Measuring the Efficiency of Conventional Measuring the Efficiency of Conventional and Islamic Banks inand Islamic Banks in IndonesiaIndonesia andandand Islamic Banks inand Islamic Banks in IndonesiaIndonesia and and

MalaysiaMalaysiayy

Center for Central Banking Education and Studies

PPSK-2006 ®CCBES-2007 ®

IntroductionBackgroundBackground

• Indonesia started the dual banking system in 1992, currently g y , yIslamic banking reach 1.7% market share, expected to reach 5% market share at the end of 2008.

• Dual banking system and global market integration force Islamic banks to be competitive and efficient to sustain and win the market.

• The measure of efficiency could be used as a guide for Islamic banks to improve their weaknesses to be able to compete in the domestic as well as global markets.

• Moreover, the goal to strengthen Islamic banking structure could be achieved.

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IntroductionObjectives

• To compare the efficiency of Islamic banks and

Objectives

To compare the efficiency of Islamic banks and conventional banks in Indonesia

T th ffi i f I l i b k i• To compare the efficiency of Islamic banks in Indonesia and Malaysia

• To identify the sources and level of inefficiency for each of the inputs and outputs p p

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IntroductionMethodology

• This study will apply parametric approach Stochastic

Methodology

This study will apply parametric approach Stochastic Frontier Approach (SFA) and Distribution Free Approach (DFA).Approach (DFA).

• This study will also apply nonparametric approach D t E l t A l i (DEA) iData Envelopment Analysis (DEA), using intermediation approach.

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Why Parametric SFA & DFA

• SFA and DFA are parametric approach to measure efficiency p pp yuses stochastic econometric and tries to eliminate the impact of disturbance to inefficiency.

• SFA assumes that inefficiency measures, 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 σ2.

• DFA tries to avoid the arbitrary assumptions of the stochastic frontier approach, where panel data are available. DFA also separates the composite error term into inefficiency andseparates the composite error term into inefficiency and statistical noise component. DFA assumes that there exists a core inefficiency.

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y

Why Nonparametric DEA

• DEA is a non parametric and non deterministic method to pmeasure relative efficiency of production frontier, based on empirical data of multiple inputs and multiple outputs of decision making units.

• DEA can be applied to analyze multiple outputs and multiple inputs without pre-assigned weights.

• Relative efficiency can be calculated with observed data without any knowledge of the production function.

• Decision makers’ preferences can be incorporated into the model.

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LITERATURE REVIEWSFA & DFASFA & DFA

Author Functional Form Input Output

Allen & Rai ‘95 Translog Labor, capital, borrowed funds

loans

Yildirim &Philippatos ’05

Multiproduct Translog

borrowed funds; labor; phisical capital

loans; investment; deposit

H d d t l ‘03 T l P i f l b ( l L t th b kHadad et.al. ‘03 Translog Price of labor (employees cost to total activa); price of funds (interest cost to total pasiva)

Loans to the bank; loans to the stakeholder (exclude bank); securitiestotal pasiva) bank); securities

Saaid et.al. ‘03 Translog Labor, fixed assets, deposit Investment

7 [1] As data on the number of employees are not readily made available, this study uses personnel expenses as a proxy measure.

LITERATURE REVIEWDEA

Author Input Output

Intermediation Approach

DEA

Ascarya & Yumanita’07b Labor Costs; Fixed Assets; Total Deposits Total Loans; Income

Ascarya & Yumanita’07a Labor Costs; Fixed Assets; Total Deposits Total Loans; Income

Sufian’06 Labor Costs[; Fixed Assets; Total Deposits Total Loans; Income

Ascarya & Yumanita’06 Staff Costs; Fixed Assets; Total Deposits Total Loans; Other Income; Liquid Assets

Yudhistira’03 Staff Costs; Fixed Assets; Total Deposits Total Loans; Other Income; Liquid Assets

Jemrić & Vujčić’02 No. of Employees; Fixed Assets & Software; Total Deposits

Total Loans; Short-term SecuritiesDeposits

Mochtar et.al ‘07 Labor Costs; Total deposits, other operating/overhead expenses

Total earning assets (financing/loans; dealing securities; investment securities; placements with other banks)

Zamil & Rahman ‘07 staff cost; capital (net book value of premises and fi d ) l d i l bl f d

Loans and advances; Income (total interst income, non-i i d i f )fixed asset); Total deposits & loanable funds interest income and income form IBS)

Production ApproachAscarya & Yumanita’06 Interest Costs; Staff Costs; Operational Costs Interest Income; Other Operational Income

Jemrić & Vujčić’02 Interest & Related Costs; Commissions for Services & Related Costs; Labor Related Adm. Costs; Capital Related Adm. Costs

Interest & Related Revenues; Non-interest Revenues

Asset Approach

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ppHadad et.al’03. Staff Costs to Total Assets; Interests Costs to Total

Assets; Other Costs to Total AssetsFinancing to Connected Party; Financing to Other Party; Financial Papers

METHODOLOGYTh M t T l

Consumer Theory

ParametricSFA TFA DFA

Theory Measurement Tools

Efficiency Concept

Theory

Producer Theory(Production

Technical Efficiency

All ti

cono

mic

ffi

cien

cy

SFA, TFA, DFA

Frontier Line) Allocative Efficiency

E E

NonparametricData Envelopment

Analysis (DEA)Input – Output

Maximum OutputMinimum Input

C t t R t t S lBANK

Concept

Constant Return to ScaleVariable Return to Scale

BANK EFFICIENCY

Production Approach

Intermediation Approach

ModernApproach

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Approach

METHODOLOGYThe Measurement of Efficiency

Parametric Approach:

The Measurement of Efficiency

a. Stochastic frontier approach (SFA);

b. Thick frontier approach (TFA); and

c. Distribution-free approach (DFA).

Advantage:Advantage:It allows for random error, so these methods are less likely to misidentify measurement error, transitory differences in cost, or specification error for y pinefficiency

Disadvantage:Have to impose more structure on the shape of the frontier by specifying a functional form for it

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METHODOLOGYThe Measurement of Efficiency

Nonparametric Approach:M ffi i i t h ti h th t t d t bi

The Measurement of Efficiency

Measure efficiency using non-stochastic approach that tends to combine disturbance into inefficiency. DEA 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. DEA can also determine how a DMU can improve its performance to become efficient.

Advantage:Advantage: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 p p y pefficient frontier No misspecification.

Disadvantage:It 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).

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y)

There exists a potential problem of “self identifier” and “near-self-identifier”.

METHODOLOGYData Envelopment Analysis

DEA is a methodology for analyzing the relative efficiency and managerial performance of productive or decision making units (DMUs), having the same

Data Envelopment Analysis

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 banks by determining the ffi i t b k b h k d b i th i ffi i i i i tefficient banks as benchmark and by measuring the inefficiencies in input

combinations (slack variables) in other banks relative to the benchmark.

DEA is a non-parametric, deterministic methodology for determining the p , gy grelative efficient production frontier.

Assumption: Random errors do not exist and that all deviations from the f fffrontier indicate inefficiency.

Advantage: It does not require an a priori assumption about the analytical form of the production function No misspecificationform of the production function No misspecification.

Disadvantage: It is sensitive to extreme observations and measurement error. There exists a potential problem of “self identifier” and “near-self-

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error. There exists a potential problem of self identifier and near selfidentifier”.

METHODOLOGYData Envelopment Analysis

CharacteristicsDEA b li d t l diff t ki d f i t d t t ith t

Data Envelopment Analysis

DEA can be applied to analyze different kind of input and output without initially assigning weight.

The efficiency produced is a relative efficiency based on observed data. y p y

DEA does not need assumption of the production function.

Preference of decision maker can be accommodated in the model.

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METHODOLOGYData Envelopment AnalysisData Envelopment Analysis

Two Models of DEA:

1. CCR Model (1978)Developed by Charnes, Cooper, and Rhodes.

Assumption: constant return to scale (CRS).

Measure OVERALL efficiency (OE = TE x SE)

2. BCC Model (1984)Developed by Banker, Charnes, and Cooper.

A i i bl l (VRS)Assumption: variable return to scale (VRS).

Measure TECHNICAL efficiency (TE).

CCR/BCC measures SCALE efficiency (SE).

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METHODOLOGYParametric vs NonparametricParametric vs. Nonparametric

Nonparametric ParametricNonparametric ParametricDeterministic Stochastic

Based on external observation Based on central tendenciesBased on external observation Based on central tendencies

Analyses each vector (DMU) separately individual measure

A single estimated regression equation applies to each obs. vector q pp

No assumption on production function no misspecification

Have to impose the functional form

Random error does not exist sensitive to extreme obs. and measurement error

Allows for random error minimize specification error for efficiency

Efficient frontier produced is relative to Efficient frontier produced is relativeEfficient frontier produced is relative to other DMUs

Efficient frontier produced is relative to other DMUs

Identifies the source of inefficiency N/A

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PERFORMANCE MEASUREMENTIslamic Bank

Performance of Islamic bank should be measured comprehensively

Islamic Bank

Aspects to be measured include BUSINESS, SOCIAL, IBADAH/DA’WAH, and SHARIAH COMPLIANCE. Parameters of each aspects should reflect the true essence and characteristics of Islamic bankingthe true essence and characteristics of Islamic banking

BUSINESS: financial, management, operation, etc. Financial performance is one important aspect, since Islamic bank is a financialperformance is one important aspect, since Islamic bank is a financial institution

FINANCIAL: profitability, liquidity, risk & solvency, etc.

SOCIAL: ZIS, Qardhul Hasan, commitment to Muslims, MSMEs or remote area, CSR, charitable activities, community involvement, etc.

IBADAH/DA’WAH: HR iman improvement, ibadah facilities, socialization, etc.

SHARIAH COMPLIANCE: PLS ratio FDR etc

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SHARIAH COMPLIANCE: PLS ratio, FDR, etc.

PERFORMANCE MEASUREMENTIslamic vs Conventional

In general, performance of Islamic bank can not be compared to that f

Islamic vs Conventional

of conventional bank apple to apple, since they are essentially different kind of financial institutions

Limited aspects of BUSINESS and SOCIAL may be compared withLimited aspects of BUSINESS and SOCIAL may be compared with cautions and notes. Parameters of each aspects should be selected carefully to reflect comparability

BUSINESS aspects could include financial, management, operation, etc. Financial performance is one important aspect, since both Islamic and

ti l b k fi i l i tit ticonventional banks are financial institutions

FINANCIAL: profitability, liquidity, risk & solvency, etc.

SOCIAL aspects could include commitment to economic developmentSOCIAL aspects could include commitment to economic development (MSMEs or remote area), CSR, etc.

POSITIONING is more appropriate than COMPARISON

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POSITIONING is more appropriate than COMPARISON

THE STUDY

Specification:l l i d d i l i b k d iSample: Malaysian and Indonesian Islamic banks; Indonesian

Conventional and Islamic banks in the period of 2002-2006. Classification of data: 1) Type (Islamic, conventional; full fledged, full branch, windows); 2) Ownership (domestic, regional, foreign); 3) Size (small, large)

SFA & DFA: Labor, Assets, Deposits, Financing, and Income; Functional form: TranslogFunctional form: TranslogDEA: Inputs: Labor, Assets, and Deposits; Outputs: Financing and Income; Approach: Intermediation Approach

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PRE TESTS

Test Group

P t i N P t iSamples of IBs in M l i d I d i Parametric Non Parametric

Individual Test ANOVA Test t-test Mann-Whitney

Hypothesis MeanI=MeanM MedianI=MedianM

Malaysia and Indonesia are from the same population and are

Test Statistics F(Prb>F) t(Prb>t) z(Prb>z)

Overall 0 3305 0 645 (0 004)

considered have the similar technology level.

Malaysian IBs can beEfficiency

0.3305 0.645 (0.004)

Technical Effi i

0.3540 0.492 (0.004)

Malaysian IBs can be compared to IndonesianIBs.

Efficiency0.3540 0.492 (0.004)

Scale Efficiency 0.0003 0.051 (0.017)

Accept Ho: There is no significant differences

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RESULTS and ANALYSISSFA & DFA Malaysia vs IndonesiaSFA & DFA Malaysia vs. Indonesia

1

0.8

0 4

0.6 MalaysiaIndonesia

0.2

0.4

SFA: Malaysian Islamic banks were more efficient in the early years of 2002-2004,

2002 2003 2004 2005 2006

y y y ,but in 2005 Indonesian Islamic banks became more efficient. OVERALL EFFICIENCY of Malaysian and Indonesian Islamic banks have been converged to 0.99 in 2006.

DFA: OVERALL EFFICIENCY Malaysian Islamic banks is 0.94, Indonesian Islamic banks

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DFA: OVERALL EFFICIENCY Malaysian Islamic banks is 0.94, Indonesian Islamic banks is 0.96.

RESULTS and ANALYSISDEA Malaysia vs Indonesia

0 90

1.00

DEA Malaysia vs. IndonesiaOVERALL EFFICIENCY of Malaysian Islamic banks has been stable at low

Malaysia

0.80

0.90Scale

Technical

point around 0.64

SCALE EFFICIENCY of Malaysian Islamic banks has always been high at around

0.60

0.70

Overall

ba s as a ays bee g at a ou d0.94

0.502002 2003 2004 2005 2006

Overall

0.90

1.00Scale

f d i

Indonesia

0 70

0.80

TechnicalOVERALL EFFICIENCY of Indonesian Islamic banks has been moved up and down at higher point, and improved in 2006 t 0 82 d t SCALE & TECHNICAL

0.60

0.70

Overall

2006 to 0.82 due to SCALE & TECHNICAL EFFICIENCIES improvement

SCALE EFFICIENCY of Indonesian Islamic b k h b i d i ifi l

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0.502002 2003 2004 2005 2006

banks has been improved significantly in 2006 to 0.98

RESULTS and ANALYSISDEA Reference SetDEA Reference Set

N B k C t N B k C tNo Bank Count No Bank Count

1 BUS Indonesia 12 8 BUS Indonesia 42 UUS Indonesia 10 9 Windows Malaysia 32 UUS Indonesia 10 9 Windows Malaysia 33 Windows Malaysia 9 10 REGIONAL Islamic 34 UUS Indonesia 8 11 Windows Malaysia 25 UUS Indonesia 6 12 REGIONAL Islamic 26 Windows Malaysia 5 13 REGIONAL Islamic 17 REGIONAL Islamic 5 14 BUS Indonesia 0

10 out of 17 (59%) Indonesian Islamic banks and 4 out of 14 (29%) Malaysian Islamic banks are on efficient frontiers that set as benchmarks for other

7 REGIONAL Islamic 5 14 BUS Indonesia 0

Islamic banks are on efficient frontiers that set as benchmarks for other inefficient banks.

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RESULTS and ANALYSISDEA Potential ImprovementsDEA Potential Improvements

INCOME is the most EFFICIENT, while DEPOSITS & LABOR is the most Asset

Income3.09%

INEFFICIENT of Malaysian IBs.

Other input (Assets) and output (Financing) can be improved further.

Asset11.22%Financing

10.68%

imp ( a c g) ca be p o ed u t eLabor

38.93%Deposits36.08%

Malaysia

Indonesia

IncomeAsset

23.24%Financing19.32%

0.16%

INCOME is the most EFFICIENT, while

Labor26.68%

Deposits30.58%

,other input (DEPOSITS & LABOR) and outputs (ASSET & FINANCING) can be improved almost evenly in Indonesian

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IBs.

Islamic Banks MALAYSIA vs INDONESIAANALYSIS

Islamic Banks MALAYSIA vs. INDONESIAINDONESIA

Even though, Indonesian Islamic banks are younger and smaller than Malaysian Islamic banks, they are already in the same level as (or better than) their Malaysian counterpartsbetter than) their Malaysian counterparts.

All BUS and many regional Islamic banks in Indonesia are in the efficient frontiers. UUS are mostly less efficient.y

Efficient banks tend to be profitable

MALAYSIA

Windows are more efficient than full fledged in Malaysia, while Domestic Windows are more efficient than Foreign Windows

Efficient banks tend to be profitable

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RESULTS and ANALYSISSFA DFA Conventional vs Islamic in IndonesiaSFA DFA Conventional vs. Islamic in Indonesia

1.2

0.8

1.0

0 4

0.6 KonvensionalSyariah

0.2

0.4

0.02002 2003 2004 2005 2006

SFA: OVERALL EFFICIENCY of Islamic banks are similar or better than conventional banks in Indonesia during the period of study.

DFA: OVERALL EFFICIENCY of Islamic banks is 0 87 while conventional banks is

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DFA: OVERALL EFFICIENCY of Islamic banks is 0.87, while conventional banks is 0.89.

RESULTS and ANALYSISDEA Conventional vs Islamic in Indonesia

OVERALL EFFICIENCY of conventional banks declined in 2004 and improved in

1.00 Conventional

DEA Conventional vs. Islamic in Indonesia

p2005 to reach 0.69, due to the improvement of TECHNICAL EFFICIENCY

Conventional banks always have high0.80

0.90

Technical

Scale

Co e t o a ba s a ays a e gSCALE EFFICIENCY around 0.95

0.70

0.602003 2004 2005

Overall

0 90

1.00

ScaleIslamic

OVERALL EFFICIENCY of Islamic banks declined in 2004 and improved in 2005 to reach 0.81, due to the improvement

0.80

0.90Technical

, pof SCALE & TECHNICAL EFFICIENCIES

Conventional banks are more SCALE EFFICIENT, while Islamic banks are

0.70Overall

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EFFICIENT, while Islamic banks are more TECHNICAL & OVERAL EFFICIENT 0.60

2003 2004 2005

RESULTS and ANALYSISDEA Conventional vs Islamic in Indonesia

No Bank Count No Bank Count

DEA Conventional vs. Islamic in Indonesia

1 Conventional Bank 85 7 BUS 192 REGIONAL Islamic 28 8 Conventional Bank 153 BUS 2 9 C i l B k 103 BUS 27 9 Conventional Bank 104 UUS 27 10 Conventional Bank 95 UUS 23 11 UUS 86 Conventional Bank 20 12 Conventional Bank 6

6 out of 19 (32%) Islamic banks and 6 out of 63 (9.5%) conventional banks are on efficient frontiers that set as benchmarks for other inefficient banks.

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RESULTS and ANALYSISPotential ImprovementsPotential Improvements

INCOME is the most EFFICIENT, while LABOR is the most INEFFICIENT of CBs.

A tFinancing,

Other inputs (deposits and assets) and output (financing) can be improved further.

Income, 0.50%

Assets, 20.12%

16.08%

u t e

Deposits, 26.22%

Labor, 37.08%

Financing, 0 00%

Income, Assets,

Conventional

Islamic

FINANCING is the most EFFICIENT, while

0.00% 19.64%25.07%

,LABOR is the most INEFFICIENT of IBs.

Other inputs (deposits and assets) and output (other income) can be improved

Deposits, 25.73%Labor,

29 56%

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output (other income) can be improved further.

29.56%

Conventional vs Islamic Banks in INDONESIAANALYSIS

Conventional vs. Islamic Banks in INDONESIAEven though Islamic banks in Indonesia are still young and small, they are more technical and o erall efficient than their con entionalare more technical and overall efficient than their conventional counterparts, while conventional banks are more scale efficient, since they counted for 98.3% market share.y

More Islamic banks are in the efficient frontier.

Islamic banks are better in extend financing, while conventional banks gare better in generating income.

Labor is the common inefficient input in both banks.

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RECOMMENDATIONS

Islamic banks in Indonesia are still young and relatively small, th t i h ld b th b i it t hso that expansion should be the number one priority to reach

economies of scale and critical mass in the shortest time possiblepossible.

To accelerate expansion Islamic banks in Indonesia, the government should have the political will, commitment, andgovernment should have the political will, commitment, and courage to expand organically and inorganically, and expand the network in rural areas throughout Indonesia.

Office channeling through BRI Rural Unit could expand network to reach MSEs in rural areas.

Human resource improvements for short term and long term should be the next priority.

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Wallahu a’lam BishawwabWallahu a lam BishawwabQuestions and Answers

PPSK-2006 ®CCBES-2007 ®