EFFICIENCY IN ISLAMIC BANKING: AN EMPIRICAL ANALYSIS OF EIGHTEEN BANKS

INTRODUCTION

In recent years, financial institutions have experienced a dynamic, fast-paced, and competitive environment at a cross-border scale. One of the fastest growing industries is Islamic banking. There are now more than 160 Islamic financial institutions around the world (Dar 2003). Though most of Islamic Banks are within the Middle-East countries, many universal banks in developed countries have begun to tap the massive demand of Islamic financial products. The main difference between the Islamic banks and the contemporary banks is that while the latter is based on the conventional interest-based principle, while the former follows the principle of interest-free and profit and loss sharing (PLS) in performing their business as intermediaries (Ariff 1988). Under the term of Islamic PLS, the relationship between borrower, lender and intermediary are rooted on financial trust and partnership. Dar (2003) classifies four types of financing used as alternatives of interest; investment-based, sale-based, rent-based and service-based. Despite considerable development of Islamic banking sector, there are still limited studies focusing on the efficiency of Islamic banks. Several studies that have been devoted to assess the performance of Islamic banks generally examine the relationship between profitability and banking characteristics. Bashir (1999)and Bashir (2001) perform regression analyses to determine the underlying determinants of Islamic performance by employing bank level data in the Middle East. His results indicate that the performance of banks, in terms of profits, is mostly generated from overhead, customer short term funding, and non-interest earning assets. Furthermore, Bashir (2001) claims that since deposits in Islamic banks are treated as shares, reserves held by banks exert negative impacts such as reducing the amount of funds available for investment. Samad and Hassan (1999) apply financial ratio analysis to see the performance of a Malaysian Islamic bank over the period 1984-1997 and generally find that bankers' lack of knowledge was the main reason for slow growth of loans under profit sharing. The Islamic bank was found to perform better than conventional banks in terms of liquidity and risk measurement (less risky). Although this study is based only upon one Islamic bank in Malaysia, the result has given some insight on the example from outside the Middle East area. Similarly, utilizing Banking Efficiency Model, Sarker (1999) claims that Islamic banks can survive even within a conventional banking architecture in which PLS modes of financing is less dominated1. Using Bangladesh as a case study, Sarker (1999) argues further that Islamic products have different risk characteristics and consequently different prudential regulation should be applied download