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Cost and profit efficiency of conventional and Islamic banks in GCC countries

Author(s): Samir Abderrazek Srairi


Source: Journal of Productivity Analysis, Vol. 34, No. 1 (August, 2010), pp. 45-62
Published by: Springer
Stable URL: http://www.jstor.org/stable/41766614
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J Prod Anal (2010) 34:45-62
DOI 10.1007/sl 1123-009-0161-7

Cost and profit efficiency of conventional and Islamic banks


in GCC countries

Samir Abderrazek Srairi

Published online: 28 November 2009


Springer Science+Business Media, LLC 2009

Abstract Using stochastic frontier approach, this paper The globalization of financial markets and institutions
investigates the cost and profit efficiency levels of 71 which has been accompanied by government deregulation,
commercial banks in Gulf cooperation council countries financial innovations, information revolution and advanced
over the period 1999-2007. This study also conducts a application in communication and technology, has created a
comparative analysis of the efficiency across countries and competitive banking environment and modified the tech-
between conventional and Islamic banks. Moreover, we nology of bank production. Due to these developments and
examine the bank-specific variables that may explain the changes in the modern banking field, banks are trying to
sources of inefficiency. The empirical results indicate that operate more efficiently in terms of cost and profit in order
banks in the Gulf region are relatively more efficient at to stay competitive (Karim and Gee 2007). Moreover, to
generating profits than at controlling costs. We also find assist banks in confronting these challenges, financial
that in terms of both cost and profit efficiency levels, the authorities in both developed and developing countries have
conventional banks on average are more efficient than implemented various measures to restructure their financial
Islamic banks. Furthermore, we observe a positive corre- sectors and to promote a deregulated banking environment.
lation of cost and profit efficiency with bank capitalization Consistent with the transformation of the banking sec-
and profitability, and a negative one with operation cost. tors throughout the world, the literature related to the
Higher loan activity increases the profit efficiency of banks, performance and the efficiency of banks is proliferating,
but it has a negative impact on cost efficiency. and the majority of these studies cover the US and Euro-
pean countries. However, a little empirical work has been
Keywords Banking Cost efficiency Profit efficiency undertaken to investigate efficiency in Arabian banking,
Islamic banks Stochastic frontier approach and especially in Gulf countries despite the importance of
GCC countries this region on political and economic levels.
To fill this gap and to contribute to the existing litera-
JEL classification C30 G21 ture, the main objective of this study is to provide more
information on the efficiency of the banking industry in the
six Gulf cooperation council (GCC) countries (Bahrain,
1 Introduction Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab
Emirates). Thus, we analyze the cost and profit efficiency
The banking industry around the world has undergone of GCC banking employing a parametric approach, and
profound and extensive changes over the last two decades. using a panel data of 71 commercial banks over a recent
period 1999-2007. This paper has extended the literature in
two directions. First, to our knowledge, this is the first
S. A. Srairi (IS!) empirical study that has analyzed profit efficiency of
Riyadh Community College, King Saud University,
commercial banks in the Gulf region. Second, cost and
Kingdom of Saudi Arabia, P.O. Box 28095, Riyadh 1 1437,
Kingdom of Saudi Arabia profit efficiency levels are compared between conventional
e-mail: srairisamir3@gmail.com; samirsra@ksu.edu.sa and Islamic banks in this region.

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46 J Prod Anal (2010) 34:45-62

Founded in May 1981, the GCC countries produce about Despite the very favourable economic environment in
23% of the world's oil and control more than 40% of the GCC countries and the robust growth of both conventional
world's oil reserves. On average, oil represents more than and Islamic commercial banks, the Gulf banking industry is
80% of export receipts and budget revenues, respectively.1 facing many challenges especially in view of the pressures
Over the last 6 years, the GCC incomes grew substantially of globalization and the changes in the world economy and
as a result of the increase in oil prices. In consequence, the the impact of the latest financial crises on GCC economy.
economies of these countries show growth rates much These changes have a direct impact on the banks' main
above the world average, and are in a relatively strong activities, and on their performance and ability to develop
position as compared to 10 years ago. In 2001, the GCC and expand their international competitive activities. Due
states decided to establish a common market by 2007, and to these changes and the new competition from foreign
a monetary union, and to have a single currency before banks and non-financial companies, banks in GCC coun-
2010. These goals are likely to promote policy coordina- tries were induced to improve their productive perfor-
tion, reduce transaction cost, and provide a more stable mances by reducing their costs, controlling the price of
environment for business and facilitate investment deci- funds and improving the pricing and mix of their outputs.
sions. To reach these objectives and in response to the This study, using the bank-scope database, focuses on
globalization of financial markets, the financial and mon- the analysis of cost and profit efficiency of the commercial
etary authorities in GCC countries, during the last decade, banks in GCC countries in order to provide some inter-
have adopted financial sector liberalization programs to esting insights on the efficiency of the Gulf banking sys-
free their economies. These measures included liberalizing tems that could be used by managers and policy makers
trade, encouraging foreign direct investment (FDI), interest operating in these countries. Thus, the purpose of this paper
rates liberalization, allowing entry of new private banks is threefold. First, we estimate a stochastic cost and profit
both domestic and foreign, strengthening the central bank's frontiers using a specific functional form (standard translog
supervisory capacity, and implementing regulations that function). To follow Perera et al. (2007) and Mamatzakis
helped in progressively moving the Gulf states toward et al. (2008), country-level variables are incorporated in the
market-based economies (Elton 2003; Al-Obaidan 2008). common cost and profit frontiers to account for variation in
The GCC countries have a fairly high number of banks banking technologies that may be related to macro-eco-
with an extensive network of branches. But Gulf banks are nomics conditions and to structural and institutional fea-
still small compared to the big international banks. Most tures of a country. In this research, we use the maximum
banks are family-owned with modest government equity likelihood procedure of Battese and Coelli (1995) that
and a large number of specialized banks are fully owned by permits in a single step to estimate the parameters of the
the government (Elton 2003). Banks in these countries are cost and profit frontiers and to investigate the determinants
financially strong, well capitalized and have adopted of bank efficiency. As a second step in the analysis, we
modern banking services (Srairi 2009). Their operations calculate and compare the cost and alternative profit effi-
can be characterized by satisfactory asset quality, adequate ciency scores between country and type of banks. The
liquidity and high levels of profitability (Islam 2003a). study of the differences in efficiency among GCC countries
Local banks follow international account standards (IAS) will explain the competitive starting position of each
and the central monetary authorities of Gulf countries have country, which may also shed light on the capacity to
strengthened the prudential norms in recent years (Islam respond to the new changing environment. Level of bank
2003b). Furthermore, one important group of banking efficiency is also compared between conventional and
services that have experienced rapid growth in GCC Islamic commercial banks in order to provide information
countries is the Islamic financial services. In 2007, Gulf on comparative managerial performance. This comparison
States capture about 35% ($178 billion) of the total assets is related to a controversial question about the impact of
of Islamic banks. These are mainly concentrated in Bah- type of banks on efficiency in the banking industry (Hasan
rain, Kuwait and the UAE. During the last 10 years, the 2004). Measuring the cost efficiency of 34 commercial
concept of Islamic banking has likewise developed to cover banks in Malaysia, Majid et al. (2003) show that the effi-
activities of other types of financial institutions including ciency of Islamic banks is not statistically different from
insurance, investment and fund management companies. the conventional banks. However, other studies (Saaid
Moreover, to take advantage of Islamic financial instru- et al. 2003; Kabir Hassan 2005) conclude that Islamic
ments, many conventional banks in GCC countries have banking industry is relatively less efficient compared to
added Islamic banking services to their regular banking their conventional counterparts. Finally, yet not less
operations. importantly, we also explore the impact of certain factors
that may be correlated with bank's efficiency. Indeed, we
1 Statistics of Global Investment House (2007). include in the cost and profit functions (inefficiency term) a

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J Prod Anal (2010) 34:45-62 47

bank-specific variables such as size, capital adequacy, through merging with other banks, than from reducing
profitability, operation cost and credit risk. notably their technical inefficiency. Finally, the results show
The paper is structured as follows: in the next section, that larger bank size, higher share of equity capital in assets
we discuss the studies on efficiency especially in the Gulf and greater profitability are associated with better efficiency.
banking industry. Section 3 presents the methodology and In addition to the single-country studies of cost effi-
the econometric model used to estimate the common cost ciency in Gulf banking, there have been three recent cross-
and profit frontiers. The data and variables concerning country studies, Grigorian and Manle (2005), Ariss et al.
outputs, input prices, country-level and bank specific are (2007), and Ramanathan (2007).
described in Sect. 4. Section 5 explains the empirical Griogorian and Manle (2005) compare the efficiency
results of the cost and profit efficiency of commercial indicators of banks for the period 1997-2002 with that
banks in GCC countries, while the final section summarizes of their counterparts in Kuwait, Qatar, the United Arab
and concludes this study. Emirates, and Singapore, obtained by using DEA approach.
The results of this study show that, on average, banks in
Bahrain are more technical efficient compared to other
2 Literature review GCC countries, but they still lag behind their Singaporean
counterparts. The paper also finds that in terms of scale
Over the last decades, there has been an extensive literature efficiency, banks in Bahrain operate at the same level as
on the cost and profit efficiency of financial institutions in banks in Singapore. In addition, the findings of these
the competitive banking markets of Western Europe and authors reveal that the inefficiencies seem to be largely
North America2 (e.g., Dietsch and Lozano-Vivas 2000; caused by pure technical inefficiency and to a lesser extent
Berger and Mester 1997; Altunbas et al. 2001; Weill 2004; by scale inefficiency.
Pasiouras 2008). More recently, there have been some The most recent study by Ariss et al. (2007) uses a non-
studies on countries in transition (e.g., Fries and Taci 2005; parametric frontier approach (DEA with constant return to
Bonin et al. 2005; Kasman and Yildirim 2006; Mat- scale (CRS) assumption) to compare cost efficiency and
matzakis et al. 2008). However, empirical research on bank Malmquist productivity index (MPI) of 45 banks operating in
efficiency in Arabic countries appears relatively scarce the six GCC countries during the period 1 999-2004. They find
(e.g., Bouchaddakh and Salah 2005 in Tunisia; Al-Fayoumi an average overall efficiency scores of about 78% for all banks
and AlKour 2008 in Jordan). A few studies using single in GCC countries. They also find that there is a decline in the
country (Limam 2001; Darrat et al. 2003) or cross-country overall efficiency index from 1999 to 2004. This decline is
comparison (Grigorian and Manle 2005; Ariss et al. 2007; caused by the decrease in allocative rather than technical
Ramanathan 2007) have been done on GCC countries. efficiency (and its component of pure technical rather than
Our aim in this section is to survey key studies on scale efficiency). The results of country specific efficiency
efficiency in Gulf banking and summarize the most sig- indices indicate that banks in Oman on average have been the
nificant results. most efficient among GCC countries followed narrowly by
In a study of cost and technology efficiency in Kuwait, banks from Bahrain and Kuwait, with Saudi Arabia being the
Darrat et al. (2003) employed the data envelopment anal- least efficient. Finally, the findings of the MPI show that
ysis (DEA) to estimate a number of efficiency indices for between 1999 and 2004, GCC banks on average have expe-
banks over a period between 1994 and 1997. They find that rienced a decline in the productivity of their banking system
cost efficiency of Kuwaiti banks averages about 68% and albeit with different degree. The decline in productivity of
that the sources of the inefficiency are a combination of banking in Kuwait, Oman, and Qatar was due to both tech-
allocative (regulatory) and technical (managerial) ineffi- nological regress and decline in overall technological effi-
ciency. The results also indicate that larger banks are less ciency. However, for Bahrain, Saudi Arabia and UAE, the
efficient than smaller ones, and that profitability is posi- decline in MPI was the net results of technological regress and
tively related to efficiency indices. improvement in overall technical efficiency.
For the same country, Limam (2001) estimates the tech- To assess the efficiency of banks in GCC countries,
nical efficiency of eight Kuwaiti banks from 1994 to 1999, Ramanathan (2007) examines nearly the same sample
using the stochastic cost frontier approach. The author fol- (over 9 banks), the same period (2000-2004), and uses the
lows the intermediation approach and finds that the average same approach (MPI and DEA: CRS and VRS3) as that
cost efficiency is 91% for all banks. He also finds that banks
3 DEA can run under either CRS or VRS. The main difference
produce earning assets at constant returns to scale and hence
between these two models is the treatment of returns to scale. The
have less to gain from increasing scale of production,
VRS model ensures that a bank is compared only with banks of a
similar size, while the CRS assumption is only justifiable when all
See the survey article by Berger and Humphrey (1997). banks are operating at an optimal scale.

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48 J Prod Anal (2010) 34:45-62

adopted by Ariss et al. (2007). He finds, under CRS (2002) defined cost efficiency as a measure of how far bank's
assumption, that, for the year 2004, all six GCC countries cost is from the best practice bank's cost if both were to
have at least one CRS efficient bank, and all the countries produce the same output under the same environmental
have registered their CRS efficiencies reasonably close the conditions. It is measured as the ratio between the minimum
GCC average (90.1%). When the variable return to scale cost at which it is possible to attain a given volume of pro-
(VRS) assumption is implemented in DEA, all GCC duction and the observed costs for firm. A cost efficiency
countries have at least two VRS efficient bank, and the score of 0.85 would mean that the bank is using 85% of its
average VRS efficiencies (94.2%) is larger than the cor- resources efficiently or alternatively wastes 15% of its costs
responding average CRS efficiencies. The study also relative to a best-practice bank. Profit efficiency is a broader
reveals that all GCC countries have registered reductions in concept than cost efficiency since it takes into account the
productivity in terms of technology change (a similar result effect of the choice of vector of production on both cost and
was reached by Ariss et al. 2007). However, banks in four revenues (Ariff and Can 2008). It is defined as the ratio
of the six GCC countries (Bahrain, Kuwait, Saudi Arabia, between the actual profit of a bank and the maximum level
and the UAE) registered progress in terms of MPI during that could be achieved by the most efficient bank (Maudos
2000-2004. The highest improvement in MPI (1.009) is et al. 2002). In other words, the number represents the per-
registered by the selected banks in Bahrain, while the cent of the maximum profits that a bank is earning. Thus,
selected banks in Qatar have presented the highest reduc- profit efficiency level equal to 0.75 means that a bank is
tions in productivity during the same period. losing 25% in terms of profit fund. Two different versions of
Our study differs from the existing literature on banking the profit efficiency concept can be distinguished depending
efficiency in GCC countries on several points: First, we use on whether or not market power or output a price is taken
a larger number of banks (71). Second, we cover a wider into account (Berger and Mester 1997). The standard profit
range of bank types: conventional and Islamic, and for a efficiency (SPE) estimates how close a bank is to producing
longer period of time (9 years). Third, it is the first study of the maximum possible profit given a particular level of input
Gulf banking efficiency to consider both cost and profit prices and output prices. In this case, the profit function
efficiency using a parametric method (SFA). Fourth, to assumes that markets for outputs and inputs are perfectly
estimate cost and profit frontier functions, we have intro- competitive. In contrast, the alternative profit efficiency
duced country-specific variables to account for variation in (APE) developed by Humphrey and Pulley (1997) assumes
banking technologies that may be related to macroeco- the existence of imperfect competition or firms that have
nomic conditions and to the structure of the banking sector market power in setting output prices. In this approach,
of a particular country.4 Fifth, our paper compares cost and banks take as given the quantity of outputs and the price of
profit efficiencies scores between country and type of banks inputs and maximize profits by adjusting the price of outputs
(conventional and Islamic banks). Finally, this study tries and the quantity of inputs, unlike the standard profit effi-
to identify the possible factors explaining the observed ciency concept. Since our sample includes several countries
differences of cost and profit efficiency between banks in with different levels of competition, it seems more appro-
GCC countries. priate to use alternative profit efficiency than standard profit
efficiency. Moreover, the latter concept requires information
on output prices which is not available.
3 Methodology To examine the efficiency of banks using frontier
approaches, there are two models. Parametric technique,
In this study, we examine cost and profit efficiency rather such as stochastic frontier analysis (SFA), thick frontier
than technical efficiency.5 According to Pasiouras et al. approach (TFA) and distribution free approach (DFA), uses
(2008), cost efficiency is a wider concept than technical econometric tools and specifies the function form for the
efficiency, since it refers to both technical and allocative cost or profit function. On the contrary, the non-parametric
efficiency. Likewise, the profit efficiency is also a wider approaches (such as DEA) and free disposable hull analysis
concept as it combines both costs and revenues in the (FDHA) do not make an assumption concerning the func-
measurement of efficiency. tional form of frontier and use a linear program to calculate
The definitions of cost and profit efficiency correspond, efficiency level. In the present study, we use the SFA, as
respectively, to two important economic objectives: cost developed by Aigner et al. (1977), to estimate cost and
minimization and profit maximization. Isik and Hassan profit efficiency frontier. The main advantage of SFA over
DEA is that it allows us to distinguish between inefficiency
4 These variables will be explained in detail in Sect. 4.2.2. and other stochastic shocks in the estimation of efficiency
5 Technical efficiency is the ability to produce the maximum output levels. In addition, by using this model, it would be easier
for a given bundle of inputs. to add control variables, such as country-level variables, in

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J Prod Anal (2010) 34:45-62 49

the equation of this model than in non-parametric tech- function of a set of bank-specific characteristics. In order to
niques. Hence, this approach allows us to compare effi- model inefficiency, we use the following auxiliary model:
ciency between country, and the efficiency of conventional
uijt = Z i + wijt (2)
and Islamic banks.6 We illustrate the methodology using
cost efficiency first and discuss its application to the profit where Z is a vector of explanatory bank-specific variables,
function later. w represents a random variable which has a truncated
In line with the recent developments in the literature normal distribution (wijt ~ N (0, and is a vector of
(Fries and Taci 2005; Perera et al. 2007; Mamatzakis et al. unknown parameters to be estimated.
2008) and in order to capture heterogeneity across coun- For our cost function, we choose the translog specifi-
tries, the cost function in this study is extended to cation.7 According to Greene (1980), this function is the
accommodate country-specific variables and thus appears most frequently selected model to measure bank efficiency,
as follows: because it presents the well-known advantage of being a
flexible functional form. Moreover, it includes, as a par-
TCy/ =y(Pty, Yyf, E//f) Bi and Syt = H- uijt (1)
ticular case, the Cobb-Douglas specification (Carvallo and
where TC is total cost including both interest expenses and Kasman 2005).
operating costs, P is the vector of outputs (loans and The translog stochastic cost takes the following form:
investment), Y is a vector of input prices (price of labor 2 2

and funds), and E is a vector of country-specific variables. In TCy, = ao + ^2 ccm In Ym4jt + ^ s In Ps4j, + lxT
m= 1 5=1
The detailed definitions of these variables are presented,
along with those of other variables used in Eq. 2 in 8 [22
Table 2. This approach assumes that total cost deviates ^ ^ Pi In E ,jt -h 1 /2 ^ ^ ^ ^ In Ym,ijt
1= 1 _m= 1 n= 1
from the optimal cost by a random disturbance vijt and an 2 2
inefficiency term uijt. vijt corresponds to random fluctua-
* In Y njjt ^ ^ ^ ^ s,r In P s,ijt * In Pr ^ I2T
tions, it is a two-sided classical statistical error term that s= 1 r=l

incorporates the effect of errors of measurement of the 2 2

explanatory variables. vijt is assumed i.i.d. with [v^ - N +5>-. s In Ymiy, * 111 PSiy,
m= 1 s= 1
(0, <7v)]. The second error term uijt captures inefficiency
2 2
effects, and is assumed to follow an asymmetric half nor-
mal distribution in which both the mean u and variance + ^ In Ym,y, + ^4VTln P^, + (3)
m= 1 5=1
may vary. The general procedure adopted in this study is to
estimate coefficients and e of Eq. 1, and to calculate effi- where subscripts / denote banks, j countries and t time
ciency score for each bank in the sample. The cost frontier horizon and InTC the natural log of total costs, In Ym the
can be estimated by maximum likelihood, and efficiency natural log of input prices, In P5, the natural log of output
levels are estimated using the regression error. In the values, while E is a vector of country-level variables in
estimation, the terms o2u and o2 are reparameterized by natural log. T is the time trend variable used to capture
tf2 = + <7v and J - o/g2. The parameter, y , lies technical change; a, , 1, p, 0, 2, and ij/ are the parameters
between 0 and 1. If it is close to zero, little inefficiency to be estimated, and e the composite error term. To ensure
exists and the model can be consistently estimated using that the estimated cost frontier is well behaved (Fries and
ordinary least squares. But a large value of y suggests a Taci 2005), we impose constraints on symmetry:
deterministic frontier (Coelli 1996).
&m,n = 0Cn,m V/7, fli and s r = r s T
The measure of cost efficiency for any bank at time t is 2 n s

calculated from the estimated frontier as CE/ = 1/exp (uit). Homogeneity in prices E m = 1 ; E m, = E 'Pm, s =
2 m= 1 m m
This measure takes a value between 0 and 1. Banks with
scores closer to one are more efficient. Em = 0.
m

In order to identify factors that are correlated with bank Moreover, the linear homogeneity conditions are
inefficiency, we use the model of Battese and Coelli (1995) imposed by normalizing TC and Ym (the price of labor and
which permits in a single-step to calculate individual bank the price of funds) by the price of physical capital before
efficiency score (Eq. 1) and to investigate the determinants the log transformation.
of inefficiency (Eq. 2). Specifically, u is assumed to be a

7 Berger and Mester (1997) have compared the translog to the


6 The thick frontier approach (TFA) only provides average efficiency alternative fourrier flexible form. They find negligible difference
scores for the whole sample. between both methods.

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50 J Prod Anal (2010) 34:45-62

In this study we also employ the profit efficiency con- Since all countries have different currencies, all the
cept that implies that managers should not only pay annual financial values are converted in US dollar using
attention to reducing a marginal dollar of costs, but also to appropriate average exchange rates for each year. Also, to
raising a marginal dollar of revenue. Our approach follows ensure comparability of data across countries, all values are
Pulley and Humphrey (1993) and Berger et al. (1996) by deflated to the year 1999 using each country's consumer
assuming that firms have some market power in output price index (CPI).
markets. Hence we choose alternative profit function
(APE) which takes output quantities as given instead of 4.2 Variables definition for estimation of cost

taking output prices as given. This approach incorporates and profit efficiency functions
differences across banks in market power and their ability
to exploit it (Dietsch and Weill 1999). For the APF, we use 4.2.1 Output s t input price s y total cost , and total profit
the same translog form of the cost function, except that
total costs in Eq. 3 are replaced by total profits before tax. In the present study, and following the most recent studies
To avoid a log of negative number, we transform the profit in the field, we adopt the intermediation approach to define
variable as follows: In (n + 0 +1), where 0 indicates the bank outputs and inputs in both cost and profit models.
absolute value of the minimum value of profit (n) over all According to Bos and Kool (2006), this approach is
banks in sample. Thus for the bank with the lowest profit appropriate when the banks in the sample operate as inde-
value for the year, the dependent variable of profit function pendent entities. In this method, banks are viewed as
will be equal to In (1) = 0. Also for measuring efficiency financial intermediates that collect purchased funds and use
score under the profit function the composite error is labor and capital to transform these funds into loans and
= V,- II/. other earning assets. In the alternative production approach,
The measure of profit efficiency is defined as PEi = exp banks are assumed to produce deposits, loans and invest-
(- u/). In this case efficiency scores take a value between 0 ments services, using labor, physical capital and financial
and 1 with values closer to one indicating a fully efficient capital as inputs. Bank branch efficiency studies frequently
bank. use this method. Berger and Humphrey (1997) argue that
The stochastic frontiers for cost and profit are estimated the intermediation approach is superior because the
using Frontier version 4.1 program developed by Coelli's majority of banks' expenses are interest related.
(1996). The software estimates in a single-step the cost or In the cost and profit models, we consider two outputs8:
profit model using maximum likelihood estimation tech- net total loans (total customer loans) and other earning
nique, and identifies potential correlates of the cost and assets which include in the IBCA terminology investment
profit efficiency scores. securities, inter-bank funds and other investments. The
input prices are: the price of capital, measured by the ratio
of non-interest expenses (operating cost net of personnel
4 Data and definition of variables expenses) to total fixed asset, the price of funds, computed
by dividing interest expenses9 to total deposits, and the
4.1 Data price of labor. Due to the lack of information about the
number of employees,10 we follow Altunbas et al. (2000),
Our sample is an unbalanced panel data of 71 commercial and use a proxy measure of labor price by using the ratio of
banks (48 conventional and 23 Islamic) from six GCC personnel expenses divided by total assets. For the
countries: 14 banks in Bahrain, 11 banks in Kuwait, 5 dependent variable, total cost is defined as interest and non-
banks in Oman, 8 banks in Qatar, 1 1 banks in Saudi Arabia, interest costs in cost efficiency function. In the case of
and 22 banks in the United Arab Emirates. Altogether the profit function, total profit is measured by net profit before
final data set contains 594 observations over the period
1999-2007 (see Table 1). All data on the bank's balance For Islamic banks, loans = Islamic operations = Murabaha receiv-
able + Mudaraba investments + Musharaka investments + loans
sheets and income statements are obtained mainly from
without interest (Qard hasan) + loans with service charge (Ju-
bankscope database of BVD-IBCA (June 2008) which ala) + other short operations (e.g., investment in Ijara assets:
provides homogenous classification of banks and infor- leasing); other earning assets = equity investments + investment in
associates + investment securities (Islamic bond: Sukuk). For details
mation. In the case of missing information, we use annual
of Islamic financing contracts see (e.g., Archer et al. 1998; Zahar and
reports provided by individual banks via their websites. Hassan 2001; Rosly 2005).
The sources of macroeconomic data and the structure of
In case of Islamic banks, interest expenses represent profits
banking industry for the GCC countries are the central distributed to depositors.
banks annual reports of the respective countries and the 10 Bankscope database does not provide information on the number
international financial statistics (IFS). of employees for each bank.

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J Prod Anal (2010) 34:45-62 51

Table 1 Number of sample


Country Number of banks Number of observations
banks by country and type
Total Islamic Conventional

Bahrain 14 7 7 119
Kuwait 11 5 6 84

Oman 5 0 5 45

Qatar 8 2 6 68
Saudi Arabia 11 2 9 93

U.A.E 22 7 15 185

Total 71 23 48 594

tax earned by the bank, to avoid the bias of differences in Table 2 Variables' description
tax regimes between GCC countries. Variables Definition

Dependant variable
4.2.2 Country-level variables TC: total cost Interest expenses + personnel
expenses + other administration
expenses + other operating
To identify the common frontier, we include several coun-
expenses
try-level variables in the estimation of the cost and profit
7i : total profit Total income - total cost
functions. Based on previous studies (Fries and Taci 2005;
Input prices outputs and
Carvallo and Kasman 2005; Perera et al. 2007), these vari-
Yi: price of labor Personnel expenses divided by total assets
ables are categorized in two groups and include macroeco-
nomic variables and a measure of the structure of the Y2: price of fund Interest expenses (interest paid) divided by
total deposits
banking industry. The first group comprises five variables:
Y3: price of physical Other administration expenses + other
per capita GDP, Degree of monetization, density of demand, capital operating expenses divided by fixed assets
annual average of inflation and density of population. The Pi: net total loans Total customer loans
definitions of these indicators and others (outputs, input P2: other earning Inter-bank funds +investments securities
prices, and bank-specific variables) are presented in Table 2. assets (treasury bills + government bonds +
Per capita GDP is used as the proxy for overall eco- other securities) + other investments

nomic development. It also has an impact of the demand Country-specific variables

and supply for deposits and loans. This indicator is CGDP: per capita Ratio of GDP to total population
GDP
expected to be negatively associated with total costs and
positively related to total profits. The ratio of money supply DMON: degree of Broad money supply (M2) divided by GDP
monetization
(M2) to the gross domestic product (GDP) measures the
DDEM: density Total deposits of the banking sector to area
degree of monetization in the economy. The density of of demand
demand is measured as the total deposits of the banking
INFR: annual average (CPI,_CPI,_ i )/CPT,_ i
sector divided by area in square kilometers. Banks that rate of inflation

operate in an economic environment with a lower density DPOP: density Total inhabitant divided by area
of demand may have higher expenses to collect deposits of population
and offer loans. The rate of inflation affects interest rate. CONC: concentration Assets of three largest banks to total assets
market of the sector
Therefore, the higher these variables, the lower bank effi-
ciency will be in activities such as risk management and INTR: intermediation Total loans of the banking sector divided by
ratio total deposits
credit screening. In a recent study on profit efficiency in the
ACAP: average capital Total equity of the banking sector to total
banking industry of four new European Union Member ratio assets
States, Koutsomanoli-Filippaki et al. (2008) show that
Determinants of efficiency
banks in high inflation countries usually incur lower profits.
Log (Ass): size Natural logarithm of total assets
Finally, banking efficiency may be affected also by the
EQAS: capital Equity to total assets
ratio of inhabitants per square kilometer. Banks operating
adequacy
in areas of low population numbers may incur higher
ROAA: profitability Net profit to average total assets
banking costs. LOAS: credit risk Loans to total assets
The second group includes market structure variables
COIN: operation cost Cost to income
that may affect banking technology and service quality. We

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52 J Prod Anal (2010) 34:45-62

selected three indicators: concentration ratio, intermedia- of data on non-performing loans especially in Islamic
tion ratio and average capital ratio. Concentration ratio is banks prevents us from utilising this ratio. Thus, this data
calculated as the assets of the three largest banks divided limitation constrains us to proxy credit risk by another
by the total assets of the sector. If higher concentration ratio: loans to total assets which has been utilized in some

reflects market power for some banks, total cost is recent studies (Isik and Hassan 2002; Havrylchyk 2006;
increased through slack and inefficiency. However, if Pasiouras 2008) as a measure of risk and of bank's loans
concentration is the result of superior management and intensity. Banks which provide more loans are expected to
market selection of such banks, market concentration be more efficient in profit as they take more risks (Maudos
would be associated with lower costs because markets et al. 2002). However, in the case of Chinese banks, Ariff
remain contestable (Dietsch and Lozano-Vivas 2000; Fries and Can (2008) find an inverse relationship between this
and Taci 2005; Lensink et al. 2008). The intermediation variable and efficiency. They argue that banks which have
ratio is measured by total loans to total deposits. This a higher ratio of loan to total assets incur higher credit risk,
variable is included in the cost and profit functions to and thus higher loan-loss provision, and are less efficient.
capture differences among the banking sectors in terms of Moreover, these banks provide a large proportion of loans
their capacity to convert deposits into loans. According to to some inefficient state owned firms. The final variable
Carvallo and Kasman (2005), we expect an inverse rela- includes the operation cost indicator. It is measured as cost
tionship between this ratio and bank costs and a positive to income, and is expected to be negatively related to
association with profits. As a proxy for the difference in the efficiency.
regulatory conditions among countries, we use the average
capital ratio. It is measured by equity over total assets and a
negative association with total costs is expected because 5 Empirical results
less equity implies higher risk taken at greater leverage.
The discussion of the results on the cost and profit effi-
4.3 Determinants of efficiency ciency of banks in GCC countries is organized into four
parts. First, we describe the variables used in this paper by
Once the cost and profit efficiency scores are calculated, country and type of bank. Next, we analyze the parameters
we examine internal factors that may explain the differ- of cost and profit frontier obtained by the stochastic frontier
ences in efficiency across banks. For this objective, we approach. Third, we discuss and compare the cost and
follow previous studies (Weill 2004; Ariff and Can 2008; profit efficiency scores of banks by year, country and type
Pasiouras 2008), and we include in Eq. (2) five bank-spe- of banks. Finally, we investigate the determinants of
cific variables: size, capital adequacy, profitability, opera- efficiency.
tion cost and credit risk.

The natural logarithm of total assets is used as the proxy 5.1 Summary descriptive statistics of the data
for bank size. An overview of research shows ambiguous
results. According to Perera et al. (2007), but also Berger Table 3 displays some descriptive statistics by country for
et al. (1993) and Miller and Noulas (1996), larger banks are the variables used in the study. Comparing the average
more cost efficient than smaller banks, because large size values across countries, we can then observe some differ-
allows wider penetration of markets and increase in reve- ences regarding total cost and profit values, outputs, input
nue at a relatively less cost. However, some recent studies prices and other bank-specific (panels A and B). The
(Girardone et al. 2004; Dacanay 2007) report a significant average cost to asset ratio is nearly similar in GCC coun-
negative relationship between bank size and efficiency. tries; it ranges from 3.74% in Saudi Arabia to 5.24% in
Capital adequacy is measured as equity divided by total Kuwait. The same report is observed for the average profit
assets. For many (e.g., Casu and Girardone 2004; Pasiouras efficiency measured by the ratio of profit before tax to total
2008), this variable is positively related to efficiency. assets of banks. This variable varies from 2% in Oman to

Banks with higher ratio of equity to total assets have lower 3.17% in Bahrain. Regarding the levels of output, differ-
cost and profit inefficiency. A third variable, return on ences in average value are significant, especially in the
average assets, is included as a proxy for profitability. This ratio of net total loans to total assets which fluctuates from
ratio should be positively correlated with efficiency. Gen- 40.77% in Bahrain to 69.72% in Oman. The difference is
erally, highly profitable banks are less cost and profit also greater when we see the ratio of other earning assets to
inefficient. The credit risk or loan quality is generally total assets, which ranges between 12.82% in Oman to
defined in the most banking efficiency studies (Mester 33.21% in Bahrain. However, the average prices of labor
1996; Fries and Taci 2005; Das and Ghosh 2006) by the and funds seem to be show closer similarity between GCC
ratio of non-performing loans to total loans. However, lack countries. Indeed, the price of labor (Yl) measured by the

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J Prod Anal (2010) 34:45-62 53

Table 3 Descriptive statistics or dataset by country (average values)

Variables UAE Saudi Arabia Bahrain Kuwait Qatar Oman

Panel A: cost and profit value, outputs and input prices


Total costs to total assets 3.97 3.74 5.23 5.24 4.02 5.06

Total profit to total assets 2.51 2.45 3.17 3.11 2.49 1.99
Net total loans to total assets 63.00 50.83 40.77 44.84 52.27 69.72

Other earning assets to total assets 13.92 29.51 33.21 33.18 22.11 12.82
Price of labor 1.03 0.94 1.35 0.97 0.92 1.29
Price of fund 2.82 2.42 4.53 4.13 4.26 3.22

Panel B: bank- specific variables


Total assets (US$ millions) 4,246 16,171 9,371 6,850 2,774 2,361
Equity to total assets 19.06 12.39 28.36 20.96 21.97 12.80
ROAA 2.87 2.59 3.61 3.30 2.81 1.88
Cost to income 39.81 39.51 51.83 42.21 37.87 45.91

Panel C: country-specific variables


Per capita GDP (US$) 24,041 11,193 15,009 20,229 34,908 10,074
Degree of monetization 64.59 41.11 74.62 70.68 43.83 33.91
Density of demand (US$/km2) 87.29 70.15 1395.73 215.01 136.82 4.15
Inflation rate 5.05 0.57 1.04 2.26 5.18 1.00

Density of population (hab/km2) 48.73 9.86 1,001.05 137.58 65.89 9.32


Concentration ratio 42.52 50.41 87.21 60.88 78.08 80.73

Intermediation ratio 79.38 73.92 58.53 87.59 81.38 111.66

Average capital ratio 11.98 20.11 8.96 11.65 11.54 11.93

All variables are in percentage, except where indicated

ratio of personnel expenses to total assets, which has the Saudi Arabia, 5.18% in Qatar) vary greatly across coun-
lowest dispersion, fluctuates from 0.92% in Qatar to 1.35% tries, especially between Bahrain and Oman. Regarding the
in Bahrain. Likewise, and to a lesser degree, the ratio of market structure variables, Bahrain and Oman have higher
interest expenses to total deposits (Y2) varies from 2.42% concentration ratios (87.21 and 80.73%, respectively)
in Saudi Arabia to 4.53% in Bahrain; the highest interest, compared with Saudi Arabia (50.41%) and UAE (42.52%).
hence, was paid by banks in Bahrain, Qatar and Kuwait. We can also see a variation in intermediation ratio between

Turning to the variables that may affect the efficiency of countries. Average ratio of total loans to total deposits
a bank (panel B), we observe that there is a greater dif- ranges from 58.53% in Bahrain to 111.66% in Oman. The
ference in the average size of banks measured by total large difference observed across GCC countries in most
assets. Saudi Arabia banks are the largest among GCC variables provides argument for the inclusion of country-
countries followed by Bahrain and Kuwait. We also find level factors in cost and profit efficiency functions.
significant variations between countries regarding capital Table 4 provides summary statistics of cost and profit
adequacy and the operation cost indicator. The ratio of values, products, factor prices, and other bank-character-
equity to assets is much higher in all GCC countries; it istics. It reports simple means for the overall sample and
ranges from 12.39% in Saudi Arabia to 28.36% in Bahrain. for conventional and Islamic banks. We can then observe
When comparing average value for cost to income ratio, minor differences for the most average values between
this mean is comparable in UAE, Saudi Arabia and Qatar, both types of banks. In terms of profit efficiency measured
while the Bahrain (51.83%) has the highest value of this by the ratio of profit before tax to total assets, Islamic
ratio. banks have higher profit value (3.5%) compared with
Finally, concerning the country-level factors (panel C), conventional banks (2.8%). We find a large difference
there are large differences in all macroeconomic variables between banks if we calculate the ROAA (2.39% for
across GCC countries. In particular, the per capita GDP ($ conventional banks and 4.42% for Islamic banks). How-
10,074 in Oman, $34,908 in Qatar), the deposit per square ever, the average cost efficiency measured by the ratio of
kilometer ($0.04 per km2 in Oman, $13.95 per km2 in total costs to total assets is nearly similar for the two cat-
Bahrain), the degree of monetization (33.91% in Oman, egories of banks (4.89 and 4.28%, respectively for Islamic
74.62% in Bahrain), and the rate of inflation (0.57% in and conventional banks).

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54 J Prod Anal (2010) 34:45-62

Table 4 Descriptive statistics of dataset by type of banks (average values)

Variables Full sample Islamic banks Conventional banks


Mean SD Mean SD Mean SD

Panel A: cost and profit value, outputs and input prices


Total costs to total assets 4.45 2.09 4.89 3.09 4.28 1.52

Total profit to total assets 2.68 3.12 3.96 5.13 2.18 1.55
Net total loans to total assets 53.30 18.98 55.36 25.66 52.60 15.72

Other earning assets to total assets 23.80 16.78 25.04 22.28 23.27 14.05
Price of labor 1.08 0.72 1.43 1.11 0.94 0.42

Price of fund 3.48 3.96 3.75 4.92 3.37 3.52

Panel B: bank- specific variables


Total assets (US$ millions) 7,188 11,207 3,198 5,521 8,759 12,418
Equity to total assets 20.01 17.94 31.00 25.45 15.75 11.49
ROAA 2.95 3.82 4.42 6.12 2.39 2.15

Cost to income 42.75 25.91 49.40 35.78 40.17 20.37

All variables are in percentage, except where indicated

Turning to the levels of output, Table 4 shows slight These differences in GCC banking between conven-
differences in structure of activities between conventional tional and Islamic banks may have some influence on the
and Islamic banks. Furthermore, these banks focus their cost and profit efficiency levels.
activities on loan (53.3%) than on other earning-assets
(23.8%). It is interesting to note that there is not much 5.2 Estimation of the cost and profit efficiency frontiers
variation in the level of other earning assets between
conventional and Islamic banks despite the large difference Table 5 reports the stochastic translog cost and profit
in the nature of activities in these banks. Conventional frontier parameter estimates from the maximum-likelihood
banks invest in government securities whereas Islamic model. Overall, the estimation results show good fit and the
banks invest in Islamic bonds.11 Additionally, Islamic signs of most of the variables conform to the theory. First,
banks are more actively engaged in equity investment.12 out of the 28 regressors, the profit and cost estimates report,
Table 4 also shows that the input prices are somewhat 21 and 19 regressors as statistically significant, respec-
higher for Islamic banks, especially for the mean price of tively. Second, and most importantly, the value of the log-
funds (1.43%). This means that borrowed funds are more likelihood functions of the profit and cost estimates is high
expensive in Islamic banks than in conventional banks. (-530.46 and -1,584.57, respectively) and statistically
Regarding the other bank-specific variables, we observe significant at the 1% level. Third, the sigma-squared is
that the average value of total assets varies greatly among significant at 1% level for both cost and profit functions
the two groups of banks. Conventional banks ($ 8,759 and indicates highly significant parameter estimates. In
million) are approximately three times bigger than Islamic addition, the parameter y is also significant for the profit
banks ($ 3,198 million). In terms of capital adequacy and cost function (0.997, 0991) and clearly means that
(equity to total assets), Islamic banks (31%) are better a large part of the residual consists of bank-specific
capitalized than conventional banks (15.75%). Finally, the inefficiency.
mean ratio of cost to income is larger in Islamic banks Table 5 (panel A) shows a positive significant relation-
(49.40%) than in conventional banks (40.12%). ship between the coefficients of the two outputs (loan and
other earning assets) and the two dependant variables. This
Issuance of Islamic bonds is a major advancement in the field of means that higher outputs generate higher total costs and
Islamic finance. The difference between a conventional bond and
increase profits. Similar findings, especially for the cost
Islamic bond (Sukuk) is that the latter is asset-backed and in
function, are reported by several recent studies (e.g., Da-
accordance with Shariah principle. Islamic bonds exist in most GCC
countries, especially in Bahrain, Qatar and UAE. Sukuks are also canay IE 2007; Lensink et al. 2008; Staikouras et al. 2008).
issued and bought outside the Islamic world. The price coefficients of the cost function are all positive
There are several ways in which Islamic banks undertake direct and significant, as expected, because higher prices of inputs
investment: a number of Islamic banks in GCC countries (Bahrain, lead to higher costs. The elasticity of the cost of labor
UAE, Qatar) have taken the initiative in establishing and managing
(a2 = 1.011) is greater than the elasticity of the cost of
subsidiary companies; other banks (Saudi Arabia) have participated in
the equity capital of other companies. fund ( oil = 0.325). This suggests that banks should control

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J Prod Anal (2010) 34:45-62 55

Table 5 Estimation results for


Dependent variables (total costs, Cost efficiency Profit efficiency
the cost and profit frontier
total profits before tax)

Parameters Notation Coefficient -Ratio Coefficient -Ratio

Panel A: input prices, outputs and multiplicative term


a0 Constant -4.153 -18.265a 8.314 24.2a
a! In (yl) 0.325 3.415a 0.083 8.523a
a2 In (y2) 1.011 22.159a -0.333 -1.915e
i In (pi) 0.559 7.313a 0.849 15.866a
2 In (p2) 0.195 1.951e 0.124 2.635b
an In (yl) In (yl) 0.085 0.722 0.075 2.548b
a12 In (yl) In (y2) -0.055 4.315a -0.759 -4.958a
0C22 In (y2) In (y2) 0.501 16.373a 0.685 3.578a
n In (pi) In (pi) 0.587 16.312a 0.435 3.056a
l2 In (pi) In (p2) -0.159 -8.634a 0.006 1.905e
22 In (p2) In (p2) 0.005 4.859a 0.073 3.452a
011 In (yl) In (pi) -0.001 -1.712 0.035 0.395
012 In (yl) In (p2) 0.139 6.601a 0.025 1.205
021 In (y2) In (pl) 0.017 2.125b -0.019 -0.022
022 In (y2) In (p2) -0.196 -11.359a 0.05 0.226
11 T 0.016 0.654 0.411 8.195a
12 TxT 0.187 1.273 0.072 0.978
T X In (yl) -0.016 0.229 0.372 4.054a
2 TX In (y2) -0.419 1.100 0.205 5.662a
i/fi 7 x In (pi) 0.031 0.143 0.024 2.917a
i//2 Tx ln(p2) 0.186 1.246 0.303 8.193a
Panel B: country level variables
Pi CGDP 0.222 5.013a 0.027 3.332a
p2 DMON -0.183 -0.986 0.039 1.967e
p3 DDEM -0.122 -4.912a 0.025 0.250
p4 INFR 0.126 0.538 0.035 1.44
p5 DPOP -0.116 -4.015a 0.021 0.886
p6 CONC 0.063 2.594" 0.017 2.279b
p7 INTR -0.095 -2.409" 0.028 3.853a
Ps ACAP -0.032 -1.926e 0.113 3.156a
Panel C: diagnostics
Sigma squared 42.21 33.26a 25.37 17.1a
Gamma 0.991 1,350.52a 0.997 2,637.3a
a Significant at 1% level, Log-likelihood function -15,84.57 -530.46
b significant at 5% level, LR test of the one-sided error 61.12a 1,942.86a
c significant at 10% level

more personnel expenses than interest expenses when pri- and significant at 1% level, implying that the profit of GCC
ces increase. Surprisingly, the price of labor in the profit banks have been increasing with time. This is likely to be
function is positive (only at the 10% level), although it is the result of economic development in these countries
expected to be negative like price of fund, since higher resulting from the rise of oil prices over the last years.
prices incur lower profits. The coefficient of the cross- Concerning the country-level variables, Table 5 (panel
output term (a12) is negative and statistically significant at B) shows that the level of economic development measured
1% level. This finding confirms the presence of scope by per capita GDP is significant and positively related to
economies in GCC banking. The results also show that the costs and profits. This suggests that banks in higher per
time coefficient is insignificant for the cost function. capita income countries present higher levels of profit and
However, this coefficient for the profit function is positive are less cost efficient than banks in low income countries.

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56 J Prod Anal (2010) 34:45-62

These results conform with those of Koutsomanoli-Flip- less pressure to control their costs (Maudos et al. 2002).
paki et al. (2008) and Carvallo and Kasman (2005). The results also indicate that financial depth (loans to
However, Lensink et al. (2008), found a negative rela- deposits) decreases banking costs and increases profits.
tionship between GDP per capita and total costs, indicating Similar findings are reported by several studies (e.g., Fries
that an increase in GDP lowers costs. The degree of and Taci 2005; Carvallo and Kasman 2005; Perera et al.
monetization is positively associated with profits and is not 2007). Finally, banking systems with a higher capital ratio
significantly related to costs. This finding differs signifi- have significant higher profits and lower costs. Most
cantly from the study of Perera et al. (2007) which found a studies found that well capitalized banks are more efficient
significant positive relationship between the ratio of broad (Berger and Mester 1997; Perera et al. 2007).
money supply to GDP and total costs. Regarding other
elements of macroeconomic variables, our findings on the 5.3 Average banks efficiencies by year, country
effect of the density of demand is consistent with those of and type of banks
Carvallo and Kasman (2005) who report a negative impact
of this variable on total costs. However, we find that the Table 6 summarizes the average cost and profit efficiency
inflation rate is neither associated with cost nor with profit. scores of the banking industry in GCC countries during the
This is because inflation during the period 1999-2007 was period 1999-2007, estimated by the stochastic frontier
largely moderate in the GCC countries. The results also approach with a translog cost and profit function. It also
show, as expected, that the sign of the population density provides information about the level of bank efficiency by
variable is negative in cost function. year (panel A), country (panel B) and by type of bank
Turning to the market structure variables, we find that (panel C), based on common frontier with country-specific
the degree of the concentration has a positive influence on environmental variables.

both total costs and total profits. This is consistent with the Looking at the overall mean, the cost and profit effi-
findings of Staikouras et al. (2008) and Perera et al. (2007). ciency scores are equal to 56 and 71%, with standard
The positive association between market concentration and deviation of 20.28 and 16.48%, respectively. This implies
banks costs may indicate that banks that operate in less that during the period of study, the average bank in GCC
competitive markets can charge higher prices and are under countries could reduce its costs by 44% and improve its

Table 6 Average cost and


Number Cost efficiency scores (%) Profit efficiency scores (%)
profit efficiency scores by year, of observations

country and by type of bank Mean Std Meana Std

Panel A: mean by year


1999 60 52.08 18.75 60.16 24.96

2000 62 56.92 19.18 65.74 17.89

2001 64 60.39 19.86 66.97 19.97

2002 65 59.18 18.85 68.31 18.78

2003 66 61.01 19.41 69.71 16.62

2004 68 64.59 19.73 73.64 9.33

2005 71 62.43 22.09 73.22 6.61

2006 71 60.88 21.44 74.98 7.07


2007 67 56.42 21.97 72.11 15.78

Panel B: mean by country


Bahrain 119 52.15 13.54 68.20 14.12

Kuwait 84 51.31 12.82 70.21 13.74

Oman 45 74.65 8.05 73.90 6.04

Qatar 68 57.93 7.56 73.64 9.77


Saudi Arabia 93 57.78 14.67 71.20 16.34
a The means by year, country
UAE 185 62.11 15.87 68.16 16.23
and by type of bank are
calculated from the total sample Panel C: mean by type of bankb
b The mean difference is Conventional banks 428 62.71 13.36 73.43 14.56
significant at 5% and 10% for Islamic banks 166 51.55 12.92 61.82 11.37
cost and profit efficiency scores
Overall mean 594 56.35 20.28 71.14 16.48
respectively

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J Prod Anal (2010) 34:45-62 57

profit by 29% to match its performance with the best- present profit efficiency scores below the average for all
practice bank. The first result to note is the existence of GCC countries (71.14%). Except for Oman, the cost effi-
lower level of cost efficiency rather than of profit effi- ciency scores of each country are always lower than profit
ciency. Therefore, it seems that Arab Gulf banks are more efficiency, the extreme cases being of about 15-18 per-
efficient at generating profits than controlling costs. Our centage point in Bahrain, Kuwait, Qatar and Saudi Arabia.
findings are different from those obtained in the most On the other hand, in the UAE the difference between
studies carried out in developed countries (e.g., Maudos profit and cost efficiency scores is about 6%. We can also
et al. 2002; Bos and Kool 2006; Ariff and Can 2008; observe that the most profit efficient banks are not neces-
Staikouras et al. 2008). According to the hypothesis of sarily the most cost efficient ones and vice versa. For
Berger and Mester (1999), the increase of profit efficiency example, banks in Kuwait ranked fourth in terms of profit
and the decrease of cost efficiency are the consequences of efficiency, but they are the least cost efficient in the sam-
an increasing quality of banking services which led to an ple. Likewise, the UAE' s banks are the most cost efficient
improvement of revenues. We can also explain the result (second place) among banks in GCC countries, while they
by the imperfect competition hypothesis. Indeed, due to the ranked last in terms of profit efficiency. This observation is
dominant position of banks in GCC countries and the high in line with many studies achieved in developed countries
demand of financial services, these banks may have gained (e.g., Berger and Mester 1997 and Rogers 1998 in USA
higher monopoly power resulting in higher profit efficiency banks, Guevera and Maudos 2002 in EU 15 countries). If
and, in consequence, face less pressure to decrease costs we compare our findings concerning the classification of
and to restructure their activities. country in terms of efficiency with those of the study of
The inter-temporal comparison of the scores (panel A) Ariss et al. (2007), we find some differences. For example,
suggests that the average cost efficiency ranges between in our study banks in Bahrain are the least efficient, while
52.08% (1999) and 56.42% (2007), while the correspond- they occupied the second place in the study of Ariss et al.
ing values for the average profit efficiency are 60.16% (2007). Likewise, banks in Saudi Arabia are the least
(1999) and 72.91% (2007), respectively. Hence, along the efficient in the later study, but their ranks are the third and
9 years of our sample, the profit efficiency levels (12%) the fourth in terms of profit and cost efficiency in our study.
have increased more than the cost efficiency scores (4%). We think that these differences are due to several reasons.

However the observed improvement in efficiency is not First, our sample contains an important number of Islamic
continuous over the period of study. Indeed, both cost and banks which are absent in the study of Ariss et al. (2007),
profit efficiency scores witnessed a growth of 12% between and that has probably an effect of the efficiency of banks,
1999 and 2004.13 But during the period 2004-2007, the especially in Bahrain, Kuwait and in the UAE.15 Second, in
average cost efficiency level declined from 64.59% in 2004 our model we have introduced country-specific variables
to 56.42% in 2007, while the average profit efficiency which are omitted in the study of Ariss et al. (2007).
scores were practically stable in the same period. The Finally, it seems that the choice of approach (Ariss et al.
decrease of efficiency can be explained by the increase of 2007 have employed non-parametric technique) and vari-
competition among banks due to liberalization and open- ables probably had an impact on results.
ness measures adopted recently in the countries, especially We now turn to the efficiency of conventional banks as
in Kuwait, Qatar, Saudi Arabia and in the UAE.14 opposed to the efficiency of Islamic banks (panel C). As
The comparison of the cost and profit efficiency scores concerns cost efficiency, comparison of the two groups of
by country (panel B) reveals that cost efficiency varies banks shows that the conventional banks are more efficient,
considerably across countries. Table 5 indicates that on average, than Islamic banks. The mean cost efficiency
Omani banks (74.65%) are the most efficient, followed by score is 62.71% for conventional banks while it is equal at
the UAE (62.11%) and Qatari (58%) banks. The Kuwaiti 51.55% for Islamic banks. The Analysis of the dispersion
banks are the least cost efficient in the sample with a score of efficiency levels shows insignificant differences between
of 51.31%. However, profit efficiency levels show less Islamic and conventional banks (12.92 and 13.36%,
variation across countries. The average profit efficiency respectively). In terms of alternative profit efficiency, we
ranges from 68.16% in the UAE to 73.90% in Oman. reached the same result. From Table 5, we also see that
Banks in Kuwait (70.21%) and in Bahrain (68.26%) conventional banks (73.43%), again, on average, prove to
be the most efficient than Islamic banks (61.82%).
Our findings are in line with the studies of Rosly and
13 For the same period, Ariss et al. (2007) find that there is a decline
Abu Baker (2003) and Yudistira (2003) which find that
in efficiency in GCC countries due to the decrease in allocative
efficiency.
Islamic banks are less efficient than conventional banks.

New licenses to Islamic and foreign banks, new financial free


zones in Qatar, Dubai, and Ras Al Kaima (UAE). 15 An important number of Islamic banks exist in these countries.

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58 J Prod Anal (2010) 34:45-62

Table 7 Regression analysis of


Independent variables Cost inefficiency Profit efficiency
the potential correlates with
profit efficiency and cost Parameters Notation Coefficient i-Ratio Coefficient - Rati o
inefficiency scores
o Constant -2.409 -4.782a -3.259 -9.653a
01 log Assets -0.050 -2.635b 0.003 0.382
02 EQAS -0.594 -12.581a 1.791 24.098a
03 ROAA -0.170 -7.624a 0.154 2.565b
04 COIN 0.196 5.071a -0.015 -1.861e
05 LOAS 0.053 1.935e 0.001 15.725a
a Significant at 1% level, Log-likelihood function -1,584.57 -530.46
b significant at 5% level, LR test of the one-sided error 61.12a 1,942.86a
c significant at 10% level

A recent study performed by Kamaruddin et al. (2008) the larger the total assets, the higher the efficiency. However,
reveals that Islamic banks in Malaysia during the period some studies did not find any efficiency advantage related to
1998-2004 are twice as inefficient (cost inefficiency is large banks (Girardone et al. 2004; Berger and Mester 1997)
equal at 28%) as typical conventional banks in the world. or reported a negative relationship between efficiency and
This inefficiency can be explained by the lack of econo- size (Allen and Rai 1996; Christopoulos et al. 2002).
mies of scale due to smaller size of Islamic banks. In As expected, the equity ratio has a negative and statis-
addition, According to Olson and Zoubi (2008), the inef- tically significant impact on cost and profit inefficiency.
ficiency of Islamic banks may be due to the fact that their Hence, the result suggests that well-capitalized banks are
customers are pre-disposed to Islamic products regardless more efficient than their poorly capitalized counterparts,
of cost. In the case of Islamic banks in Malaysia, Kama- both in terms of cost and profit efficiency. This finding
ruddin et al. (2008) explain the lower cost efficiency scores could be explained by the fact that high capital require-
of these banks compared to the conventional banks in ments may result in higher levels of equity capital reducing
Western countries, essentially, by the high level of cost to the probability of financial distress, which reduces costs by
income ratio due to the increase of staff costs and over- lowering risk premium on substitutes for other potential
heads. Moreover, In order to have greater marketing and more costly risk management activities (Berger and Bon-
promotional activities and higher investment in technology, accorsi di Patti 2006; Casu and Molyneux 2000). In addi-
Islamic banks in Malaysia have incurred higher costs. tion, some studies (Isik and Hassan 2003) which find that
To examine whether the bank type implies different high capital requirements increase the efficiency of banks
scores of efficiency, we perform a t parametric test.16 The are in favour of the theory of moral hazard.17 Our results
result confirms significant difference in cost and profit contradict those of Staikouras et al. (2008) and VanHoose
efficiency levels between conventional and Islamic banks. (2007) who report a negative association between capital
adequacy and profit efficiency. They explain this result by
5.4 Potential determinants of cost and profit efficiency the fact that banks, in light of stricter capital standards,
may decide to switch loans with other less risky assets
In this section, we investigate the sources of bank effi- (e.g., government securities) that can reduce the profit of
ciency in the banking industry of GCC countries. For this banks.

reason, we regress the cost and profit efficiency scores on a Turning to the effect of ROAA, our findings confirm the
number of bank-specific. Table 7 reports the results of general notion that profitability is inversely related to cost
regression using the model of Battese and Coelli (1995). and profit inefficiency. Hence, banks with higher profit tend
As can be seen in Table 7, the coefficient of log (Assets) is to be more efficient. Similar results are reported by several
statistically significant and negatively related to cost ineffi- studies (Isik and Hassan 2002 for Turkish banks; Pasiouras
ciency scores. The result means that bank size has positive 2008 for Greek commercial banks; Perera et al. 2007 for
impact on cost efficiency, implying that larger banks are 111 commercial banks in South Asia). However, some
more efficient than the smaller ones. Our findings are in line studies found no conclusive relationship between profit-
with many studies (e.g., Chu and Lim 1998 for Singapore ability and efficiency (e.g., Staikouras et al. 2008 for the
banks; Papadopoulos 2004 for the European banking
industry; Pasiouras 2008 in Greece) which concluded that
17 The managers of banks that are closer to bankruptcy will be more
inclined to pursue their own goals (knowing the end is near) which are
16 The null hypothesis of t test indicates that conventional and not necessarily in line with the owners' objectives (Grigorian and
Islamic banks have the same mean. Manle 2000).

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J Prod Anal (2010) 34:45-62 59

banking sector of 6 South Eastern European countries) or specific environment variables. We used IBCA information
reported a negative association (Casu and Girarrdone 2004 to form an unbalanced panel and estimated cost and
for Italian banks). alternative profit efficiency scores for a sample of 71
Regarding the sign of coefficient on cost to income, we commercial banks. We also compare the efficiency levels
observe, as expected, that this variable is positively cor- of banks between country and type of bank (conventional
related to cost inefficiency. This implies that banks with versus Islamic banks). Finally, we use the model of Battese
lower cost ratio exhibit higher levels of efficiency. We also and Coelli (1995) to estimate the sources of inefficiency.
find that there is a negative association (significant at 10% Using a translog function with three input prices, two
level) between profit efficiency and the operation cost. outputs and eight country-level variables, we find that the
Indeed, a high profit efficiency score is more likely to be price coefficients of the cost function are all positive and
related with a low cost ratio. Our findings are consistent the elasticity of the cost of labor is greater than the elas-
with many studies performed in other countries (Weill ticity of the cost of fund. This suggests that banks in GCC
2004 in five European countries; Carvallo and Kasman countries should control personnel expenses more than
2005 in 16 Latin American Countries; Ariff and Can 2008 interest expenses in the case of the increase of prices. The
in China). results also indicate that higher outputs (loan and other
Finally, the coefficient measured the credit risk is sig- earning assets) generate higher costs and profits. Regarding
nificantly and positively related to profit efficiency levels. country-specific factors, GCC banking efficiency with high
Therefore, banks with higher loans-to-assets ratios take levels of per capita GDP and degree of concentration seem
more risk and are more profit efficient. However, in the to be associated with higher banking costs. In contrast,
case of cost inefficiency, this variable has a positive sign at banking systems with higher ratios of capital to total asset,
the 10% level of significance, suggesting that banks which loan to deposit, density of demand and population tend to
have a higher ratio of loans to assets are less cost efficient have lower costs. In addition, country-level that increase
because the expenses associated with loans are quite sub- profit efficiency are per capita GDP, financial depth, capital
stantial. Moreover, the banks are under pressure to control ratio, and degree of monetization and concentration.
costs (Maudos et al. 2002; Staikouras et al. 2008). This Taking all Gulf banks together, the results of the second
finding is different from other studies (Isik and Hassan part of the analysis show that cost efficiency scores (56%)
2003; Pasiouras 2008). For instance, using a stochastic are lower than the profit efficiency Scores (71%). This
frontier model, Carvallo and Kasman (2005) for a panel of means that banks in these countries are more efficient at
481 banks in Latin American countries, find a negative generating profits than at controlling costs. Due to the high
relationship between the loans to assets ratio and cost demand of financial services and the dominant position of
inefficiency. They argue that banks which engaged in commercial banks in the Gulf region, banks have gained
greater amounts of lending activity have the ability to higher monopoly power and are less pressured to decrease
manage operations more productively. This enables them costs and to restructure their activities. However, with the
to have lower production costs and consequently tend to be increase of competition, the decrease of oil prices and the
more efficiently operated. impact of the latest financial crises, banks were induced to
To sum up, we can conclude that most of the estimated reduce their costs, their monopoly rents and to exploit scale
cost and profit efficiency can be explained by bank-specific and scope economies. It is also interesting to note that there
factors. is a rise in the cost and profit efficiency scores of banks in
Gulf region from 1999 to 2007, but the improvement in
efficiency was not continuous over the sample period.
6 Conclusion Concerning the comparative cost and profit efficiency
scores of banks in different GCC countries, the empirical
In response to globalization and deregulation, decision findings indicate that there is a notable wide range of
makers in GCC countries over the past decade have variation in efficiency levels. The variation in terms of cost
implemented various measures to enhance the credibility of efficiency (23%) between countries is being greater than in
the banking sector and improve its performance and effi- terms of profit efficiency (6%). Geographically, Omani
ciency. These measures included liberalizing interest rates, banks (75%) are the most cost efficient while Kuwaiti
according new licenses to foreign banks, implementing banks (51%) are the least cost efficient. The results also
progressive legal and regulatory reforms and reducing the show that banks in Oman (73.9%), on average, have been
direct government control. the most profit efficient followed narrowly by banks from
In this context, this study investigates the cost and profit Qatar (73.6%), and a lower profit efficient scores in Bah-
efficiency of the Gulf banking industry for the period rain (68.2%) and UAE (68.1%). We can also observe that
1999-2007 using a stochastic frontier model with country- the cost efficient banks are not necessarily the most profit

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60 J Prod Anal (2010) 34:45-62

efficient ones and vice versa. In view of these results, it new challenges over the next years. In this regard, to
appears that there is still room for improving the efficiency improve the efficiency of GCC commercial banking indus-
of banks in this region. These countries, especially Saudi try and to create a more competitive environment, the
Arabia, Kuwait, Bahrain and the UAE, need to continue the supervisory authorities in these countries should continue to
reform process in order to improve cost conditions and to reinforce reforms by further liberalizing the banking sector
enhance financial sector performance. and financial market, completing legal and regulatory
Among other interesting results of this study, we find reforms, and expanding the role of private sector in the
that conventional commercial banks in GCC countries, on process of economic development. Second, commercial
average, are most cost and profit efficient than Islamic banks in GCC countries have to draw suitable strategies to
banks. The lower cost and profit efficiency of Islamic banks obtain an optimal size and to establish large entities in order
could be explained by several reasons. First, due to smaller to be more efficient and to face the challenges and risks of
size assets of Islamic banks compared to conventional banking activities, locally and internationally. Additionally,
banks, these banks do not benefit of economies of scale and Gulf banks have to better control their costs, to enhance their
in consequence are not yet ready to compete with their policies concerning the managing and supervising of various
conventional counterparts. banking risks, and to improve asset quality control. Finally,
Second, many studies (Archer and Abdel-Karim 2002; as suggested by many studies (Archer and Abdel-Karim
Kamaruddin et al. 2008) conclude that cost of fund and 2002; Kabir Hassan 2005), Islamic banking has to undertake
labor in Islamic banks is higher when compared with those several actions to improve their efficiency and compete with
in conventional banks. This finding can be explained by the conventional counterparts. Indeed, Islamic banks should try
structure of Islamic banks which tends to be more complex to expand activities in line with those of contemporary
and by the higher remuneration package offered to retain financial markets and develop innovative products and
expertise in Islamic banking. Third, the lower profit effi- modes of finance which conform with shari 'ah law. It is also

ciency is the result of a lower amount of risk carried by necessary for Islamic banks to increase their size through
Islamic bank transactions. Finally, according to Kabir merger among Islamic financial institutions in order to
Hassan (2005), Islamic banks are relatively less efficient in achieve unrealized economies of scale. Further, to decrease
containing cost because they operate in overall regulatory their costs, Islamic banks should make their services open to
environment which are not very supportive of their a wider clientele (i.e., not necessarily Muslims) and improve
operations. their banking system through the use of new technology.
Having estimated the cost and profit efficiency levels of Finally, future research can extend the present study in
the different banking systems in GCC countries, it should many directions. First, we can consider off-balance sheet
be interesting to identify the possible sources of the dif- activities and risk management activities during the esti-
ference in inefficiency between banks. The results indicate mation of efficiency scores as additional output, and adopt
that bank size measured by total assets has a positive effect other recent method such as the profit-oriented approach.
on cost efficiency. This suggests that consolidation of Second, the comparison of efficiency between domestic
smaller banks in the region would contribute to greater cost and foreign banks, and state-owned banks versus private
efficiency in banking. In addition, the study findings also banks has not received attention in the Gulf banking sector.
show that banking systems with higher ratios of equity to Finally, it would be interesting to compare the findings of
total assets and return on average assets (ROAA) tend to be this paper with future research which analyze banks from
more efficient. The results which are consistent with sev- other emerging markets such as the Middle East and North
eral studies (Pasiouras 2008; Perera et al. 2007) mean that Africa (MENA), Latin American countries, and South
well-capitalized and highly profitable banks are less cost Asian countries.

and profit inefficient. Turning to the effect of operation


cost, the regression analysis indicates that this variable is Acknowledgments I am grateful to Prof. Laurent Weill and anon-
ymous referees for helpful, comments and suggestions. I also
inversely related to cost and profit efficiency. This implies
acknowledge the financial and administrative support provided by the
that banks with lower cost-to income ratios exhibit higher Deanship of Scientific Research of King Saud University. The
level of efficiency. Finally, as expected, the ratio loan to remaining errors are the sole responsibility of the author.
asset is positively related to profit efficiency and has a
negative impact on cost efficiency.
Our results have the following policy implications: first,
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