Efficiency Evaluation of Islamic Banking in the Dual Banking System: An Analysis of Commercial Banks in Malaysia

This study presents new perspectives on performance evaluation of Islamic banking operations by investigating for the first time, both cost and profit efficiency of full-fledged Islamic banks and the Islamic window operations of domestic and foreign banks in Malaysia. The best period is from 1998 to 2004. The application of Data Envelopment Analysis (DEA)technique has provided several efficiency measures such as allocative, pure technical and scale efficiency that explain cost and profit efficiency differentials among banks, as well as the sources of productivity growth and efficiency change of these banks. In addition, the Generalized Least Square (GLS) multiple regressions explain the differences in the calculated efficiency measures. We also investigate the relation between risk, asset quality factors and a new variable called corporate social responsibility (CSR), and the bank's degree of efficiency. Finally, we test the impact of CSR on bank profitability. The following are the main findings. Profit efficiency levels of banks are lower than cost efficiency levels. This implies that banks are better at controlling costs than maximizing profit. The main contributor for cost efficiency of domestic and foreign banks comes from improved resource management practices and improved economies of scales respectively. In contrast, both domestic and foreign banks record improved resource management practices as the highest profit efficiency contributor. The results of productivity show that increases in productivity are mainly due to technological advancement for the cost model and increases in technical efficiency for the profit model. Despite technological advancement for the cost model, there is little improvement in cost efficiency of banks. The efficiency and productivity analyzes indicate that the average cost and profit efficiency of Islamic banks in Malaysia over the test period is far from satisfactory, that is, there is lack of full efficiency. Unlike the results in the profit model, the increase in technical efficiency has improved the profit efficiency levels of banks. For both cost and profit models, the scale efficiency change result indicate that size is significantly related to efficiency in terms of economies of scale. The regression results identify size of operation, market power, profitability, and capitalization level to be characteristics of efficient banks in the sample. Finally, as expected CSR is positively and significantly related to profitability of banks. Overall the results from this study support the efficient structure theory which suggests that increased profit is derived from firm-specific efficiency