An Islamic banking and finance 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 first 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 Skim Perbankan Islam (SPI) in March 1993. 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, finance companies and merchant banks to operate the scheme in July 1993 subject to the specific guidelines issued by the central bank. From only three banks offering Islamic financing in March 1993, the number of commercial banks that offered Islamic financing has increased to 15 (of which four are foreign banks).

The Islamic banking system, which forms the backbone of the Islamic financial system, plays an important role in mobilising deposits and providing financing to facilitate economic growth. The Malaysian Islamic banking system is currently represented by 21 banking institutions comprised of nine domestic commercial banks, four foreign commercial banks and two Islamic banks offering Islamic banking products and services under the Islamic Banking Scheme (IBS). These Islamic banking institutions offer a comprehensive and broad range of Islamic financial products and services ranging from savings, current and investment deposit products to financing products such as property financing, working capital financing, project financing, plant and machinery financing, 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, reflecting the capacity of the Islamic banking system as an effective means of financial intermediation, with extensive distribution networks of Islamic banking institutions, comprising 152-full-fledged Islamic banking branches and more than 2,000 Islamic banking counters. Islamic banking has also spurred the efforts by other non-bank financial intermediaries such as the development financial 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 the first nation to have a full-fledged Islamic system operating side-by side with the conventional banking system. Throughout the years, Islamic banking has gained significance, and has been on a progressive upward trend. Since 2000, the Islamic banking industry has been growing at an average rate of 19 per cent 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 per cent of the total assets in the banking system. The market share of Islamic deposits and financing increased to 11.2 per cent and 11.3 per cent of total banking sector deposits and financing respectively. The rapid progress of the domestic Islamic banking system, accentuated by the significant expansion and developments in Islamic banking and finance has become increasingly more important in meeting the changing requirements of the new economy (Bank NegaraMalaysia, 2004).

1.3 .Problem Statement Despite the growing interest and the rapid growth of the Islamic banking and finance industry, analysis of Islamic banking at a cross-country level is still at its infancy. This could partly be due to the unavailability of data, as most of the Islamic financial institutions, particularly in the Asian region, are not publicly traded.

Since early 1990s, studies that were focused on the efficiency of financial institutions have become an important part of banking literature (Berger and Humphrey, 1997). Perhaps, one of the reasons is, efficiency can be used as an indicator to measure a banks success. Specifically, using the efficiency criterion, the performance of individual banks as well as the industry can be gauged. Another reason is that the efficiency can also be used to investigate the potential impact of government policies on a banks efficiency. Indeed, it is of regulators interest to know the impact of their policy decisions on the performance and efficiency of the banks, as they will enormously affect the economy.

While there has been extensive literature examining the efficiency of the US and European conventional banking industries over the recent years (Berger and Humphrey, 1997; Goddard et al., 2001), the empirical work on Islamic Banking efficiency, particularly in Malaysia, is still in its infancy. Typically, the studies on

Islamic banks have focused on theoretical issues, and empirical work has relied mainly on the analysis of descriptive statistics rather than rigorous statistical estimation (El-Gamal and Inanoglu, 2003).

In Malaysia, the first Islamic bank, Bank Islam Malaysia Berhad (BIMB), operated as the only Islamic bank for 10 years since July 1983 before the government allowed other conventional banks to offer Islamic banking services using their existing infrastructure and branches in 1993 (Bank Negara Malaysia, 1994, 1999). The government decided to allow the conventional banking institutions to offer Islamic banking services or Islamic windows, because this was thought to be the most effective and efficient mode of increasing the number of institutions offering Islamic banking services at the lowest cost and within the shortest time frame (Bank Negara Malaysia, 1994, 1999). By so doing, it would also forge the Malaysian banking industry to be more competitive, which would then drive an improved performance and leading to enhanced efficiency of the Islamic banking industry (Alias et al., 1994; Kaleem, 2000). However, with the facilities and incentives extended, most especially by the Central Bank, to both the full-fledged Islamic banks and Islamic windows, one wonders whether they had over the two-decade period (from 1980s to 1990s) performed efficiently? Although this issue is very pertinent, only a few studies have been undertaken to investigate it.

The efficiency measurement would also give an indication whether current Islamic banks in Malaysia are ready to face financial liberation. This being the case because under the Phase Three of the Financial Sector Master Plan, the Central Bank of Malaysia had issued full-fledged Islamic bank licenses to foreign banks as part of the financial liberalisation of Islamic banking in Malaysia (Bank Negara Malaysia, 2004).

In a rapidly changing financial market worldwide, bank regulators, managers, and investors are concerned about how efficiently banks transform their expensive inputs into various financial products and services. According to Berger et al. (1993), although rapid changes in the financial services industry have been taking place all around the globe, the efficiency research has not kept pace with these changes, in terms of both maturity and breadth. In their recent excellent international survey paper, Berger and Humphrey (1997) also underscored the imbalance of the focus in

the literature after reviewing 130 frontier (X-) efficiency studies from 21 countries and various types of financial institutions. They reported that the vast majority of the studies on banking efficiency focus on the banks of developed countries in general (about 95%) and of the US in particular (about 70%). While giving possible directions for future research, both survey studies suggest that more research is needed in measuring and comparing the efficiency of banks and other financial institutions from different countries. The economic and political environments surrounding financial institutions differ substantially across countries. For research and policy purposes, results from banking markets that are more national in scope with much higher levels of concentrations may shed some light on the efficiency impact of various regulatory policies.

Carvallo and Kasman (2005) noted that the liberalisation of financial markets at a global scale, the increasing use of advanced technology, and the information revolution have put competitive pressure on banking firms, both domestically and internationally. This competitive pressure is particularly important for banks in the emerging markets as they constitute the main financial intermediaries to channel savings and investment. In this context, the competitive advantage is enhanced if banks can function efficiently.

In this regard, conventional banks enjoy several advantages over Islamic banks. For example, conventional banks have a very long history and experience, accept interest which is a major source of bank revenues, do not share loss with clients, ask for guaranteed collaterals in most transactions, enjoy very huge capital, spread very widely, have much more developed technologies, can enter Islamic banking market (e.g. Citibank, Bank of America, Deutsche Bank, ABN, AMRO, USB, HSBC, and ANZ Grindlays) and are proved to benefit from theoretical and empirical research. In light of the above advantages, it is interesting to examine the efficiency of both banking streams. Further, some important (both positive and negative) changes have taken place in recent years. For example, many large international conventional banks have started to compete by offering Islamic banking services, and the number of Islamic banks has increased causing competition among Islamic banks themselves. Knowledge and practice of Islamic banking is spreading quickly

and as more Islamic banking entities are established, new regulations, policies, and accounting standards are designed to accommodate these changes.

Despite the above-discussed advantages and challenges, the literature (Hassan and Bashir, 2003; Sarker, 1999; Bashir, 1999; Samad andHassan, 1999;Yudistira, 2003;Hussein, 2004) suggests that Islamic banks are more efficient than conventional banks. However, there is no conclusive evidence in this regard. To further substantiate this controversial issue, this study uses a new set of international data in the Middle-East countries over the period 1990-2005 and applies data envelopment analysis (DEA) to test the comparative cost, revenue, and profit efficiency of the conventional and Islamic banking.

1.4..Objectives Of The Study This study could be an initial effort to analyse the performance of the Malaysian full fledged Islamic bank and further make comparison with foreign Islamic bank , Islamic Windows and conventional bank. Therefore, the objectives of this study are:

1. To analyze the performance of the overall Islamic banking in Malaysia 2. To compare the performance of the overall Islamic banking full fledged companies inclusive of foreign Islamic bank and Islamic windows conventional banks in Malaysia 3. To measure the efficiency of Islamic banking in Malaysia for the year 2000 2009 by using the Data Envelopment Analysis (DEA) and

1.5..Research Question

1. Is Islamic Banking in Malaysia operate efficiently? 2. What are the elements of efficiency to achieve? 3. How to measure efficiency in Islamic banking? 4. Why must Islamic Banks operate efficiently? 5. Is Islamic Banking operate more efficient compared to Conventional Banking?

6. Is it true that due to new regulations and liberalisation implemented by Malaysian Government in Islamic Banking, create more competition among the banks and drive the Islamic banks to operate more efficient?

1.6..Research Hyphothesis

1. The local full fledged Islamic banks operate more relatively efficient compared with other Islamic banks. 2. Increased market competition brought about by deregulation and liberalisation at national level drive local full fledged Islamic banks to operate more efficiently and increase their performance and competition. 3. The efficient-structure suggests that banks that are able to operate more efficiently than their competitors, incur lower costs and achieve higher profits and increased market shares that may result in increased concentration.

1.7..Significance Of The Study There are many studies that tackle various aspects of the efficiency features of the financial system. These studies have many objectives; although, generally speaking, it is rare to find a single study that examines all the efficiency features of a financial system.

Studies on bank efficiency have gained more attention from financial system policy makers and regulators, researchers, managers, and owners of financial institutions in recent years. Policy-makers and regulators can benefit from a further understanding of the efficiency of banks as the performance of the banking can impact on certain policies implemented in the financial system. For example, bank efficiency studies are helpful in judging the extent to which changes in the regulatory environment impact on efficiency. For instance, the removal of restrictions (e.g entry barriers) should stimulate industry performance and create social benefits by reducing waste in resources. Deregulation should foster competition and reduces the market prices of financial services (Burger and Humphrey 1997). The study of

banking sector efficiency can therefore help identify whether policy action are effective.

Regulators can also use efficiency studies to investigate market structure and performance issues, especially in examining whether bank profitability is driven by market power factors or efficient operations (see Berger,1995; Molyneux, Altunbas and Gardener,1996,Ch.4).Concentrated banking sectors may make banks operating in the same industries earn high profits through settings prices of financial products and services at levels unfavourable to customers. This situation is known as the market-power hypothesis. An alternative view, known as the efficient-structure hypothesis, suggests that more efficient banks are able to generate higher market shares and earn high profits that are mostly induced by competitive prices enabled by efficient operations rather than market power practices. Hence, testing whether the efficient-structure or market-power hypothesis prevails can provide regulators with information about the appropriate conduct of the banking industry.

Studies on efficiency can also provide signals as to the health of the financial sector. They can help to identify efficiency sources that could either strengthen or harm the performance of the banking industry. For example, many studies have found that strong capital levels are connected to efficient bank performance, because banks that perform well are able to generate higher profits that strengthen their solvency base. On the other hand, the level of problem loans is found to be negatively related to bank efficiency (Berger and Humphrey, 1992; Hermalin and Wallace, 1994; Mester,1996). Studies that link bank efficiency to financial soundness help to provide regulators with information about the source of inefficiency and how this may be related to banking sector risk.

Efficiency studies are important for managers, since, from the point of view of business strategy, managers need to take the steps or find the reasons and the determinants for why and how they cam improve their efficient performance from both the input side (by improving cost efficiency using better information technology, managerial practices, and enhancing capital) and the output side (by improving profit efficiency through their marketing and pricing strategies). Efficiency studies can also help managers benchmark the performance of their banks with their main

competitors (they can also be used to compare the efficiency of their own branch networks). Studies on bank efficiency may also be important from a shareholders perspective because they appoint managers and expect them to run their financial firms efficiently. Having a wider range of best-practice benchmark indicators may help shareholders monitor their managers more effectively. It is clearly in shareholders interest that managers maintain efficient performance that ensures stable profits and soundness for the bank or banks in question.

Overall, bank efficiency studies can provide results that are of interest to financial policy-markers, financial institution managers and owners. The study of banking sector efficiency can provide useful added information institutions profitability, market power, and the overall safety and soundness of the financial system.

1.8..Operational Definition

1.8.1..Defining Financial System Efficiency In economics, the word efficiency is always linked to the allocation of resources. Its narrow definition usually refers to resources being employed in a way that gives the maximum production of goods and services. When this is achieved then allocation is said to be optimal. Generally the concept of economic efficiency means that the economy produces goods and services that fully reflect the preferences of consumers, given that the production of these goods and services is made with minimum costs. In addition to this, economists may also include environmental and social aspects in the calculus of economic efficiency.

Financial system efficiency is measured in term of efficiency achieved in mobilizing savings from the saving-surplus units in the economy and in allocating this funds among saving-deficits units in the economy. Efficiency measurement is one aspect of investigating a firms performance. Efficiency can be measured in three ways; maximisation of output, minimisation of cost, and maximisation of profits. In general, efficiency is divided into two components (Kumbhakar and Lovell, 2003). A firm is

regarded as technically efficient if it is able to obtain maximum outputs from given inputs or minimise inputs used in producing given outputs. The objective of producers here is to avoid waste. According to Koopmans (1951) a producer is considered technically efficient if, and only if, it is impossible to produce more of any output without producing less of some other output or using more of some inputs. On the other hand, allocative efficiency relates to the optimal combination of inputs and outputs at a given price. The objective of producers might entail the following: to produce given outputs at minimum costs; to utilise given inputs so as to maximise revenue; and to allocate inputs and outputs so as to maximise profit. This technique of production is widely known as economic efficiency where the objective of producers becomes one of attaining a high degree of economic efficiency (cost, revenue or profit efficiency).

1.8.2..Types of Efficiency as Applied to the Financial System In Islam, all Muslim have the ultimate objective to ensure all activities in life in accordance with Shariah i.e meeting Redha Allah SWT. Today must be better than yesterday in all aspect of life

i)..Informational Efficiency Informational efficiency refers to the extent to which a financial system is able to provide information that helps allocate financial resources to their most productive uses. Indeed, information is one of the most important factors affecting the process of funds allocation. This is because the acquisition of information by both lenders and borrowers may be the most determinant for financing activities. In addition, the more information available on the quality of borrowers (i.e their success in loans repayment and their projects feasibility) the more funds the lenders are willing to provide the borrowers. If the lenders lack information, the risk of non-payment of the debt will increase, and risk averse lenders will be less willing to finance borrowers. In this case, informational inefficiency leads to more market imperfections, which reduces the supply of funds available for economic growth.

Informational efficiency could be viewed as how parties deal with asymmetric information problems and the ability of the financial markets to reflect the financial assets prices according to market fundamentals.

ii)..Symmetric Information Efficiency Symmetric Information Efficiency deals with how the financial system is able to provide all relevant information for parties engaged in financial deals. When the distribution of information between these parties is uneven, then this is known as an asymmetric information problem. That is, when the less informed party deals in a transaction with the more informed party, it s difficult for the less informed party to make accurate decisions.

Asymmetric information in the financial system can appear before and/or after the transaction. Pre-transaction asymmetric information problems relate to adverse selection; while morald hazard comes after the transaction. Adverse selection occurs when the lack of information makes it difficult for the financier to make successful selections. In the case of banking, adverse selection exists when a bank is not able to distinguish between borrowers with low or high default probabilities. In this case, the quality of borrowers would be indistinguishable to the bank. By applying Akerlofs (1970) lemons model, the credit market will suffer fro market imperfections in which the lack of information will induce lenders to raise the interest rate.

The second sort of asymmetric information is called moral hazard. It appears after the parties agree to make a transaction. The hazard in the transaction exists when one of the parties engages in behaviour that is undesirable to the other party. In banking, morald hazard arises when the borrower uses funds in activities that increase the probability of default. In financial markets, since a firm has no obligation to repay the nominal value of the stock, the incentive of firms managers to undertake risky investments is more likely.

When funds allocation to risky uses becomes a norm for getting high returns, instability in the economy will become more likely. If borrowers fail to repay their loans and firm failure increase, it would be difficult for banks to meet savers withdrawals, and this could make banks insolvent. Moreover as the likelihood of

firms failures increase, stock holders will still rush to sell shares of these firms, and the stock market might crash.

Therefore, in the absence of an efficient market, asymmetric information problems will increase market imperfections that may destabilize the financial system and the economy. In order to overcome asymmetric information problems, these

informational efficiencies (obviously) have to be improved. The literature explains several methods that the financier might use to increase information about the quality of funds applicants. Among theses are screening, credit rationing, monitoring and commitment (Stiglitz,1989;Mishkin,1998).The first two, screening and credit rationing, are used to alleviate the adverse selection problem. The others, monitoring and commitment, are used to reduce moral hazard.

The importance of informational efficiency aspects in alleviating asymmetric information problems is that they contribute to real economy efficiency by deriving process allows the financial system to achieve socially beneficial projects by reducing or eliminating inferior projects and diverting resources to more productive projects. Moreover, the collection of information about investors creditworthiness creates a valuables database for intermediaries and a network of information that facilitates information transmission (Greenwood and Jovanovic,1990).For example, the existence of private firms (such as Moodys and Standard and Poors in the US and London-based Fitch IBCA credit rating agencies)specializing in collecting information and evaluating the performance of firms will guide financiers who

purchase such information to determine which firms are worthy of receiving funds. These agencies typically rate relatively large companies. However, banks may use consumer credit rating firms (like Experian in the UK) to credit score retail customers as well as using their own extensive internal databases.

iii)..Operational Efficiency Operational efficiency in the financial system relates to the systems ability to organise the channelling of funds with minimum cost. As we will show below, when the cost of intermediation is at a minimum, this means that fewer resources are utilized to channel a greater volume of funds. Operational efficiency has mostly been studied in the context of financial institutions, such as banks (although it can also

relate to the operational characteristics of capital market organizations and exchanges).

Before talking about the operational efficiency elements of financial intermediaries, it is essential that we explain the bank production process. Namely, we need to define what a bank or financial firm produces before we can say whether it is relatively efficient or not. The measurement of what a bank produces (its outputs) is a controversial issue in financial studies since the production of financial institutions is characterized by its non-physical (services) nature.

In banking studies, there are however two views of measuring outputs; the production and the intermediation approaches. The production approach, banks are viewed as firms that use labour and capital to produce loans, deposits and other earning assets. In addition, this approach measures outputs as the number of loans and deposits accounts. The intermediation approach views banks as firms that use labour, capital and deposits to produce loans and other earning assets. The intermediation approach measures outputs in terms of their values, but not number of accounts. Therefore, the difference between both approaches lies mainly in whether deposits should be considered among inputs or outputs: and whether banks input and output are measured according to the number of value of accounts. Most of the banking efficiency study adopt the intermediation approach because it is easier in term of data availability, and it is at the heart of measuring the cost of intermediating deposits to the receivers of loans (Berger and Mester, 1997)

Returning to operational efficiency, most of the work undertaken in the financial area focuses on modelling the efficiency of banks. In particular, substantial emphasis in recent years has been made attempting to measure X-inefficiency (a term initially coined b Leibenstein, 1966) that refers to deviations from the cost-efficient frontier that depicts the lowest production cost for a given level of output. X-efficiency stems from technical efficiency, which gauges the degree of friction and waste in the production processes, and allocative efficiency, which measures the levels of various inputs. These two are neither scale nor scope dependent and thus X-efficiency is a measure of how well management is aligning technology, human resources management, and other resources to produce a given level of output.

X-efficiency is defined as the distance of the actual performance of banks from their efficiency frontier. It could come from both the cost and revenue sides. The cost Xefficiency refers to how close the actual cost performance is to the cost frontier while the revenue X-efficiency measures the distance of the actual revenue from its frontier. Following Berger et al. (1993), we also decompose Xinefficiency into

allocative X-inefficiency and technical X-inefficiency. Allocative X-inefficiency is defined as the effects of basing production decisions on shadow prices that deviate from the actual ones. Technical X-inefficiency measures losses from failing to meet this defective production plan by using more inputs to produce fewer products. Gains of X-efficiency from consolidations refer to whether the actual performance of banks moves closer to the optimal frontier or not after consolidations.

The literature on X-efficiency obtains consistent results. There is significant Xinefficiency in the banking industry from the perspectives of both cost and revenue, although quantitative conclusions vary greatly across estimate methods. On the cost side, X-efficiency refers to how close the actual cost performance is to the optimal cost frontier, which is defined as the minimum cost operation given prices and

output bundle. In the early studies on cost Xefficiency, estimating X-efficiency is defined as distinguishing systematic management inefficiency from random errors that might temporarily impose relatively high costs on certain institutions. This concept of X-efficiency also has the potential to be extended into studies of Xefficiency on the revenue side. The four approaches employed in evaluating U.S. banking data are reviewed in detail in Berger et al. (1993).

X-efficiency is usually decomposed into technical and allocative efficiency. In welfare economics, allocative efficiency is used to show the situation in which the prices of goods and services produced in the economy reflect the minimum cost of supplying them. Thus in perfect competition, consumers pay prices that reflect the minimum cost of production at which producers receive normal profits that are adequate to make their business continue supplying the products. In a market with a sole producer, the price is set above the minimum cost, where the price consumer pay deviates from being allocatively efficient. In financial studies, specifically banking, allocative efficiency denotes the ability of a bank to use inputs in optimal

propotions with respects to their prices (Farrell, 1957). In banking studies most authors, including Berger et al (1993a), find that banks inefficiencies are technical in nature rather than allocative. Therefore, many authors, such as Mester (1993) and Altunbas et al (2000) do not decompose the X-efficiency measurements. In general, the empirical banking literature provides more attention to technical rather than allocative efficiency.

Technical efficiency relates to the avoidance of excessive use of inputs, i.e. more than that is optimal for the given level of output (Berger et al. , 1993). In banking, the measurement of the optimal use of inputs, once technical efficiency is achieved, involves the analysis of the cost or price of inputs. From societys point of view, society is better off if a cost-inefficient bank improved its operational efficiency towards reducing inefficient and unproductive usage of its inputs. There are many reason why technical inefficiency might exists. A managerial element might have an influence on a firms operation s through mistakes in choosing the optimal size of inputs. However, if sub-optimal level of deposits are obtained using this strategy then the bank may not be able to fulfil its output obligations, resulting in a misuse of inputs.

iv)..Scale Efficiency Scale economies exist when a bank operates on its decreasing long-run total average cost curve. The concept of scale efficiency was first introduced by Farrell (1957), which can be simply defined as the relationship between a banks per unit average production cost and volume, and thus a bank is said to have economies of scale when the increase in outputs is accompanied by a lower unit cost of production. The concept of scale efficiency was first introduced by Farrell (1957), which can be simply defined as the relationship between a banks per unit average production cost and volume, and thus a bank is said to have economies of scale when the increase in outputs is accompanied by a lower unit cost of production.

Scale efficiency measures banking operations across sizes. Its specifies the movement of profit frontiers as banking scale grows following bank consolidations. Such movement comes from both the cost and the revenue sides. Given fixed prices, the cost side scale efficiency occurs when large banks are able to produce

identical services at lower cost than small banks. The revenue side scale efficiency occurs when large banks are able to provide more services at the same cost as small banks. Higher scale associated with consolidations is therefore potentially able to increase profit efficiency.

Earlier studies on banking scale efficiency focus on the cost side of production and then later extend into the revenue side. Some recent studies also analyze scale efficiency of banks from the perspective of profit. The results of the studies on the cost side consistently show that scale efficiency depends on individual banks scale level before consolidations although some recent studies find growing trend in scale efficiency overtime.

On the revenue side, the literature shows mild revenue scale efficiency. Finally, from the perspective of profit, the literature shows mixed results. On the cost side, the literature finds that there is an optimal scale in terms of saving cost. This result suggests that banks that are below the optimal scale reduce their unit cost by increasing scale until the optimal scale is obtained. In contrast, banks that above the optimal scale would raise their unit cost by increasing scale.

Earlier studies of cost efficiency on scale rely on Cobb-Douglas production function, mainly because of its tractability, and use data on small size banks, because of lack of available data for large banks. The works of Benston (1972) and Bell and Murphy (1968) are representative of this literature. Using different data mainly from the 1960s, these studies suggest that the scale elasticity of operating cost is somewhere around 0.95 and statistically significant. In other words, according to these studies, with one percent growth in banking scale, operating costs will rise by only 0.95 percent. Therefore, for these small banks, scale efficiency in terms of scale elasticity of operating cost is slight but statistically significant.

The scale efficiency studies in the late 1980s and early 1990s use translog functional forms and focus on average cost. The use of these forms supersedes the CobbDouglas functions by accommodating more flexible functional forms (Berger et al., 1999 gives a comprehensive review of this literature). Using the data on U.S. banks from the 1980s, studies in this period suggest that the average cost curve of banks

has a relatively flat U-shape form with median sized10 banks being slightly more scale efficient than others. According to these results, large banks cannot gain any scale efficiency and may even lose some of it by increasing their size. Unfortunately, these analyses do not agree on the location of the bottom of the average cost U the optimal scale point. Studies using various data that contain diversified banking sizes usually identify greatly different optimal scale points. This incongruence leads to failure in fitting large and small banks on the same parametric cost function. Further studies confirm this failure and attribute it to the limited flexibility of the translog functional form when data are located far from the mean values of themselves (McAllister and McManus, 1993, Mitchell and Onvural, 1996).

Later studies continue to search for more flexible functional forms. McAllister and McManus (1993), Berger et al. (1997), and Berger and DeYoung (1997) suggest that the Fourier-flexible functional form should be used for U.S. financial institution studies instead of the translog. In addition, Mester (1992) estimates a hybrid translog function. Berger et al. (1993), Berger (1995, 2000), and Akhavein et al. (1997a, 1997b) estimate a Fuss normalized quadratic variable profit function. Most of these studies argue for the result that scale Some studies find efficient scale assets to be at a range of $75 million and $300 million (Berger et al. 1987, Berger and Humphrey 1991, Bauer et al. 1993).

On the revenue side, there is evidence of mild revenue scale efficiency (Berger et al. 1996). Other studies in this literature use the profit function to jointly evaluate the combined effects of scale changes on the cost and the revenue sides. In some studies (Berger et al. 1993, Clark and Siems 1997), profit efficiency is measured as being highest for large institutions. While Berger (1995) argues that large and small institutions are equal in terms of scale efficiency.

v)..Scope And Product Mix Efficiencies Scope economies exist when it costs the same or less if one or more output are added (to the available output set) than if different firms produce each output separately. Scope economies may be realized when mergers or acquisitions take place between firms producing different outputs. Individual banks producing a variety of services may also be enjoying scope economies. As an example, one bank may

provide loans and another bank may engage in portfolio investments. If these two banks join together and produce both loans and investments, scope economies may be achieved when joints production of these two outputs are less costly than the total cost of these output being produced separately by individual banks.

The majority of empirical studies on scope economies in banking have been undertaken in US banking industry. Evidence to support the hyphotesis that multiproduct banks have lower costs than specialists has been put forward in studies such as by Gilligan and Smirlock (1984) and Lawrence and Shay (1986). However, others including Hunter, Timme and Yang (1990) and Mester (1987) find no strong support for the existence of scope economies in banking.

Changes in business scope and product mix are capable of improving bank efficiency as well. Scope efficiency occurs when it is more efficient for multiple financial services to be provided by a single institution instead of separate specialized ones. In empirical studies, scope efficiency is often difficult to estimate for the banking industry because there are very few specialized banks in the data sample. Studies of product mix efficiency solve this problem by evaluating somewhat different output combinations. Other studies use the concept of expansion-path subadditivity to measure a combination of scope and product mix efficiencies simultaneously. The empirical results in the literature are mixed on the cost side; but show no efficiency gains on the revenue side.

On the cost side, improvement in business scope and product mix may reduce operating cost in two ways: one is by the sharing of fixed costs over multiple products; the other is by the cost complementarities in providing different products. Fixed costs are shared when the fixed capital of an institution is more fully utilized by providing multiple services (issuing transaction accounts, savings accounts, consumer loans, and trust services, etc.).

Cost complementarities occur when there is some benefit in providing one service as a result of producing another one. For example, the payment flow information developed in providing deposit services can be employed to reduce the cost of acquiring credit information in monitoring loans to the same customers. Using these

concepts, Pulley and Humphrey (1993) analyze the effects of changing scopes on bank operating cost with data of large U.S. banks between 1978 and 1990. Their estimates of scope efficiency in a five-output model (real estate, commercial and industrial, and consumer installment and credit card loans) average at 20% of those banks total cost. Moreover, they conclude that this efficiency gain is not due to cost complementarities between deposits and loans but rather due to 13 sharing of fixed costs.

However, Ferrier et al. (1993) suggest otherwise by using the concept of expansionpath with data of U.S. banks operating in 1984. They exam the cost effects of product line expansion, and find slight inefficiency. In addition, Berger et al. (1987) and Hunter et al. (1990) draw qualitatively similar conclusions using U.S. banking data in the 1980s: very few cost savings are found from consolidating outputs of different banks.

On the revenue side, improvements in scope and product mix can raise banking efficiency by enhancing their revenue. However, no empirical studies show evidence supporting such enhancement. Pulley et al. (1993) study this from the perspective that consumers are generally willing to pay higher prices for multiple financial services in one location to save on transportation and time costs. They define scope in terms of deposits and loans and find no efficiency gains from combining them. In another study, Berger et al. (1996) find no evidence of significant scope efficiency gains on the revenue side using data from 1978 through 1990.

From the perspective of both cost and revenue, Berger et al. (1993) construct a twooutput profit function of banks and conclude that banks would be better off by producing either one of these two goods instead of both. Clark and Siems (1997) also arrive at a similar conclusion that change in product mix yields no profit advantages.

vi)..Other Aspects Of Operational Efficiency Risk-pooling comes from the role of diversification and spread of assets being invested in the financial system (Tobin, 1984). Banks can spread risk across large numbers of borrowers with different risk types different projects and different sectors

of an economy. Also, financial markets allow investors to make their portfolios more efficient by choosing well-diversified assets. The general idea behind risk spreading is to avoid non-systematic risk; that is the fall in the return of investment will be recovered by the rise of return of another.

Uncertainty reduction has been explained by Tobin as an aspect of efficiency, which he calls, full insurance efficiency. Insurance efficiency implies that the financial system enables its participants to have their financial assets delivered and obtained with insurance against all future contingencies. In other words, this is called hedging against uncertainty. Since the volatility of stocks and exchange rates impede the trade of financial assets, financial derivatives (such as forward contracts, financial futures, options, swaps and so on) are tools that allow individuals and companies to engage in contracts that contain the delivery of a specified amount and quantity of assets on a certain date. Therefore, future financial instruments are, in general important for financial system efficiency because they reduce the risk associated with the volatility of assets prices and provide confidence and stability in the transactions within the financial system.

Funds-pooling refers to the law of aggregation as an important efficiency feature of the financial system, which helps maximize the level of funds intermediated in the economy. Banks are the main financial system institutions able to aggregate and pool small savings I order to make large loans. Financial markets can also aggregate small funds from the new issues of societys wealth classes to participate with their funds in a way that matches their wealth capacities.

2.0..Literature Review Efficiency measurement is one aspect of investigating a firms performance. Efficiency can be measured in three ways; maximisation of output, minimisation of cost, and maximisation of profits. In general, efficiency is divided into two components (Kumbhakar and Lovell, 2003). A firm is regarded as technically efficient if it is able to obtain maximum outputs from given inputs or minimise inputs used in producing given outputs. The objective of producers here is to avoid waste.

According to Koopmans (1951) a producer is considered technically efficient if, and only if, it is impossible to produce more of any output without producing less of some other output or using more of some inputs. On the other hand, allocative efficiency relates to the optimal combination of inputs and outputs at a given price. The objective of producers might entail the following: to produce given outputs at minimum costs; to utilise given inputs so as to maximise revenue; and to allocate inputs and outputs so as to maximise profit. This technique of production is widely known as economic efficiency where the objective of producers becomes one of attaining a high degree of economic efficiency (cost, revenue or profit efficiency).

A few studies had been conducted to investigate the impact of bank deregulation on competition, efficiency and performance. The issues addressed were centred on whether deregulation had increased competition, improved efficiency and performance. There is a consensus view that deregulation had enhanced competition. But a mixed result was found on efficiency and performance. In the case of the US banking industry, for example, there was evidence that deregulation did not change efficiency (Elyasiani and Mehdian, 1995). A study by Bauer et al. (1993) found little change in average inefficiency, but productivity over the period had deteriorated, which they attributed to deregulation and increases in competition. They, however, did not examine the differences in efficiency and productivity among banks of different sizes and they had excluded the very small banks.

A number of studies on Spanish banks also focused on efficiency and performance during the deregulation period. Among others are Grifell-Tatje and Lovell (1996, 1997), and Lozano (1997, 1998). The most important finding that is worth highlighting is that the efficiency and productivity of Spanish banks have not improved during the deregulated phase. Worse still, after the deregulation phase, the studies showed a reduced efficiency among Spanish savings banks (Khumbakar et al., 2001). The findings tend to suggest that the Spanish banks performed badly in terms of efficiency because the banks found it difficult to adjust themselves to the increased competition as a result of the deregulation.

Meanwhile, depending on the types of ownership, the empirical results of the impact of deregulation on banking efficiency and productivity in developing countries are

varied (Bhattacharya et al., 1997; Burki and Niazi, 2003). Bhattacharya et al. (1997) focused their study on the efficiency of three different kinds of ownership (private, public and foreign) of Indian commercial banks. Public-owned banks were found to be the most efficient but somehow demonstrated temporal decline in efficiency. This was followed by foreign banks, which had temporal increase in efficiency. Privately owned banks were the least efficient banks and the pattern did not significantly change over the 1986-1991 period.

A study conducted by Burki and Niazi (2003) on the banking industry in Pakistan showed that state-owned bank was the most inefficient followed by private banks. Foreign banks were the least inefficient over the period of 1991 to 2000. Noulas (2001) study on the efficiency of Greek banks for the period 1993 to 1998 concluded that the private banks were more efficient than state-controlled banks.

The comparison of efficiency between foreign and domestic banks provides evidence that foreign banks in developing and transition countries have succeeded in capitalizing on their advantages and show a higher level of efficiency than their domestic peers (Bonin et al., 2005; Isik and Hassan, 2002; Hasan and Marton, 2003; Bhattacharyya et al., 1997). Furthermore, several papers tested whether foreign and domestic banks came from the same population, in other words whether they operated in the same environment. These tests are especially important for efficiency studies in order to determine whether to construct separate or common frontiers for domestic and foreign banks. Parametric and non-parametric tests usually failed to reject the null hypothesis that foreign and domestic banks came from the same population (Isik and Hassan, 2002; Sathye, 2001).

Notwithstanding, a few studies had shown a good impact of deregulation on efficiency and productivity. Specifically, deregulation has resulted in improvement in productivity in Norwegian Banks (Berg et al., 1992). Shyu (1998) also reported improved efficiency of the Taiwanese banking industry after deregulation. The efficiency of the Turkish commercial banks had also increased as a result of deregulation (Zaim, 1995). A recent study by Isik and Hassan (2003) on Turkish banks also showed an increase in their efficiency. They attributed the increase in efficiency to improved resources management practices. In addition, the finding

showed that the efficiency gaps between private banks and public banks have also been narrowed. Perhaps, the successful story of banking deregulation in Turkey, which triggered better efficiency, could be due to the support of small and medium industry, and commercial businesses to the Turkish banking industry.

From the empirical studies mentioned above, there is strong evidence to believe that efficiency gains can be secured through competition. In other words, regulation, if properly implemented, will enhance competition and make it more effective in the market place.

Samad (1999) was among the first to investigate the efficiency of the Malaysian Islamic banking sector. In his paper, he investigates the relative performance of the fully fledged Malaysian Islamic bank compared to its conventional bank peers. During the period of 1992-1996 he found that the managerial efficiency of the conventional banks was higher than that of the fully fledged Islamic bank. On the other hand, the measures of productive efficiency revealed mixed results. He suggests that the average utilization rate of the Islamic bank is lower than that of the conventional banks.

Donsyah Yudistira (2004) conducted research on technical, pure technical, and scale efficiency and measures are calculated by utilizing the non-parametric technique, DEA. The inefficiency across 18 Islamic banks is small at just over 10 percent, which is quite low compared to many conventional counterparts. Similarly, Islamic banks in the sample suffered from the global crisis in 1998-1999 but performed very well after the difficult periods. This would suggest that the interdependence of Islamic banks on other financial system is significant and any regulator, especially in which the bank operates, should consider Islamic banking in the search of global financial stability.

There are finding on diseconomies of scale for small-to-medium Islamic banks which suggests that Merger &Acquisition should be encouraged. Supported by the nonparametric technique and regression analysis, Islamic banks within the Middle East region are less efficient than their counterparts outside the region. Additionally, market power, which is common in the Middle East, does not significantly impact on

efficiency. The reason is that Islamic banks from outside the Middle East region are relatively new and very much supported by their regulators. Furthermore, publicly listed Islamic banks are less efficient than their non-listed counterparts.

More recently, Sufian (2006) examined the efficiency of the Malaysian Islamic banking sector during the period 2001-2004 by using the non-parametric DEA method. He found that scale efficiency (SE) outweighs pure technical efficiency (PTE) in the Malaysian Islamic banking sector, implying that Malaysian Islamic banks have been operating at the non-optimal level of operations. He suggests that the domestic Islamic Banking Scheme banks have exhibited a higher technical efficiency compared to their foreign Islamic Banking Scheme bank peers. He suggests that during the period of study the foreign Islamic Banking Scheme banks inefficiency was mainly owing to scale rather than pure technical.

He found that larger Malaysian Islamic banks tend to disburse more loans and are more efficient compared to its smaller counterparts. His results suggest that market share has a positive and significant effect on Malaysian Islamic banks efficiency. Finally, the results also suggest that the more efficient banks tend to be more profitable.

Fadzlan Sufian and Mohamad Akbar Noor Mohamad Noor ( 2009 ) examine the performance of the MENA and Asian Islamic banks during the period 2001-2006. The efficiency estimates of individual banks are evaluated using the non-parametric DEA approach. The empirical findings suggest that pure technical inefficiency outweighs scale inefficiency in the Islamic banking sector, implying that the Islamic banks have been managerially inefficient in exploiting their resources to the fullest extent. The empirical findings seem to suggest that the MENA Islamic banks have exhibited higher technical efficiency compared to their Asian Islamic bank counterparts. During the period of study we find that pure technical inefficiency has greater influence in determining the total technical inefficiency of the MENA and the Asian Islamic banking sectors.

The findings contribute significantly to the existing knowledge of the operating performance of the Islamic banking industry in the MENA and Asian countries.

Nevertheless, the study has also provided further insight into the banks specific management as well as the policymakers with regard to attaining optimal utilization of capacities, improvement in managerial expertise, efficient allocation of scarce resources and the most productive scale of operation of the banks in the industry. This may also facilitate directions for sustainable competitiveness of Islamic banking operations in the future.

The study conducted by Hamim S. Ahmad Mokhtar et al (2008) has established empirical evidence of Islamic banks efficiency in Malaysia for the years 1997-2003. This was the period where Islamic windows were introduced and further financial liberalisation of the Islamic banking industry was promulgated. The findings showed that the average efficiency of the overall Islamic banking industry has increased during the survey period. The study also revealed that the full-fledged Islamic banks were more efficient that the Islamic windows. However, the efficiency level of Islamic banking was still less efficient than the conventional banks. On the other hand, foreign banks were found to be more efficient than domestic banks.

Islamic banks in Malaysia are now facing ever-increasing competition, particularly with the issuance of three new licenses to three foreign full-fledged Islamic banks. The competition from conventional banks is also expected to increase further in the near future due to globalisation. The findings of this study revealed that the technical and cost efficiencies of Malaysian Islamic banks could be improved further. In this regard, it requires a concerted effort from the management and policy-makers to try to optimise the utilisation of scarce resources owned by the banking industry in Malaysia. This finding would also facilitate them to set the directions for future improvement of Islamic banking operations in Malaysia. Finally, this study would open a fruitful avenue for future research in the area of Islamic banking efficiency and competition in other Muslim countries.

Similarly, he found that profits earned by the fully fledged Islamic bank, either through the use of deposit or loanable funds, or used funds, are also lower than the conventional banks, reflecting the weaker efficiency position of the fully fledged Islamic bank. In contrast, the productivity test by loan recovery criterion indicates that the efficiency position of the fully fledged Islamic bank seems to be higher and that

bad debts as a percentage of equity, loans, and deposits also show a clear superiority over the conventional bank peers.

Hassan Taufiq et al 2009 conducted on efficiency study of conventional versus Islamic banks in the Middle East One of the main and important findings suggests that there is no significant difference between the overall efficiency results of conventional versus Islamic banks. Given the advantages that the conventional banks enjoy over the Islamic banks, the results in this paper are in favour of the later banking system. Taken together, these findings suggest that there is substantial room for more cost minimisation, and revenue and profit maximisation in both banking systems. To some extent, conventional banks behave similarly to Islamic banks in respect of efficiency. On average, unlike age, the size differences do not contribute towards efficiency differences between both streams.

3.0 Research Methodology 3.1 Introduction Conceptually, there are two general methodologies to measure frontier efficiency; the parametric approach using econometric techniques, and the non-parametric approach utilising the linear programming method. Both approaches differ mainly in how they handle the random error and the assumptions made on the shape of the efficient frontier. However, each of the techniques has its own strengths and weaknesses. The most widely employed parametric methods are stochastic frontier approach (SFA), thick frontier approach (TFA) and distribution-free approach (DFA). On the other hand, the commonly used non-parametric techniques are free disposal hull analysis (FDH) and Data Envelopment Analysis (DEA).

This paper follows the DEA nonparametric approach. In this regard, Farrell (1957) originally developed this non-parametric efficiency approach. The DEA is nonparametric in the sense that it simply constructs the frontier of the observed inputoutput ratios by linear programming techniques (Iqbal and Molyneux, 2005). For an introduction to DEA methodology, see for instance Coelli et al. (1998) and Thanassoulis (2001).

Technical efficiency reflects the ability of a firm to obtain maximum output from a given set of inputs (Farrell, 1957). There is an increasing concern to measure and compare efficiency of firms under different environments and activities. If a firm produces only one output, using one input this could be done easily. However, this method is often inadequate as firms normally produce multiple outputs by using various inputs related to different resources.

The parametric approach has the advantage of allowing noise in the measurement of inefficiency. However, the approach requires us to specify the functional form for the production, cost or profit function. On the other side of the coin, the non-parametric approach is simple and easy to use since it does not require any specification of the functional form (Coelli, 2004). However, it suffers from the drawback that all deviations from the best-practice frontier are attributed to inefficiency as it did not allow for noise to be taken into account.

3.2..Data Envelopment Analysis (DEA) To measure efficiency, the DEA will be this study choice because it does not require us to specify the functional form or distributional forms for errors. In essence, it is more flexible than the parametric approach. Furthermore, the reason for using DEA is that it has been extensively used in measuring the efficiency of banks in many countries by many researchers like Aly et al. (1990), Elyasiani and Mehdian (1992), English et al. (1993), Favero and Papi (1995), Bhattacharya et al. (1997) and Katib (1999). Apart from the above reasons, DEA is chosen because it can be applied to multi-input and multi output variables.

The term Data Envelopment Analysis (DEA) was first introduced by Charnes, Cooper and Rhodes (1978), (hereafter CCR), to measure the efficiency of each Decision Making Units (DMUs), that is obtained as a maximum of a ratio of weighted outputs to weighted inputs. This denotes that the more the output produced from given inputs, the more efficient is the production. The weights for the ratio are determined by a restriction that the similar ratios for every DMU have to be less than or equal to unity.

This definition of efficiency measure allows multiple outputs and inputs without requiring pre-assigned weights. Multiple inputs and outputs are reduced to single virtual input and single virtual output by optimal weights. The efficiency measure is then a function of multipliers of the virtual input-output combination.

The CCR model presupposes that there is no significant relationship between the scale of operations and efficiency by assuming constant returns to scale (CRS), and it delivers the overall technical efficiency (OTE). The CRS assumption is only justifiable when all DMUs are operating at an optimal scale. However, firms or DMUs in practice might face either economies or diseconomies of scale. Thus, if one makes the CRS assumption when not all DMUs are operating at the optimal scale, the computed measures of technical efficiency will be contaminated with scale efficiencies.

Banker et al. (1984) extended the CCR model by relaxing the CRS assumption. The resulting BCC model was used to assess the efficiency of DMUs characterised by variable returns to scale (VRS). The VRS assumption provides the measurement of pure technical efficiency (PTE), which is the measurement of technical efficiency devoid of the scale efficiency effects. If there appears to be a difference between the TE and PTE scores of a particular DMU, then it indicates the existence of scale inefficiency.

Amongst the strengths of the DEA is that, DEA is less data demanding as it works fine with small sample size. The small sample size is among other reasons, which leads us to DEA as the tool of choice for evaluating Malaysian Islamic banks Xefficiency. Furthermore, DEA does not require a preconceived structure or specific functional form to be imposed on the data in identifying and determining the efficient frontier, error and inefficiency structures of the DMUs[1] (Evanoff and Israelvich, 1991; Grifell- Tatje and Lovell, 1997; Bauer et al., 1998). Hababou (2002) adds that it is better to adopt the DEA technique when it has been shown that a commonly agreed functional form relating inputs to outputs is difficult to prove or find. Such specific functional form is truly difficult to show for financial services entities. Avkiran (1999) acknowledges the edge of the DEA by stating that this technique allows the researchers to choose any kind of input and output of managerial interest, regardless

of different measurement units. There is no need for standardisation. Three useful features of DEA are first, each DMU is assigned a single efficiency score, hence allowing ranking amongst the DMUs in the sample. Second, it highlights the areas of improvement for each single DMU. For example, since a DMU is compared to a set of efficient DMUs with similar inputoutput configurations, the DMU in question is able to identify whether it has used input excessively or its output has been underproduced. Finally, there is possibility of making inferences on the DMUs general profile. We should be aware that the technique used here is a comparison between the production performances of each DMU to a set of efficiency DMUs.

The set of efficiency DMUs is called the reference set. The owners of the DMUs may be interested to know which DMU frequently appears in this set. A DMU that appears more than others in this set is called the global leader. Clearly, this information gives huge benefits to the DMU owner, especially in positioning its entity in the market.

The main weakness of the DEA is that it assumes data that are free from measurement errors. Furthermore, since efficiency is measured in a relative way, its analysis is confined to the sample set used. This means that an efficient DMU found in the analysis cannot be compared with other DMUs outside of the sample. The reason is simple. Each sample, separated, let us say, by year, represents a single frontier, which is constructed on the assumption of same technology. Therefore, comparing the efficiency measures of a DMU across time cannot be interpreted as technical progress but rather has to be taken as changes in efficiency (Canhoto and Dermine, 2003).

DEA can be used to derive measures of scale efficiency by using the variable returns to scale (VRS), or the BCC model, alongside the constant returns to scale (CRS), or the CCR model. Coelli et al. (1998) noted that the BCC model have been most commonly used since the beginning of the 1990s. A DEA model can be constructed either to minimise inputs or to maximise outputs. An input orientation aims at reducing the input amounts as much as possible while keeping at least the present output levels, while an output orientation aims at maximising output levels without increasing use of inputs (Cooper et al., 2000). The focus on costs in banking and the

fact that outputs are inclined to be demand determined means that input-oriented models are most commonly used (Kumbhakar and Lozano Vivas, 2005).

There Envelopment Model in DEA having two alternative approaches to determine the efficient frontier characterized that is input-oriented, and the other outputoriented. Input-oriented model where the inputs are minimized and the outputs are kept at their current levels (Banker, Charnes and Cooper, 1984) On the return to scale assumption, this study uses the variable returns to scale (VRS) assumptions to define the best practice frontier, which guarantees that a bank is only compared with another bank of similar size. Finally, this study uses the input based orientation. This method of measuring efficiency has been employed by many studies, among others, Aly et al. (1990), Ferrier and Lovell (1990), Furukawa (1995), Elyasiani and Mehdian (1995), Zaim (1995), Miller and Noulas (1996), Resti (1997), Bauer et al. (1998), and Casu and Molyneux (2000). The Envelopment Models in Spreadsheets using Excel Solver for Input-oriented VRS Envelopment Spreadsheet Model DEA is indicated in Appendix 1. Chapter 1 Envelopment DEA Models (Joe Zhu 2002:Quantitative Models for Performance Evaluation and Benchmarking Data Envelopment Analysis with Spreadsheets Second Edition,)

DEA allows us to compute overall cost, technical, allocative, pure technical, and scale efficiency. Technical efficiency (TE) refers to the ability to produce the maximum outputs at a given level of inputs, or ability to use the minimum level of inputs at a given level of outputs. Allocative efficiency (AE) refers to the ability to select the optimal mix of inputs in light of given prices in order to produce a given level of outputs.

The measure of overall cost efficiency (CA) is the product of technical and allocative efficiency. The TE measure can be further decomposed into pure technical efficiency (PTE) and scale efficiency (SE).

3.3 Input and output variables and the data (Data sample, inputsoutputs definition and the choice of variables) Despite the large body of literature on bank efficiency, there is no general consensus on how to define inputs and outputs as variables in analysing the efficiency. In

general, the literature on bank efficiency has two prominent approaches, they are: production; and, intermediation approach (Elyasani, 1990; Aly et al., 1990; Ferrier and Lovell, 1990; Mester, 1997).

Under the production approach, pioneered by Benston (1965), banks are primarily viewed as providers of services to customers. The input set under this approach includes physical variables (e.g. labour and material) or their associated costs, since only physical inputs are needed to perform transactions, process financial documents, or provide counselling and advisory services to customers. The output under this approach represents the services provided to customers and is best measured by the number and type of transactions, documents processed or specialized services provided over a given time period. This approach has primarily been employed in studying the efficiency of bank branches.

Under the intermediation approach, financial institutions are viewed as intermediating funds between savers and investors. In our case, Islamic banks produce intermediation services through the collection of deposits and other liabilities and in turn these funds are invested in productive sectors of the economy, yielding returns uncontaminated by usury (riba). This approach regard deposits, labour and physical capital as inputs, while loans and investments are treated as output variables. Following among others, Hassan and Hussein (2003), Hassan (2005) and Sufian (2006), a variation of the intermediation approach or asset approach originally developed by Sealey and Lindley (1977) will be adopted in the definition of inputs and outputs used in this study. Furthermore, as at most times bank branches are engaged in the processing of customer documents and bank funding, the production approach might be more suitable for branch efficiency studies (Berger and Humphrey, 1997).

This study employs the intermediation approach for three reasons: First, it will be evaluating the banks efficiency as a whole; two, this approach is widely used (Kwan, 2002), and three, the principle of Islamic financial system is based on participation in enterprise or equity-based where the business participants may end up with profit or loss. This, by no means, implies the importance of intermediary activities.

For the choice of input and output, this study uses two inputs and one output variables. The first input, denoted by X1 (i.e. the quantity of input X1), is total deposits, which includes both Al-Wadiah Savings Deposits and Mudharabah Investment Deposits from customers and other banks. The second input, denoted by X2 (i.e. the quantity of input X2), is total overhead expenses, which includes the personnel expenses and other operating expenses. This represents the resources expended, which converted deposits into financing and other earning assets. The output is total earning assets, denoted by Y1 (i.e. the quantity of output Y), which includes financing, dealing securities, investment securities and placements with other banks.

For the empirical analysis, all Malaysian conventional banks that offered Islamic banking window services and their Islamic windows, 2 full-fledged Islamic banks from 2000 to 2009. will be incorporated in the study (see Table I). The annual balance sheet and income statement used to construct the variables for the empirical analysis were taken from published balance sheet information in annual reports of each individual bank.

The financial statements were individually obtained from each bank. Some of the information was also obtained from the Bank Negara Malaysia reports. The samples are selected on the basis that the bank had Islamic banking operations within the study period and data availability. The conventional banks included are the parent banks of Islamic windows. Table AI in Appendix 2 shows the list of the banks.

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 a multi-product firms producing one output by employing two inputs.

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APPENDIX 2

Banks that offered Islamic banking services in Malaysia is as follows: 1) Domestic banks offering window Islamic banking services Affin Bank Alliance Bank Arab-Malaysian Bank EON Bank Hong Leong Bank Maybank Public Bank RHB Bank Southern Bank

2) Foreign banks offering window Islamic banking services Standard Chartered Bank Hong Kong Bank OCBC Citibank

3) Domestic full fledged Islamic banks Bank Islam Malaysia Bank Muamalat