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Measuring and Explaining the Efficiencies of the United Arab

Emirates Banking System

By
Mohamed Y. El-Bassiouni i

Fatima S. Al Shamsi

Hassan Y. Aly

UAE University

The Ohio State University

UAE University

Accepted and forthcoming in Applied Economics


i

The authors would like to thank a reviewer for his/her helpful comments and would like to
acknowledge with gratitude the financial support provided by the UAE University
(interdisciplinary research grant # 01-4-12/02).

Measuring and Explaining the Efficiencies of the United Arab


Emirates Banking System

Abstract
Using a newly collected data from a survey distributed to all banks in the
United Arab Emirates (UAE), this paper measures economic efficiency in the banking
industry, namely allocative, technical, pure technical and scale efficiency. Employing
a non-parametric -DEA- approach, the study estimates the efficiency for a cross
section of the UAE banks in 2004. The results indicate that the dominant source of
inefficiency in the UAE banking is stemming from allocative inefficiency rather than
technical inefficiency. Furthermore, the main source of the relatively small size,
technical inefficiency in the UAE banking industry is not the scale inefficiency but
rather the pure technical inefficiency. The results further indicate that the UAE banks
are able to use their input resources more efficiently when they have more branches,
and that newer banks are performing better than older banks on average. Moreover,
the results also show that short experiences of employees affect efficiencies
negatively and government ownership tends to reduce efficiency (as the government
shares increases in the bank, the efficiency scores get lower). Finally, the most
interesting results have to do with finding higher average efficiencies in banks that
employ more women, more mangers, and less national citizens of the UAE.

I.

Introduction
The banking industry worldwide is facing competitive pressure as the world

financial structure is changing rapidly due to the ramifications of the establishment of


the World Trade Organization. Deregulating the financial sectors and financial
services, the increasing use of information technology, and the huge speed of
dispensing financial information are also among the factors leading to reevaluating
and restructuring of financial institutions worldwide. In such conditions, bank
regulators, managers, investors as well as governments are concerned about how
efficiently banks transform their inputs into various financial products and services or
in simple wording how efficiently banks performs their functions. Thus, in order for
financial institutions to survive the upcoming battles created by the expected stiff
worldwide competition, as by product of the enactment of WTO regulations, it is
imperative that these institutions be subjected to measurement and evaluation of its
own economic efficacies and performance.
The UAE banking sector is no exception. Having served as a financial center
for the Middle East region, the UAE banking institutions need to revaluate their
performance. Moreover, the financial sector needs to compare its economic
efficiencies with the competitors from around the world who soon might be able to
enter the UAE market and seize part of the local share.
It is a matter of vital importance for bank managers, bank regulators, and the
Central Bank authority of the UAE to get full information about the banks economic
efficiencies (technical, allocative and scale efficiencies). To this end, the current study
provides estimates of the various efficiency scores for the UAE banking sector,
investigates the types of inefficiencies (if any) and identifies their sources.

However, while the measurement and the comparisons of efficiencies are


significant and vital objectives for this study, explaining the efficiencies and
attempting to analyze them is more important than ever. Accordingly, additional
demographic, social and technical data were collected and used to go one step further
beyond the classical analysis and explain why the efficiency scores are what they are
and what are the factors that could help enhance them and finally how governmental
regulations may help their improvement.
The main findings of the study indicate that UAE banks are generally
technically efficient but allocatively less efficient. Also, the results show real small
scale inefficiency, if any, exist in the UAE banking sector. In explaining these results,
the study confirms that factors such as branching, having more women employees as
well as more managers, and having longer experience for employees do positively
impact average efficiencies. On the other hand, government ownership and having
more national citizens as employees do negatively affect the average efficiencies
In section II a background of the UAE banking industry is provided whereas
a pertinent review of literature is presented in Section III with special attention to
studies conducted on MENA (Middle East and North African) countries or
comparable economies. Section IV outlines the methodology used in this study in
addition to identifying the models, variables and data sources. Section V presents the
empirical DEA results (efficiency scores), while Section VI explains these results in
light of the explanatory variables (demographic, social, regulatory, and economic)
that are used for the first time in such studies. Section VII concludes by policy
implications, limitations, and a brief summary.

II.

Background of the UAE Banking Industry


The UAE banking sector consists of the UAE Central Bank, the commercial

banks (local and foreign) and other specialized banks and financial institutions. The
Central Bank of the UAE was formed in 1980. Its duties include advising the
government on monetary and financial issues, issuing currency, maintaining gold and
foreign currency reserves, formulating credit policy and providing regulation and
supervision. Total assets of the UAE Central Bank (CB) reached AED 67.6 billion in
2004 and its net earnings during 2004 increased by 34.4% from AED 559.2 million to
AED 801.9 million (MENAFN.Com, 2005).
Banks play a critical role in the UAE economy, and the banking system is
strong and developed, technologically advanced and more integrated into the world
economy. According to the IMF, the banking system is broadly profitable, well
supervised, and capitalized (IMF public information notice, March 2003). Benefiting
from relatively low operating costs and widening margins between deposit and
lending interest rates, combined net profits of UAE banks rose by 39.55% in 2004
(MENAFN.Com, 2005). The ratio of gross nonperforming loans to total loans
continued to decline, but remains high at 14% compared to other GCC countries
(Kuwait is 6%), while capital adequacy ratios remained significantly above
international standards. Bank assets constitute around 184% of non-oil GDP and
125% of total GDP in 2003 (Central Bank, 2004). The growth in the banking GDP is
attributed to the high credit and deposit growth on the back of low interest
environment. Consolidated assets of the banking sector grew by 11.3% to AED 413.7
billion due to the growth of total credit by 17.3% to AED 238.2 billion in 2004
(Central Bank, 2004). Some selected monetary and banking indicators are given in
Table 1.

Indicator

Table 1. UAE Selected Monetary and Banking Indicators


1990 1995 1999 2000 2001 2002 2003

CB assets (billion
21.1
27.2
39.2
45.8
52.5
55.3
54.5
AED*)
CB assets to equity
20.5
20.2
20
18.9
18.2
ratio
Banks assets
153.9
180.9
251.1
264.2
235.1
331.6
366.9
(billion AED*)
Gross non
15.2
14.4
13.6
12.7
15.7
15.3
14.3
performing
loan/total lending
Return on assets
1.9
2.0
1.5
1.8
2.6
2.2
2.3
Return on equity
17.1
18.3
12.8
14.9
16.7
15.6
16.4
Average interest
4.4
4.5
5.8
3.7
4.7
5.6
4.7
rate spread (%)
UAE Banks** (No.)
207
241
295
370
324
345
367
F. Banks** (No.)
119
119
110
109
109
112
112
Labor (No.)
9,677 10,916 14,274 14,385 15,191 16,080 17,229
GDP*** share (%)
4.2
4.9
6.4
5.8
6.6
6.6
6.3
Non-oil GDP***
8.7
9.6
9.5
9.5
share (%)
Notes:
* 1 AED = US$ 3.668
** includes head offices and their branches
*** For all financial institutions and insurance
Sources: Central Bank of the UAE, Statistical Bulletin volume 24, No.3 September 2004 and
IMF (2004), Country report No. 04/ 175, June 2004.

2004
59.9

394.1

377
112
18,381

The UAE commercial banks market is quite large compared to other Gulf
States. At the end of the 2004, there were 46 banks, with 489 branches, serving a
population of around 3.6 million compared to 14 banks in Saudi Arabia serving some
23.5 million inhabitants (Central Bank & Global Investment House, 2004). Of the
UAE commercial banks, 21 were locally incorporated, with a total of 377 branches
and 70-100% UAE ownership. The remaining 25 banks, with 112 branches, are
foreign owned. It is worth mentioning here that foreign banks are restricted to no
more than five branches. The total assets of the commercial banks have expanded
significantly during the past years reaching AED 413.7 billion in 2004 (of which more
than 27% are foreign assets). The UAE banking sector is the second after Saudi
Arabia within the GCC in term of asset size. Asset size of national banks increased
by 11.5% to AED 314.3 billion in 2004, while that of foreign banks increased by a
similar rate (11.2%) to AED 99.5 billion for the same year (Central Bank, 2004). The

financial institutions GDP share reached 6.3% in 2003 and their share of non-oil
GDP reached almost 10% for the same year, while the total workforce in the banking
sector reached 18,381 workers in 2004 (of whom less than 2% are nationals). The top
five banks dominate the industry, accounting for roughly 50% of all assets and 75%
of all deposits. They are partly owned by the governments of Abu Dhabi and Dubai.
Among the local banks, there are four Islamic banks that follow the Islamic banking
principle.
The UAE commercial banks provide a full range of financial services;
covering retail and investment banking, and their commercial lending are dominated
by short- and medium-term loans. Total bank credit extended to residents and nonresidents reached AED 238.2 billion in 2004, a rise of 17% from 2003. An analysis
of the components of bank credit according to economic activities reveals that the
largest share of bank credit was extended to the trade sector which attains an average
share of 29% for the last three years. The second sector in term of acquired credit is
the construction sector with a share of 14.5% on average for the period from 20022004 (see Table 2). The distribution of credit by economic activities shows an
increase in the credit extended to the government in the last three years by 22.5% in
2003 and 32.5% in 2004, which increased the government share in total bank credit
from 9.2% in 2002 to 12.8% in 2004.
Table 2. Bank Credit by Economic Activity 2002-2004 (Million AED)
Activity
Trade
Construction
personal loans for Business
personal loans for consumption
Government
manufacturing
Transport, communication
Electricity, water and gas
Mining and quarrying
Agriculture

2002
48870
27063
20716
17704
15222
9901
5127
3219
2213
1154

%
29.5
16.3
12.5
10.7
9.2
5.9
3.1
1.9
1.3
0.7

2003
57053
26845
23965
21443
19650
11082
6325
11110
2077
830

%
28.9
13.6
12.2
10.9
9.9
5.6
3.2
5.6
1.1
0.4

2004
69083
31856
30392
23195
29134
13717
6573
9113
2497
880

%
29.0
13.5
12.8
9.7
12.2
5.8
2.8
3.8
1.0
0.4

Non-banking financial institution


1903
1.1
2272
1.2
Other
12512
7.8
14254
7.4
Total
165604
100
196906
100
Source: Central Bank of the UAE, Statistical Bulletin volume 24, No.3 September 2004.

3745
18023
238208

In compliance with the Central Bank regulation, all 46 banks operating in the
UAE met the 10% capital asset ratio. Bank lending has grown substantially,
increasing at an annual rate of 17% during 2001-2003.
Securities markets are a new development in the UAE financial systems that
were launched in 2000. There are two exchanges in the UAE, Abu Dhabi securities
market (ADSM) and Dubai financial market (DFM). ADSM is the third stock market
by capitalization in the Arab world after Saudi Arabia and Kuwait which was
estimated to be at more than AED 111 billion at the end of 2003 and DFM has a
market capitalization at about AED 60 billion. The transaction volume of the UAE
securities markets increased by 40% in 2003; however, market liquidity remains low
and speculation is restrained. The general market index grew at 32% in 2003, "among
the lowest appreciation in the GCC market" (IMF, 2004, p47).
Dubai International Financial Center (DIFC) is another new development that
added to UAE financial system in 2004. DIFC was initiated by Dubai government as
a free zone financial center and is expected to encompass a comprehensive set of
international financial functions. DIFC activities will include institutional and
investment banking, insurance and re-insurance, asset management, Islamic financial
services, back office operation and an international exchange that will trade a full
range of financial instrument (IMF, 2004, p49). DIFC is intended to be segregated
from the UAE financial sector and its banking operation is confined to institutional
wholesale banking. The launch of DIFC is expected to give the country an
opportunity to be a "universally recognized hub for institutional financial services and

1.6
7.4
100

the regional gateway for capital and investment " (Global Investment House, 2004,
p.3).
III.

Review of Pertinent Literature


There are two major approaches for measuring efficiency that have been used

in all studies; the parametric approach and the non-parametric approach. In general,
the parametric approaches specify a functional form for the cost, revenue, profit, or
production relationship among inputs, outputs and others (for instance, environmental
factors), and allow for random error. The most famous technique used in the
parametric approach is Stochastic Frontier Approach (SFA).
On the other hand, the nonparametric approach most well-known technique is
the Data Envelopment Analysis (DEA). The DEA- to be used in this study- computes
the relative efficiency of each bank by using multiple inputs and multiple outputs.
Linear programming techniques allow for the construction of best practice cost and
production frontiers from these data and the performance of a particular bank is then
judged relative to this frontier. The specific efficiency measures calculated can be given
fairly simple interpretations. The technical efficiency measure gives the proportional
reduction in input usage, which could have been achieved if the firm operated on the
efficient frontier. The technical efficiency can be decomposed into the proportional
reduction in input usage, if inputs were not wasted (pure technical efficiency) and that
reduction if there existed constant returns to scale (scale efficiency). As such, pure
technical inefficiency reflects excess input levels for a given level of output. This
inefficiency is unique in that it is caused and could be corrected by proper management.
From the economics standpoint, firms that operate at constant returns to scale represent
the long run socially efficient level of operation. Therefore, choosing non-constant scale
of operation also constitutes inefficiency.

In this section a review of the DEA literature limited to recent studies that
applied the technique to MENA (Middle East and North African) countries or
comparable emerging economies or made international comparisons between different
countries is presented ii .
First, a comprehensive study by Berger and Humphrey (1997) surveyed over
125 studies that applied frontier approaches to measure the performance and
efficiency of financial institutions in more than 20 different countries. Most of the
studies are conducted in the U.S. banking industry between 1990 and 1998. Very few
studies were done outside the US and a call for the need to examine the efficiency of
banks outside the United States was emphasized. In their article, Berger and
Humphrey, illustrated differences and dispersion in efficiency estimates between
nonparametric and parametric frontier techniques. They reviewed and critically
analyzed empirical estimates of financial institution efficiency in order to address the
implications of efficiency results in the areas of government policy, research, and
managerial performance.
Mohd Zaini Abd Karim (2001) investigates whether there are significant
differences in bank efficiency across select ASEAN countries (Indonesia, Malaysia,
Philippines, and Thailand). The study indicates that the substantial proportion of a
total variability is associated with inefficiency of input used. It also highlights the fact
ii

For more details on the issue of measuring bank efficiency, using the non-parametric DEA
approach and its comparability across different countries, regions of the world and under various
operational and environmental working conditions, the interested reader is referred to Drake 2001,
Devaney and Weber 2002, Kong and Tongzon 2006, Steinmann and Zweifel 2003, Sathye 2001,
Miller and Noulas, 1996, Hasan and Marton 2003, Drake and Hall 2003, Akhigbe and McNulty, 2003,
Esho 2001, Santomero and Seater, 2000, De Young, Robert 1997, Barnum and Gleason 2006, Allen
and Anoop 1996, Lozanzo-Vivas et al. 2002, Orea 2002, Staat, Matthias 2006, Cook 2000, Clark and
Siems 2002, Vennet, 2002, Von Hirschhausen et al 2006, Shujie Yao 2006, Wheelock and Wilson
1999, Athanassopoulos 1998, Peristiani 1997, Clark 1996 and Allen N. Berger and Loretta J. Mester
(1997). These studies may be considered examples and are not intended to be an exhaustive survey.

that inefficiency tends to decrease with bank size and increase with government
ownership.
David A. Grigorian and Vlad Manole (2002), using both cross-country and
cross-regional settings, and applying the DEA approach, tried to calculate an
appropriate measure of commercial bank efficiency in a multiple input/output
framework for transition economies, and to identify the effects of policy framework
on the performance of commercial banks. The results of the study illustrated that
banks with a larger market share and a larger controlling foreign ownership are likely
to be more efficient than those with a smaller market which was attributed to their
better risk management and operational techniques. They also discovered that banks
in higher per capita income countries are more efficient in terms of attracting more
deposits and generating stronger cash flows than banks in low income countries. It is
also indicated that while privatization of state-owned enterprises, enterprise
competition and corporate governance related improvements are important in
boosting commercial bank efficiency, the securities market and non-bank financial
institutions development hinders the efficiency of banks.
Ihsan Isik, M.Kabir Hasssan (2002) estimated allocative efficiency, scale
efficiency and overall cost efficiency of Turkish commercial banks. The study
correlated 4 measures of financial performance with the 5 measures of cost efficiency
and investigated whether higher performance impacts bank cost efficiency. They
discovered that the efficiency of the Turkish commercial banks had deteriorated in the
90s and the dominant source of the cost inefficiency is technical, which they
suggested might be attributable partly to the recent abnormal growth of small and
medium banks, and partly to the recent heavy investment in expensive
computerization and automation projects and consequently idle capacity. They

examined the relationship between the X-efficiency measures and the proxy measures
of performance to reveal that there is a statistically significant relationship. The study
also suggests that strong competition might have induced more market discipline on
small banks, leading to greater cost efficiency. The study also indicates that foreign
banks are significantly more efficient than their domestic peers and private banks are
more efficient than public banks. Their study suggested that publicly traded banks are
more technically efficient than privately held banks, and banks under a holding
company structure are more efficient than independent banks.
In their study, Ali F. Darrat et.al (2002), investigated the efficiency of banks in
the MENA region. The study uses DEA and Malmquist total factor of productivity
index to evaluate the performance of 8 locally incorporated Kuwaiti banks, in terms of
their efficiency, productivity growth and technological change over the period 19941997. The study indicates that small banks are more efficient and there is an upward
trend in cost efficiency of Kuwaiti banks. The study also suggests that while technical
efficiency of Kuwaiti banks is consistently higher than allocative efficiency, scaleefficiency is also persistently higher than pure-technical efficiency over the estimation
period. Market power plays an important role in cost and allocative efficiencies and
capitalization of Kuwaiti banks positively impacts their cost efficiency. It is also
suggested that Kuwaiti banks experienced productivity growth over the sample period
from becoming more technologically advanced rather than being more technically
efficient.
Claudia Girardone et.al (2004) examined the determinants of Italian banks
cost efficiency over the period 1993-1996 by employing a Fourier-flexible stochastic
cost frontier in order to evaluate X-efficiency and scale economies and to identify the
main characteristics of efficient banks. The important findings of the study include:

deregulation has a positive impact and X-efficiency levels seem to decrease over time,
for all sizes of banks, the smallest banks appear to be less inefficient than their larger
counterparts, the main differences between the most efficient and the least efficient
bank seem to be mainly related to staff expenses, efficient banks always appear to
have lower levels of equity/assets and higher levels of non-performing loans,
inefficiencies appear to be inversely correlated with capital and positively related to
the level of non-performing loans, inefficient banks tended to have (on average) a
greater retail banking orientation, higher interest margins and more branches
compared with their efficient counterparts, no clear relationship between assets size
and bank efficiency.
Finally Berger (2007) conducted a comprehensive survey article where he
reviewed and critiqued over 100 studies that compare bank efficiencies across nations.
His goal was explaining the consolidation pattern among financial institutions in
developed versus developing countries. He grouped these studies into three distinct
categories: (1) studies that make the comparisons of bank efficiencies in different
nations based on the use of a common efficient frontier, (2) other that make the
comparisons of bank efficiencies in different nations using nation-specific frontiers,
and (3) finally the ones that compare the efficiencies of foreign-owned versus
domestically owned banks within the same nation using the same nation-specific
frontier. He used the results to explain the consolidation patterns in different part of
the world and he concluded that the efficiency disadvantages of foreign-owned banks
relative to domestically owned banks tend to outweigh the efficiency advantages in
developed nations on average, and this situation is generally reversed in developing
nations.

IV.

Methodology and Data


From section III, we can clearly conclude that each approach of measuring

efficiency (parametric or non-parametric) has its own advantage and shortcomings.


The main disadvantage of the parametric approach is the imposition of certain
functional forms on the technology used in production. The approach does dictate the
type of technology used by utilizing certain functional forms and not others. Some of
these restrictions on the technology could be very severe depending on the flexibility
of the functional form (or lack thereof). While the non-parametric approach does not
impose any restrictions on the technology, it does not allow for any stochastic random
disturbances. Variations in efficiency might be due to random shocks stemming from
external factors like weather changes or the like.
The approach selected for use in this study is the non-parametric approach.
The random disturbance in the banking industry is insignificant in comparison to
another industry (e.g., agriculture) where weather and external factors could have
great impact on productivities. Also, the benefits from using no restricting technology
could be greater in the banking industry compared to others, due to the varied
methods of producing financial services among different financial institutions. In
addition, it is clear from the review of relevant literature (Berger and Humphrey,
1997, cited earlier) that efficiency estimates from nonparametric studies are very
similar to those from parametric frontier models; but nonparametric methods
generally yield slightly lower mean efficiency estimates. Also, since most of the
studies conducted on the banking sectors in other countries have used the nonparametric approach, for the sake of consistency in comparison, this study uses the
same approach.

The specific technique to be used to measure the overall technical efficiency


index of a bank is the solution of a group of linear programming problems that are
very well known by now. They can be illustrated by:
Min such that

(1)

L1Z1 + L2Z2 + . . . + LnZn Ln


K1Z1 + N2Z2 + . . . + KnZn Kn
Y1Z1 + Y2Z2 + . . . + YnZn Yn
Zi 0 , i = 1, . . ., n ,

where n denotes the number of observations, represents the overall technical


efficiency index and Z is a variable measuring the intensity of production, Y denotes
output and L and K denote labor and capital as defined below. Note that the condition
Zi 0 imposes constant returns to scale in the underlying technology.
In order to relax the assumption of constant returns to scale (CRS) and
separate into pure technical efficiency (PTE) and scale efficiency (SE), an
additional linear programming problem suggested by Fre, Jansson and Lovell (1985)
is constructed and solved as follows:
(2) Min such that

L1Z1 + L2Z2 + . . . + LnZn Ln


K1Z1 + K2Z2 + . . . + NnZn Kn
Y1Z1 + Y2Z2 + . . . + YnZn Yn
n Zi = 1,
where is a measure of pure technical efficiency. Having calculated , a measure of
scale efficiency (SE) can be computed as follows:

(3)

SE = /.
The efficiency scores of all Decision Making Units (banks in this case) are

bounded between 0 and 1, with the most efficient banks receiving an efficiency score
of unity. The CRS assumption is appropriate if all banks are operating with optimal
scales. Otherwise, technical efficiency scores could be confounded with scale
efficiency. For more details on the specificities of the techniques see among others
Aly et al. 1988 and 1990.
Now, we turn to the data and definition of input and output variables. That
part of the required data is collected from balance sheets and income statements from
most of the commercial bank, operating in the UAE for the last five years. The three
major inputs targeted by this study are labor, capital and deposits, and the two outputs
are loans and investments. The choice of inputs and outputs for banks has received
much attention in literature due to the unique nature of the banks production process.
There are two approaches in the literature. The production approach and
intermediation approach. In the production approach, banks are considered as units
producing services for clients such as performing transactions and processing
documents. Therefore, inputs are measured by physical units, and outputs are
measured by the number and type of transactions or documents processed over a
given time period. Under the other intermediation approach, banks are viewed as
channeling funds between depositors and borrowers. Thus, banks sustain labor,
capital and loanable funds expenditures to transfer funds from those with surplus of
funds to those with shortage of funds. Thus, total costs should include interest
expenses as well as operating costs (Topuz and Isik, 2004). The study follows the
second approach.

Labor (L) is measured by the total number of employees, capital (K) by the
book value of fixed assets and premises, and deposits (D) by the sum of demand and
saving deposits. The analysis also includes input prices in order to measure cost
efficiency. The unit price of labor (WL) is the total cost of all bank employees (i.e.,
salaries, employee benefits, etc) divided by the total number of employees. The unit
price of capital (RK) is measured by the total expenditure on fixed assets and
premises divided by the book value of fixed assets and premises. The unit price of
deposits (PD) is computed by the total interest expenses of deposits divided by the
sum of demand and saving deposits. As to the outputs, loans (L) include all types such
as real estate loans, commercial and industrial loans, and consumer loans. Investments
(I) reflect the value of all securities other than those held in the banks trading
accounts.
It is important to mention here that the appropriate number of inputs and
outputs is determined based on the available data. As a general rule, the product of
inputs times outputs in a DEA approach should optimally be less than the sample size
in order to effectively differentiate among banks. In our case, the general rule is
satisfied since the total number of valid and non missing observations is 22 (twenty
two banks) and the restriction based on the general rule requires only 6 (six banks).
In addition, data on the education, gender, ethnicity and race mix of the
employees; number of branches; size of foreign transactions; proportion of different
types of loans; and number of financial products offerings are needed for explaining
the efficiency scores as mentioned earlier.
This major part of the data (demographic, social, and technical variables) was
collected through a survey instrument (see Appendix I) that was designed and tested
on two banks before it was distributed to all commercial banks operating in the UAE

in the year 2004. The Central Bank assisted in collecting the data by providing an
attached letter encouraging the banks to respond to the survey. However, the response
rate is about 54% (25 banks out of 47) and the usable observation is 22 banks. While
the collection was conducted in the Spring and Fall of 2004, the data were collected
for the year ending in December of 2002, the last year that banks had full information
for the required data.
To explain the efficiency scores based on socioeconomic, regulatory, and
demographic variables, we used the regular ordinary least square method as well as a
logistic regression approach due to the nature of the dependent variable which lies in
the interval [0,1]. The logistic regression analysis was performed through the
implementation of Weighted Least Square (WLS), with a backward stepwise
elimination option, to relate the dependent variable: efficiency score (y), and the
independent variables: number of years in operation (X1), the percentage of
government participation (X2), the number of branches (X3), the number of IT
employees (X4), the percentage of males (X5), the percentage of managerial
employees (X6), the percentage of national employees (X7), the percentage of
employees with higher education; university plus (X8) and the percentage of
employees with short experience; less than 5 years (X9). The logit transformation was
used to obtain the logistic regression model

(4)

y
= 0 + 1 X 1 + 2 X 2 + ... + 9 X 9 .
ln
1 y

The weights which are inversely proportional to the variances of the logits were
approximated by (yi(1-yi)).
The descriptive statistics on the variables used in this study are reported in
Table 3.

Table 3. Descriptive Statistics for the UAE Banking Data


Item

Mean

Total wages**
No. of employees (Labor)
Wages per capita** (Unit price of labor)
Book value of assets and premises**
Total spending on fixed assets and
premises**
Sum of current accounts and savings
deposits**
Sum of commercial loans**
Sum of industrial loans**
Sum of consumer loans**
Sum of other loans (if any)
Total interest on current accounts and
savings deposits**
Sum of real estate loans**
Total loans** (L)
Total investments** (I)
Unit price of capital**
Unit price of deposit**

Min

Max

48.35
486.05
0.11
138.11
36.82

Std.
deviation
45.75
431.13
0.03
151.87
67.24

3.92
39
0.07
4.00
0.00

148.26
1386
0.18
547.00
274.60

2333.54

3775.54

111.85

16507.00

1469.98
1032.23
1448.74
719.42
406.50

2593.60
1959.31
2275.17
1971.31
1080.52

0.37
0.00
7.98
0.00
0.00

12131.65
8917.29
8262.31
9088.00
5054.00

779.66
2957.70
740.83
0.62
1.93

1591.10
4148.52
1123.20
1.18
3.62

0.00
217.09
0.00
0.00
0.00

6678.80
17815.00
3579.36
5.163
16.58

** in million AED

V.

DEA Results
The DEA analysis produced the various efficiency scores in Table 4. The

average overall cost efficiency is a bit low (55%). This means that the average UAE
bank could have produced the same level of output using only 55% of the resources
actually employed had it been producing on the frontier rather than at its current level.
Another way to explain this is to say that the UAE banks do have potentials to
increase their level of output by another 45% using the same level of input they
actually have.
Also, such an overall average of cost efficiency (55%) is a bit lower than those
typically reported for developed countries. Here, we make the comparison between
the efficiencies of banks in different nations, with banks from each nation measured
against their own nation-specific frontier not against a common frontier iii .
iii

For

In this case, the standardization of the DEA methodology seems to tolerate such comparisons of the
size of the efficiency coefficients. However, one has to bear in mind the national differences in
regulations, legal system, economic and financial markets conditions in the different countries, as well
as the differences in the time period the research covers - that will surly results in different frontiers
(see Berger, 2007).

example, Aly et al. (1990) reported overall efficiency of 65% for US banks, Berger et
al. (1993) estimated cost efficiency at 80% for U.S. banks, and Altunbas et al. (1994)
estimated it at about 95-90% for British banks. In another Gulf country (Kuwait)where the legal, economic, financial, and social conditions are almost the sameDarrat et al. 2003 reported banks to have cost efficiency of 67%.

Table 4. Efficiency Scores for the UAE Banks in 2002


Bank*
Bank 1
Bank 2
Bank 3
Bank 4
Bank 5
Bank 6
Bank 7
Bank 8
Bank 9
Bank 10
Bank 11
Bank 12
Bank 13
Bank 14
Bank 15
Bank 16
Bank 17
Bank 18
Bank 19
Bank 20
Bank 21
Overall Average
CE: Cost Efficiency
AE: Allocative Efficiency
TE: Technical Efficiency
PTE: Pure Technical Efficiency
SE: Scale Efficiency

CE
0.45
0.30
0.03
0.45
0.22
0.89
1.00
0.79
0.87
0.37
0.22
0.57
1.00
0.81
0.31
0.68
0.30
0.53
0.07
1.00
0.75
0.55

AE
0.45
0.42
0.82
0.94
0.38
0.92
1.00
0.79
1.00
0.43
0.28
0.57
1.00
0.81
0.31
1.00
0.36
0.54
0.57
1.00
0.75
0.68

TE
1.00
0.71
0.04
0.48
0.59
0.97
1.00
1.00
0.87
0.85
0.77
1.00
1.00
1.00
1.00
0.68
0.83
0.98
0.12
1.00
1.00
0.80

PTE
1.00
0.71
0.04
0.48
0.59
0.97
1.00
1.00
0.87
0.88
0.78
1.00
1.00
1.00
1.00
0.68
0.83
0.98
0.12
1.00
1.00
0.80

SE
1.00
1.00
1.00
0.99
1.00
1.00
1.00
1.00
1.00
0.96
0.98
1.00
1.00
1.00
1.00
1.00
1.00
0.99
1.00
1.00
1.00
0.99

RTS
CRS
CRS
CRS
DRS
CRS
CRS
CRS
CRS
CRS
DRS
IRS
CRS
CRS
CRS
CRS
CRS
CRS
DRS
CRS
CRS
CRS

RTS: Returns to scale


CRS: Constant returns to Scale
DRS: Decreasing returns to scale
IRS: Increasing returns to scale

* Due to a confidentiality clause in the survey we used to collect the data, the names of the banks are not revealed in this research
project and will be provided to the participating banks upon request.

The results also reveal several other very important inferences. Firstly, the low
overall cost efficiency stems from allocative inefficiency rather than technical
inefficiency. Actually, the technical efficiency (.80) of UAE banks is consistently
higher than the allocative efficiency (.68) for most of the banks included in the

sample. Whether small or large, local or foreign, banks in the UAE seem to be doing
a better job technically than allocatively. This indicates that the leading source of cost
inefficiencies in the UAE banking industry is likely to be regulatory (rather than
managerial) in nature. The results imply that UAE banks do a better job utilizing
available inputs than choosing the proper input combination given the input prices.
Secondly, the main source of the relatively small size technical inefficiency in
the UAE banking industry is not the scale inefficiency (operating on non-optimal
scale) but rather the pure technical efficiency (resources being underutilized or merely
wasted). Actually, the UAE banks in the sample have consistently higher scale
efficiency than pure-technical efficiency. This happened without exception over every
single bank in the sample. Surprisingly, the UAE banks have almost perfect scores
when it comes to scale efficiency. Only 1% of the technical inefficiency in the UAE
could be attributed to scale. This is probably the lowest scale inefficiency in
comparison to all previous studies done all over the world.
VI.

Regression Results
In this section the more interesting part of the study, namely explaining the

efficiency scores based on socioeconomic, regulatory, and demographic variables will


be attempted. We have used both the regular ordinary least squares and the logistic
regression methods, but we put more emphasis on the logistic approach due to the
nature of the dependent variable which lies in the interval [0, 1]. Due to the
importance of the logistic approach, its results for cost efficiency are detailed in
Appendix II.
Some of the interesting results obtained from the attempts above include:
Firstly, the fact that only technical and pure technical efficiency scores seemed to be
partially explainable by the number of branches. The coefficient of this variable

(branching) is positive and statistically significant (under 95% percent level of


confidence with respect to technical efficiency scores). This means that the more
branches the bank has, the higher its technical and pure technical efficiency scores.
This result was confirmed by both logistic and OLS regressions. Overall, it matches
other studies where banks are able to use their input resources more efficiently when
they have more branches.
Secondly, it is also interesting and surprising to see that the variable reflecting
the banks number of years in business is negatively impacting all the efficiency
scores, but at a statistically lower level of confidence (90% on average). This implies
that newer banks are performing better than older banks on average. While this is
surprising since experienced banks are expected to perform better, it may have to do
with newer and more recent banks adopting newer and more modern technology. This
interpretation is supported by a negative correlation of -0.686, with an associated pvalue of 0.007, indicating a highly significant inverse relationship between the banks
number of years in operation and the IT share (percentage) of its budget. Also, newer
banks are always able to attract experienced employees from existing and older banks.
Thirdly, while the variable representing private versus government ownership
(percentage of government ownership) is not statistically significant for any efficiency
score (only at 75% level of confidence on average), it is interesting to see a negative
sign in all regressions and with all types of efficiency scores. This indicates that as
the government shares increases in the bank, the efficiency scores get lower. This
may lead us to trust that privatization might be an appealing option for government
owned banks that are under performing in terms of efficiency scores.
Fourthly, an easy variable to explain is the short experience variable
(percentage of employees with less than five years of experience to total employees).

This variable seems to be negative and statistically significant at all levels. Thus,
banks with higher percentage of employees with short experience are definitely less
efficient than its counter parts. This will give credence to human resource mangers
as they always opt to hire employees with more experience.
Fifthly, a very interesting variable to explain is the percentage of male
employees to total employees.

The logit analysis indicates that this variable is

negative and statistically significant. This is good news to the women labor force in
the UAE, as it signifies that banks with higher percentage of women are more
efficient than their counter parts. While this result is hard to explain, the connotation
is to give more attention to hiring more women in the banking industry if the bank
wants to be more efficient. Definitely, more studies need to be done here to explain
why women might have a comparative advantage in this industry. Also, the variable
of percentage of mangers to total employees, having statistically positive impact on
efficiency, needs a more careful look on why it is conducive to enhancing efficiency.
Finally, the most interesting and important findings here have to do with the
variable representing the percentage of nationals (citizens) to the total labor force.
This variable is found to be negative and highly statistically significant in the logit
analysis. This means banks with higher percentages of UAE nationals are under
performing in terms of overall efficiency in comparison to their counter parts. This
result is very important due to the ongoing efforts to nationalize the banking industry.
The UAE established a law requiring banks to hire at least 4% of its labor force from
the local nationals and has given a lot of consideration to this issue.
This last result coupled with the allocative (regulatory) inefficiency being the
major source of inefficiency, as shown in Table 4, should call attention to the wisdom
of enforcing the nationalization policies on the UAE banking sector.

VII.

Summary and Policy Implications


The descriptive analysis of the UAE banking system shows that it is strong

and highly developed in structure and size, technologically advanced and more
integrated into the world economy. This superior picture may be attributed to many
factors. The most important is an overall improvement in the countrys economic
conditions that have enhanced the provision of the financial services to all sector of
the economy. Also, there is always government intervention and support for the
country financial sector. "the UAE has used its wealth to cushion financial sector
shocks and has the authority to recapitalize systematically important financial
institutions" (IMF: 2003). In addition, there is, to some extent, an insufficient
competition from foreign banks.
However, this rosy picture is not supported by the empirical results of
efficiency measures, as highlighted in Table 4. The results indicate that the UAE
banks' overall average of cost efficiency is a bit lower than those reported for
developed countries. It is also lower than that of another GCC country, Kuwait. The
study also indicates that the low overall cost efficiency of UAE banking stems from
allocative inefficiency rather than technical inefficiency. Furthermore, the main
source of the relatively small size, technical inefficiency in the UAE banking industry
is not the scale inefficiency but rather the pure technical efficiency. It is also
suggested that the UAE banks are able to use their input resources more efficiently
when they have more branches and that newer banks are performing better than older
banks on average. The results also show that short experiences of employees affect
efficiencies negatively and government ownership may tend to reduce efficiency (as
the government shares increases in the bank, the efficiency scores get lower).

The most interesting results have to do with finding higher efficiencies in


banks that employ more women, more mangers, and less national citizens of the UAE.
These last results should be investigated further in order to determine what can
be done about it. The results go against the current government policies of
nationalization and should be looked upon more carefully. Other means of employing
nationals without imposing a restriction on banks in terms of employment policies
should be considered. It goes against efficiency optimization to ask a bank to employ
certain resources without given much attention to the banks own profit maximization
policy. Perhaps, a direct subsidy to the employees who are working in the banking
sector could be an alternative approach.
The results of the study are very much consistent with previous studies
(especially in the Gulf). Banks are overall more technically efficient than allocatively
efficient.
It should be realized that all across the globe, a great force of change is
sweeping the banking industry, forcing radical adjustments to new business
conditions. As the UAE is entering a new era of structure change and development, it
is essential to prepare its domestic banking system for global competition, and it has
no choice but to integrate into the global economy. Such development will require
careful handling of the existing structural weaknesses and adopting bank policies that
keep pace with the new evolution and development in the world financial sector.
Thus, attention to the results of this study might prove useful in this regard.

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Appendix I
UAE Banking Sector Survey 2004
Serial Number:

Interviewer code:

Date: / / 2004

Bank Title:
Number of years in operation
Years
Ownership Structure (% government participation)
%
Number of branches
Branches
Number of Employees by Gender
Gender / Employees
Males
Females

Managerial

Rest

Managerial

Rest

Managerial

Rest

Number of Employees by Ethnicity


Ethnicity / Employees
National
Arab
Asian
Western
Others
Number of Employees by Education
Education / Employees
No education
Primary (grades 1-6)
Preparatory (grades 7-9)
Secondary (grades 10-12)
Two-years college
University
Higher degree (e.g., diploma,
Master, Ph. D.)

Number of Employees by Experience


Experience / Employees
Lass than 5 years
5 to less than 10 years
10 to less than 15 years
15 years and more

Managerial

Rest

Total Wages
Employees
Managerial
Rest

Total wages

Department of Information Technology (IT)


Number of employees in IT department
Percentage of IT departments operating budget
to total operating budget
Financial Services Offered
Services
Branch banking
ATM
EFTPOS
Credit cards
Telephone banking
PC banking
Internet banking
Others (specify)

Yes / No

Financial Products Offered (to attract new deposits)


Products
Special accounts
Certificate of Deposits (CD)
Others (specify)

Value

Bank Main Activities


Item
Book value of fixed assets and premises
Total spending on fixed assets and premises
Sum of current accounts and savings deposits
Total interests on current accounts and savings deposits
Sum of real estate loans
Sum of commercial loans
Sum of industrial loans
Sum of consumer loans
Sum of other loans (if any)
Total investments (all security other than those held in
trading accounts)
Percentage of foreign transactions to total transactions
Percentage of foreign assets to total assets

Value

Off Balance Sheet Activities


Item
Swaps
Future contracts
Others (specify)
Thank you very much for your time

Value

Appendix II
Regression Model 1
A logistic regression analysis was performed, through a backward stepwise
elimination option, to relate the dependent variable: cost efficiency (y) and the
independent variables in equation (4). The following model was obtained:
y
= 51.111 0.337 X 1 + 0.286 X 3 59.692 X 5 + 19.286 X 6 14.814 X 9 .
ln
1 y
For Model 1, R2 = 0.784 and the standard error of the estimate = 0.284. The
regression coefficients, their standard errors and the corresponding t and p-values are
given in the following table:
Table II-1: Logistic Regression Coefficients for Model 1
Std.
Coeff.

51.111

Std.
Error
14.777

-.337

.078

-1.925

.286
59.692

.078

1.892

17.525

-2.061

19.286

7.613

.818

2.533

.044

14.814

4.458

-1.909

3.323

.016

Variable

Coeff.

Constant
Numbers of years in operation (X1)
Number of total branches (X3)
Percentage of males (X5)
Percentage of managerial employees
(X6)
Percentage of employees with short
experience (X9)

t
3.459
4.336
3.681
3.406

pvalue
.013
.005
.010
.014

Regression Model 2
A second logistic regression analysis was performed through a forward
stepwise option, to relate the dependent variable: cost efficiency (y) and the
independent variables in equation (4). The following model was obtained:
y
= 5.305 0.91 X 1 13.295 X 7 .
ln
1 y
For Model 2, R2 = 0.563 and the standard error of the estimate = 0.330. The
regression coefficients, their standard errors and the corresponding t and p-values are
given in the following table:

Table II-2: Logistic Regression Coefficients for Model 2


Variable
Coeff. Std. Error Std. Coeff.
t p-value
Constant
5.305
1.541
3.444
.007
Percentage of nationals (X7)
-13.295
4.258
-.723 -3.122
.012
-.091
.041
-.521 -2.247
.051
Numbers of years in operation (X1)