SIZE AND RETURNS TO SCALE OF THE ISLAMIC BANKING INDUSTRY IN MALAYSIA: FOREIGN VERSUS DOMESTIC BANKS

Abstract

This paper investigates the efficiency of the Malaysian Islamic banking sector during the period of 2001-2004. The efficiency estimates of individual banks are evaluated using the non-parametric Data Envelopment Analysis (DEA) method. The method allows for the decomposition of the technical (overall) efficiency into its pure technical and scale efficiency components. In accordance with Islamic financial system principles, the intermediation approach is applied to the specification of input-output variables. The findings suggest that scale inefficiency dominates pure technical inefficiency in the Malaysian Islamic banking sector, implying that Malaysian Islamic banks have been operating at the wrong scale of operations. We have also found that the domestic Islamic banks have exhibited higher technical efficiency compared to that of their foreign peers. Although the findings suggest that the foreign Islamic banks’ technical efficiency is lower compared to its domestic counterparts, the results seem to suggest that the foreign Islamic banks have been relatively more efficient in controlling their operating costs, thus implying that the foreign banks’ inefficiency was mainly attributed to scale.

JEL classification: G21, G28

Key words: Islamic banks efficiency, Data envelopment analysis (DEA), Malaysia.