Academic journal article International Journal of Business and Management Science

Assessing Production Efficiency of Islamic Banks and Conventional Bank Islamic Windows in Malaysia

Academic journal article International Journal of Business and Management Science

Assessing Production Efficiency of Islamic Banks and Conventional Bank Islamic Windows in Malaysia

Article excerpt


Interest-free banking is growing in Malaysia very quickly and widely accepted by the public, standing at an average rate of 19 percent per annum in terms of assets since 2000. By the end of 2004, total assets of the Islamic banking sector increased to RM 94.6 billion which accounted for 10.5 percent of the total assets in the banking system. The market share of Islamic deposits and financing also increased to 11.2 percent and 11.3 percent of total banking sector deposits and financing respectively (Bank Negara Malaysia, 2004). This is contributed by 2 Islamic banks regulated and supervised under the Islamic Banking Act; 13 commercial banks, 3 finance companies and 4 merchant banks. The latter three types of interest-based banking institutions offer interest-free banking through special outfits called 'Islamic windows'. Islamic windows are departments within conventional banks set up, operating and maintaining Islamic banking operations as profit and cost entities separate from their conventional banking operations. Malaysia pioneered the implementation of Islamic widows for Islamic banking. Due to the success, the Islamic window set up serves as a model for Islamic banking systems in other countries such as Indonesia and Thailand.

The main issue is the unavailability of documented evidence on both cost and profit efficiency of Islamic banking operations. Most of the past studies focused on either cost efficiency or profit efficiency (Fare et al., 2004; Fitzpatrick and McQuinn, 2005; Akhigbe and McNulty, 2005). A study on one aspect of efficiency does not provide a comprehensive assessment of a state of efficiency of a bank. Studies by Chu and Lim (1998), Isik and Hassan (2002) and Maudos and Pastor (2003) emphasize the importance of investigating both cost and profit efficiency in the analysis of bank production efficiency. However, these studies were conducted on conventional commercial banks in Singapore, Turkey, Spain, and Australia respectively. Meanwhile, Malaysian studies conducted by Karim (2001) and Majid et al. (2005) only measured cost and technical efficiency of conventional banks. It is not possible to generalize their findings as conventional banks and Islamic banks are two different entities and are operating in different economic environment and banking systems.

The contribution to the banking sector an. national economy as well the issue of cost and profit efficiency for Islamic banking is considerably as area of investigation. This study evaluates the performance of Islamic banking operations on the operations efficiency aspect; particularly, both the cost and profit efficiencies of the Islamic banks and Islamic windows of commercial banks over 1998-2004 period. A comparison has also been made to examine the efficiency of the Islamic domestic banks and locally incorporated Islamic foreign banks over the same period.

The study discuses the relevant literature reviews in the following section followed by a method section to provide the details in analyzing data. Next section analyzes and interprets the findings. Concluding section follows.


The concept of production efficiency originated from Cobb and Douglas (1928). The study is premised on the structural relation between inputs and outputs in economic production. Berger and Humphrey (1997) extended the Cobb-Douglas model to the banking sector by focusing mainly on financial sector efficiency. Financial sector efficiency emphasizes that for fostering productivity, there has to be efficient allocations of financial resources. This means that the economy has the opportunity to shift what it saves from the resources for more productive investments. The economy may also utilize them in future allocations.

There are two efficiency concepts used in banking performance: production efficiency (Farrell, 1957) and X-efficiency (Leibenstein, 1966). Farrell (1957) concentrates on measurement of production efficiency, while Leibenstein (1966) concentrates on explaining why firms might not be achieving maximum efficiency in their productive decisions and behavior. …

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