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Efficiency of Islamic Banking Industry in Malaysia.

1. INTRODUCTION

Islamic banking is the one and only choice that all Muslim depositors or investors

have to make sure their money’s transactions being done in accordance to Shari’ah

principal. According to Majid et al (2011) Islamic banking differs from conventional

banking, because it strives to be compliant with the basic precepts of Shari’a, the

legal code of Islam, which is based on the principles of justice, fair dealings and

harmony through equitable distribution of wealth. Conventional banks on the other

hand uphold capitalism that makes the rich become richer and poor poorer.

The salient features of Islamic banking are therefore the prohibition of interest

payment in transactions, and the prohibition of undertaking or financing anti-social

and unethical behaviour such as gambling, prostitution, alcohol and narcotics.

1.1 Development of Islamic Banking in Malaysia

The first Islamic bank in Malaysia is Bank Islam Malaysia Berhad (BIMB) where it first

commencement was on 1 July 1983. Mokhtar et.al (2008) had explained that from

1983 to 1993, BIMB had enjoyed ten years of monopoly as the sole provider of

banking services based on Islamic principles. This exclusive right given to BIMB was

to allow the bank to develop as many Islamic products as possible and to get them

tested in the market. BIMB had a rapid achievement and it encouraged Central Bank

to introduce the Skim Perbankan Tanpa Faedah (SPTF) or interest-free banking

scheme in 1993 whereby the conventional banks were allowed to offer similar Islamic

banking facilities as the full-fledged Islamic bank did.

According to Suffian (2002) reasons for allowing conventional banks to offer Islamic

windows in 1993 is firstly because that is the fastest way to disseminate Islamic

banking nationwide. Besides, this alternative also can optimise existing banking

infrastructure, resources and network. It believed that Islamic windows will bring

higher level of sophistication in term of products and services and also facilitate

achievement of economic of scale, synergies and critical mass.

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The final phase of Islamic banking Malaysia is instant emergence of three new

foreign full-fledged Islamic banks and all of them are from the Middle-east, (Bank

Negara Malaysia, 2004).The first full-fledged foreign Islamic bank issued with license

to operate in Malaysia was Kuwait Finance House, while the second and third were

Al Rajhi Banking & Investment Corporation, and a consortium led by Qatar Islamic

Bank (Sidhu, 2004b;Bank Negara Malaysia, 2004).

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). It

has been supported by Mokhtar et. al (2008) efficiency play an important role in

banking literature because it can be used as an indicator to measure a bank’s

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

bank’s 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.

The efficiency measurement would give an indication whether current Islamic banks

in Malaysia are ready to face financial liberation without neglecting the ultimate goal

of it establishment which is to achieve success in the world and hereafter.

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2. LITERATURE REVIEW

Alwyni (2011) had explained that since the last five years, the growth in Islamic

banking in Malaysia is rapid and higher, as being compared to the overall growth of

the country’s banking industry. This study had shown that the average growth rate of

Islamic banking in Malaysia is 19 percent per annum, compared to the banking

industry’s 11 percent growth. Therefore, following the aspirations of the Central Bank

of Malaysia’s Financial Sector Plan (Central Bank of Malaysia, 2001) to make

Malaysia a global centre for Islamic financial services, there is a need to observe the

performance and efficiency of Islamic banks in order to oversee the development of

Islamic banking sector,

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. According to Mokhtar et.al(2008) efficiency can be measured in three

ways which are maximisation of output, minimisation of cost and maximisation of

profit. 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.

Kamarudin et.al(2008) have explained in detail for cost efficiency model, the labor

input is represented by personnel expenses (Yudistira, 2004), deposit input by total

deposits, and physical capital input by premises and fixed assets; and input prices (i)

price of labor, (ii) price of deposits,and (iii) price of physical capital. Outputs are (i)

earning assets (includes loans, advances and financing, and securities and

investments), (ii) liquid assets (includes cash and short-term funds, and deposits and

placements with financial institutions), and (iii) other income (includes commission,

service charges and fees).

On the other hands, for profit efficiency model, the inputs are: (i) personnel

expenses, (ii) total deposits, and (iii) premises and fixed assets; and input prices (i)

price of labor, (ii) price of deposits, and (iii) price of physical capital. The output for

both models is profit before taxation and zakat.

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Finally is technical efficiency of Islamic banking. Technical efficiency is the ability of a

firm to achieve the maximum amount of output given a set amount of inputs.

According to Ebrahim and Joo (2001), an efficient Islamic financial system is able to

allocate limited capital resources to the most profitable ventures and contribute

towards wealth creation.

3. DISCUSSION

In measuring the efficiency of Islamic banking, most of the researchers were using

Data Envelopment Analysis (DEA) technique .DEA provided several efficiency

measures such as allocative, pure technical and scale efficiency that explain cost

and profit efficiency differentials among banks. Yahya et.al (2012) were looking the

efficiency level of banks in Malaysia by comparing between Islamic banking and

conventional banking in year 2006, 2007 and 2008. Yahya et.al found that banks that

are engaged in Islamic banking are able to compete and be at par with their

conventional counterparts. Even though Islamic banks are limited by Islamic tenets in

its operations, they are able to maintain a performance that is equivalent to the

conventional banks.

On the other hands, Rozzani and Abdul Rahman(2013) had concluded there were

three factors that affected the efficiency of Islamic banks which include bank size,

credit risk and operational costs . By using Stochastic Frontier Analysis, they found

that levels of profit efficiency achieved by both conventional and Islamic banks in

Malaysia were highly similar. The overall efficiency of banks in Malaysia was found to

be below 50 percent of optimum efficiency, showing that banks operating in Malaysia

were still slacking in utilizing its resources, in terms of deposits and capital, efficiently

to produce similar service at a lower cost (Hassan et al., 2009). This could be caused

by the aspiration of these banks to provide services with better quality for their

customers, leading these banks to incur higher costs (Kraft &Tirtiroğlu, 1998). As for

Islamic Banking it suggested to find alternative to reduce operational cost in order to

increase it cost efficiency.

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Finally, Mokhtar et.al (2008) stated the technical efficiency and cost efficiency of

Islamic banking in Malaysia by also using DEA by obtaining from 288 banks in

Malaysia from year 1997 to 2003. Although this study was quite outdated, it

comprised a high range of years with more than 200 of banks. It also catered full-

fledged Islamic banks, financial institutions that offer Islamic windows and

conventional banks. Mokhtar et.al (2008) found that the average of technical

efficiency(TE) and cost efficiency(CE) for Islamic banking is still lower than the TE

and CE for conventional banks. However, they argued that the results were not fairly

compared. Although the efficiency results of the Islamic banking were somewhat

smaller than that of the conventional banking, they are still acceptable considering

the fact that the banks had been in the market for less than two decades.By any

standard, 20 years of Islamic banking existence in the Malaysian banking industry is

too short a period compared with conventional banking, which has the history of

more than 100 year existence in this country.

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4. CONCLUSION

For overcoming the challenges of cost inefficiency, it is suggested by Majid et.al

(2011) that it a need for managers to simultaneously develop new Islamic banking

products and consolidate operations after mergers, may have contributed to this poor

performance. Policy makers must continue to work both to make the banking

environment more conducive for Islamic banking and to encourage managers to

reduce these cost disadvantages. If these goals can be achieved, this majority

Muslim country will not only be able to satisfy its demand for Islamic banking

services, it will also be able to minimize the increase in costs associated with a move

to a dual-banking system.

From the discussion also, it can be conclude that Islamic banking have a high

prospect in banking industry in Malaysia. Based on that reason, Islamic banks should

provide appealing and updated facilities and amenities in their branches, since this is

complementary of the good reception criteria of the customers. These items will

subsequently strengthen the image and reputation of the Islamic banks in Malaysia,

especially in the current period. According to Echchabi and Olaniyi (2012), the

qualitative findings revealed that majority of the customers have chosen Islamic

banks because of their religious motivation, and their duty vis-a`-visthe achievement

of full shari’ah compliance of Islamic banks in the future. This was subsequently

proven by the customers’ perceived importance of shari’ah compliance of Islamic

banks, unanimously expressed by the interviewees. Based on that reason, the

efficiency of Islamic banking should not only solely on cost minimisation and profit

maximisation. It should be related to the customer satisfaction and also not far away

from objective of the Syariah or known as maqasid al-syariah.

On top of that, the quality of Islamic banking service should be enhanced. This

passes through training and updating the personnel on the latest innovations in terms

of Islamic banking service. Furthermore, Islamic banks in Malaysia should position

their branches where there is concentration of habitat as well as working areas, such

as commercial complex and so on. The customer of Islamic banking in years to come

might including non-Muslim and this should be a platform of spreading Islam by

spreading good conduct and excellent services.

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Government also should play their role in inculcating awareness to public on the

importance of choosing Islamic Banking instead of conventional banking. Expose the

Islamic Banking products not only to investors but also to students and ordinary

depositors for the sake of ummah’s prosperity.

5. REFERENCES

Echchabi,A and O,N,Olaniyi (2012) Malaysian consumers’ preferences for Islamic

banking Attributes, International Journal of Social Economics Vol. 39 No. 11, 2012

page. 859-874

Majid,M,A, Saal.D,S, and Battisti,G (2011) The impact of Islamic banking on the cost

efficiency and productivity change of Malaysian commercial banks, Applied

Economics, 2011, 43, page 2033–2054

Mokhtar,H,S,A,Abdullah,N and Alhabshi,S.M (2008) Efficiency and competition of

Islamic banking in Malaysia, Humanomics Vol. 24 No. 1, 2008 page 28-48

Rozzani,N and Abdul Rahman,R(2013) Determinants of Bank

Efficiency :Conventional versus Islamic International Journal of Business and

Management; Vol. 8, No. 14 page 98-109

Yahya,M,H,Muhammad,J and Abdul Hadi,A,R(2012), A comparative study on the

level of efficiency between Islamic and conventional banking systems in Malaysia

International Journal of Islamic and Middle Eastern Finance and Management

Vol. 5 No. 1, 2012 page. 48-62