Edited Full Report

CHAPTER 1

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Islamic finance industry in Malaysia has been existence for almost 30 years and it is still new

compared to conventional banking system. The act of Islamic Banking which is Islamic Banking

Act 1983 has enabled Central Bank to establish first Islamic Bank in this country. Malaysia’s

long track record of building a successful domestic Islamic financial industry for over than 30

years gives the country a solid foundation that adds to the richness, diversity of financial system

due to the steady progress of Islamic banking since the establishment of the first Islamic bank

(Bashir, 2005). Islamic banking can be defined as a banking activity that was guided by Islamic

Law or known as Shariah principle and conducted based on Islamic economics. It collects

deposits and give financing to the customers by using various financial instruments such as

Mudharabah, Murabahah, Bai Bithaman Ajil, Ijarah and others.

In other words, Islamic banking is a business activity where the principles underlying its

operations are founded in Islam. Thus, any operations that are contradicted with Islam are

forbidden as been stated in Holy Quran:

You are the best of peoples, evolved of mankind, enjoining what is right, forbidding what is

wrong, and believing in Allah. (Qur’an 3: 110)

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Those who devour usury will not stand as stands one whom the Evil by his touch driven to

madness. That is because they say: “Trade is like usury,” but Allah has permitted trade and

forbidden usury.” (Qur’an 2:275)

For example, Shariah principle prohibits usury which is the collection and payment of interest or

in Islamic banking term known as Riba’. The obvious different between Islamic banking system

and conventional banking system is Islamic banking operates based on the profit sharing while

conventional banking operates based on pre-fixed interest and earn profits by attracting

depositors at low interest rate then reselling the funds to the borrower at higher interest rate

(Mohamad, Hassan and Bader, 2008).

Islamic banking in Malaysia has begun in September 1963 due to the establishment of

Perbadanan Wang Simpanan Bakal-Bakal Haji (PWSBH) where it was set up to serves as an

institution for Muslims to make savings in order to enable them to perform Hajj. In 1969,

PWSBH was merged and changed its name to Lembaga Urusan dan Tabung Haji (LUTH) or

presently known as Tabung Haji. The establishment of Tabung Haji has led to the beginning of

the Islamic banking in Malaysia. The idea of setting up Islamic banks was started at Kongres

Ekonomi Bumiputera in 1980. Through a collaboration effort between private and Islamic

institutions, Study Group on Islamic Banking was founded to examine Islamic economic system

and Islamic banking institutions in Middle East. Then on 30 th July 1981, National Steering

Committee (NSC) has been appointed by government to study proposal on Islamic banks and the

proposal was approved on 5th July 1982. Consequently, Islamic Banking Act (IBA) has come

into effect on 7 April 1983 (Masruki,Ibrahim, Osman and Wahab,2011).

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Bank Islam Malaysia Berhad (BIMB) was the first Islamic bank in Malaysia and was

commenced its operations on 1st July 1983.Following from that period, on 4 March 1993 BNM

introduced a scheme known as "Skim Perbankan Tanpa Faedah" (Interest-free Banking Scheme)

or SPTF. Afterwards, many commercial banks and financial institutions has joint the scheme.

Later, in year 2008, the government has permitted domestic banks to establish full-fledged

Islamic subsidiaries (Azahari, 2009). According to annual banking statistics 2010 from Bank

Negara Malaysia, currently, Malaysia’s Islamic banking assets has an average growth rate up to

20% annually and at the end of year 2010, Islamic banking sector was represented by 17 Islamic

banks, 22 commercial banking institutions, 8takaful companies, an Islamic money market and a

broad range of financial products offered to customers.

Generally, efficiency means the maximum output that can be produced from any given total

output given total of inputs. This refers to the efficiency of a firm which allocates resources in

such a way as to produce the maximum quantity of output (Tahir, Bakar and Haron, 2009).

Efficiency of banks in Malaysia is important since it dealt with mobilizing resources for finance

productive activities and provides better financial services. It will indirectly affect the country’s

economics, wealth and operations because banks play an important role as financial

intermediaries. So, it channels the funds from those who have excess funds to those who need the

funds. Another reason is that as the evidence proven that banks play an important role in Global

Financial Crisis 2008, however, Malaysian capital and debt market are not well developed (Zin,

Ishak, Kadir and Latif, 2011). Thus, success of banks in term of efficiency able to attract the

depositors and investors since it will improve banking and finance industry. Because of that,

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optimal usage of resources and outputs should be fully achieved by all Islamic banks. If not,

problems of inefficiency would arise in their operations.

The financial indicators of a bank’s operating performance such as operating costs divided by

total assets or return on equity or assets have also been used to compare efficiencies but it has its

limitations. The problem is, financial ratios are regarded as misleading indicators of efficiency

because they do not control for product mix or input prices. Besides that, by using cost-to-asset

ratio have assumes that all assets are equally costly to produce and all locations have equal costs

of doing business. From that it can be concluded financial ratios are not able to distinguish

between efficiency gains and scope efficiency gains.

Recent approach to measure bank efficiency is include non parametric approach by assumes that

random error is zero so that unexplained variations are treated as reflecting inefficiencies. Non

parametric approach such as Data Envelopment Analysis (DEA) is describing an application of

mathematical programming to observe data to locate a frontier which can then be used to

evaluate the efficiency of each organization responsible for the observed output and input

quantities. This efficiency measurement can be seen in two aspects, technical efficiency which

reflects the ability of firm to obtain maximum output from a given set of inputs and allocated

efficiency that reflects the firm’s ability to use inputs in optimal proportions. The concept of

technical efficiency is referring to Decision Making Unit (DMU’s) ability to avoid being

inefficient by producing as many output as the input allow. It shows technical efficiency consists

of input and output orientation. An input orientation seeks for a solution such as the proportional

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reduction in inputs is maximized while output oriented process is to achieve the efficiency by

focusing on the productivity gains (Singh and Munisamy, 2008).

This study is focuses on the output orientation in order to evaluate the efficiency’s score of all

Islamic banks that was selected as the sample. The inputs for this research are total deposit,

overhead expenses and the capital while the outputs are total earning assets, net income and

loans. For output orientation, total earning asset, net income and loans will be maximized

without altering the deposit, overhead expenses and the capital of the banks. The measurement of

technical efficiency is based upon the deviations of observed output from the best efficient

frontier. It means that if the firm’s actual production point lies on the frontier, it is perfectly

efficient but if it lies below the frontier then it is technically inefficient.

1.2 PROBLEM STATEMENT

The efficiency of Islamic banking system has been one of the hot issues in financial

environment. Since their products and services are an intangible nature, so it is hard to measure

the efficiency and competitiveness of banking institutions (Imam and Kpodar, 2009). Besides

that, the performances of Islamic banking are also being questioned because some argued that it

is wrong to compare Islamic banks with conventional banks since they have been existence for

decades. In this context, conventional banks gained several advantages over Islamic banks. For

instance, conventional banks have long history and experience, accept interest which is a major

source of banks revenues, do not share loss with clients as practiced by Islamic banking system,

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enjoy very huge capital and ask for guaranteed collaterals in most transactions (Mohamad,

Hassan & Bader 2008).

Related to that issue, many researchers have attempted to determine the efficiency features of

Islamic banking system because from the efficiency, it provides signal to depositors and

investors whether to invest or not and at the same time help bank’s managers to know the

performance of the banks. It is interesting to look at the current performance of Islamic banks in

order to assess the current condition of Islamic banking system since Islamic Banking industry in

Malaysia has been increased rapidly and have a good potential market (Rahim, Madnor, Ramlee

and Ahmad, 2007). The main factor that influences banking sector to go for Shariah compliant is

due to customer awareness regarding on the need to avoid transactions against Shariah compliant

which have elements that might burden them in future (Hamid, Yaacob, Mujani and Sharizam,

2011).

Furthermore, by applying banking system has enabled Islamic banks to have more profits since

it provides variety of products and facilities includes consumer banking, commercial financing,

savings and investments as well as products of financial planning to satisfy demands of customer

Apart from that, this study is going to measure the performance and efficiency of four selected

Islamic banks which are Bank Kerjasama Rakyat Malaysia Berhad, Bank Islam Malaysia Berhad

(BIMB), Bank Muamalat Malaysia Berhad (BMMB) and RHB Islamic. However, previous

research shows that the efficiency studies on Islamic banking are still lacking in this country. As

a result, this study will use the data starting from year 2004 until 2010 to fill the gap of study and

examine current efficiency level of four selected Islamic banks by looking at their performance.

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There are many changes might occurs during this timeline of study. Therefore, the findings and

the result of study might also differ from the previous research. Furthermore, there only few

literatures available regarding on the efficiency of Islamic banks in Malaysia so this study is

important to provide valuable information to the management of Islamic banks, policy makers,

customers and other regulation bodies.

However, the main issue arise is the efficiency level on Islamic banks are still lacking in

Malaysia (Rosnia and et al, 2011) even though most of the banks able to perform a good

performance in their operations (see Figure 1.1). As a result, this study will fill the gap and

examine the current efficiency performance of Islamic banks in this country. Thus, the research

will look into the performance and efficiency of Islamic banking system by choosing one of

Islamic banks which is Bank Kerjasama Rakyat Malaysia Berhad.

Figure 1.1: The performance and efficiency of Malaysian Islamic banking sector from year 2006

until 2010 and Islamic banking growth

(Source: Bank Negara Malaysia)

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1.3 RESEARCH QUESTIONS

In studying the performance and efficiency of selected Islamic banks in Malaysia, there are two

research questions as followings:

i. Is Shariah compliant affecting the performance among selected Islamic banks?

ii. Are Islamic banks is efficient before and after Shariah compliant?

1.4 OBJECTIVES OF THE STUDY

This study attempts to examine the performance and efficiency of Bank Rakyat in comparison to

selected Islamic banks in Malaysia. Specifically the objectives of this study are:

To evaluate performance of Bank Rakyat with other selected Islamic Banks in Malaysia.

To measure the efficiency score of Bank Rakyat before and after Shariah Compliant and

other selected Islamic Banks in Malaysia.

To analyze the trend and cross sectional efficiency score of Bank Rakyat with other

selected Islamic Banks in Malaysia.

1.5 CONCEPTUAL FRAMEWORK

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Figure 1.2: Conceptual Framework

(Source: Wen, Lim and Huang,2003)

1.6 SIGNIFICANCE OF STUDY

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FINANCIAL RATIOS

INPUT

Total Deposit Total overhead

expenses Total capital

OUTPUT

Total earning asset Net Income Loans

Promethee Method

Data Envelopment Approach (DEA)

model

Performance And Efficiency Of Islamic

Banks Institution

i. Investors

This research is important to investors as they can analyze, evaluate and identify

the determinants of efficiency in Islamic banking in Malaysia. Then, they can

choose which financial institutions are suitable for them since efficiency criteria is

one of the important elements to acknowledge that the banks is strong to face with

the financial crisis that might occurs in future.

ii. Banking institutions

It helps banking institutions to improve the performance of the bank in order to

meet the bank’s objectives towards profitability. The studies of the efficiency of

Islamic banks can provide valuable information to the management of Islamic

banks, policy makers, clients and other regulation bodies. Besides that, it helps

bank to meet the requirement of the customer since this is the most important

thing that will influence bank performance now and in future.

iii. Future Researcher

This research is significant to the future researcher because they can get

knowledge since this study provides them with relevant and up-to-date

information an bank’s performance and efficiency. The result of this study can be

used as a guideline for other researcher in conducting further analysis in future.

1.7 SCOPE OF THE STUDY

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The scope of the study includes the following:

1. Four selected Islamic banks have been chosen to see the real condition of Islamic banking

operation. The performance of Bank Kerjasama Rakyat Malaysia Berhad, BIMB, RHB

Islamic Bank Berhad, and BMMB has been analyzed according to the annual data from

2004 until 2010.

2. This research is focusing on the efficiency of selected Islamic banks after Shariah

compliant which starting from 2004 until 2010.

3. The inputs for the study are total deposit, overhead expenses and capital. While the

output variables are total earning asset, net income, and loan.

4. All the data are obtained from the web sites of the respective banks and data stream.

1.8 DEFINITIONS OF TERMS

i. Bank Efficiency

It is refers to the productivity of banks and it can be evaluated in term of its performance.

It takes many aspects into consideration to measure the bank efficiency as it may require

the number of accounts or total assets, total loans and total deposits since it provide a

good index of output. Moreover, the value added of banks given by their labor costs and

profit will measure both output and cost of banking. Many analysts use accounting data

on bank margins, costs, and profits as a measurement of bank efficiency.

ii. Capital Output

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It is an output produce over a period of time. The ratio of capital output has a tendency to

be high when capital is cheap as compared to other inputs. For example, a country with

abundant natural resources can use its resources in term of capital to boost its output and

thus result the capital output ratio to be low.

iii. Conventional Banking

It is a financial institution that the operations is based on interest and involved the

elements that is prohibited in Islam. It does not focus on human welfare instead the goals

of most of conventional banks is to get more profit.

iv. Data Envelopment Analysis

It is software used to estimate the efficiency of individual banks by evaluated using the

non-parametric Data Envelopment Analysis (DEA) method. It is a piece-wise linear

combination that connects the best practices observations and forms a convex production

possibility set.

v. Deposit

It is a term included in balance sheet of a bank. Total deposit from bank’s perspective is

refers to various kinds of deposits that are taken into consideration and then these all

deposits are add together to determine the Total Deposits. Interest and Non-interest

bearing deposits are the cumulative examples of deposit items that were summed in order

to get the value of Total Deposits.

vi. Equity

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In the company’s balance sheet, equity can be defined as the amount of the funds that

contributed by the owner (the stockholders) plus retained earnings or losses. It also

referred as shareholders’ equity.

vii. Islamic Banking

Islamic Banking is a financial institution where the status, rules and the procedures are

governed by the Syariah principles. It provides an operation that is free from the elements

that is prohibited by Allah such as avoiding taking interest in any transactions.

viii. Islamic Finance

The provision of financial products and services by institutions which offers Islamic

financial services (IIFS) for Shariah approved underlying transactions and economic

activities based on contracts that comply with Shariah laws.

ix. Loan

Loans is the investment assets for a bank or known as financing service that offered by

the banks to the customers where it is an arrangement which the lender gives money to

the borrower and the borrower agrees to return the property or repay the money normally

together with interest at some future period of time and the lender has to bear the risk that

the borrower may not repay a loan.

x. Overhead Expenses

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It is general charges or expenses in business which cannot be charged up as belonging

especially to particular part of work or product. There has many different name for

overhead expenses for instance in business, it was called as fixed charges, establishment

charges, administration charges, selling charges, distribution charges or establishment

charges in manufacturing business. The example of overhead expenses can be utilities,

rent and subscriptions.

xi. Riba

It is a concept in Islamic Banking that refers to charged interest or in other word it was

known as usury. In Islamic law, it is forbidden because it can be thought to be exploitive

as it can exploit people’s life. Depending on the interpretation, it may only refer to

excessive interest but to others, the whole concept of interest is riba and thus it is

unlawful.

xii. Shariah Compliant

Shariah compliant is a fundamental that guides the operation of Islamic Banks in order to

avoid them from involve in the prohibited activities

xiii. Shariah

Shariah is also known as Islamic laws or Islamic Jurisprudence where it governs the

human life. The law was created based on the Al-Quran and As-Sunnah and other sources

like qiyas, ijtihad and others

CHAPTER 2

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LITERATURE REVIEW

2.1 THE DEVELOPMENT OF ISLAMIC BANK IN MALAYSIA

During the past few decades, Islamic banking system has developed in many countries. Most of

banking and financial institutions in country such as Iran, Sudan, and Pakistan has conforms to

Shariah compliant system that will govern level of charges and returns in the system to ensure

that their charges will not burden the customers (Hassan, 2006). Islamic bank introduced Profit-

Loss Sharing (PLS) system and other Islamic contracts in order to avoid interest in any form of

its transaction and will attract customers that seek for interest-free based system in banking

transaction (Saud, 2011). Islamic banking also plays an important role for economic

development by mobilizing funds from savers or depositors to provide funds to entrepreneurs or

businessman. That will improving quality of life by apply welfare oriented in their business

projects. Moreover Islamic banks will ensure stable economy, fair distribution of income, reduce

injustice and lesser financial crisis (Ahmad, Rehman, Safwan, 2010).

In Malaysia, the first Islamic bank was Bank Islam Malaysia Berhad (BIMB) that commenced

their operations on 1 July 1983 with the objectives to follow Shariah compliant system in all its

banking transaction. On October 1999, BMMB become the second Islamic bank in Malaysia

with all its transaction is based on Shariah principle that comprise prohibition of interest, on the

basis of fair and legitimate profit, giving zakat, prohibit the system of monopoly, and practices

cooperation system for the benefit of society ( Doraisamy, Shanmugam, and Raman, 2011).

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2.2 OVERVIEW ON GROWTH OF ISLAMIC BANKING

Shariah compliant is the fundamental that guides the operation of Islamic Banks in order to avoid

from involve in the prohibited activities. It has list out several principles underlying in Islamic

Banking System that must be followed by most of the financial institutions. It comprises the

rules that have been explicitly stated in the Qur'an that trading is permitted but usury is

forbidden. Many reasons have been advanced to why usury has been forbidden due to the belief

that capital should not generate profit unless combined with human effort (Obiyathulla, 2006).

For example, under the condition of uncertainty, the interest on loans is an inequitable payment.

Thus, no borrower can guarantee that enough profit will be made to pay the interest due. An

uncertainty about the future makes it unjust to guarantee return on capital or loan and when no

human effort has been exerted (Bashir, 2006).

In Malaysia, the role of Shariah Compliant was undertaken by BIMB with the provision of

Islamic Banking Act 1983. The main objective is to advise the bank on the operation of its

banking business in order to ensure that they do not involve any element which not approved by

Shariah (Hairun, Sukor,Muthalib and Gunawa, 2009).In short it can be said that Islamic

principles are focus on the improvement life in all aspect which comprises of economic and

social life.

Islamic finance is the provision of financial services on a basis that is compliant with the

principles and rules of Islamic commercial jurisprudence or known as fiqh muamalat. The focus

is on contracts and it lays down what types of contract that is permissible or valid and what types

are impermissible or invalid. In this scope, contracts are impermissible if they involve interest

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(riba), uncertainty or ambiguity (gharar), gambling or speculation (maysir). Interest is banned

because a pure return or rent on money is considered to be immoral. A provider of finance must

either undertake business risk or provide some other service such as supplying an asset in order

to be entitled to a return (Ahmad and Archer, 2007).

The role of intermediary taken by Islamic banks raises issues of corporate governance in the case

of conventional banks. The latter receive deposits on the basis of debt contract, where the

depositors’ capital and returns are not at risk. Islamic banks, by contrast, receive deposits on the

basis of a profit-sharing mudarabah contract which both returns and capital bear risk by

shareholders. However, the holders of profit-sharing investment accounts do not have any rights

as shareholders do in the corporate governance of the bank (Ebrahim and Tan, 2006). The

distinguishing feature of Islamic Finance can be seen in term of prohibition of interest (usury).

The Islamic Financial system opposes all forms of investment involving activities that are

deemed to be incompliant with Shariah law. The rejection of riba is a fundamental feature of the

Islamic Banking system and there also has another aspect in which Islamic banking differs from

conventional banking, particularly the role of Islamic banking within the system (Chawki and

Obeid, 2010).

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2.3 THE PERFORMANCE OF ISLAMIC BANK

The performance of Islamic banks can be investigated by relying on the key performance

indicator which are accounting or economic measures. For example, a study have been

conducted by using economics measure and it shows that performance of banking organizations

can be measured by looking at the financial strengths and weaknesses of a firm by establishing

relationship between the items of the balance sheet, the profit and loss account (Jaffar, 2009).

Fadzlan (2004) reports that through computing the financial ratios it can measure the

performance of the bank since it shows the relationship between data in the financial statement.

These financial statements are prepared as general information models at regular period,

normally each year. Financial statement that should consider in measuring the performance

includes the following:

a) Balance sheet

b) The income statement

c) Statement of retained earnings

d) Statement of cash flow

According to Hsiu, Chien and Fang (2007), the ratio that commonly used as performance

indicators is Return on Assets (ROA) where it can be defined as the ratio of profits to total

assets. The idea for this model emerged based on the question of whether conventional financial

indicators such as return on assets (ROA) and return on equity (ROE) can be used to gauge the

performance for Islamic banks, or should there be a different set of indicators suitable for Islamic

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banking institutions. The research by Mudiarasan, (2010) has applied conventional financial

indicators to measure performance of Islamic Banks. the results shows that he financial

performance of Islamic banks should be done by using a combined set of indicators, since these

do not overlap and essentially evaluate two different aspects of Islamic banks. The traditional

performance indicators which are ROA and ROE are the most relevant indicators for

performance. It should be noted that these two indicators were considered as the best measures of

a bank’s overall performance.

In addition, due to the study by Samad (2004), after examining the income statement and balance

sheet of Islamic banks and conventional commercial banks of Bahrain, the study had utilizes

eight financial ratios for evaluating the financial performance of Islamic and conventional of

bank of Bahrain. Among all of ratios, ROA is a good indicator of a bank’s financial performance

or profitability of the banks and ROE shows a rate return on base capital. Research by Bashir,

(2003) examines the effects of scale on the performance of Islamic banks. The profitability

measures used in the study include ROA and ROE. ROA is the most comprehensive accounting

measure of a bank’s overall performance. Since it is defined as net income over total assets, it

shows the profit earned per dollar of assets. It is an indicator of bank efficiency and a measure of

the bank’s ability to earn rent from its total operations. More important, it gauges how effectively

a bank uses its financial and real investment to generate profits. Large size is, therefore,

predicted to reduce ROA.

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2.4 OVERVIEW ON EFFICIENCY OF ISLAMIC BANK

The previous study is regarding on examination of the efficiency of full-fledged Islamic banks

and Islamic Windows in Malaysia from 1997 until 2003. It measures the technical and cost

efficiency using Data Envelopment Analysis (DEA). It focused on the efficiency of financial

institutions which become an important part of banking literature. The reason is efficiency can be

used as an indicator to measure banks’ success (Fred, Stephen and Arthur, 2010). Specifically,

the efficiency criterion can be used to measure the performance of individual banks as well as the

industry in overall. It also can be used to investigate the potential impact of government policies

on a bank’s efficiency in term of regulators’ interest since they want to know the impact of their

policy decisions on the performance and efficiency of the banks, which may affect the economy

(Mokhtar, Abdullah and Habshi, 2008). Thus it can be summarized that full-fledged Islamic

banks were more efficient than the Islamic Windows but less efficient than the conventional

banks and lastly, the Islamic Windows of the foreign banks were more efficient than the Islamic

Windows of the domestic banks. In addition commercial banks which are the main component of

the banking system, have to be efficient otherwise they will create barriers in the process of

development in any economy (Tahir, Bakar and Haron, 2009).

Technological advancements and globalization have added pressure on the part of the banks to

maintain market share for survival and remain competitive. Competition from foreign and

domestic banks creates greater pressure. Commercial banks in Malaysia are of no exception.

Therefore not only commercial banks need to be profitable, but also efficient since banks are

exposed to intense competition both locally and globally. The basic benefit to enhanced

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efficiency is a reduction in spreads between lending and deposit rates and this will likely

stimulate both greater loan demand for industrial investment and greater mobilization of

financial savings through the banking system (Hisham, Said and Matnor, 2006).

The past study examines the productive efficiency of the commercial banks which includes

conventional and Islamic banks by using data for 1993 to 2000 time period. The objective of the

analysis is to measure the efficiency levels of the two bank sets in the country for purposes of

comparison. The researcher have chosen the stochastic frontier cost function and compute the

efficiency scores for each of the 34 banks included in their sample for determining relative

position on the efficiency ladder. The results show that the efficiency level of Islamic banks is

not statistically different from the conventional banks (Majid, Madnor and Said, 2005). In

addition parallel with a study regarding on the efficiency of Islamic Banks in term of

performance, it shows there is no significant difference is observed in interest free and interest

based banking in respect of profitability because the trend analysis reveals the good trend of

balance sheet of Islamic bank while in income statements there is no meaningful difference

(Akhter, Raza and Akram, 2011)

2.5 VARIABLES

2.5.1 Total Deposits

The conventional banking theories assume that banks earn profits by purchasing deposits

from the depositors at low interest rate, the reselling those funds to the borrowers at

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higher interest rate, based on its competitive advantage at gathering information and

underwriting risk. Therefore, conventional banks makes profits from the spread between

interest rate received from borrowers and the interest rate paid to depositors. While,

Islamic banking performs the same intermediary function but does not receive a

predetermined interest from borrowers and does not pay a predetermine interest to the

depositors (Mohamad, Hasan and Bader, 2009).

The amount of profits is based on the profit sharing agreements with the depositors and

also with the borrowers. In addition, there are fee-based banking services that are similar

to conventional banks as long as there is no predetermined interest payment or receipt in

the transaction. Thus, Islamic banking is considered as different banking stream as it

prohibits interest and replace with profit share and the profit share depends on the extent

of the risk participation of the parties. The absences of predetermined rewards are based

on Quranic commands and as interpreted using Syariah principles (Rahim and Ismail,

2009).

Past research had covered a study on the efficiency of the Islamic banking sectors in 25

countries during the period of 1997-2009 consists of 78 Islamic banks. The efficiency of

individual banks is evaluated using the non-parametric Data Envelopment Analysis

(DEA) method. The findings show that the World Islamic banks have exhibited high pure

technical efficiency and there has positive relationship between bank efficiency and the

bank’s total deposits. It because as a proxy of bank‘s deposit, it shows positive and

significant coefficients suggesting that the greater amount of deposits the more efficient

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the bank will be (Ahmad and Mohamad, 2010). Besides that, the intermediation approach

also had been introduced which viewed Islamic banks produced intermediation services

through collection of deposits and other liabilities and these funds are invested in

productive sectors of the economy where the returns was not affected by usury (Majid

and Sufian, 2008).

2.5.2 Overhead Expenses

The efficiency for conventional bank was stable over the time while the average

efficiency of the overall Islamic banking industry has increased during the period of

study. However, the efficiency level of Islamic banking still less efficient than the

conventional banks. This study has used two variables and one output variables which is

total deposits which include deposits from customers and other banks and total overhead

expenses which include the personnel and other operating expenses. The results stated

that full-fledged Islamic banks are more efficient than Islamic windows and the foreign

banks are also found to be more efficient than domestic banks (Hassan, 2006).

In comparing the efficiency of conventional and Islamic banks, overhead cost was

computing by dividing total operating costs with total cost. The research also found that

Islamic banks have higher overhead costs in their smaller sample than in the large

sample. The results show that by including bank and country controls, Islamic banks are

more efficient than conventional banks and have higher capitalization ratios but they are

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not significantly more or less stable, do not have significantly different business models

and have similar assets quality (Beck, Kunt and Merrouche, 2010).

2.5.3 Capital Output

The efficiency is important in Islamic banking since it able to mobilize the resources to

finance its productivity and outputs. Thus, it will improve the bank and finance industry as

well as growth in the economy. The bank uses inputs of capital to offer deposits and loans

to the customers and this approach normally make use of numbers such as accounts and

transactions to measure the outputs. From the studies it shows that there is a significant

relationship between bank efficiency and loans intensity, size, capitalization and

profitability (Zainal and Ismail, 2012). The determinant of profitability has been one of the

more popular topics among researchers in banking studies to identify various factors that

have a significant influence on bank’s profitability.

Besides that, the previous study also has examines the effects of the factors that contribute

towards the profitability of Islamic banks. The study finds that internal factors such as

capital, total expenditures, funds invested in Islamic securities, and the percentage of the

profit-sharing ratio between the bank and the borrower of funds are highly correlated with

the level of total income received by the Islamic banks (Sudin, 2004). Similar effects also

found in another study where it stated that total capital, funds deposited into current

accounts, and reserves, the percentage of profit-sharing between bank and depositors and

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money supply also play a major role in influencing the profitability of Islamic banks

(Sadiq, 2006).

During the financial crisis between 2007 until 2009, the efficiency between Islamic and

conventional banks is different. This research used DEA model to measure the efficiency

of these different banking types. The input of the model for this research include labor cost,

capitals, and total deposits while for the output include total loans, liquid assets and other

income (Said, 2012). The findings show by using a sample of banks across 13 countries

during 2000–2006, there is a competitive condition for Islamic and conventional global

banking which leads to the differences in profitability between these markets.

Furthermore, Islamic banks allocate a greater share of their assets and capital for financing

activities compared to conventional banks (Ariss, 2008). The different computed measures

of competition indicate that Islamic banking is less competitive compared to conventional

banking and through a second-stage analysis, it shows capital is the determinants of

profitability and significantly increases the market power but this does not warrant higher

profitability levels for Islamic banks(Rossi, Schwaiger and Winkler, 2005).

According to past study regarding on production efficiency of Islamic Banks and

conventional bank, the capital, cost and profit efficiency of full-fledged Islamic Banks and

Islamic window operations of domestic and foreign banks has been investigated. It

provides several efficiency measures such as pure technical and scale efficiency to explain

cost and profit efficiency differentials among banks. Besides that Islamic banking

25

operators are more efficient in controlling the capital than generating profits because the

main contributor for domestic and foreign banks efficiency comes from resource

management and economies of scale respectively (Hisham and Mohamad, 2008). Through

investigates open economic implications on adopting Islamic banking for growth and

stabilization of the economy by analyzing international capital flows and economic

capacity, it shows that monetary policy can be used effectively for stabilization purposes

and disturbances to asset positions is absorbed efficiently in an Islamic financial system

(Iqbal and Abbas,2008).

The efficiency of Islamic banks was examined through data envelopment analysis (DEA)

and annual frontier specific approach where it gives the result that MENA Islamic Banks

has higher mean technical efficiency in relative to their Asian Islamic bank counterparts.

The findings shows that MENA region were found to be global leaders by dominating the

efficiency frontier since it has positive relationship between bank efficiency and loans

intensity, size, capital and profitability where the efficient banks is the banks that has

smaller market share and low non-performing loans ratios (Sufian and Noor, 2009).

Furthermore, there also have a research on the inefficiency of Islamic banks where the

efficiency of the bank is only ten percent compared to many conventional banks since the

capital is one of their major production and hence deserves for a good performance in term

of efficiency. Besides that, Islamic Banks has been found performed very well after the

difficult period in global crisis which is between the 1998 until 1999 (Donsyah, 2004).

26

2.5.4 Total Earning Asset

Research done by Ahmad Mokhtar, Abdullah and Al-Habshi (2006) has choose total

earning assets as the output to investigate the efficiency of the full-fledge Islamic banks,

Islamic windows and conventional banks in Malaysia by using intermediation approach

for four main reason including it will be evaluate the bank’s efficiency as a whole, widely

used of approach, financial institutions normally employ labor, physical capital and

deposits as their inputs to produce earning assets and the main principle of the Islamic

banking itself.

Ismail, Ab Rahim, and Abd Majid (2011) had done the research to determine the

efficiency in Malaysian Banking Sector by using 8 domestic Islamic commercial banks

and 9 domestic conventional commercial banks. The purpose of this study is to evaluate

the efficiency bank overall by employs intermediation approach also that is most

consistent with the concept of Islamic Banking that focus on a bank’s role as financial

intermediaries between investor and entrepreneur. In this study the output used including

other assets by using the DEA Excel Solver.

Study by Zainal and Ismail (2012) other earning assets is used other than total

financing and advances in order to measure Islamic banking efficiency in Malaysia in the

year 2006 until 2010 by using DEA approach in estimate the efficiency using input

orientation. All these variables were employed in calculating the technical efficiency,

pure technical efficiency and scale efficiency.

27

2.5.5 Total Loan

Yudistira (2004) used logarithm of total assets as a measurement for size of financial

institutions. In this research, the total loans of Islamic banks in the sample consist of

mostly Islamic transaction. Ahmad and Mohamad Noor (2011) analyzed efficiency of

World Islamic banks by using sample of 78 Islamic banks during the period of 1992 until

2009. For DEA, total loans has been used and measured in millions of Dollars.

Abd Hadi and Md. Saad (2010) in their research have use total loan as output and

analyzed using the non-parametric DEA method or intermediation approach. The

intermediation approach assumes that financial firms act as an intermediary between

savers and borrowers and for the purpose of this study intermediation approach was used

because according to Berger and Humphrey (1997) the production approach was more

suitable for branch efficiency studies because bank branches usually process customer

documents and bank funding while investment decision are mostly not under the control

of branches. In the DEA technique, researcher has measured the efficiency using

Malmquist index and use Islamic banks as a model for their research. Ong, Lim, and Teh

(2011) examined a comparison on efficiency of domestic and foreign banks in Malaysia

by using DEA approach and the analysis used 9 domestics banks and 12 foreign banks

in Malaysia over the period of 2002 until 2009. This research also used intermediation

approach for their analysis and finding of this research show that domestics banks more

efficient than the foreign banks which can define that domestic bank is more efficient

in term of their management in controlling their costs.

28

2.5.6 Net income

Form the research of Sat Paul and Jyothi (2010) on how did Islamic banks do during

global financial crisis have stated that in order to measure the efficiency of banks, one of

the important ratios is the cost to income ratio (CTI). The standard benchmark of bank

efficiency is the cost to income ratio or efficiency ratio. It measures the major element

that include overhead or costs of running the bank normally salaries as the percentage of

income generated before provisions. In case that the lending margin of some country is

very high, it can still be a measure of efficiency and the ratio will improve as a result.

Abd Kadir, Selamat, and Idros, (2010) investigates the extent of merger and acquisition

activity that affect Malaysian bank’s productivity from 2003 until 2007. This study also

used DEA and Malmqusit Index Approach in order to analyze the technological changes

and also technical efficiency changes of the merged banks in Malaysia. Output used for

this research is net income interest where it is the difference of the interest that the banks

receive on loans to customers and the interest that the bank pays to the depositors.

Moreover in the research of Mat-Nor, Mohd Said, and Hisham (2006) which is

financial performances and efficiency changes of Malaysian banking institutions in

mergers and acquisition where this paper try to analyses the efficiency of the bank from

the consolidation. In order to evaluate the efficiency of the institution in utilizing its

assets in creating its income, net income of the institutions is divided by the total assets of

the company.

29

CHAPTER 3

RESEARCH METHODOLOGY

3.1 INTRODUCTION

In this chapter it involves data analyzing and interpretation of the result from the data and it

discussed the procedures used to conduct the study by choosing and analyzing method that

related to the research in order to answer the objectives of study.

3.2 DATA

Data collection method is an integral part of research design. In this study, the data of input and

output was collected by using Data Stream which is a sequence of digital data packets used to

receive information such as financial report of company. Besides that, some of data also was

obtained from the web sites of the banks itself by looking at the balance sheet and income

statement that was published in the annual reposts. The data used in this study is from 1996 until

2002 which cover the period before Shariah compliant and 2004 till 2010 which represents

period after Shariah compliant.

30

3.3 SAMPLE

Sample of the banks in this study are all those involved prior to the Shariah compliant and the

resultant of four Islamic banks in Malaysia which are Bank Kerjasama Rakyat Malaysia Berhad,

BIMB, BMMB and RHB Islamic.

3.4 FINANCIAL RATIOS MEASUREMENT

Financial ratio analysis has been commonly used to evaluate the performance of bank. In this

study, five financial ratios analysis has been selected to compare the performance of Bank

Rakyat with others banks through trend analysis. Trend analysis is a method of time series data

analysis involving comparison of the same items over a significantly long period in order to

detect general pattern of a relationship between associated factors and to project the future

direction of patterns. All selected financial ratio analysis for commercial banks plotted by trend

analysis from 2004 until 2010.

3.4.1 Return on Asset (ROA)

Return on asset is an indicator of how profitable a company is relative to its total assets,

ROA gives an idea as to how efficient management is at using its assets to generate

earnings. Calculated by dividing a company’s annual earnings by its total assets, ROA is

displayed as percentage. Sometimes this referred to as Return on Investment.

ROA = Net Income before Taxes / Total Asset

31

3.4.2 Return on Equity (ROE)

Return on equity measures a corporation’s profitability by revealing how much profit of

the company generates with the money shareholders have invested.

ROE = Net Income before Taxes / Shareholder’s Equity

3.4.3 Loans to Deposits Ratio

This ratio is commonly used statistic for assessing a bank's liquidity by dividing the

banks total loans by its total deposits. If the ratio is too high, it means that banks might

not have enough liquidity to cover any unforeseen fund requirements; if the ratio is too

low, banks may not be earning as much as they could be. It can be calculated by:

Loans to Deposits Ratio= Loans/ Deposits

3.4.4 Deposits to Total Assets Ratio

Deposits represent all kind of bank’s deposits such as current deposits and withdrawal

deposits and this ratio is used to measure the impact of changes in deposits on capital.

The formula is:

Deposits to Total Assets Ratio = Deposits / Total Assets

32

3.4.5 Equity to Deposits Ratio

It is shareholder’s equity to establish the equity that the bank has from the existing

property in order to use as a deposit. The formula is:

Equity to Deposits Ratio = shareholders’ Equity/Deposits Ratio

3.5 PROMETHEE METHOD

Another method that can be used as suggested other than trend analysis is Promethee method

which is widely used in the assessment of banking performance., The Prormethee method was

first proposed by Brans (1982) and the main advantage of Promethee method is that it does

not use a linear evaluation model and can easily use with qualitative data. Furthermore,

Promethee is easier to implement and does not require the specifications of inputs and outputs

that may not be easy to identify.

According to Brans and Mareschal (2000), the main principles of Promethee method are

including: 1) Extension of the notion of criteria 2) Valued outranking relation 3) Exploitation

of outranking relation. The extension of the nation of criterion is based on the introduction of

a preference function giving the preference of the decision-maker for an action a with regard

to b. This function will be defined separately for each criterion and its value will be between 0

and 1. The smaller the function, the greater the indifference of the decision-maker and in case

of strict preference, the function will be 1.

33

For the actions a, b ∈ K, first it must be define a preference index for a, with regard to b over

all the criteria. The preferred index can be calculated by:

(1)

Where:

π = The weight for each criterion f i(i=1,2… ..k )

П (a, b) = Intensity of the preference of the decision maker for alternative solution

a with regard to b, when the criteria are considered simultaneously.

П (a,b ) ≈ 0 = Weak preference of the alternative solution a with regard to b, for

all the criteria

П (a,b ) ≈ 1 = Strong preference of the alternative solution a with regard to b, for

all the criteria

For the exploitation of the outranking relation for the rank of the alternative, two flows are

defined and the outflow is calculated as below:

(2)

The inflow can be calculated by:

(3)

34

A high value of means that the alternative action exceeds the other alternative

actions of the total actions K, while the smallest value of means that the alternative

action a is dominated by the alternative actions. We can then consider for each action a ∈ K the

net-flow:

(4)

3.6 DATA ENVELOPMENT ANALYSIS

Data was analyzed by using DEA Excel Solver, (Zhu, 2003). There is no consensus on the best

procedures in measuring the efficiency. This study is focusing on the technical efficiency which

may reflects the ability of an organization to obtain maximal output from a given set of inputs

(Cordia, Roll and Subrahmahnyam, 2005). To study technical efficiency, two main approaches

has been adopted which are parametric approach and Non parametric approach but this study

only employs non parametric approach which provide piece-wise linear combination that

connects the best practices observations and forms a convex production possibility set. It was

developed by Charnes, Cooper and Rhodes and applied to non- profit organizations where the

objectives of profit maximization and cost minimization may not be considered as the vital

factor. DEA also had the advantage of working with a small sample size and that does not

require price information. Many studies have used DEA to evaluate the efficiency of financial

institutions due to several reasons. Among the reasons are DEA is the most important approach

to measure efficiency (Fadzlan, 2004).

35

Besides that, DEA has main advantages were unlike the regression analysis, it did not require a

prior assumption about the analytical form of the production function. Instead it constructed the

best practices production function solely on the basis of observed data and therefore it was not

possible to make mistake in specifying the production technology. Therefore, DEA is the chosen

methodology because the method is less data demanding. As a consequence, this study employs

DEA to measure efficiency in Islamic banking banks.

3.4.1 The Reasons of Selecting Input and Output

To determine the inputs and outputs of banks, researcher must decide based on the nature of

banking technology. There are two main approaches in the banking literature which are

production and intermediation approach.

Production approach can be defined as a producer of services for account holders which they

perform transaction on deposit accounts and process documents such as loans. The best measure

for output according to this measure is the number of accounts or related transaction while the

input is the number of employees and physical capital.

Intermediation approach assumes when the financial firms act as an intermediary between savers

and borrowers. For example, total loans and securities as outputs, whereas deposits, labor and

capital are define as inputs (Sufian, 2007). This is the reason why we have choose deposit,

overhead expenses and capital for the input and total earning assets, net income, and loans as the

outputs.

36

We have chosen Technical Efficiency because this is the most common concept for Data

Envelopment Analysis which transferring physical inputs into outputs at the best level of

performance (Khalaf Al- Delaimi and Al- Ani, 2006).

3.4.2 A graphical Illustration of DEA

Figure 3.1: Two output, one-input output oriented DEA Model

The figures above illustrates the possibility frontier for producing two outputs which is Y and Z

by using input x in the most efficient manner. Since P lies below the efficiency frontier, DMU is

inefficient relative to P1 and P2 which is both P1 and P2 are peers of P since it define the relevant

portion of the frontier to produce efficient production for P. Then P’s efficiency can be

determined by comparing it to a virtual DMU P’ or its target that was made up by different

proportions of P1 and P2. The percentage of P2 and P1 in P’ is P2P’/P1P2 and P1P’/P1P2

37

respectively. The figure also highlights that in order to compute the relative efficiency score of P1

and P2, the ratios of OP1/OP’ and OP2/OP’ will be equal to 1. While the inefficient units like P’

will have the efficiency score less than 1 but more than 0 (Forsund, 2001).

Figure 3.1 is an example of output oriented efficiency measures that defines the efficiency in

term of maximization of the output given the input vector. Thus, this model is suitable to be used

in this study since it focuses on the output oriented approach. In many literatures regarding on

DEA, most of the researchers have applied input oriented models because in DMU’s, input

quantities seem to be the primary variables. It is less applicable in banking industry because

banks have limited control over the inputs.

3.7 THE MODEL

According to Chansara (2008), the efficiency can be defined as follow:

Efficiency = Weighted sum of outputs / Weighted sum of inputs

DEA calculates a ratio of outputs to inputs for each decision making unit (DMU) and the result is

reported as the relative efficiency score. It ranges between zero and one or 0 and 100 percent

(Avkiran, 1999). Thus, the unit which scores one is 100 percent or fully efficient while those

with results less than one are inefficient relative to other units. DEA can be applied by assuming

either constant return to scale (CRS) or variable return to scale (VRS). Mathematically, relative

38

efficiency of a DMU is defined as the ratio of weighted sum of outputs to weighted sum of

inputs. This can be written as:

ho = (Equation 5)

Where:

s = Number of outputs;

Ur = Weight of output r;

Yro = Amount of r produced by the DMU;

m = Number of inputs;

Vi = Weight of input i; and

Xio = Amount of input i used by the DMU.

Equation 1 assumes CRS and controllable inputs. While outputs and inputs can be measured and

entered in this equation without standardization, determining a common set of weights can be

difficult (Avkiran, 1999). DMUs might assess their outputs and inputs in a different way. This

issue is answered in the Charnes, Cooper and Rhodes (known as CCR) model. Charnes et al.

(1978) developed the CCR model that had an input orientation and assumed CRS.

The result of CCR model indicates a score for overall technical efficiency (OTE) of each DMU.

In other words, this model calculates the technical efficiency and scale efficiency combined for

each DMU. The CCR model addressed the above problem by allowing a DMU to take up a set

39

of weights that maximize its relative efficiency ratio without the same ratio for other DMUs

exceeding one. Thus equation 1 is rewritten in the form of a fractional programming problem:

Max ho = (Equation 6)

Subject to:

≤ 1 for each DMU in the sample,

Where j = 1… n (number of DMUs)

To measure efficiency, Equation 2 is converted into a linear programming problem. In Equation

3, the denominator is a set of constant and the numerator is maximized:

Max ho = (Equation 7)

Subject to:

= 1

≤ 0

Ur, Vi ≥

40

Therefore, in order to avoid exclusion of an output or an input in the calculation of efficiency,

weights u and v are not permitted to fall below non-Archimedean small positive number, ( ).

Equation 3 utilizes controllable inputs and CRS. It is a linear programming problem that

minimizes the input models.

3.8 RESEARCH HYPHOTHESES

There are several hypothesis need to be tested in this research which is:

a) Hypothesis 1

H0: Bank Rakyat is not performing well compare with the other selected

Islamic banks in terms of ROA

H1: Bank Rakyat is performing well compare with the other selected Islamic

banks in terms of ROA

b) Hypothesis 2


Islamic banks in terms of ROE


banks in terms of ROE

c) Hypothesis 3

41


Islamic banks in terms of Loan to Deposit Ratio


banks in terms of Loan to Deposit Ratio

d) Hypothesis 4


Islamic banks in terms of deposit to total asset ratio


banks in terms of deposit to total asset ratio

e) Hypothesis 5


Islamic banks in terms of equity to deposit ratio


banks in terms of equity to deposit ratio

f) Hypothesis 6

H0: Efficiency before = Efficiency after

H6: Efficiency before ≠ Efficiency after

g) Hypothesis 7

42

H0: Efficiency of Bank Rakyat is not at par with other selected Islamic bank

H7: Efficiency of Bank Rakyat is at par with other selected Islamic bank

CHAPTER 4

FINDINGS AND ANALYSIS

4.1 INTRODUCTION

This section discusses on the results of findings regarding the performance and efficiency of

Islamic banks. in evaluating the data, DEA has been used in order to analyze and explaining the

hypothesis. This chapter begins with the results of financial ratios to measure the Islamic bank’s

performance followed with the interpretation of DEA result based on four Islamic banks

efficiency score. Then, hypotheses were tested to answer the objective whether the efficiency

bank before Shariah compliant is equal with the efficiency after Shariah compliant.

4.2 BANK’S PERFORMANCE ANALYSIS

The performance analysis in this study focused on the trend analysis. It includes measuring five

performance indicators which are ROA, ROE, loans to deposits ratio, deposits to total assets

ratio and equity to deposits ratio. The table records the results of five ratios that have been

calculated for Bank Kerjasama Rakyat Malaysia Berhad in comparing with BIMB, RHB Islamic

Berhad, and BMMB starting from year 2004 until 2010.

43

4.2.1 ROA Trend Analysis

The trend analysis for ROA was arranged accordingly to compare Bank Rakyat with others

leading Islamic banks. First it looks at the ROA trend analysis to evaluate the performance

of Bank Rakyat itself.

Figure 4.1: Return on Asset (ROA) for four Islamic banks from year 2004 until 2010

Figure 4.1shows ROA trend analysis for Bank Rakyat compared with others selected Islamic

banks in Malaysia from 2004 until 2010. This graph clearly shows that ROA for Bank

Rakyat is more consistent compare with other banks since the ratio is higher than other three

banks. Therefore, it is shows that the performance of Bank Rakyat is maintained from year

44

to year. For BIMB, the trend is fluctuated and obviously can be seen in year 2006 where the

ratio is sharply decreased compared to the previous year. However, it extremely increased in

year 2007. While the other two bank, the performance is stable in term of ROA ratio.

4.2.2 ROE Trend Analysis

In this section, the analysis is further look at the ROE trend analysis as show in Figure

below.

Figure 4.2: Return on Equity (ROE) for four Islamic banks from year 2004 until 2010

Graph from Figure 4.2 shows that the performance of Bank Rakyat is increase consistently

from year to year compare with other banks. While others banks were does not look

uniformly increase. For example the performance trend of RHB Islamic is dropped from

45

year 2007 till 2009. Besides that the figure also illustrated that the trend was fluctuated over

the year for BIMB and BMMB.

4.2.3 Loans to Deposits Ratio Trend Analysis

Figure 4.3: Loans to Deposits Ratio for four Islamic banks from year 2004 until 2010

Figure 4.3 shows the ratio for Bank Rakyat compare with other banks to evaluate the

liquidity of Bank Rakyat. The ratio for Bank Rakyat is high and it means that Bank Rakyat

earning more than others banks. By looking at BMMB’s trend, the ratio is lowest and able to

maintain the performance over the period. Contrast with BIMB, the trend is slightly

decreasing from year 2004 until 2009. However, the high ratio means that banks might not

have enough liquidity to cover any unforeseen fund requirements as shown by trend of RHB

Islamic where it is drastically increase in year 2009 till 2010.

46

4.2.4 Deposits to Total Assets Trend Analysis

Figure 4.4: Deposits to Total Assets Ratio for four Islamic banks from year 2004 until

2010

From Figure 4.4, it can be concluded that the entire bank has a consistent trend and it shows

that most of the assets in the banks are funded by deposits rather than borrowed funds or

equity except for RHB Islamic where the ratio is extremely dropped in year 2009.

47

4.2.5 Equity to Deposits Trend Analysis

Figure 4.5: Equity to Deposits ratio for four Islamic banks from year 2004 until 2010

Based on the Figure 4.5, the ratio for RHB Islamic and BMMB are almost consistent from

year to year. Same goes with Bank Rakyat even though the ratio slightly drops in year 2010.

From that, it shows Bank Rakyat, RHB Islamic and BMMB able to survive in long-term

period. But, it is different with Bank Islam where the ratio is always fluctuated and it shows

that this bank is having less deposit in their operations.

48

4.3 RESULT OF DEA

The DEA analysis was conducted on input and output for selected Islamic banks in

Malaysia. The inputs for this study are total deposit, total overhead expenses and total

capital while the outputs are total earning assets, net income and loan. By using DEA Excel

Solver, the data was run and the result obtained whether the score of 1.000 which means

perfect efficiency and less than 1.000 which represent inefficient result.

4.3.1 Efficiency Trend Analysis of Bank Rakyat Before and After Shariah

Compliant

Table 4.1 shows the efficiency scores result for Bank Rakyat before Shariah compliant

(1996-2002) and after Shariah compliant (2004-2010). While Table 4.2 presents cross

sectional efficiency score of Bank Rakyat with other selected Islamic banks.

DMU’S BEFORE DMU’S AFTER

1996 1.0000 2004 0.9741

1997 1.0000 2005 0.8648

1998 1.0000 2006 0.8454

1999 1.0000 2007 1.0000

2000 0.9577 2008 0.9382

2001 0.9979 2009 0.9395

2002 1.0000 2010 1.0000

49

Average 0.9926 Average 0.9374

Table 4.1: Efficiency scores result for Bank Rakyat before Shariah compliant

It should be noted that this study is using DEA model that focus on productive or

technical efficiency rather than other types of efficiency such as cost efficiency or profit

efficiency. Therefore, the interpretation of the scores should be confined to technical

efficiency of the banks. The computation for efficiency levels can be divided into two

periods range, before and after Shariah compliant with period of study is from 1996 to

2010.

1996 1997 1998 1999 2000 2001 2002 2004 2005 2006 2007 2008 2009 2010

Efficiency

1 1 1 1 0.957700000000001

0.99789

1 0.97407

0.864840000000002

0.84537

1 0.93821

0.93952

1

0.775

0.875

0.975

Efficiency

Scor

e

Figure 4.6: Efficiency scores result for Bank Rakyat before Shariah compliant

The result of DEA analysis are presented in Figure 4.6, showing the average efficiency

scores of output orientation by using DEA model with respect to technical efficiency

(TE) for Bank Rakyat before and after Shariah compliant periods. Even though in year

2000 and 2001the efficiency score are less than 1 but the average efficiency score before

50

Shariah compliant is 0.9926 which almost reached perfect efficiency score 1. It shows

this period is more efficient than after Shariah compliant which only achieved average

efficiency score 0.9374.

4.3.2 Efficiency Trend and Cross Sectional Analysis of Bank Rakyat with other

Selected Islamic Bank

DMU’S AVERAGE EFFICIENCY SCORE

Bank Rakyat 0.93743

BIMB 0.99549

RHB Islamic 0.93670

BMMB 0.98404

Table 4.2: Cross Sectional Efficiency Score of Bank Rakyat with Other Selected Islamic

Banks.

Table 4.2 above shows average efficiency scores for four selected Islamic banks which

are Bank Rakyat, BIMB, RHB Islamic and BMMB. The highest is BIMB since it

achieved average efficiency score of 0.99549 followed with BMMB with the score of

0.98404. While for Bank Rakyat and RHB Islamic, their average efficiency scores are

0.93743 and 0.93670, respectively.

51

2004 2005 2006 2007 2008 2009 2010

Bank Rakyat

0.97407 0.864840000000

003

0.84537 1 0.93821 0.93952 1

BIMB

1 1 1 1 1 1 0.96846

RHB Is-lamic

0.962950000000

001

0.96357 1 1 0.87332 0.757040000000

003

1

Bank Muamalat

0.93659 0.951700000000

002

1 1 1 1 1

0.6500000000000010.7500000000000010.8500000000000010.950000000000001

1.05

Efficiency of Islamic

Sco

re E

ffici

en

cy

Figure 4.7: Cross Sectional Efficiency Score of Bank Rakyat with Other Selected Islamic

Banks.

Figure 4.7 illustrates the trend of Bank Rakyat with selected Islamic bank efficiency from

2004 until 2010. Based on the graph, BIMB maintain the perfect score efficiency which

is 1 for over the year except for the year 2010. BMMB also scores the perfect

efficiency after the year 2005. However, it differ with Bank Rakyat and RHB Islamic the

score efficiency score fluctuated from 2004 until 2010. Even though the efficiency scores

among these bank shows different trend but the range of score is not significantly wide

range where as between 0.9 until 1 only. Therefore, it can be conclude that Bank Rakyat

is at par with other Islamic bank.

52

4.4 DESCRIPTIVE STATISTICS

4.4.1 Descriptive Statistics for Performance

RANK ROA ROE LOANS/DEPOSITS

DEPOSITS/TOTAL ASSETS

EQUITY/DEPOSITS

1st Bank Rakyat(2.05)

Bank Rakyat(21.14)

Bank Muamalat

(0.89)

BIMB(0.90)

Bank Rakyat(0.15)

2nd RHB Islamic(1.12)

RHB Islamic(15.38)

Bank Rakyat(0.82)

Bank Muamalat(0.89)

BIMB(0.14)

3rd Bank Muamalat

(0.53)

Bank Muamalat

(8.57)

RHB Islamic(0.78)

Bank Rakyat(0.83)

RHB Islamic(0.09)

4th BIMB(-1.02)

BIMB(5.51)

BIMB(0.53)

RHB Islamic(0.78)

Bank Muamalat(0.07)

Table 4.3: The average of financial ratio analysis of Bank Rakyat with other selected Islamic

banks

Table 4.3 shows that the average of financial ratio analysis of Bank Rakyat with other selected

Islamic banks from year 2004 until 2010 for five financial ratio analyses. Based on the table

above stated the rank for Bank Rakyat performance compare with others selected Islamic banks.

ROA, ROE and Equity to Deposit Ratio, Bank Rakyat was at rank first while Loans to Deposits

Ratio was at second ranking and at third ranking for Deposits to Total Asset Ratio compare with

other selected banks. From table 4.3 also shows that BIMB was the less performed compare with

others banks because the BIMB was at last rank for three financial ratios.

53

4.4.2 Descriptive Statistics for Efficiency of Bank Rakyat

YEAR EFFICIENCY

DEPOSIT

(RM 000’)

OVERHEAD

(RM 000’)

CAPITAL

(RM 000’)

1996 1.0000 4437.8 148.1 0

1997 1.0000 4564.2 160.7 0

1998 1.0000 5114.0 76.6 799.2

1999 1.0000 6150.7 178.4 981.5

2000 0.9577 7985.7 198.1 1263.9

2001 0.9979 9609.8 240.5 1416.7

2002 1.0000 11227.6 254.7 2011.6

2004 0.9741 17131.5 325.7 3718.5

2005 0.8648 22710.8 367.4 4026.2

2006 0.8454 27253.6 444.4 4136.6

2007 1.0000 32512.5 450.4 4593.7

2008 0.9382 38921.6 643.5 4778

2009 0.9395 50624.3 765.9 5633.9

2010 1.0000 50217.6 808.7 6304.8

Table 4.4: Descriptive Statistics of Bank Rakyat Efficiency Before and After Shariah

compliant

54

96' 97' 98' 99' 00' 01' 02' 04' 05' 06' 07' 08' 09' 10'0

10000

20000

30000

40000

50000

60000

EfficiencyDepositOverheadCapital

Figure 4.8: Trend of Bank Rakyat Efficiency Before and After Shariah compliant

Table 4.5 stated the data for trend efficiency of Bank Rakyat and the input variables

selected. Figure 4.1illustrate the trend of bank efficiency before and after Shariah

compliant from 1996 until 2010 and three input variables trend. Based on the Figure 4.8,

the deposits of banks for year 1996 before Shariah compliant period is RM 44.38 million.

However, it is sharply increased to RM 50.22 million for the recent year 2010 after

Shariah compliant. Capital variable shows the slightly increased from RM 148,100 in

1996 to RM 808,000 in year 2010. However, it differs with Overhead variable which is

almost stable for over the period from year 1996 until 2010. The efficiency score

however is remaining below after Shariah compliant.

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Year less efficient after Syariah Compliant

Year more efficient after Syariah compliant

2004 20072005 20102006 -2008 -2009 -

5/7 = 71.4% 2/7 = 28.6%

Table 4.5: Efficiency pattern for Bank Rakyat after Shariah compliant

The purpose of descriptive statistics is to give strong evidence regarding on the finding as

shown in Table 4.5 where the result shows Bank Rakyat is less efficient after Shariah

compliant. Table 4.5 explained patterns of efficiency for Bank Rakyat from 2004 until

2010. The first pattern shows only five years which are year 2004,2005,2006,2008 and

2009 score less efficient while second pattern shows the years of 2007 and 2010 are more

efficient after Shariah compliant. From the table it can be seen that 71.4% out of 100% of

the year are less efficient while the remaining is more efficient.

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4.5 HYPOTHESES TESTING

a) Hypothesis 1


Islamic banks in terms of ROA


banks in terms of ROA

The average of ratio in term of ROA for the performance of Bank Rakyat is

leading than other bank’s performance. Thus, the decision here is to reject null

hypothesis (H0) and accept alternate hypothesis (H1) which Bank Rakyat is

perform well compare with the other selected Islamic banks in terms of ROA.

b) Hypothesis 2


Islamic banks in terms of ROE


banks in terms of ROE

The average of ratio in term of ROE for the performance of Bank Rakyat is better

than other bank’s performance. Thus, the decision here is to reject null hypothesis

(H0) and accept alternate hypothesis (H2) which Bank Rakyat is perform well

compare with the other selected Islamic banks in terms of ROE.

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c) Hypothesis 3


Islamic banks in terms of Loan to Deposit Ratio


banks in terms of Loan to Deposit Ratio

The average of ratio in term of Loan to Deposit Ratio for the performance of Bank

Rakyat is less than other bank’s performance. Thus, the decision here is to accept

null hypothesis (H0) and reject alternate hypothesis (H3) which Bank Rakyat is not

perform well compare with the other selected Islamic banks in terms of Loan to

Deposit Ratio.

d) Hypothesis 4


Islamic banks in terms of Deposit to Total Asset Ratio


banks in terms of Deposit to Total Asset Ratio

The average of ratio in term of Deposit to Total Asset Ratio for the performance

of Bank Rakyat is lower than other bank’s performance. Thus, the decision here is

to accept null hypothesis (H0) and reject alternate hypothesis (H4) which Bank

58

Rakyat is not perform well compare with the other selected Islamic banks in terms

of Deposit to Total Asset Ratio.

e) Hypothesis 5


Islamic banks in terms of Equity to Deposit Ratio


banks in terms of Equity to Deposit Ratio

The average of ratio in term of Equity to Deposit Ratio for the performance of

Bank Rakyat is higher than other bank’s performance. Thus, the decision here is

to reject null hypothesis (H0) and accept alternate hypothesis (H5) which Bank

Rakyat is perform well compare with the other selected Islamic banks in terms of

Equity to Deposit Ratio.

f) Hypothesis 6

H0: Efficiency before = Efficiency after

H6: Efficiency before ≠ Efficiency after

The average efficiency score of Bank Rakyat before Syariah compliant is higher

than after Syariah performance. Thus, the decision here is to reject null hypothesis

(H0) and accept alternate hypothesis (H6) which Bank Rakyat is more efficient

before Syariah compliant while after Syariah compliant is less efficient.

59

g) Hypothesis 7

H0: Efficiency of Bank Rakyat is not at par with other selected Islamic bank

H7: Efficiency of Bank Rakyat is at par with other selected Islamic bank

Since the range average of efficiency selected Islamic banks including Bank

Rakyat is between 0.9 until 1, therefore, Efficiency of Bank Rakyat is at par with

other selected Islamic bank. Thus, the decision here is to reject null hypothesis

(H0) and accept alternate hypothesis (H7).

4.6 DISCUSSION ON FINDINGS

4.6.1 Performance

The trend analysis for ROA was arranged accordingly to compare Bank Rakyat with

others leading Islamic banks. First it looks at the ROA trend analysis to evaluate the

performance of Bank Rakyat itself. ROA for Bank Rakyat is more consistent since the

ratio is higher than other three banks. Moreover, from the trend, it can be concluded that

the performance of Islamic banks is improving due to the higher demand by customers

towards the Islamic banks’ services and lead to the increasing number of Islamic banks

in Malaysia.

After that, the analysis is look further at the ROE trend analysis. From the result

previously, the performance of Bank Rakyat is increase extremely from year to year. It

60

shows the bank able to generate more profit with the shareholders investment (Jha and

Hui, 2012) because the investors and customers had started to deal with Bank Rakyat.

Loans to Deposits Ratio is designed to determine the percentage of deposit funding that

is tied-up in the loan portfolio which is not normally considered very liquid. From the

results for this performance, it shows most of the banks is having a good performance

since they are able converting their assets to cash cover their non-performing loan

(NPL) especially for BIMB where the trend is continuous declining from year to year. It

is contrast with RHB Islamic where the ratio is sharply increased in 2009 and it shows

the banks not have enough liquidity to cover any unforeseen fund requirements (Abbadi

and Abu-Rub, 2012). In overall, the liquidity performance of Bank Rakyat helps this

bank to manage its own liquidity risk since them able to maintain the ratio from year to

year.

Deposits to Total Assets Ratio is a traditional liquidity measure that indicate the broad

reliable base of funding for the bank and this ratio is used to know the nature of the

deposits deemed to be reliable (Pratomo and Ismail,2008) . From the result previously,

it can be concluded that the entire bank has a consistent trend and it shows that most of

the assets in the banks are funded by deposits rather than borrowed funds or equity

except for RHB Islamic where the ratio is extremely dropped in year 2009.

Equity to Deposits Ratio is used to identify the capabilities of the banks towards total

banks equity against total deposit. It can be categorized under solvency ratio where it

61

measures the degree of financial risk that the bank faces or the bank’s ability to pay all

debt, particularly long-term debt (Rasiah, 2010). Based on the result above, the ratio for

RHB Islamic and BMMB are almost consistent from year to year. Same goes with Bank

Rakyat even though the ratio slightly drops in year 2010. From that, it shows Bank

Rakyat, RHB Islamic and BMMB able to survive in long-term period. But, it is different

with Bank Islam where the ratio is always fluctuated and it shows that this bank is

having less deposit in their operations.

4.6.2 Efficiency

The main objective of this study is to examine the efficiency score before and after

Shariah compliant of Bank Rakyat. The efficiency scores for Bank Rakyat from year 1996

until 2010 are obtained from the analysis and explained below. Year 1996 until 2002 were

the period time of before Shariah compliant applied by Bank Rakyat. The figure trend

illustrate that the efficiency score is 1 for over the year except in year 2000 and 2001

which are the score efficiencies 0.95770 and 0.99789 respectively. Otherwise, after

Shariah compliant the figure shows that not efficient where only two years score perfect

efficiency in year 2007 and 2010 only.

According to Zainal and Ismail (2012) research, bank applied Shariah compliant such as

BIMB is not efficient as other conventional bank. However, other researchers such as San,

Tang and Heng (2011) found that foreign bank applied Shariah compliant is more

efficient than local bank applied Shariah compliant. Thus, this study is consistent with

both researches. Overall efficiency for all banks in Malaysia can be referred to the

62

research done by Singh, Singh and Munisamy (2008) where they found out that among

other banks in the Asia Pacific region, Malaysia’s financial institutional managed to get

only 0.710 of efficiency score in 2006.

The measure of technical efficiency was done using the 2006 data using the non-

parametric frontier technique called data envelopment analysis (DEA) to derive the

technical efficiency score of banks in Malaysia. Mokhtar, Abdullah and Al-Habshi (2007)

also reported the efficiency score for all banks applied Shariah compliant apart from the

conventional bank 1995-2005. The average score for all banks before applied Shariah

compliant stated at 0.904 while the score slightly decrease to 0.827 after applied Shariah

compliant. Comparing the result between both researches, Malaysia’ financial institutions

still inefficient in the period of after bank applied Shariah compliant. However, the score

of efficiency although it is not score as 1.0000, it is still near to the perfect efficiency

score.

4.6.3 Reason Islamic banking transaction is not efficient compared to conventional

banking system

Islamic bank has involved in many social and economic activities that may causes for

increasing in their operational cost and reduce the efficiency of Shariah-compliant

transaction. (Kabir, 2006). The social and economic activities including the Shariah

compliant banking transaction that practices partnership and profit sharing transaction

rather than interest based transaction. So, it will incur profit and loss sharing rather than

63

conventional banking system that charge interest to public whether incurs profit

or loss. Other example include Islamic financing, it charge fixed rate compare to

conventional banking that charge base lending rate and the rate is fluctuate according to the

condition of the economy. It is to ensure that conventional banking will gain profit even

though economy not in good condition. So by this condition, profit for Islamic banking is

lower than conventional banking and affect their efficiency.

Furthermore, the level of efficiency also is based on the country whether the country

implement entire banking system operates under Islamic compliant system or dual

banking system. There are different types of banking and its functioning in the market so

competition is created between Islamic and conventional banking system (Akram,

Rafique and Alam, 2011). Most of Islamic banks have smaller size compared to

conventional counterparts. Islamic bank be allowed to merge with other Islamic bank to

get an optimal size in order to be more efficient and compete with other conventional

banks. Multinational conventional banks that engage in Islamic banking usually have

bigger size rather than Islamic banks. So, the alternative to ensure that Islamic banks stay

competitive with multinational are by expand their score and scale of their operations,

utilize modern technology, and bring Islamic products and services with true spirit of

Islamic prohibition of interest ( Kabir, 2006)

Moreover, customers nowadays prefer more on system that give more wealth to them.

Most customers aware about Islamic banking system but not all of them prefer to have

accounts with Islamic banks due to customer preference that conventional banking has all

64

these factors include high interest in savings, fast transaction, and reputation that bring

them to choose conventional banking rather than Islamic banking. (Barathy, Arunagiri,

and Ravindran, 2011)

Furthermore, Islamic banks also face with several technical and organizational problems

including lack of standardization of Shariah opinions, unclear and sometimes ambiguous

relationship between the management and Shariah Advisory Board. Other problems

include inadequate and not suitable supervision standards by both internally and

externally by the central banks, lack of creativity in financial engineering and marketing

and less sensitivity to customer satisfaction. Customer satisfaction is one of the important

things to improve efficiency because they was the main contributor for the profit and

automatically will help banking institutions to survive in the market.

Another factor that will lead to the inefficient of Islamic banking is insufficient training

of Islamic bank’s personnel. Usually, Islamic banks will derive their employees from

conventional banks so it will cause some problems to understand the new technique of

Shariah rulings and have problems to explain to the customers on the different types of

the new Islamic banking products and services and benefits that will attract the

customers. This is due to the faster of Islamic banking system in the market and

employees must adapt and truly understand the entire concept in order to make customers

have confidence with Islamic banking products.

65

Lack of creativity and innovations in terms of banking services offered by Islamic bank

to the public also the reason for lack of efficient. For example, Islamic banks did very

little mode of saving and investment to mobilize resources and create an investment for

them. (Kahf, 1996). The marketing department must be the main focus for Islamic banks

although most Islamic banks pay little attention to it. This department has a key role in

the bank’s ability to attract deposits as well as investments from customers and also

responsible for the promotion and growth of the bank’s business. Marketing department

will create the strategies and policies of the bank’s products and services to the clients

and potential customers in order to increase their customers and volume of transactions

with Islamic banks.

Furthermore, to maintain efficiency of Islamic banks, there must be able to have modern

technologies in their transaction that will reduce the size and cost of automated

equipment thus will enable bank to purchase expensive and superior technologies such as

information technologies to assess difficult quantitative and qualitative information

(Sufian, 2007). Besides that, technology advancement is important to assess and monitor

risk throughout the time which is necessary to stay competitive in the market (Iqbal,

2008).

Other than that, factor that will contribute to the inefficient is when customers of the bank

did not confidence with the bank’s capital strength. Capital strength of the bank is

important for customers to ensure that bank’s future and safety of deposits, and give

customers sense of security on their investment and current deposits (Kahf, 2004).

66

For Bank Rakyat one of the reason that may causes to the inefficiency after Shariah

compliant implemented include higher cost of business due to the new products in the

market and initiative that must be taken in order to introduce this products and make

customers aware and accept well in the market (Bank Kerjasama Rakyat, 2006).

Furthermore there also have challenges from places like Bahrain which is the world’s

biggest hub for Islamic banking. It wills causes domestic banks incur more cost in order

to compete with foreign banks by applying more banking skills and enhancing technology

(Ong, Lim, and Teh, 2011).

Furthermore, Bank Rakyat also has to compete with other international banking groups

operating in Malaysia with the government have allowed them to expand in this country.

For example, Citibank, Standard Chartered, and HSBC that have the resources and big

name in the industry with their products and services. So, Bank Rakyat have to compete

with them and in the early stage of Shariah compliant implemented is the toughest time in

order to adapt with the competitive environment (Bank Kerjasama Rakyat, 2006).

67

CHAPTER 5

CONCLUSION AND RECOMMENDATION

5.1 INTRODUCTION

This chapter summarizes the result of the analysis on the performance and efficiency of

Bank Rakyat with other selected Islamic banks. It reported on the main findings of the

study that is on the efficiency score. Towards the end of this chapter, it also included the

recommendation for future studies as well as the limitation that arise while conducting

this study.

5.2 SUMMARY AND CONCLUSION

The main aim of the study is to measure the performance and efficiency of Bank Rakyat

with other selected banks using DEA. First objective of this study is focus on the

performance of bank. In summary, for the performances of Bank Rakyat with other

selected Islamic banks for all five financial ratio analysis shows are well performed.

Bank Rakyat performed well than other three banks in terms of ROA, ROE and Equity to

Deposit Ratio. However, Bank Rakyat less performed in terms of Loan to Deposit

Ratio and Deposit to Total Asset Ratio.

68

Second objective of this study is focus on the analysis of the efficiency of Bank Rakyat

before and after Shariah compliant shows the result that before Shariah compliant is

more efficient than after Shariah compliant. This analysis continued with the comparison

of Bank Rakyat efficiency with other selected Islamic bank. The result previously shows

all the banks seem to have similar average efficiency score where as the range of score

between 0.9 until 1 only. Therefore, it is prove that the efficiency of Bank Rakyat is at

par with other selected Islamic banks for this study. As mentioned before that the

efficiency of Bank Rakyat before Shariah compliant where during conventional period is

more efficient that after Shariah compliant. Thus, it is means the Shariah compliant that

applied by other Islamic banks is less efficient than not applied Shariah compliant which

is conventional bank.

5.3 RECOMMENDATION FOR FUTURE STUDIES

From the study that had been conducted, there are some recommendations that can be proposed

for future investigations. These are as follow:

i. Study with extended duration to gain more data for a better result.

ii. Study on effects of other factors such as inputs and outputs selection in order to

gain the better efficiency results.

iii. Study on the efficiency by comparing the efficiency level with other commercial

banks in Malaysia that also implements Shariah compliant will give more

information about Shariah compliant efficiency.

69

5.4 LIMITATION OF STUDY

This study is not drawn without limitation. However, this study only has one obvious

limitation with regards to the method used in the analysis. Previous study mostly used

DEA method in order to measure efficiency, therefore this study also need to carry the

same method since DEA can give accurate result. The limitation with regards to this

method is difficult to get the software as well as expertise since not too many research

used DEA in this study.

Moreover, there have another limitation for this study which is the period of year that

chooses for analyzing the performance and efficiency. It is because of the starting of

RHB Islamic is early year 2004, thus for the performance and efficiency analysis of Bank

Rakyat compare with other banks starting from 2004 until 2010 recently. However, for

the efficiency of Bank Rakyat itself the analyzing was starting from a year 1996 until

2010 because to there have two stage of period where before (1996 - 2002) and after

(2004 - 2010) Shariah compliant.

70

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80

APPENDICES

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Edited Full Report

Documents

wise linear

unforeseen

reject alternate

reject null

accept alternate

accept null

linear programming

malaysian