Technical Efficiency Of Islamic Banks Versus Domestic Banks: Evidence From Bangladesh

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1. The International Journal of Business and Finance Research Vol . 10, No. 2, 2016, pp. 31-40 ISSN: 1931-0269 (print) ISSN: 2157-0698 (online) www.theIBFR.com TECHNICAL EFFICIENCY OF ISLAMIC BANKS VERSUS DOMESTIC BANKS: EVIDENCE FROM BANGLADESH Abdus Samad, Utah Valley University ABSTRACT This paper empirically estimates the technical efficiencies (TE) of Islamic banks compared to conventional banks in deposit mobilizations and loans production for 2010. This analysis uses the stochastic frontier production function. Estimates of the mean TE of Islamic banks and conventional banks for loans are 59.6 percent and 62.8 percent respectively, and for deposits are 0.61 and 0.60 respectively. Parametric tests, test, Satterthwaite-Welch t-test, Anova F-test, and Walch F-test, indicate no statistical evidence of significant differences between the TE of Islamic and conventional banks. The competitive market structure for loans and deposits markets, evidenced by the Herfindahl-Hirschman Index of less than 400, provides an explanation for the equality of mean TE between Islamic and conventional banks. JEL: G20, G21, C33 KEYWORDS: Efficiency, Foreign Bank, Domestic Bank, Stochastic Frontier INTRODUCTION S ince the liberation in Bangladesh in 1971, there has been a rapid development of banking as well as of deposit mobilizations and financing bank loans. At the time of liberation, Bangladesh had only five domestic banks (Sonali Bank, Rupali Bank, Janata Bank, Agrani Bank, and Pubali Bank). All were nationalized by the then-government. When the privatization policy was introduced in 1982, one of the five banks, Pubali Bank, was sold to the private sector. Currently, there are forty-seven banks operating in Bangladesh with a total of 8,375 branches. Of these forty-seven banks, forty are conventional (i.e., interest-based banks), and seven are Islamic banks. Among the forty conventional banks, eight are foreign banks. All banks operate side by side and compete for deposit and loan markets. During the period 2012-2013, total deposit mobilizations of banks were TK 5388.39 billion and loan financings totaled TK 5547.99 billion. These numbers were significant improvements over the past. The operation of Islamic banks is a new phenomenon compared to that of conventional banks. Conventional banks are centuries old and therefore have significant experience in portfolio management, deposit mobilization, and loan financing compared to Islamic banks. Even though Islamic banks are new, however; they compete with conventional banks and operating side by side with them. So, the study of comparative technical efficiency (TE) between conventional banks and Islamic banks in deposit mobilizations and financing loans is important. The comparative study of TE has not been explored in Bangladesh. The study of comparative efficiency in Bangladesh is important to several agents, including bank customers, depositors, and lenders. Bank customers may decide whether they should approach conventional banks or Islamic banks and which may be the better choice for them. 31 Electronic copy available at: https://ssrn.com/abstract=2825983
2. A . Samad | IJBFR ♦ Vol. 10 ♦ No. 2 ♦ 2016 The study of TE is also helpful for bank management, who can improve their efficiency level if they determine their comparative efficiency level in the banking market. Bank management must know whether they are performing below the average or above the average level of efficiency of their rival banks (foreign banks) before making any reallocation of resources for output optimization or cost minimization. Thus, bank management can improve and maintain their competitive skill and efficiency in a competitive market for their survival only when they know current level of efficiency. As Islamic banks enter into the banking sector, competition in the banking market is increasing and demanding the determination of efficiency for determining comparative efficiencies. A current literature survey shows no record of comparative efficiency studies between conventional banks and Islamic banks. The absence of comparative efficiency studies between Islamic banks and conventional banks in Bangladesh in particular provides a key motivating factor for this study. This study thus makes an important contribution to the banking literature by providing the comparative status of efficiency. It is not only important for bank management and bank regulators but also for bank customers. Relative efficiency information might also provide valuable information to bank customers their decision to choose banks. The study is organized as a brief survey of literature, discussion of data, methodology and the description of model, and a final section that provides empirical results and conclusions. LITERATURE REVIEW The literature on bank efficiency studies is plentiful. However, the number of bank efficiency studies covering less developed countries is limited. For the banking systems of Southeast Asian countries, including Bangladesh, such studies are almost non-existent. El-gamal and Inanoglu (2004) estimated the comparative cost efficiency of Turkish banks for the period 1990-2000 using the data envelopment analysis (DEA) method. They found that Islamic banks were more efficient due to their asset-based financing. Samad (2004) compared the performance of Islamic banks and conventional commercial banks of Bahrain with respect to (a) profitability, (b) liquidity, and (c) capital management. A comparison of eleven financial ratios for the period 1991-2001 found no difference in profitability and liquidity performance between Islamic and conventional banks for that period. Sufian and Majid (2006) investigated the comparative efficiency of foreign and domestic banks of Malaysia during 2001-2005. They found that banks’ scale inefficiency dominated pure technical efficiency during the period. They also found that the foreign banks had higher technical efficiency than the domestic banks. There has been some analysis of bank efficiency in India. For the most part, these analyses have used financial indicators for measuring bank efficiency as in the articles by Rammohan and Roy (2004) and Sarkar et al. (1998). Rammohan and Roy found that public sector banks are more efficient than private sector banks in India. In another study, Kumbhakar and Sarkar (2003) used a cost efficiency approach for measuring bank efficiency and also concluded that private sector banks had higher levels of efficiency in contrast to public sector banks in that country. Another group of Indian scholars used the DEA approach in measuring bank efficiency, including Saha and Ravishankar (2000), Bhattacharyya et al. (1997) and Sanjeev (2006). Bhattacharyya et al. (1997) determined that public sector banks were the best performing banks in India during the late 1980s and early 1990s. Shanmugam and Das (2004) used a stochastic frontier analysis (SFA) process for measuring technical efficiencies of Indian commercial banks and found that a group of state banks were more efficient than a comparable group of foreign banks during a period from 1992-1999. 32 Electronic copy available at: https://ssrn.com/abstract=2825983
3. The International Journal of Business and Finance Research ♦ VOLUME 10 ♦ NUMBER 2 ♦ 2016 Andries and Cocris (2010) analyzed the comparative efficiency of banks in several southern European countries during the period of 2000-2006 using both DEA and SFA analytic processes. They found that banks in Romania, the Czech Republic, and Hungary all operated at relatively low levels of technical efficiency. Samad has done several evaluations of the Bangladesh banking system. Samad’s (2009) review of technical efficiency using data for 2000 found the average efficiency of those banks was 69.6. Samad (2007) also examined the comparative performance of foreign banks verses domestic banks in Bangladesh using various financial ratios of bank performance and found no difference in profit performance between domestic banks and foreign banks in the period 2000-2001. In yet another analysis, Samad (2010) estimated the technical efficiency of Grameen bank micro-financing activities in Bangladesh as developed by Nobel Laureate, Dr. Muhammad Yunus. Samad (2009) has also previously examined the TE of Bangladesh banking industry, but the current analysis is different from the previous studies in several ways. First, there was no comparison in the previous study. Second, unlike the 2009 study, this study estimates loan and deposit for technical efficiencies instead of profits of the previous study. Samad (2013) investigated the efficiency of Islamic banks using the time varying Stochastic Frontier function on the Islamic banks of 16 countries. Mean efficiencies between the pre global financial crisis and the post global crisis were estimated at 39 and 38 percent respectively and the difference was not statistically significant. DATA AND METHODOLOGY Data Forty three banks were examined. Data for labor, deposits, loans and investments were obtained from the Bank and Financial Institutions’ Activities, Division of Finance, Ministry of Finance, the Peoples’ Republic of Bangladesh for2010. Data for fixed capital were obtained from the Website of the respective banks. Data are annual. The descriptive statistics of variables are provided in Table 1. Table1: Descriptive Statistics of Variables Mean LABOR CAPITAL LOANSINVT DEPOSIT 2,812.35 2,575.93 83,302.51 83,578.84 Median 1,511.00 1,615.53 68,434.00 65,126.00 Maximum 20,840.00 26,888.23 390,837.0 464,886.0 Minimum 49.00 0.00 2,804.000 1,851.000 Std. Dev. 4,088.80 4,360.86 77,609.86 85,924.20 43 43 43 43 Observations Labor refers to the number of fulltime and part-time workers working for the bank. Capital describes the fixed capital of banks such as bank premises, computers, etc., and is expressed in Taka, the local currency of Bangladesh. Deposits, Loans and investments are considered the banks’ output. Methodology-Stochastic Frontier Each bank’s efficiency was analyzed using the time invariant stochastic frontier method developed by Aigner, Lovell, and Schmidt (1977) and later refined by Pitt and Lee (1981) and Batties and Colie (1992). As this experience has developed, stochastic frontier modeling has become popular using distinct 33
4. A. Samad | IJBFR ♦ Vol. 10 ♦ No. 2 ♦ 2016 parameterizations of an inefficiency term in stochastic production or cost frontier models. The frontier production assumes that a producer has a production function: Qi = f(Xi, β) (1) where Xit is a (1x k) vector of inputs and other explanatory variables used for the quantity of output of ith firm and β is a (k x 1) vector of unknown parameters to be estimated. Stochastic frontier analysis assumes that each firm potentially produces less than it might produce due to a degree of inefficiency. Specifically, Qi = f(Xi, β)ξi (2) where ξi is the level of efficiency for ith firm; 0 ≤ξi ≤ 1. That is, efficiency (ξi ) lies in the interval between zero and one. If ξi =1, the firm achieves the optimum output with the technology provided by the production function Qi = f(Xi, β). When ξi <1, the firm is not making the most of the inputs Xi given the technology embodied in the production function (2). Since output is assumed to be strictly positive (Q>0), the degree of technical efficiency ( ξi) is assumed to be strictly positive, i.e. ξi >0. The production of output assumes that it can be subject to random shock, implying that Qi = f(Xi, β)ξi exp(