Evaluating the Productive Efficiency of Islamic Banking in GCC: A Non-Parametric Approach

By El Moussawi, Chawki; Obeid, Hassan | International Management Review, January 1, 2011 | Go to article overview

Evaluating the Productive Efficiency of Islamic Banking in GCC: A Non-Parametric Approach


El Moussawi, Chawki, Obeid, Hassan, International Management Review


[Abstract]

The purpose of this paper is to propose a method of evaluating the productive performance of Islamic banks operating in the GCC region over the period 2005-2008. Thus, we evaluate the productive performance of Islamic banks with the technique of productive efficiency proposed by Farrell (1957). We use the method of data envelopment analysis (DEA) to decompose the productive efficiency into technical efficiency, allocation efficiency, and cost efficiency. The application of this technique on a sample of 23 Islamic banks reveals that the technical inefficiency and allocation inefficiency increased bank costs, on average, by about 14% and 29%, respectively. In addition, the results show that internal and external factors seem to contribute significantly to the evolution of efficiency scores of Islamic banks operating in the GCC region.

[Keywords] efficiency; Islamic banking; data envelopment analysis

(ProQuest: ... denotes formulae omitted.)

Introduction

The distinguishing feature of Islamic finance is its prohibition of interest (usury). The Islamic financial system opposes all forms of investment involving activities that are deemed to be not compliant with "Sharia law." Islamic banks are the fundamental components of the Islamic financial system, carrying out the full range of banking activities in accordance with Islamic law. The principle of the rejection of "Riba," a loan with interest, is a fundamental feature of the Islamic banking system. However, there are other aspects in which Islamic banking differs from conventional banking, in particular by virtue of the specific role of Islamic banks within the system. The notion underlying the activities of Islamic banks are the principle of risk-sharing, known as "al-Ghunm bi al-Ghurm." The principle is that a lender is committed to sharing both the benefits and the risks of the loan with the borrower. To this extent, Islamic banks act as partners, sharing both the gains and the losses generated by their customers. Banks will guarantee their continued role over time by multiplying the number of customers (in order to share the risk) and by providing advice and support services in management.

While Islamic banks offer simple deposit accounts for individuals, of which the management costs are covered by depositors, their main function is to provide financial services for entrepreneurs and commonly take the following forms:

* Mudharabah or "passive partnership": a bank provides the entire funds for an entrepreneur and shares the resulting profit (assuming there is any) with the entrepreneur based on a fixed percentage determined by contract. The sole source of revenue for the borrowers is their own profit share; they do not receive a salary. The bank is entirely liable for any potential losses.

* Mousharaka or "active partnership": in this type of contract, the bank acts as a shareholder, and both the profits and the losses shared between the bank and the borrower in accordance with the level of ownership of the company's assets.

* Mourabaha or "commercial funding with profit margin": the bank acquires merchandise for its customer in return for a profit margin defined by contract. The bank transfers the ownership of the merchandise to its customer once the latter has paid both the cost of the merchandise and the margin defined by contract. This type of contract differs from loans with interest insofar as the margin is fixed and does not increase in line with the term of payment.

The first attempts to create Islamic financial institutions were made in the 1960s with the rural savings banks "MitGrammar" in Egypt and the "Pilgrim's Management Fund" in Malaysia. The aim of these institutions was to reduce the level of banking exclusion and to promote the development of underprivileged sectors of the population. While not ignoring these initial experiences, many economists agree that the early 1970s are the real birth date of modern Islamic finance. …

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