Measuring the Efficiency of Islamic Banks in Indonesia

and Malaysia using Parametric and Nonparametric

Approaches
Ascarya, Diana Yumanita, Noer A. Achsani1, and Guruh S. Rokhimah
Center for Central Banking Education and Studies, Bank Indonesia
Jl. M.H. Thamrin 2, Radius Prawiro Tower, 18th fl., Jakarta 10110, Indonesia
Email: ascarya@bi.go.id; diana_yumanita@bi.go.id; achsani@yahoo.com

ABSTRACT
Islamic banks in many countries have emerged as important component of
financial system that contributes to the growth and development of the
countrys economy. They have proven to be a viable and competitive
component of the overall financial system. In the dual banking system, Islamic
banks have to be competitive to survive. One of the key to competitiveness is
efficiency. This study will measure and compare the efficiency of Islamic
banks in Malaysia and Indonesia using parametric approach stochastic
frontier approach (SFA) and distribution free approach (DFA), as well as
nonparametric approach data envelopment analysis (DEA). These
measurements will provide comprehensive and robust results of efficiency of
individual bank compare to its peer group in every aspect considered.
The results using parametric SFA and DFA show that Islamic banking in
Malaysia has been improving and has become as efficient as Islamic banking
in Indonesia in 2006. Meanwhile, the results using non-parametric DEA show
that Islamic banking in Indonesia is slightly more efficient than Islamic
banking in Malaysia, especially due to better technical efficiency. Funding
(deposits) and human resource (labor) are the sources of inefficiency in
Malaysia as well as Indonesia. Therefore, Islamic banks should redirect their
marketing and communication strategies to focus more on targeting floating
customers, while the shortage in human resource should be given serious
attention with short term and long term strategies.
JEL Classification: C14, C33, G21, G28
Keywords: Islamic Banking, Performance, Efficiency, Stochastic Frontier
Approach, Distribution Free Approach, Data Envelopment Analysis

Paper to be presented at State Bank of Pakistan (SBP) Islamic Research and Training Institute
(IRTI-IDB) 3rd International Conference on Islamic Banking and Finance, SBP-IRTI, Karachi,
Pakistan, October 27-28, 2008.
1
Visiting researcher from International Center for Applied Finance & Economics (InterCAF),
Department of Economics, Faculty of Economics and Management, Bogor Agricultural University.

1. Introduction
1.1

Background

Islamic banks have been in existence since early 1960s. The first Islamic bank
established in 1963 as a pilot project in the form of rural savings bank in a small town
of Egypt, Mit Ghamr. After that, Islamic banking movement came back to life in mid
1970s. The establishment of Islamic Development Bank in 1975 triggered the
development of Islamic banks in many countries, such as Dubai Islamic Bank in
Dubai (1975), Faisal Islamic Bank in Egypt and Sudan (1977), and Kuwait Finance
House in Kuwait (1977). By the end of 2005, more than 300 institutions in over 65
jurisdictions are managing assets worth around US dollars 700 - 1000 billion in a
Shariah compatible manner. A large part of the banking and Takaful concentration is
in Bahrain Malaysia, and Sudan. A significant part of mutual funds concentrate in the
Saudi Arabian and Malaysian markets in addition to the more advanced international
capital markets.
In Indonesia, Islamic financial institutions started to emerge in early 1980s with the
establishment of Baitut Tamwil-Salman in Bandung dan Koperasi Ridho Gusti in
Jakarta. The first Islamic Bank in Indonesia, Bank Muamalat Indonesia, established in
1992. The development of Islamic bank has been accelerated since Bank Indonesia
(the central bank of Indonesia) allowed conventional banks to open Islamic branch.
This Islamic branch can offer Islamic banking products and services separated from
its conventional parent with its own infrastructure, including staff and branches.
The Islamic banking system in Indonesia is currently represented by 3 Islamic banks,
24 Islamic branches, and 107 Islamic Rural Banks, with 679 offices and 1005 office
channeling spread throughout the country. They offer comprehensive and wide range
of Islamic financial products and services and cater 1.7% of the banking market share.
It is expected that the Islamic banking industry in Indonesia would reached 5% of the
banking market share in 2008.
Despite these impressive achievements, Islamic banking in Indonesia has
experiencing a slower growth in the past two years. There are many factors that could
be attributed to this slower growth. One of these factors is the competitiveness of
Islamic Banks within the banking system, since, in the dual banking system, they have
to compete head to head with conventional banks.
One important aspect of competitiveness is efficiency. Inefficiency would become a
great disadvantage to face a fierce competition in the banking industry. To win the
competition, Islamic banks should know the strengths and weaknesses of themselves
as well as of their competitor. Know yourself and know your competitor is a halfway
to success. Therefore, analysis of the efficiency of Islamic banks in comparison with
conventional banks is very important to give a big picture of the strengths and
weaknesses of Islamic banks and their competitors.
Despite of the importance, there are very limited studies comparing the efficiency of
Islamic and conventional banks within a country or between countries using
nonparametric approach, especially in Indonesia and Malaysia. But, there is no study
of this topic using parametric approaches. Therefore, there should be a study that
measure efficiency of Islamic and conventional banks using parametric and
nonparametric approaches in Indonesia and Malaysia to provide comparison and to

improve the robustness of previous measurement. These measures could also be used
as a guide for Islamic banks to improve their weaknesses to be able to compete head
to head with conventional banks and to achieve the intended goals to improve the
market share. Moreover, the goal to strengthen Islamic banking structure could be
achieved.
1.2

Objective

The objective of this study is to measure and compare the efficiency of Islamic banks
in Indonesia and Malaysia using parametric approach stochastic frontier approach
(SFA) and distribution free approach (DFA), as well as nonparametric approach data
envelopment analysis (DEA). These measurements will provide comprehensive and
robust results of efficiency of individual bank compare to its peer group in every
aspect considered.
1.3

Scope of Study

Islamic banks included in this study are all full fledged Islamic banks and business
unit Islamic banks in Indonesia, as well as all full fledge Islamic banks and Islamic
windows in Malaysia. The measurement will compare the efficiency of Islamic banks
in Indonesia and Malaysia using parametric approach (SFA and DFA) and
nonparametric approach (DEA), and compare them with the classic performance
measurement of return on asset (ROA).
1.4

Data and Methodology

The time frame of this study is 2002 2006. The data used in this study are the data
of published annual financial statements (balance sheets and income statements) of
Islamic banks in Indonesia and Malaysia.
This study will apply stochastic frontier approach (SFA) and distribution free
approach (DFA). SFA and DFA are two well known parametric approaches to
measure efficiency using cross section or panel data of multiple inputs and outputs of
business units. This study will also apply Data Envelopment Analysis (DEA). DEA is
a non-parametric and non-deterministic method to measure relative efficiency of
production frontier, based on empirical data of multiple inputs and multiple outputs of
decision making units. The non parametric nature of DEA makes it does not need
assumption of the production function. DEA will generate production function based
on data observed. Therefore, misspecification can be minimized. DEA can be applied
to analyze different kind of inputs and outputs without initially assigning weight.
Moreover, the efficiency produced is a relative efficiency based on observed data.
Preference of decision maker can also be accommodate in the model.
1.5

Benefit of the Study

The results of this study will be very useful for many stakeholders of Islamic banks in
Malaysia and Indonesia, especially the regulator (Bank Negara Malaysia and Bank
Indonesia), to formulate appropriate policy recommendations to improve the
competitiveness of Islamic banks.
Islamic banks in Malaysia and Indonesia will also benefit from this study to see where
they are in the competitiveness of the banking system. They will also be able to
determine the potential improvements of weak aspects.

2. Literature Review
Banking efficiency has been a very important issue in a transition economy. All
countries in transition have been encounter at least with one banking crisis, and many
with more than one crisis (Jemri and Vuji, 2002). Banking efficiency is also an
important issue in a developing open economy, since most of them have also been
faced a banking crisis in the past. Malaysia and Indonesia are no exception. There are
many studies about banking efficiency using parametric and non-parametric methods.
Moreover, those studies are applied to conventional as well as Islamic banks.
2.1 Efficiency Measurement using Parametric Approach
SFA and DFA have been used for some studies to measure the X-efficiency of
commercial bank or other financial institution such as studies that were conducted by
Allen and Rai (1995), Semih and Philippatos (2001), Hadad et.al (2003). Allen and
Rain (1995) measured operational efficiency in banking. Yildirin and Philippatos
(2001) measured the efficiency of banks during 1993 2000 to evaluate impact of
trantition economies to banks efficiency. Hadad et.al (2003) used SFA and DFA
methods to measure the efficiency of banks in Indonesia.
Table 2.1 Summary of Parametric Approach Applied
No

Author

Functional Form

Input

Output

Allen&Rai 95

Translog

Labor, capital, borrowed

funds

loans

Yildirim &
Philippatos 05

Multiproduct Translog

borrowed funds; labor;

physical capital

loans; investment;
deposit

Hadad et.al. 03

Translog

Price of labor (employees

cost to total assets); price
of funds (interest cost to
total liabilities)

Loans to the bank;

loans to the
stakeholder (exclude
bank); securities

Saaid et.al. 03

Translog

Labor, fixed assets, deposit Investment

Translog functional form

No
1

Translog functional form

2
2
2 2
2 2
2 2
4

lnTC = o + i ( pi )+ j ln(y j )+0.5 ik( pi )(pk )+0.5 jhln(y j )ln(yh)+ ijyi lnpj + lYRl +
i=1
j=1
i=1k=1
j=1h=1
i=1 j=1
l=1
2

ln(C / w3 z ) = + ln(w1 / w3 ) + 0.5 lh ln(w1 / w3 ) ln(w1 / w3 ) + k ln( yk / z ) +

l =1

l =1 h =1

k =1

0.5 kj ln( yk / z ) ln( yk / z ) + lk ln( yk / z ) ln(w1 / w3 ) + 1 ln Z +

k =1 j =1

k =1 l =1

k =1

l =1

0.5 2 (ln Z ) 2 + k ln( yk / z ) ln Z + l ln(wl / w3 ) ln Z + ln eti + ln uit

ln TC = 0 + ln w1 + 0.5 ij ln wi w j + ij ln wi + ln y + 0.5 yy (ln y ) 2 +

i =1

i =1 j 1

i =1

2.2 Efficiency Measurement using Non-parametric Approach

Three of those studies that measure efficiency of Islamic banks using DEA
application are conducted by Yudistira (2003), Ascarya and Yumanita (2006), and
Sufian (2006). Yudistira measured the efficiency of 18 Islamic banks from various
countries during 1997 2000 using intermediation approach, since intermediation is a
fundamental principle of Islamic banking. Ascarya and Yumanita measured the
efficiency of Islamic banks in Indonesia during 2002 2004 using intermediation and
production approaches, since Islamic banking not only can be viewed as intermediary
institution, but can also be viewed as a production entity. Meanwhile, Sufian
measured the efficiency of Islamic window banks in Malaysia during 2001 2004
using intermediation approach with the same reason as that of Yudistira.
Other studies of banking efficiency using DEA are done by Jemri and Vuji (2002)
and Hadad et al. (2003). Jemri and Vuji measured efficiency of banks in Croatia
during 1995 2000 using intermediation and production approach, since banking is
not just functioned as intermediary, but also as a producer of loans and investments.
Meanwhile, Hadad et al. measured efficiency of banks in Indonesia during 1995
2003 using asset approach to see the impact of merger and acquisition.
The efficiency measurement, parametric or non-parametric, of financial institution
like banks can be approached from their activities. There are three main approaches to
explain the relationship between input and output of banks. Two approaches, namely,
production (or operational) approach and intermediation approach, apply the classical
microeconomic theory of the firm, while one approach, namely modern (or assets)
approach applies modified classical theory of the firm by incorporating some
specificities of banks activities, namely risk management and information
processing, as well as some form of agency problems, which are crucial for
explaining the role of financial intermediaries (Freixas and Rochet, 1998). The
production approach describes banking activities as the production of services to
depositors and borrowers using all available factors of production, such as labor and
physical capital. The intermediation approach describes banking activities as
intermediary in charge of transforming the money borrowed from depositors (surplus
spending units) into the money lent to borrowers (deficit spending units). Meanwhile,
the asset approach or the modern approach tries to improve the first two approaches
by incorporating risk management, information processing, and agency problems into
the classical theory of the firm. The summary of approaches applied by previous
authors can be read in table 2.1.
Table 2.1 Summary of Non-parametric Approach Applied
Author

Input

Output

Intermediation Approach
Ascarya &
Yumanita07b

Labor Costs; Fixed Assets; Total Deposits

Total Loans; Income

Mochtar et.al07

Labor Costs; Total deposits, other

operating/overhead expenses

Total earning assets (financing/loans;

dealing securities; investment securities;
placements with other banks)

Zamil &
Rahman07

Staff cost; capital (net book value of

premises and fixed asset); Total deposits &
loanable funds

Loans and advances; Income (total

interest income, non-interest income and
income form IBS)

Ascarya &
Yumanita07a

Labor Costs; Fixed Assets; Total Deposits

Total Loans; Income

Sufian06

Labor Costs2; Fixed Assets; Total Deposits

Total Loans; Income

Ascarya &
Yumanita06

Staff Costs; Fixed Assets; Total Deposits

Total Loans; Other Income; Liquid Assets

Yudhistira03

Staff Costs; Fixed Assets; Total Deposits

Total Loans; Other Income; Liquid Assets

Jemri &
Vuji02

No. of Employees; Fixed Assets & Software; Total Loans; Short-term Securities
Total Deposits

Production Approach
Ascarya &
Yumanita06

Interest Costs; Staff Costs; Operational

Costs

Interest Income; Other Operational

Income

Jemri &
Vuji02

Interest & Related Costs; Commissions for

Services & Related Costs; Labor Related
Adm. Costs; Capital Related Adm. Costs

Interest & Related Revenues; Non-interest

Revenues

Asset Approach
Hadad et.al03.

Staff Costs to Total Assets; Interests Costs

to Total Assets; Other Costs to Total Assets

Financing to Connected Party; Financing

to Other Party; Financial Papers

From those studies it can be concluded that asset approach is an advanced approach
that views bank not only has a classical function of intermediary, but also has other
various new functions. Therefore, asset approach is not suitable to be applied to
Islamic banking which focuses on extending financing to the real sector. Production
approach can be applied for Islamic banking, since this approach views Islamic bank
as a general business unit. However, it becomes too general, so that the very essence
of Islamic banking is not represented. Meanwhile, intermediation approach can be
applied for Islamic banking since this approach views Islamic banking as an
intermediary institution. However, the input and output variables should be selected
carefully to really reflect the true essence of Islamic banking. Input and output
variables selected by Sufian (2006) are the closest to the characteristics of Islamic
banking. Some refined modifications might be needed to make it more representative.

As data on the number of employees are not readily made available, this study uses personnel
expenses as a proxy measure.

3. Methodology
The methodology of parametric Stochastic Frontier Analysis (SFA) and Distribution
Free Analysis (DFA), as well as nonparametric Data Envelopment Analysis (DEA)
will be used in this study. SFA, DFA and DEA applications are derived from the
theory of efficiency. Therefore, this chapter will first discuss the theory of efficiency,
the measurement of efficiency, the connection of SFA, DFA and DEA to efficiency
theory, and then discuss their details. Moreover, banks efficiency can be measured
from its functions. Three approaches to measure the efficiency of banks functions are
intermediation approach, production approach, and modern or asset approach. The
theory of efficiency in general, its relation to SFA, DFA and DEA, and the
measurement of banks efficiency can be described in figure 3.1.

ProducerTheory
(Production
FrontierLine)

Technical
Efficiency
Allocative
Efficiency

Nonparametric
DEA

Efficiency
Concept

Parametric
SFA,TFA,DFA

Consumer
Theory

Economic
Efficiency

TheoryMeasurementTools

InputOutput
Concept

MinimumInput
MaximumOutput

BANK
EFFICIENCY

ConstantReturntoScale
VariableReturntoScale

Production
Approach
Intermediation
Approach
Modern
Approach

Figure 3.1 Theory of Efficiency

3.1

The Theory of Efficiency

The concept of efficiency rooted from the microeconomic concept, namely, consumer
theory and producer theory. Consumer theory tries to maximize utility or satisfaction
from individual point of views, while producer theory tries to maximize profit or
minimize costs from producer point of views.
In the producer theory, there is a production frontier line that describes the
relationship between inputs and outputs of production process. This production
frontier line represents the maximum output from the use of each input. It also
represents the technology used by a business unit or industry. A business unit that
operates on the production frontiers is technically efficient. Figure 3.1 shows the
production frontier line.

Figure 3.1 Production Frontier Line

Considered from economic theory, there are two different types of efficiency, namely
technical efficiency and economic efficiency. Economic efficiency has macro
economic point of view, while technical efficiency has micro economic point of view.
The measurement of technical efficiency limited to technical and operational
relationship in a conversion process of input to output. Whereas, in economic
efficiency price can not be considered as given, since price can be influenced by
macro policy (Sarjana, 1999). According to Farell (1957), efficiency comprises of
two components, namely:
a. Technical efficiency describes the ability of a business unit to maximize output
given certain amount of input.
b. Allocative efficiency describes the ability of a business unit to utilize inputs in
optimal proportion based on their price.
When the two types of efficiency combined, it will produce economic efficiency. A
company is considered to be economically efficient if it can minimize the production
costs to produce certain output within common technology level and market price
level.
Kumbhaker and Lovell (2000) argue that technical efficiency is only one of many
components economic efficiency as a whole. Nevertheless, in order to achieve
economic efficiency a company should produce maximum output with certain amount
of input (technical efficiency) and produce output with the right combination within
certain price level (allocative efficiency).

3.2

The Measurement of Efficiency

In the past few years, performance measurement of financial institution has

increasingly focused on frontier efficiency or X-efficiency (rather than scale
efficiency), which measures deviation in performance of a financial institution from
the best practices or costs-efficient frontier that depicts the lowest production costs 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.
Frontier efficiency is superior for most regulatory and other purposes to the standard
financial ratios from accounting statements, such as, return on asset (ROA) or
cost/revenue ratio, that are commonly employed by regulators, managers of financial
institutions, or industrial consultants to assess financial performance. This is because
frontier efficiency measures use programming or statistical techniques that removes

the effects of differences in input prices and other exogenous market factors affecting
the standard performance ratios in order to obtain better estimates of the underlying
performance of the managers (Bauer, et al., 1998).
Frontier efficiency has been used extensively in regulatory analysis to measure the
effects of merger and acquisition, capital regulations, deregulation of deposit rates,
removal of geographic restrictions on branching and holding company acquisitions,
etc., on financial institution performance. Furthermore, Bauer et al. (1998) argue that
the main advantage of frontier efficiency over other indicators of performance is that
it is an objectively determined quantitative measure that removes the effects of market
prices and other exogenous factors that influence observed performance.
Tools to measure efficiency could be parametric and non-parametric. Parametric
approach to measuring efficiency uses stochastic econometric and tries to eliminate
the impact of disturbance to inefficiency. There are three parametric econometric
approaches, namely:
1. Stochastic frontier approach (SFA);
2. Thick frontier approach (TFA); and
3. Distribution-free approach (DFA).
These approaches differ in the assumptions they make regarding the shape of the
efficient frontier, the treatment of random error, and the distributions assumed for
inefficiencies and random error. The parametric methods have disadvantages relative
to the non-parametric methods of having to impose more structure on the shape of the
frontier by specifying a functional form for it. However, an advantage of the
parametric methods is that they allow for random error, so these methods are less
likely to misidentify measurement error, transitory differences in cost, or specification
error for inefficiency (Bauer, et al., 1998).
Meanwhile, non-parametric linear programming approach to measuring efficiency
uses non-stochastic approach and tends to combine disturbance into inefficiency. This
is built based on discovery and observation from the population and evaluates
efficiency relative to other units observed. One of the non-parametric approaches,
known as data envelopment analysis (DEA), is a mathematical programming
technique that measures the efficiency of a decision making unit (DMU) relative to
other similar DMUs with the simple restrictions that all DMUs lie on or below the
efficiency frontier (Seiford and Thrall, 1990). The performance of a DMU is very
relative to other DMUs, especially those that cause inefficiency. This approach can
also determine how a DMU can improve its performance to become efficient.
DEA was first introduced by Charnes, Cooper, and Rhodes in 1978. Since then its
utilization and development have grown rapidly including many banking-related
applications. The main advantage of DEA is that, unlike regression analysis, it does
not require an a priori assumption about the analytical form of the production function
so imposes very little structure on the shape of the efficient frontier. Instead, it
constructs the best practice production function solely on the basis of observed data,
and therefore the possibility of misspecification of the production technology is zero.
On the other hand, the main disadvantage of DEA is that the frontier is sensitive to
extreme observations and measurement error (the basic assumption is that random
errors do not exist and that all deviations from the frontier indicate inefficiency).
Moreover, there exists a potential problem of self identifier and near-selfidentifier.

3.3

Parametric Approaches: SFA and DFA

The parametric methods of SFA and DFA have been widely used to analyze
efficiency of banking industry, especially in the US and other well-developed
countries (see, among others, Berger, Hunter and Timme (1993), Berger and
Humphrey (1997), Berger and Mester (1997) for an extensive review of literature on
efficiency of financial institution).
The two methods have also been used in the previous researches on the efficiency of
banking industry in the transition countries. For more details see for example Yildirim
and Philippatos (2003) for central and east european countries, Bhattacharya et al
(1997) and Srivastava (1999) for India, Hasan and Marton (2000) for Hungary and
Isik and Hassan (2002) for Turkey.
3.3.1

The Cost and Profit Frontiers

Before going into the details about measuring efficiency, it is important to discuss the
concept of cost and profit. For further readings, please refer to Berger and Mester
(1997) and Yildirim and Philippatos (2003).
Cost efficiency measure the performance of banking firm relative to the best-practice
bank that produces the same output bundle under the same exogenous condition. The
cost frontier is determined by estimating the following cost function:
C = C ( y, w, z , u , e )

where C measures total costs for bank, y is a vector of outputs, w is vector of input
prices, z represents the quantities of fixed bank parameters, u is the inefficiency term
that captures the difference between the efficient level of cost for given output levels
and input prices and actual cost, and e is the random error term.
Assuming the inefficiency and random error term are multiplicatively separable from
the rest parameters, the above cost function can be expressed in logarithmic form as
follows:
ln C = f ( y, w, z ) + ln u + ln e

After estimating a particular cost function, the cost efficiency for bank i is measured
as the ratio between cost (Cmin) necessary to produce that banks output and the actual
cost (Ci) :
COSTEFFi =

C min exp[ f ( y, w, z )]x exp(ln u min ) u min

=
=
Ci
exp[ f ( y, w, z )]x exp(ln u i )
ui

where umin is the minimum ui across all the samples.

Profit efficiency measures how close a bank is attaining the possible profit as a bestpractice firm on the frontier for given levels of input and output prices and other
exogenous variables. Previous studies offered two different approaches for calculating
profit maximization objective, namely standard and alternative profit function.
However, as the situation in Indonesia and Mlaaysia, Berger and Mester (1997)
suggested that the alternative profit specification is preferred over the standard
specification when (a) there are differences in the quality of banking services, (b)

markets are not perfectly competitive, (c) outputs are not completely variable and (d)
output prices are not available.
The alternative profit frontier is formulated as follows:
P = P( y, w, z , u , e )

where P is the variable profits of the firm. Furthermore, in line with the formulation of
cost function, the profit function can be expressed in the log terms as follows:

ln ( P + ) = f ( y , w, z ) + ln e ln u
Where is a constant added to every banks profit to make it positive, so that the
natural log can be obtained. Profit efficiency is measured by the ratio between the
actual profit of a bank and the maximum possible profit that is achieved by the most
efficient bank.
PROFEFFi =

Pi
exp[ f ( y, w, z )]x exp(ln u i )
=
Pmax exp[ f ( y, w, z )]x exp(ln u max )

Where umax is the maximum ui of all banks in the sample.

3.3.2

The SFA and DFA

The Stochastic Frontier Approach (SFA) SFA asserts that managerial or controllable
inefficiencies can only increase costs (reduce profits) above (below) best-practice
frontier and that random fluctuations or uncontrollable factors can increase or reduce
cost (profits). Therefore, the model assumes that inefficiency measures, (ln u), which
represent the departure from efficient frontier follow an asymmetric half-normal
distribution, while random fluctuations are distributed as two-sided normal with a
zero mean and variance 2.
The Distribution Free Approach (DFA) tries to avoid the arbitrary assumptions of the
stochastic frontier approach, where panel data are available. This approach also
separates the composite error term into inefficiency and statistical noise component.
However, it assumes that there exists a core inefficiency for banks, which persists
over time while the random error part vanishes out over time ( Berger 1993 in
Yildirim and Philippatos 2003). According to DFA, inefficiency estimate of a bank is
determined by the difference between average residual of the bank i, (ln u), and the
average residual of the bank on the frontier (ln umin), assuming that the random errors
will cancel out over time. The estimated average residual is than transformed into a
measure of efficiency :
EFFi = exp(ln u min ln u i )
where ln umin is the average resiual for the bank with the lowest average cost residual.
The most efficient bank will be given score 1, and then the others will get score
between 0 1.
3.3.3

Functional Form

Following Yildirim and Philippatos (2003), we employ the multiproduct translog

functional form to estimate cost and alternative profit frontiers. The cost frontier
function is represented by:
2

ln (C / w3 z ) = 0 + l ln (wi / w3 ) + 0.5 lh ln (wl / w3 ) ln (wi / w3 )

l =1

l =1 h =1

+ l ln ( y k / z ) + 0.5 kj ln ( y k / z ) ln ( y j / z )
3

k =1
3

k =1 j =1

+ lk ln ( y k / z ) ln (wl / w3 ) + 1 ln Z + 0.5 2 (ln Z )

k =1 l =1
3

+ l ln ( y k / z ) ln Z + l ln (wl / w3 ) ln Z + ln eti + ln u it
k =1

l =1

where wi and yi are input prices and output amounts and z is the equity capital. We
impose the regular restrictions of symmetry and linear homogeneity for input prices in
estimating the parameters as follows :

kj = jk , lh = hl ;

l = 1,
l =1

h = 1 ,
h =1

l =1

lk

=1

Cost and input prices are normalized by the price of capital before taking logarithms
to impose linear input price homogeneity.
The alternative profit frontier estimation employs essentially the same specification as
cost function with some minor changes. For the profit frontier estimation, the
dependent variable ln(C/w3z) is replaced by ln(P/w3z) and the inefficiency term is u.
Cost, profit and output variables are normalized by equity capital (z) to control the
heteroscedasticity, scale and other estimation biases in addition to providing a more
economic meaning.

3.4

Non-parametric Approach: DEA

Data envelopment analysis or DEA is a methodology for analyzing the relative

efficiency and managerial performance of productive or decision making units
(DMUs), having the same multiple inputs and multiple outputs. DEA allows us to
compare the relative efficiency of (Islamic or conventional) banks by determining the
efficient banks as benchmarks and by measuring the inefficiencies in input
combinations (slack variables) in other banks relative to the benchmark (Jemri and
Vuji, 2002). DEA provides an alternative approach to regression analysis. While
regression analysis relies on central tendencies, DEA is based on extremal
observations. While the regression approach assumes that a single estimated
regression equation applies to each observation vector, DEA analysis each vector
(DMU) separately, producing individual efficiency measures relative to the entire set
under evaluation (Jemri and Vuji, 2002).
DEA is a non-parametric, deterministic methodology for determining the relative
efficient production frontier, based on the empirical data on chosen inputs and outputs
of a number of DMUs. From the set of available data, DEA identifies reference points
(relatively efficient DMUs) that define the efficient frontier (as the best practice
production technology) and evaluate the inefficiencies of other, interior points

(relatively inefficient DMUs) that are below the efficient frontier (Jemri and Vuji,
2002). Besides producing efficiency value for each DMU, DEA also determines
DMUs that are used as reference for other inefficient DMUs.
p

Efficiency of DMU 0 =

k =1
m

yk 0

v x
i =1

DMU = decision making unit

m : different inputs
p : different outputs

i0

n : number of DMU evaluated

xij : number of input i consumed by DMUj
ykj : number of output k produced by DMUj

There are two DEA models that are most frequently used, namely, the CCR model
(Charnes, Cooper, and Rhodes, 1978) and the BCC model (Banker, Charnes, and
Cooper, 1984). The main difference between these two models is the treatment of
return to scale. The CCR assumes that each DMU operates with constant return to
scale, while the BCC assumes that each DMU can operate with variable return to
scale.
CCR model assumes that the ratio of additional input and output is equal (constant
return to scale). It means that an additional input of x times will produce additional
output of x times. Another assumption is that every DMU operates on an optimal
scale. Therefore the efficiency of DMU can be measured as a maximum of a ratio
weighted outputs to weighted inputs. Meanwhile, BCC model assumes that every
DMU has not (or not yet) operated on optimal scale. This model assumes that the ratio
of additional input and output is not equal (variable return to scale). It means that an
additional input of x times will not produce additional output of exactly x times, but it
can be less or greater than x times.
Generally, the efficiency score of CCR model for each DMU will not exceed the
efficiency score of BCC model. This is because BCC model analysis each DMU
locally (i.e. compared to the subset of DMUs that operate in the same region of
return to scale) rather than globally (Jemri and Vuji, 2002). Furthermore, a
business or DMU, like bank, has similar characteristics one to another. However, each
bank usually varies in size and production level. This indicates that size matters in
relative efficiency measurement. CCR model represents (the multiplication of) pure
technical and scale efficiencies, while BCC model represents technical efficiency
only. Therefore, the relative scale efficiency is a ratio of CCR model and BCC model.
S k = q k ,CCR / q k , BCC
If the value of S = 1 means that the DMU operates in the best relative scale efficiency,
or in optimal size. If the value of S is less than 1 means that there still exists scale
inefficiency of the DMU. Therefore, the value of (1-S) represents the level of
inefficiency of the DMU. Consequently, when a DMU is efficient under BCC model,
but inefficient under CCR model, this means that the DMU has scale inefficiency.
This is because the DMU is technically efficient, so that the inefficiency that exists
comes from the scale.
OE = TE SE

-->

SE = OE / TE

OE: overall efficiency of CCR Model; TE: technical efficiency of BCC Model.

3.5 Measuring the Activity of Banks

The efficiency measurement, parametric or non-parametric, of financial institution
like banks can be approached from their activities. There are three main approaches to
explain the relationship between input and output of banks. Two approaches, namely,
production (or operational) approach and intermediation approach, apply the classical
microeconomic theory of the firm, while one approach, namely modern (or assets)
approach applies modified classical theory of the firm by incorporating some
specificities of banks activities, namely risk management and information
processing, as well as some form of agency problems, which are crucial for
explaining the role of financial intermediaries (Freixas and Rochet, 1998).
3.5.1

Production Approach

The production approach describes banking activities as the production of services to

depositors and borrowers using all available factors of production, such as labor and
physical capital. This approach, initiated by Benston (1965) and Bell and Murphy
(1968), considers banks as producer of deposit accounts to depositors and loans to
borrowers. Therefore, this approach defines input as number of workforce, capital
expenses on fixed assets and other materials, and defines output as the sum of all
deposit accounts or other related transactions.
According to Freixas and Rochet, (1998), the production approach suits well the case
of a local branch that is financially transparent in the sense that the money collected
from depositors is fully transferred to some main branch. Similarly, all the money lent
to borrowers is made available by the same main branch. The only outputs of the local
branch are its services to depositors and borrowers, and its only inputs are labor and
physical capital.
Parametric measurement of production approach has some difficulties. First,
disaggregation of costs prevents the study of scale and scope economies. Second,
production approach suffers from a basic problem on what the relevant measure of
output volumes is. Third, Cobb-Douglas specification for monotonicity of average
cost prevents the existence of an efficient size.
The first difficulty has been addressed by Baumol, Panzar, and Willig (1982) and the
existence of Functional Cost Analysis (FCA) program that allowed separate cost
functions to be estimated for all product lines. Disaggregated cost data for five
categories of banking activities identified are demand deposits, term and savings
deposits, real estate loans, consumer loans, and business loans. Cost functions of the
Cobb-Douglas type (one per activity i) are as follows:
log C i = i log Qi + ai log wi + (1 ai ) log ri + const
i = 1, , 5, Ci (total cost), Qi (volume of output), wi (wage rate), ri (interest)

The second difficulty is to choose output volume among the number of accounts, the
number of operations on these accounts, or the dollar amounts. Among these three
output volumes, the dollar amounts are more readily available. To correct possible
biases, heterogeneity factors for homogenizing the data (size, activity, and
composition of accounts) are introduced.

The third difficulty, the monotonicity of average cost (increasing if i > 1, decreasing
if i < 1, and constant if i = 1), has been addressed by Benston, Hanweck, and
Humprey (1982) by applying a more convenient specification of translog cost
function, in which the logarithm of the cost is quadratic with respect to the logarithms
of output and input prices. They find that a U-shaped average cost function with an
efficient size between 10 and 25 million dollars of deposits, which is surprisingly
small (Freixas and Rochet, 1998).
Moreover, Gilligan and Smirlock (1984), Gilligan, Smirlock, and Marshall (1984),
Berger, Hanweck, and Humprey (1987), and Kolari and Zardhooki (1987) use a
multiproduct cost function, which allows the discussion of scope economies and cost
complementarities. But, the results are not conclusive (Freixas and Rochet, 1998).
3.5.2

Intermediation Approach

The intermediation approach describes banking activities as intermediary in charge of

transforming the money borrowed from depositors (surplus spending units) into the
money lent to borrowers (deficit spending units). In other words, deposits that are
typically divisible, liquid, short-term, and risk less are transformed into loans that are
typically indivisible, illiquid, long-term, and risky. Therefore, this approach defines
input as financial capital (the deposits collected and the funds borrowed), and defines
output as the volume of loans and investment outstanding.
According to Freixas and Rochet, (1998), the intermediation approach is
complimentary to the production approach and is more appropriate to the case of a
main branch, which is not directly in contact with customers. In this case, the total
volume of loans granted by the local branches is in general different from the total
volume of deposit collected. Therefore, the main branch may have to borrow (or
invest) on financial markets.
Results of parametric measurement of the intermediation approach do not differ
substantially from those of the production approach. But, this approach also has some
difficulties. First, there is problematic behavior in determining deposits as output or
input. There is not enough supporting argument in selecting the variables and their
positions. Second, there is problematic behavior of the multi-product translog cost
function when some of the outputs tend toward zero (the logarithms become infinite).
On the first problem, one interesting findings are given by Hancock (1991) who runs
a linear regression of banks profit on the real balances of the items in banks balance
sheet without presuming a priori which correspond to outputs and which to inputs.
When these coefficients are positive they correspond to outputs (intuitively, the
banks profit increases when they increase), and when they are negative they are
correspond to inputs. She found that loans and demand deposits are outputs; whereas
labor, physical capital, materials, and cash are inputs. However, Hughes and Mester
(1993) found that deposits are inputs.
On the second problem, several contributions have tried to correct it. For example,
Hunter, Timme, and Yang (1990) use another specification (Minflex-Laurent) of the
cost function, and McAllister and McManus (1992) adopt nonparametric approach.
3.5.3

Modern Approach

The modern approach tries to improve the first two approaches by incorporating risk
management, information processing, and agency problems into the classical theory
of the firm. This approach introduces a possible discrepancy between banks manager
and owner in profit maximization behavior. If banks managers are not risk neutral,
they will typically chose a level of financial capital that is different from the cost
minimizing one.
Parametric measurement of the modern approach done by Hughes and Mester (1994)
find that, for larger banks, an increase in size (holding default risk and asset quality
constant) significantly lowers the price of uninsured funds (too big to fail). Moreover,
Berger and De Young (1997) find support for the bad luck hypothesis (problem
loans cause banks to increase spending on monitoring). Also, decreases in bank
capital ratios generally precede increases in non-performing loansevidence that
thinly capitalized banks may respond to moral hazard incentives by taking increased
portfolio risks (Freixas and Rochet, 1998).

4. Data Analysis
4.1 Data Description
The data needed for this empirical analysis comes from financial statements of
Islamic banks in Malaysia and Indonesia in the period of 2002 2006. There are two
types of Islamic banks in Malaysia, namely, full fledged Islamic bank and
conventional bank that offer Islamic banking products called Islamic window
(domestic and foreign owned). While in Indonesia, there are also two types of Islamic
banks, namely, full fledged Islamic bank and conventional bank that have separate
Islamic branch or Islamic business unit, including Islamic Regional Development
Branches. The data of type and number of banks included in this study can be read in
table 4.1.
[Insert Table 4.1]

Notice that BIMB is not included in 2006 data of Malaysian Islamic banks, since it
has negative income which is not acceptable by DEA (to be comparable, analysis for
parametric and non-parametric should use the same data). Statistical adjustment can
be done to include BIMB in the analysis, but some results tend to be bias. Moreover,
since the poor performance of BIMB is just a special case and not the reflection of the
whole Islamic banking industry in Malaysia, exclusion of BIMB will better reflect the
actual condition.
This study will adopt a modification of intermediation approach to better reflect
Islamic bank activities, as also adopted by Sufian (2006), Ascarya and Yumanita
(2007a and 2007b). Accordingly, we assume that Islamic banks produce Total Loans
(y1) and Income (y2) by employing Total Deposits (x1), Labor (x2) and Fixed Assets
(x3). Liquid assets are not included in this study as output variable, since Islamic
banks are not in the business of financial instruments in the financial markets, but in
the business of providing financing to the real sector. As data on the number of
employees are not readily made available, we use personnel expenses as a proxy
measure. The aggregate series of inputs and outputs of Malaysian and Indonesian
Islamic banks included in this study can be read in table 4.2.
[Insert Table 4.2]

4.2 Results and Analysis

The efficiency of Islamic banks in Malaysia and Indonesia are measured in several
ways by applying parametric SFA and DFA, as well as non-parametric DEA methods.
To make a comparable measurement, Malaysian and Indonesian Islamic Banks are
pooled together to form a common frontier. All banks for all years (2002-2006) are
pooled to measure efficiency.
4.2.1 Parametric SFA and DFA

Parametric SFA method requires time series data, so that the results can be grouped
for each year of observation, as can be seen in table 4.3, and figure 4.1.

[Insert Table 4.3]

Figure 4.1 Efficiency of Islamic Banks in Malaysia and Indonesia using SFA

The results in figure 4.1 (left) show that in 2002-2004, the efficiencies of Islamic
banks in Malaysia (0.70, 0.66, and 0.76) are better than those of Indonesia (0.56, 0.34,
and 0.67). However, while the efficiencies of Islamic banks in Malaysia have been
decreasing from 2002 to 2005, the efficiencies of Islamic banks in Indonesia have
always been increasing considerably since 2003, so that they outperformed efficiency
of Malaysian Islamic banks in 2005. Meanwhile, Islamic banks in Malaysia and
Indonesia have reached their highest efficiency in 2006 with the score of 0.99.
It should be noted that the efficiencies of Malaysian Islamic banks in 2006 have been
calculated by excluding BIMB. If we include BIMB 2006 in the sample, with some
statistical adjustment, the average efficiency of Malaysian Islamic banks will slightly
decrease in 2006, but it will make the results of DEA potential improvement bias
towards the domination of income as the most inefficient variable.
To give more convincing results, we rerun the data without 2006 series. The results in
figure 4.1 (right) are consistent with those of figure 4.1 (left) for the year 2002-2005.
Meanwhile, parametric DFA method requires panel data with minimum complete 5
period series. Therefore, only 7 Indonesian Islamic banks and 11 Malaysian Islamic
banks can be included in the sample. The results can be read in table 4.4.
[Insert Table 4.4]

The results in table 4.4 suggest that Indonesian Islamic banks have exhibited slightly
better efficiency than Malaysian Islamic banks in the period of observation (20022006). These results obtained by excluding BIMB in the sample. To give more
convincing results, we rerun the DFA without 2006 series. The results are consistent
with those of table 4.4 for the year 2002-2005, where the average efficiency of
Indonesian Islamic banks (0.9315) is better than that of Malaysian Islamic banks
(0.8941). It can also be inferred that efficiencies of Malaysian Islamic banks have
been improved considerably in 2006 to catch up those of Indonesian Islamic banks.
4.2.2 Non-parametric DEA
[Insert Table 4.5]

Summary of DEA results can be read in table 4.5. The results suggest that overall
efficiency of Malaysian Islamic banks have exhibited slight improvement and reach
the highest mean of 0.66 in 2003 and 2005, and then a slight decline to 0.64 in 2006.
The decomposition of overall efficiency into its pure technical and scale efficiency
components suggest that technical inefficiency dominates scale inefficiency of
Malaysian Islamic banks for all years. Technical efficiency has been slightly
increasing in 2002-2005, and has been somewhat declining to 0.68 in 2006.
Meanwhile, scale efficiency has always been high in 2002-2006, and has reached 0.94
in 2006. This implies that during the period of study, Malaysian Islamic banks have
been operating at high scale of operations, but technically have been operating at
lower efficiency (read figure 4.2, left).

Figure 4.2 Efficiency of Islamic Banks in Malaysia and Indonesia

Meanwhile, the overall efficiency of Indonesian Islamic banks has been declining in
2002-2005 from 0.80 to 0.67, and has been improved significantly in 2006 to reach
the highest mean of 0.82. The decomposition of overall efficiency into its pure
technical and scale efficiency components suggest that technical efficiency sharply
declined in 2003 to reach 0.73, and have been improving since, to reach 0.84 in 2006.
Meanwhile, scale efficiencies have been moving up and down, and have reached the
highest in 2003 and 2006 with score 0.97. This shows that during aggressive
expansion and the establishment of several new Islamic banks from 2002 to 2005,
overall efficiency deteriorated, while during further expansion without the addition of
new established Islamic banks in 2006, all efficiency measures have improved
considerably (see figure 4.2, right).
Overall, from table 4.5 and figure 4.2, it can be concluded that during the period of
observation from 2002 to 2006 Indonesian Islamic banks are relatively more efficient
than Malaysian Islamic banks in all three efficiency measures (overall, technical, and
scale efficiencies), except for scale efficiencies in 2002, 2004, and 2005, where
Malaysian Islamic banks were more scale efficient than those of Indonesian Islamic
banks.
Moreover, the scale efficiency of Islamic banks can also be viewed from the trend of
the return to scale (RTS)3 measured by DEA. Scale efficient banks exhibit constant
3

RTS are the increase in output that results from increasing all inputs. There are three possible cases. (1) Constant
Returns to Scale or CRS (RTS=0), which arise when percentage change in outputs = percentage change in inputs;
(2) Decreasing Returns to Scale or DRS (RTS=-1), which occur when percentage change in outputs < percentage
change in inputs; (3) Increasing Returns to Scale or IRS (RTS=1), which occurs when percentage change in
outputs > percentage change in inputs.

return to scale (CRS). Banks experiencing economies of scale exhibit increasing

return to scale (IRS), which means that the bank operates at a wrong scale of
operation. Banks experiencing diseconomies of scale exhibit decreasing return to
scale (DRS). Table 4.6 shows the results of return to scale.
[Insert Table 4.6]

The number of Malaysian Islamic banks operating at efficient scale (CRS) has been
generally low between 7%-14% (1-2 out of 15), except in 2005 that reached 27% (4
out of 15). Malaysian Islamic banks experiencing economies of scale (IRS) have been
up and down between 20%-33% (3-5 out of 15) in 2002-2005, but it has increased
considerably to 43% (6 out of 14) in 2006. Meanwhile, Malaysian Islamic banks
experiencing diseconomies of scale (DRS) have been high but decreasing from time
to time, and reached 43% (6 out of 14) in 2006 (read figure 4.3, left).

Figure 4.3 Return to Scale of Islamic Banks in Malaysia and Indonesia

Meanwhile, Indonesian Islamic banks operating at efficient scale (CRS) have been
decreasing in 2002-2004 from 29% (2 out of 7) to 15% (2 out of 13), and increasing
in 2004-2006 from 15% (2 out of 13) to 32% (6 out of 19). Indonesian Islamic banks
experiencing diseconomies of scale (DRS) have been decreasing from time to time
and reached 26% (5 out of 19) in 2006. Meanwhile, Indonesian Islamic banks
experiencing economies of scale (IRS) have been increasing in 2002-2006 from 29%
(2 out of 7) to 42% (8 out of 19) (read figure 4.3, right). Aggressive expansion of
Islamic banking industry in Indonesia during the period of observation has been
reflected in the increase of CRS and IRS Islamic banks and the decrease of DRS
Islamic banks.
Overall, from table 4.6 and figure 4.3, it can be concluded that there are more
Indonesian Islamic banks operating at scale efficient (CRS), while there are more
Malaysian Islamic banks operating at diseconomies of scale (DRS). The general trend
in both countries has been similar towards more scale efficient operation.
Other than generating efficient frontier, one salient feature of DEA is that it can
generate set of references for inefficient DMUs (Islamic banks) to benchmark to.
Table 4.7 shows Islamic banks that are referenced by other inefficient Islamic banks
in 2002-2006. There are always more Indonesian Islamic banks on efficient frontiers
that set as benchmarks for other inefficient Islamic banks to make improvements in
every year of observation. Moreover, Indonesian Islamic banks have been
benchmarked more frequently than those of Malaysian Islamic banks, except for the
year 2002 of yearly data run. For all data run, there are also more Indonesia Islamic

banks in the frontier line than Malaysian Islamic banks, but in 2003 and 2004,
Malaysian Islamic Banks were the most referred banks.
[Insert Table 4.7]

From table 4.7 it can be inferred that, in Malaysia, domestic windows perform better
than foreign windows and set as efficient benchmark for the industry. Meanwhile in
Indonesia, efficient benchmark is formed by full fledged, full branch, and regional
branch alike.
Another useful feature of DEA is that it can identify the source of inefficiency for
each DMUs or Islamic banks. The results in table 4.8 and figure 4.4 are generated by
running each year data of each country, separately.
[Insert Table 4.8]

In 2002-2006, Malaysian Islamic banks (figure 4.4, left) have always been efficient in
generating income, especially in 2003 and 2004, due to the products and services
provided that comparable to those provided by conventional banks. But, they have
always been struggling in financing, especially in 2004 and 2005, where financing
inefficiencies counted for more than 50% share. These have always been the case in
Malaysia where FDR has always been low, since the government treats Islamic bank
similar to conventional banks, where they can invest in Islamic instruments rather
than extending financing.
In 2006 deposits have become the most inefficient elements. Moreover, labor has
always been the second most inefficient elements since 2003.

Figure 4.4 Potential Improvements for Islamic banks in Malaysia and Indonesia

Meanwhile, financing has always been the most efficient elements in Indonesian
Islamic banks, except in 2004 and 2006, as also showed in the figure of FDR that
have always been high above 100%. In early 2004, there was a temporary shift of
deposits from conventional banks to Islamic banks due to the release of fatwa of the
haram-ness of interest by DSN-MUI (National Shariah Advisory Council of
Indonesia) in late 2003. Income has been improving considerably from the most
inefficient element in 2002 to the most efficient element in 2006, due to the
improvements of Islamic banks in providing financial services comparable to those
provided by conventional banks. Deposits have been worsening, and have become the
most inefficient element in 2006. The problem of deposits in Indonesian Islamic
banking intensified due to its high growth, but limited customer base. Islamic banks
have been targeting faithful customers which counted for only 1-10 percent, while

they have not been focusing on floating customers which counted for 80 percent.
Islamic banks should shift their marketing and communication strategies to target
more on floating customers.
Moreover, labor has always been inefficient. This is the case in Indonesia where the
supply of human resource is always lagging behind the demand of this still fast
growing industry. Even though there are more and more universities and higher
educational institutions offering Islamic Economic and Finance, the number of
graduates are still could not catch up with the demand. The consequence of this is
either the wage goes up or/and the human resource quality goes down. Therefore,
Indonesian Islamic banks should give more attention to human resource to improve
their efficiency. Moreover, other elements of input can also be improved further in
less priority than human resource.
Although there were many differences between Islamic banks in Malaysia and
Indonesia, the results of figure 4.4 in 2006 showed a trend of convergence, where
deposits became the most inefficient element and income became the most efficient
element, while labor has always been inefficient.
Deeper analysis can be done by investigating into individual results. Table 4.9 shows
the summary of three efficiency measures using parametric DFA and SFA, as well as
non-parametric DEA coupled with conventional measure of profitability, ROA (return
on assets). DFA gives one average measure of relative efficiency for 5-year panel data
with narrow range between 0.87 and 1.00, and mean 0.95. SFA gives one measure of
relative efficiency for each year of observation with wide range. Meanwhile, DEA
gives three measures of relative efficiency (technical, scale, and overall efficiencies)
for each year of observation.
[Insert Table 4.9]

In general, all three measures of efficiency do not always give parallel results due to
differences in methods, assumptions, and data used. However, profitable Islamic
banks tend to be efficient in one or more measure. In Malaysia, Public bank exhibits
consistent measure of efficiency and profitability (efficient for four years and
profitable for five years), followed by Maybank (efficient for five years and profitable
for two years) and Hong Leong Bank (efficient for four years and profitable for two
years). Efficient and profitable Islamic banks in Malaysia are dominated by large
domestic windows. Meanwhile in Indonesia, Bank Muamalat Indonesia exhibits
consistent measure of efficiency and profitability (efficient for four years and
profitable for five years), followed by Bank IFI (efficient for three years and
profitable for three years), Bank BNI and BPD DKI (efficient for three years and
profitable for two year), Bank Syariah Mandiri and BPD Jabar (efficient for two years
and profitable for three years), and Bank Syariah Mega Indonesia (efficient for two
years and profitable for two years). Unlike in Malaysia, efficient and profitable
Islamic banks in Indonesia are diverse in type and size.
All in all, Malaysian Islamic banks exhibit comparable and convergence measure of
efficiency to those of Indonesian Islamic banks using parametric SFA and DFA
methods. However, using non-parametric DEA method, Indonesian Islamic banks are
relatively slightly more efficient than Malaysian Islamic banks in all three measures
(technical, scale, and overall efficiencies) during the period of study. This can be
attributed, among others, to efficient financing activities. Financing to deposit ratios
has always been high above 100 percent, reflecting high contribution of Indonesian

Islamic banking to the real sector. Moreover, Malaysian and Indonesian Islamic banks
show a convergence in the characteristics of inputs and outputs, where deposits and
labor or human resource should be given top priority for improvements.

5. Conclusions and Recommendations

5.1 Conclusions

Islamic banking in Malaysia has been in existence 10 years earlier than that of
Indonesia with domestic windows play a dominant role. Their performances
have been stable with positive trend and have reached their best in 2006, where
their average SFA efficiency equal to that of Indonesian Islamic banks,
although their average DEA overall efficiency is still lagging due to low
average DEA technical efficiency.
Efficient Islamic banks in Malaysia are dominated by large domestic windows,
and profitable Islamic banks tend to be efficient, while small foreign windows
tend to be inefficient and less profitable. Large domestic windows also set a
benchmark for other still inefficient Islamic banks to follow.
In a relatively infant stage and smaller in size, Indonesian Islamic banking has
recorded positive trend and high overall efficiency in all three methods (SFA,
DFA, and DEA) that has reached equal or higher efficiency than that of its
Malaysian counterpart, due to higher average DEA technical efficiency and
improved average DEA scale efficiency. This can be attributed, among others,
to efficient financing activities with high financing to deposit ratios that has
always been high above 100 percent, reflecting high contribution of Indonesian
Islamic banking to the real sector.
Efficient Islamic banks in Indonesia vary in type and size, but they usually are
experienced Islamic banks that have been established earlier, and they set
efficient frontiers as benchmark for the others.
Islamic banks in Malaysia and Indonesia have shown a convergence in the
characteristics of inputs and outputs, where deposits and labor or human
resource are still inefficient and should be given top priority for improvements.

5.2 Recommendations

Islamic banks in Malaysia should be treated fairly and justly, which mean that
they should not be treated similar to their conventional counterpart. Islamic
banks should give more priority on financing activities to the real sector, not on
investing in monetary sector. One policy alternative is to give incentive for
Islamic banks that extend more financing and/or to give disincentive for Islamic
banks that maintain excess liquidity and opt to place them in short-term
financial instruments.

The size of Islamic (window) bank matters in Malaysia. Therefore, window

banks should be encouraged to convert to subsidiaries or full branches that are
separate from their parent conventional banks to improve their scale and overall
efficiencies, especially the small ones.

Islamic banks in Indonesia are still young and small, so that expansion should
be the number one priority to reach economies of scale and critical mass in the
shortest time possible. Other than organic expansion that naturally slow, to
accelerate expansion Islamic banks in Indonesia (i.e. the government) should
also have the political will, commitment, and courage to expand inorganically
by converting one state owned conventional bank into Islamic bank, preferably
the one that have large networks.

Funding (deposits) has become a new problem in Malaysian and Indonesian

Islamic banking. Head to head competition with conventional banks should
force Islamic banks to redirect their marketing and communication strategies to
focus more on floating customers.

Human resource has always been a problem in Malaysian and Indonesian

Islamic banking due to high demand and short supply. The improvement of the
human resources could be done with two strategies, namely, short term and
long term. In the short term, education and training should be conducted for
every level of management. In the long term, special fields of study in Islamic
economic and finance should be opened in graduate and undergraduate levels,
as well as inserting Islamic economic and finance curriculum in high school.

The improvement of the human resources from the regulator side could be done
by requiring banks to spend minimum budget for human resources
development. Moreover, the government or regulator could give incentives by
financing participation in human resources development. The regulator could
also provide free training for Islamic bank officers.

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Appendix
Table 4.1 Data of Islamic Banks

Malaysia
Domestic Full Fledged
Domestic Window
Foreign Window
Foreign Branch

Indonesia
Domestic Full Fledged
Domestic Full Branch (included)
Domestic Full Branch (no data/new)

2002

2003

2004

2005

2006

15
2
9
4
-

15
2
9
4
-

15
2
9
4
-

15
2
9
4
-

14
1
8
4
1

7
2
5
1

9
2
7
1

13
3
10
5

19
3
16
3

19
3
16
4

Table 4.2 Inputs and Outputs Data (Real US$.000)

2002

2003

2004

2005

2006

13,141,963
47,417
14,665,918
7,470,068
497,820
56.8

14,541,280
57,465
17,097,693
9,755,250
623,390
67.1

16,304,807
61,694
18,396,941
11,817,295
748,052
72.5

18,921,325
76,225
22,537,563
13,582,279
869,034
71.8

16,826,144
59,588
23,220,553
13,420,693
926,078
79.8

110,371
8,580
433,713
347,468
51,847
314.8

550,617
13,060
854,425
598,175
85,358
108.6

940,023
19,084
1,400,265
1,041,176
140,256
110.8

885,359
20,174
1,395,608
1,093,134
141,101
123.5

1,284,758
32,909
2,024,293
1,485,325
255,105
115.6

119.1
5.5
33.8
21.5
9.6

26.4
4.4
20.0
16.3
7.3

17.3
3.2
13.1
11.3
5.3

21.4
3.8
16.1
12.4
6.2

13.1
1.8
11.5
9.0
3.6

Malaysia
Deposits
Labor
Assets
Financing
Income
FDR

Indonesia
Deposits
Labor
Assets
Financing
Income
FDR

Malaysia : Indonesia
Deposits
Labor
Assets
Financing
Income

Table 4.3 Summary of Parametric SFA Efficiency

Bank

2002

Malaysia Domestic Full Fledged

Bank Islam Malaysia
0.4264
Bank Muamalat
0.5084
Malaysia Domestic Window
Maybank
0.7071

2003

2004

2005

2006

0.4616
0.3837

0.909
0.7541

0.6669
1

0.9897

0.7422

0.7057

0.9897

Public Bank
0.8544
RHB Bank
0.948
Hong Leong Bank
0.1451
Hong Kong Bank
0.6672
EON Bank
0.4833
Affin Bank
0.8078
Southern Bank
0.1638
Commerce Tijari
Arab-Malaysian Bank
1
Malaysia Foreign Full Fledged
Kuwait Finance House
Al-Rajhi Bank
Malaysia Foreign Window
OCBC
0.8544
Alliance Bank
0.9999
Citibank
1
Standard Chartered Bank
0.7211

0.7752
0.8111
0.5026
0.4566
0.815
0.8503
0.1483
0.6211

0.6594
0.9885
0.4023
0.6934
0.7004
0.9999
0.7423
0.6169

1
0.2705
0.2659
0.8204
0.4531
0.8428
0.5161
-

0.9897
0.9896
0.9895
0.9896
0.9894
0.9894
0.9895
-

0.9898
0.9895

0.7752
0.8608
0.6876
0.9346

0.6594
0.9901
0.7285
1

1
0.5441
0.6102
0.413

0.9894
0.9897
0.9898
0.9895

0.564936

0.9896

Malaysia AVERAGE
0.7045
Indonesia Domestic Full Fledged
Bank Syariah Mandiri
0.5739
Bank Muamalat Ind
0.6818
Bank Syariah Mega Ind
Indonesia Domestic Full Branch
Bank BNI
0.3307
Bank BRI
0.8867
Bank Bukopin
0.2535
Bank Danamon
0.5601
Bank Niaga
Bank BTN
Bank BII
Bank Permata
Bank IFI
Indonesia Regional Full Branch
BPD Jabar
0.6313
BPD Sumut
BPD Aceh
BPD DKI
BPD Riau
BPD NTB
BPD Kalsel
-

0.660992

Indonesia AVERAGE

0.559714

0.75945

0.3724
0.3273
-

0.8201
0.9818
0.7804

1
0.6395
1

0.9895
0.9895
0.9895

0.4492
0.4171
0.2213
0.3391
0.2469
0.1756

0.5826
0.4896
0.2322
0.9948
0.4424
0.1694
1

0.9139
0.7534
0.7303
0.2594
0.4318
1
0.6948
0.8048
0.7244

0.9896
0.9896
0.9896
0.9896
0.9895
0.9896
0.9895
0.9896
0.9895

0.5401
-

0.7688
1
0.4822
-

1
1
1
1
0.3403
0.8705
0.6382

0.9896
0.9896
0.9897
0.9896
0.9895
0.9896

0.343222

0.672638

0.779016

0.9896

Table 4.4 Summary of Parametric DFA Efficiency using 2002-2006 Data

No
1
2
3
4

Bank
Bank Syariah Mandiri
Bank BNI
Bank BRI
Hong Kong Bank

Type

Efficiency

Domestic Full FLEDGED Ind

Domestic Full BRANCH Ind
Domestic Full BRANCH Ind
Domestic WINDOW Mal

1.0000
0.9748
0.9672
0.9651

5
6
7
8
9
10
11
12
13
14
15
16
17
18

Bank Muamalat Indonesia

BPD Jabar
Affin Bank
OCBC
Alliance Bank
Bank Bukopin
Public Bank
Maybank
EON Bank
Bank Muamalat
Citibank
Bank Danamon
Standard Chartered Bank
Hong Leong Islamic Bank

Domestic Full FLEDGED Ind

Domestic REGIONAL Ind
Domestic WINDOW Mal
Foreign WINDOW Mal
Foreign WINDOW Mal
Domestic Full BRANCH Ind
Domestic WINDOW Mal
Domestic WINDOW Mal
Domestic WINDOW Mal
Domestic Full FLEDGED Mal
Foreign WINDOW Mal
Domestic Full BRANCH Ind
Foreign WINDOW Mal
Domestic WINDOW Mal

0.9603
0.9584
0.9565
0.9550
0.9544
0.9527
0.9515
0.9509
0.9504
0.9460
0.9433
0.9348
0.9343
0.8685

AVERAGE Indonesia
AVERAGE Malaysia
Overall AVERAGE

0.964
0.943
0.951

Table 4.5 Summary of Non-parametric DEA Efficiency

Efficiency Measures
ALL
Overall Efficiency
Technical Efficiency
Scale Efficiency
MALAYSIA
Overall Efficiency
Technical Efficiency
Scale Efficiency
INDONESIA
Overall Efficiency
Technical Efficiency
Scale Efficiency

2002

2003

2004

2005

2006

0.68
0.73
0.93

0.68
0.71
0.96

0.66
0.72
0.92

0.67
0.75
0.89

0.74
0.77
0.96

0.62
0.65
0.96

0.66
0.68
0.95

0.65
0.68
0.94

0.66
0.71
0.92

0.64
0.68
0.94

0.80
0.91
0.88

0.73
0.75
0.97

0.68
0.76
0.89

0.67
0.78
0.86

0.82
0.84
0.97

Table 4.6 Summary of DEA Return to Scale

2002
Bank
All
CRS
DRS
IRS
TOTAL
Malaysia
CRS
DRS
IRS
TOTAL

2003

2004

2005

2006

% Share Bank % Share Bank % Share Bank % Share Bank

% Share

3
13
6
22

14%
59%
27%

4
13
7
24

17%
54%
29%

3
15
10
28

11%
54%
36%

8
16
10
34

24%
47%
29%

8
11
14
33

24%
33%
42%

1
10
4
15

07%
67%
27%

2
8
5
15

13%
53%
33%

1
9
5
15

07%
60%
33%

4
8
3
15

27%
53%
20%

2
6
6
14

14%
43%
43%

Indonesia
CRS
DRS
IRS
TOTAL

2
3
2
7

29%
43%
29%

2
5
2
9

22%
56%
22%

2
6
5
13

15%
46%
38%

4
8
7
19

21%
42%
37%

6
5
8
19

32%
26%
42%

Frq

2006

Table 4.7 Summary of DEA Reference Set

2002

Frq

2003

Yearly Data
Citibank
B Muamalat Ind
Bank BNI
Public Bank
Maybank
BS Mandiri

15
9
5
3
3
1

Bank BNI
Hong Leong
Public Bank
Bank IFI
Bank Bukopin
Maybank
B Muamalat Ind
Affin Bank
BPD Jabar

All Data
B Muamalat Ind 44
Bank BNI
27

Bank BNI
Bank IFI
Maybank
Affin Bank

Frq

2004

Frq

2005

11 Bank Bukopin
10
Hong Leong
7
Maybank
7
Public Bank
7
Bank IFI
4
Bank BRI
2
BPD Riau
1
BPD Jabar
1 Bank Danamon
B Muamalat Ind

14 B Muamalat Ind
10
EON Bank
8
BPD DKI
7
Bank BRI
7
Bank IFI
6
Maybank
4
BS Mandiri
4
BPD Jabar
2
Bank BTN
1
Public Bank
Hong Leong
Affin Bank
Bank Danamon

13
Bank Niaga
12
BSMI
11
Bank BRI
11
Maybank
6
Hong Leong
3
EON Bank
3
BPD Sumut
2
BPD NTB
2
BPD DKI
1
BPD Jabar
1 B Muamalat Ind
1
Public Bank
0
Bank IFI

13
10
8
7
7
5
4
4
4
3
3
2
0

62
36
23
1

28
11

40
5

48
43
21
12
10
9
6

Public Bank
Bank IFI

EON Bank
Hong Leong

BSMI
Hong Leong
BPD Sumut
Bank BRI
Maybank
BPD NTB
Bank Niaga

Table 4.8 Summary of DEA Potential Improvements (in %)

2002
Malaysia
Asset
Labor
Deposits
Financing
Income
Indonesia
Asset
Labor
Deposits
Financing
Income

Frq

2003

2004

2005

2006

19.56
19.38
22.61
24.02
14.44

21.71
25.93
22.23
29.83
0.30

14.17
21.34
12.71
50.90
0.87

11.60
20.22
11.61
52.39
4.17

17.50
24.98
29.29
18.84
9.39

12.70
29.65
12.70
3.50
41.46

28.29
36.42
29.00
0.00
6.30

17.15
17.06
20.62
24.52
20.65

25.07
29.56
25.73
0.00
19.64

25.26
25.26
35.17
14.31
0.00

Table 4.9 Summary of SFA, DFA, and DEA Efficiencies

BANK

Asset
DFA
US$ M

2006
SFA

Malaysia Domestic Full Fledged

Bank Islam Malay
Bank Muamalat
3,412.6 0.946
Malaysia Domestic Window
Maybank
5,990.5 0.951
Public Bank
2,593.4 0.952
RHB Islamic Bank 2,053.1
Hong Leong Bank 1,632.3 0.869
Hong Kong Bank
1,363.3 0.965
EON Bank
1,302.8 0.950
Affin Bank
990.2
0.957
Southern Bank
Commerce Tijari
638.4
Arab-Malay Bank
Malaysia Foreign Full Fledged
KFH
764.2
Malaysia Foreign Window
OCBC
802.3
0.955
Alliance Bank
710.8
0.954
Citibank
447.2
0.943
Standard Chartered 519.3
0.934
Indonesia Domestic Full Fledged
Bank Syh Mandiri
730.4
1
Bank Muamalat Ind 642.7
0.960

2005
SFA

2003

2002

DEA ROA

SFA

DEA

ROA

SFA

DEA

ROA

SFA

DEA

ROA

-8.88 0.667 0.537 -3.20

0.417 0.31
0.9897 0.422 0.54
1

0.909
0.754

0.645
0.325

0.58
-0.36

0.462
0.384

0.326
0.897

0.57
0.05

0.426
0.508

0.256
0.850

0.28
0.29

0.962 1.68
1
0.850 2.62 0.660
0.531 0.54 0.989
1.39 0.402
1
0.660 0.78 0.693
1
2.47 0.700
0.825 0.85 0.9999
0.720 0.67 0.742
0.056 -3.15
0.617

0.917
1
0.378
0.936
0.638
0.618
0.647
0.750
0.563

0.90
2.50
2.18
1.68
0.50
1.88
1.03
1.05
-1.25

0.742
0.775
0.811
0.503
0.457
0.815
0.850
0.148
0.621

1
0.958
0.330
0.901
0.690
0.719
1
0.836
0.500

0.77
1.88
1.08
2.04
-0.38
1.50
1.22
5.04
0.18

0.707
0.854
0.948
0.145
0.667
0.483
0.808
0.164
1

0.993
0.765
0.406
0.695
0.680
0.509
0.927
0.786
0.496

1.35
1.69
1.01
1.43
2.65
1.07
0.94
3.65
1.07

0.9897
0.9897
0.9896
0.9895
0.9896
0.9894
0.9894
0.9895
-

DEA ROA

2004

1
0.838
0.632
1
0.646
0.865
0.562
0.388
-

0.08
-

0.706
1
0.271
0.266
0.820
0.453
0.843
0.516
-

0.9898 0.231

0.26

0.9894
0.9897
0.9898
0.9895

0.27
1.16
1.60
0.45

1
0.544
0.610
0.413

0.666
0.765
0.370
0.543

0.88
0.90
0.94
0.30

0.660
0.990
0.729
1.000

0.205
0.569
0.675
0.812

0.62
0.92
0.55
0.48

0.775
0.861
0.688
0.935

0.320
0.228
0.518
0.609

0.44
0.94
1.45
1.36

0.854
0.999
1
0.721

0.310
0.192
0.961
0.514

0.65
1.11
3.84
2.61

0.817
1
0.640 0.943

1.18
2.11

0.820
0.982

0.824
0.835

1.51
1.54

0.372
0.327

0.696
0.822

0.53
1.59

0.574
0.682

0.863
1

1.55
2.06

0.590
0.790
0.501
0.539

0.9895 0.860
0.9895 0.994

2.03
2.08
1.07
0.67
0.86
0.25
0.94

Bank Syh Mega Ind 178.7

Indonesia Domestic Full Branch
Bank BNI
121.5
0.975
Bank BRI
85.2
0.967
Bank Bukopin
39.0
0.953
Bank Danamon
37.1
0.935
Bank Niaga
40.4
Bank BTN
31.4
Bank BII
15.3
Bank Permata
23.8
Bank IFI
2.6
Indonesia Regional Full Branch
BPD Jabar
37.2
0.958
BPD Sumut
5.9
BPD Aceh
14.6
BPD DKI
7.8
BPD Riau
6.9
BPD NTB
1.4
BPD Kalsel
2.3
-

0.9895

0.715

0.81

0.780

0.524

2.51

0.9896
0.9896
0.9896
0.9896
0.9895
0.9896
0.9895
0.9896
0.9895

0.745
1
0.831
0.826
1
0.812
0.581
0.614
0.839

0.914
0.753
0.730
0.259
0.432
1
0.695
0.805
0.724

0.670
0.863
0.835
0.849
0.676
0.463
0.760
0.531
0.801

2.05
0.34
0.56
-11.77
-0.57
-0.76
-9.57
-3.44
2.01

0.583
0.490
0.232
0.995
0.442
0.169
1

0.723
0.766
0.854
0.929
0.205
0.677
1

N/A
-3.76
1.73
0.21
N/A
-17.20
2.50

0.449
0.417
0.221
0.339
0.247
0.176

1
0.762
0.800
0.745
0.297
1

0.01
-8.41
0.27
-2.47
-3.59
3.84

0.331
0.887
0.254
0.560
-

1
0.364
0.829
0.738
-

N/A
-15.22
-2.57
-10.18
-

0.9896
0.9896
0.9897
0.9896
0.9895
0.9896

0.777
1
0.463
0.897
0.651
1
0.598

1
1
1
1
0.340
0.871
0.638

0.694 2.82
0.164 -1.43
0.281 -0.26
0.914 2.96
0.685 0.87
0.551 -2.65
0.509 0.61

0.769
1
0.482
-

0.565
0.381
0.616
-

1.67
-1.84
N/A
-

0.540
-

0.465
-

0.77
-

0.631
-

0.808
-

0.21
-