International Journal of Islamic and Middle Eastern Finance and

Management
Are Saudi banks productive and efficient?
Mohammad Hanif Akhtar,
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Are Saudi banks

Are Saudi banks productive productive and
and efficient? efficient?
Mohammad Hanif Akhtar
Department of Finance and Accounting, College of Business Administration, 95
Prince Sultan University, Riyadh, Kingdom of Saudi Arabia

Abstract
Purpose – The purpose of this paper is to estimate the data envelopment analysis (DEA) efficiency
scores and Malmquist productivity indices of banks in Saudi Arabia, an economy that is heavily
dependant on the hydrocarbon sector.
Design/methodology/approach – The paper adopts the intermediation approach of banking
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services where financial institutions like banks are perceived to be manufacturing units, employing
inputs such as interest and non-interest expenses to produce outputs such as net interest and
non-interest incomes. The research methodology is comprised of the DEA and Malmquist productivity
index (MPI) as a measure of change in total factor productivity, reflecting industry’s performance
over time.
Findings – The results on MPI reflect an improvement in average productivity of banks. However,
the major increase in productivity gains emerged through technological change relative to the
efficiency change. The banks across the Kingdom appear to have succeeded in catching up with the
best practices, even though the average scores on technical efficiency (TE) stood beyond optimal
levels.
Research limitations/implications – The question, whether small banks are more productive and
efficient vis-à-vis large banks, remains unanswered. Likewise, to what extent the changes in oil prices
and revenues affect the efficiency and productivity of banks, a second-stage regression of efficiency on
oil prices and revenues along with other variables would help in calculating the degree of impact.
However, these are the agenda for subsequent research.
Practical implications – The banks in Saudi Arabia need to rationalize their costs to line up across
the efficiency frontiers.
Originality/value – The paper manages to explore the critical issues of TE and productivity changes
across the banking sector in Saudi Arabia. It provides valuable insights to both the bank executives
and public policy makers, who are seeking for improvements in efficiency, productivity, and
competitiveness across the banking sector in the Kingdom.
Keywords Banks, Banking, Data analysis, Productivity rate, Saudi Arabia
Paper type Research paper

1. Introduction
The banking sector, across the globe, has experienced profound changes over the past
two decades or so. Globalization, deregulation, financial innovation, and automation
have been major forces leaving their impact on performance of the banking sector,
Saudi Arabia being no exception. Such advancements pose a challenge for Saudi banks
to control their costs, maximize revenues, and line up across efficiency frontiers. International Journal of Islamic and
Middle Eastern Finance and
Management
The author is grateful to Prince Sultan University for financial support towards this research Vol. 3 No. 2, 2010
through an incentive-based research project number-FIN-2007-12-8. The author is also obliged to pp. 95-112
q Emerald Group Publishing Limited
Mr Yousuf Hindess for his corrections to the earlier draft and data processing support by 1753-8394
Syed Ehsan Zafar. All remaining errors are the responsibility of the author. DOI 10.1108/17538391011054354
 IMEFM The concern becomes more obvious with an increasing trend towards competition
3,2 among banks both locally and in the Gulf region. The drive to control costs and
maximize revenues by banks is well reflected through improvements in efficiency and
productivity over-time. These objectives also become socially optimal since they help
in rationalizing the financial costs of transaction and intermediation within the society.
Bank inefficiency has generally been found to consume a large portion of funds and to be
96 a far greater source of problems of performance. For such reasons, studies on efficiency
and productivity of banks are extremely valuable both for policy makers and for bank
executives. The present research is an attempt in this regard.
The paper proceeds as follows. The next section draws upon the empirical work on
productivity and bank efficiency around the globe. Section 3 reviews performance of the
banking sector in Saudi Arabia. Section 4 discusses the data and methodology employed
for research. Section 5 presents main findings, while the final part concludes.
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2. Review of literature
The literature on efficiency and productivity of financial institutions is enormous.
Various studies have examined the efficiency and productivity changes of financial
institutions over time. The following discussion refers to some of the studies that have
been conducted in context of the issue under consideration with a difference of choice
across variables being used as inputs or outputs (Table I).
Performance evaluation of banks should be linked to decision models to associate
the results obtained with the decision (Oral and Yolalan, 1990). They discussed critical
issues in efficiency of service organizations like banks, particularly in Turkey.
They used a number of bank transactions as the output of banks, while labor, number
of accounts and credit applications were chosen as inputs.
Jackson et al. (1998) evaluated efficiency and productivity growth in Turkish
commercial banking using the Malmquist productivity index (MPI) between 1992 and
1996 period. They used the number of employees and the total of non-labor operating
expenses as the two inputs while total loans, total demand deposits, and total time
deposits were the outputs. Their results revealed that foreign and private banks were
more efficient than their counterparts from banks in the public sector.
Isik and Hassan (2003) examined productivity growth, efficiency change, and
technical progress in Turkish commercial banks using the Malmquist index. They
found that all types of Turkish banks had recorded significant productivity gains
mostly driven by increases in efficiency rather than technical progress. Likewise, they
discovered that increases in efficiency were mostly due to improved resource
management practices rather than improved scales.
Penny (2004) investigated X-efficiency and productivity change in Australian
banking between 1995 and 1999 using the data envelopment analysis (DEA) and the
MPI. He found in his analyses that regional banks were less efficient than other bank
types. He ended up with the conclusion that diseconomies of scale start at a very early
stage and cannot be considered as sufficient evidence to allow for mergers between large
banks. Total factor productivity in the banking sector was found to have increased by
an average annual 7.6 percent between 1995 and 1999. Technological advances shifted
out the efficiency frontier leading to an increase in productivity. The performance of the
banking sector was less efficient in 1999 relative to the frontier in 1995.
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Period of
No. Study by Inputs Outputs analyses Country

1 Bhattacharyya et al. (1997)Interest expenses and operating expenses Advances, investments, and deposits 1986-1991 India
2 Jackson et al. (1998) Number of employees and non-labor Total loans, total demand deposits, and 1992-1996 Turkey
operating expenses total time deposits
3 Galagedera and Edirisuriya Customer and short-term funding and total Loans and other earning assets 1995-2002 India
(2004) operating expenses
4 Strum and Williams (2004, 1988-2001 Australia
2007)
Model 1 Employees; deposits and equity capital Loans and off-balance sheet items
Model 2 Interest expenses; non-interest expenses Net interest income and non-interest
income
5 Kumbhakar and Purchase funds and core deposits, labor, Loans and securities 1986-2000 Spain
Lozano-Vivas (2005) and physical capital
6 Chambers and Cifter (2006) Number of branches, Personnel members ROA, ROE, net interest income/total assets, 2002-2004 Turkey
per branch, share in total assets, share in non-interest income/total assets, and net
total loans, and share in total deposits interest income/total operating income
7 Rezitis (2006) Labor, capital expenses, and the value Value of loans and advances and value 1982-1997 Greece
of deposits of investment assets
efficient?

some of the studies

An overview of input and
output variables used in
Are Saudi banks
productive and

97

Table I.
 IMEFM Sturm and Williams (2004) evaluated the impact of foreign bank entry on bank efficiency
3,2 in Australia during the post-deregulation period of 1988-2001. Using the DEA and
stochastic frontier approaches, they discovered that foreign banks were more efficient
than their local counterparts. It also emerged from their findings that bank size served as
a barrier to entry for new entrants in the banking sector. They also found the emergence
of deregulation and competition as helpful towards improvement of bank efficiency in
98 Australia.
In a study on the effects of scale on productivity of Turkish banks, Chambers and
Cifter (2006) discovered that differences in efficiency mainly stemmed from technical
efficiency (TE) rather than a scale one. Their study used five inputs and five output
variables for an analysis of 18 Turkish banks covering the period from 2002 to 2004.
Their findings also revealed that Turkish banking had a “U-shaped scale efficiency”
(SCE) on selected profitability ratios.
Rezitis (2006) investigated the productivity growth and TE in the Greek banking
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industry for the period 1982-1997. The study also compared the sub-periods of 1982-1992
and 1993-1997, since after 1992 the Greek banking sector experienced substantial
changes. The MPI and the DEA methods were used to measure and decompose
productivity growth and TE, respectively. Productivity growth surfaced as higher
after 1992. Until the year 1992, growth was seen as mainly attributed to improvements
in efficiency while growth in recent times was mainly linked to technical progress.
Furthermore, after 1992, pure efficiency emerged as higher, while SCE appeared to be
lower. This reflected the fact that although banks achieved higher pure TE (PTE), they
moved away from their optimal scale of operations. Al-Muharrami (2008) estimated
technical, pure technical, and SCEs for banks from the Gulf Cooperation Council (GCC)
area for the period 1993-2002. He discovered that smaller banks demonstrated a superior
performance in terms of overall TE than did their large counterparts. There also
emerged a variation across bank size in terms of adopting the best available technology
vis-à-vis output optimality. The study found the big banks as more successful in
adopting the best available technology, while medium banks proved good at choosing
optimal levels of output. However, Islamic banks in the GCC area were seen as more
successful in both adoption of best available technology and choosing optimal levels
of output. Finally, in terms of TE, banks from Bahrain emerged as the top performers
in the region followed by those from Qatar.

3. Saudi banking sector at a glance

Saudi Arabian banking system witnessed visible improvements in the size, structure,
outreach, and financial health during the last few years (Table II). Having been heavily
dependent upon the hydrocarbon sector, Saudi economy has been able to perform well
over the past few years. With high-liquidity levels and oil-sector-driven profits, the
banking sector also managed to perform well over the years 2001-2006, recording
a growth in assets and deposits. With the changes in oil prices and quotas set by
Organization of Petroleum Exporting Countries (OPEC), the hydrocarbon sector acts
as a key source of instability in the macroeconomic and financial environment of the
Kingdom. For example, the gross domestic product (GDP) of Saudi Arabia contracted by
7 1/2 percent in 2002 as quotas were slashed and expanded by about 15 percent in 2003 as
quotas were enhanced. Nominal oil sector GDP tends to be even more volatile,
fluctuating with both output volumes and swings in world oil prices. This phenomenon
 Are Saudi banks
Indicators 2001 2002 2003 2004 2005 2006
productive and
Bank performance indicators efficient?
Interest income/total income ratio 0.75 0.70 0.64 0.55 0.55 0.57
Non-interest income/total income ratio 0.25 0.30 0.36 0.45 0.45 0.43
Interest expense/total expense ratio 0.36 0.36 0.28 0.26 0.45 0.54
Non-interest expense/total expense ratio 0.64 0.64 0.72 0.74 0.55 0.46 99
Assets (million Saudi riyals) 4,72,431 5,08,237 5,45,208 6,55,382 7,59,075 8,61,088
Deposits (million Saudi riyals) 2,90,992 3,38,097 3,62,020 4,35,965 4,89, 387 5,91,259
Bank credit (million Saudi riyals) 1,76,803 1,98,697 2,21,123 3,02,998 4,20,828 4,62,103
ROE 18.84 18.83 20.43 23.61 30.39 32.56
ROA 2.03 1.97 2.12 2.49 3.83 4.96
Loans/deposit ratio (%) 50.91 52.72 56.85 60.39 69.06 65.59
Reserve-deposit ratio (%) 6.6 8.47 7.37 7.35 6.67 8.81
Capital risk-weighted assets (%) 20.3 21.3 19.4 17.8 17.8 21.9
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Number of branches 1,199 1,203 1,209 1,216 1,247 1,289

Economic indicators
Contribution of oil sector to GDP (%) 37.6 37.7 41.5 45.6 52.7 54.4
Growth of real GDP (%) 1.0 0.1 7.7 5.3 5.6 3.1
Table II.
Growth of real GDP (oil sector; %) 2 3.9 27.5 17.2 6.7 6.2 2 0.8
Selected performance
Growth of real GDP (non-oil sector; %) 3.5 3.7 3.6 4.6 5.2 5.1
indicators of Saudi
Budget balance (percentage of GDP) 2 3.9 22.9 4.5 11.4 18.4 21.7
banking sector and the
Sources: SAMA (2006, 2007, 2008) economy: 2001-2006

leads to volatility in performance of various sectors of the economy and banking is

no exception.
Given the number of banks in Saudi Arabia[1], the banking sector takes the form of
a monopolistic type of market structure. The same is also supported by the findings
of Essayyad and Madani (2003, p. 83) who discovered that the banking system in the
Kingdom was highly concentrated. They found that the concentration ratios for the
banks were high ranging from 0.69 to 0.87 while the Hirshman-Herfindahl index (HHI)
also exceeded the threshold of 1,800 set by the US Department of Justice. High
concentration ratios are expected to allow for a higher profitability through higher bank
margins but would distort the efficiency of the sector (Cetorelli and Gambera, 2001).
Saudi Arabia has enjoyed a persistent period of enough liquidity in the banking
system due to the steady rise in oil prices, an increase in OPEC quotas of oil production
and the resulting budget surpluses during the period 2000-2007, except for the years
2001 and 2002. An upsurge in revenues from oil augurs well for the banking system
in terms of generating more deposits and revenues. This is reflected by the fact that bank
deposits represented around 90 percent of aggregate money supply (M3) at the end of the
years 2006 and 2007 (Saudi Arabian Monetary Agency (SAMA), 2008, Table II, p. 305).
The variables exhibited at Table II also reflect a rising trend in most cases. There
appears to be a significant rise in assets and deposits of banking industry in the
Kingdom during the years 2001-2006.
Data on interest and non-interest income of banks in the Kingdom reveals the fact
that the contribution of non-interest revenues[2] has increased overtime. This implies
that the banks are gradually relying more on sources of income other than loans and
advances. Likewise, the interest expense ratio has increased overtime showing that the
 IMEFM banks are forced to offer higher interest rates in order to attract deposits. This might
3,2 be the result of a gradual increase in the number of local commercial banks and foreign
bank branches. Ratio of non-interest expenses[3] to total expenses seems to be receding,
having reached at a higher level in the year 2004. This reflects the banks are conscious to
control their operating expenses and other outlays. Returns on both the assets and
equity fronts reveal a good performance by the banking sector in terms of asset
100 management and profitability. This might be the result of a higher concentration ratio
of banks in the Kingdom. Profitability of the sector might also be an outcome of a
key structural factor of non-interest-bearing (Islamic) deposits, comprising around
40 percent of total deposits.
There also appears a good mobilization of resources as portrayed by a persistent rise
in loan/deposit ratio during the period of analysis. Banks also appear to be maintaining
an adequate amount of reserve-deposit and capital risk-weighted assets ratios (Basel
standards) during the period under review. The adequate presence of liquidity among
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banks is further magnified both by expansionary trends on bank credit and an increase
in the number of bank branches (Table II) between the years 2001 and 2006.
Numerous studies on bank efficiency from the 1980s and 1990s came up with the
conclusion that commercial banks suffer from managerial inefficiency (see Berger et al.,
1993, for details). Given the hallmarks of the Saudi banking industry, a fundamental
question emerges; to what extent has the banking industry been efficient and productive
over time? The study attempts to seek an answer to this question in the discussion that
follows.

4. Research methodology
4.1. Data envelopment analysis
The theoretical development of DEA was initiated by Farrell (1957), but the model was
proposed by Charnes et al. (1978), known as Charnes, Cooper and Rhoades model with
constant returns to scale (CRS). It was extended by Banker et al. (1984) to allow for
variable returns to scale (VRS). The DEA measure compares each of the firms in the
sample with the best practice one known as a “peer or standard.” Thus, efficient banks
enjoy a DEA score of unity, while the inefficient ones receive a score of less than unity.
The present study adopts the use of DEA methodology since it has been identified
as a valuable analytical research instrument and a practical decision support tool for
a variety of reasons. First, the DEA is concerned with frontiers rather than the central
tendency measures of linear models. Second, this facilitates comparison among
decision-making units (DMUs) across efficiency and productivity. Third, the DEA has
been recognized for not requiring a complete specification for the functional form of the
production frontier nor the distribution of inefficient deviations from the frontier.
Rather, it requires general production and distribution assumptions only. Fourth, the
DEA has also proved to be useful in uncovering relationships that remain concealed for
other methodologies. Fifth, the DEA is capable of handling multiple inputs and outputs.
Sixth, the sources of inefficiency can be analyzed and quantified for each evaluated
DMU. Finally, the DEA enables us to construct a production technology frontier (Seiford
and Thrall, 1990).
The DEA methodology owes certain limitations to its credit. For instance, the
efficiency scores calculated under the DEA do not distinguish between noise and
inefficiency since no random error is assumed (Canhoto and Dermine, 2003). This tends
 to result in lower efficiency scores. As pointed out by Coelli et al. (1998), since the DEA Are Saudi banks
based Malmquist indices lack the assumption about distributional form, this holds back
conventional hypothesis testing.
productive and
efficient?
4.2. Malmquist productivity index
MPI is used as an output-oriented measure of change in total factor productivity, dealing
with the issue of maximizing output while keeping the input quantities as constant. 101
In addition to the studies mentioned earlier, the Malmquist approach has widely
been used to measure productivity change of financial sectors in various other studies.
For instance, Berg et al. (1992) applied this approach in their study of examining the
productivity of the Norwegian banking sector during the deregulation process of 1980s.
Likewise, Noulas (1997) also investigated differences in efficiency and productivity of
state vis-à-vis private banks in Greece during the period of 1991-1992. Canhoto and
Dermine (2003) examined bank efficiency and productivity in Portugal during the
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deregulation period of 1990-1995.

As presented by Färe et al. (1989), the MPI, is related to the use of distance functions.
The index depicts multi-inputs and multi-outputs production technology without a need
for data on input prices and specifying the behavioral assumptions like maximization of
profits or minimization of costs. Distance functions are grouped into output and input
distance functions. An output (input) distance function is defined as the reciprocal of the
maximum (minimum) proportional expansion (contraction) of the output (input) vector
given an input (output) vector (Färe et al., 1994). This study uses the output distance
functions where a production technology needs to be determined before an output
distance function is defined. Let a multiple-input and multiple-output production
technology at time t (R t) be defined as:

R t ¼ {ðx t ; y t Þ : x t _can_ produce _ y t }; t ¼ 1; . . . ; T; ð1Þ

where x t is an (N £ 1) input vector and y t is an (M £ 1) output vector. Thus, the output

distance function at time t can be defined as:

D to ðx t ; y t Þ ¼ inf{u : ðy t =uÞ1R t Þ}; t ¼ 1; . . . ; T: ð2Þ

The reciprocal of the maximum proportional expansion of the output vector y t, given
the input vector x t, under period t technology is defined as the distance function in
equation (2). This takes the value ¼ 1, if the output vector lies on the technology frontier,
implying that the production is technically efficient. However, if the value of distance
function is , 1, the production is technically inefficient. Färe et al. (1989) demonstrated
that the Malmquist total factor productivity index was characterized as the geometric
mean of two Malmquist indices and was defined as:

h i1=2
M o ðx tþ1 ; y tþ1 x t ; y t Þ ¼ M to ðx tþ1 ; y tþ1 x t ; y t Þ £ M tþ1
o ðx tþ1 tþ1 t
; y x ; y t
Þ
" #1=2 ð3Þ
D to ðx tþ1 ; y tþ1 Þ D tþ1
o ðx
tþ1 tþ1
;y Þ
¼ t
£ tþ1 t
;
t
D o ðx ; y Þ t D o ðx ; y t Þ
 IMEFM where D represents the inverse of the distance function introduced by Caves et al. (1982).
M to ðx tþ1 ; y tþ1 x t ; y t Þ £ M tþ1
o ðx
tþ1 tþ1 t
; y x ; y t Þ are the Malmquist indices measuring the
3,2 productivity change between periods t þ 1 and t and are defined as using technology at
time t and t þ 1, respectively. Färe et al. (1989) further pointed out to split the MPI
exhibited at equation (3) into two components. First, the efficiency change (Effch)
component, which measures how much closer to the production frontier the operating
102 unit is in period t þ 1 compared to period t and it is considered as the catching up (with
the best performance) effect. It reflects whether production is getting closer to or farther
away from the frontier. Second, the technical change (Techch) component, as a measure
of innovation, captures the change in production technology as a shift in the production
frontier. Thus, equation (3) is written as follows:
" #1=2
D tþ1
o ðx
tþ1 tþ1
;y Þ D to ðx tþ1 ; y tþ1 Þ D to ðx t ; y t Þ
M to ðx tþ1 ; y tþ1 x t ; y t Þ ¼ £ £ tþ1 ð4Þ
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D to ðx t ; y t Þ D tþ1
o ðx
tþ1 ; y tþ1 Þ D o ðx t ; y t Þ

The expression:

D tþ1
o ðx
tþ1 tþ1
;y Þ
t ;
D o ðx t ; y t Þ

in equation (4) represents the efficiency change (Effch) component i.e.:

D tþ1
o ðx
tþ1 tþ1
;y Þ
Effch ¼ t ; ð5Þ
D o ðx t ; y t Þ

while the second part in equation (4):

" #1=2
D to ðx tþ1 ; y tþ1 Þ D to ðx t ; y t Þ
£ ;
D tþ1
o ðx
tþ1 ; y tþ1 Þ D tþ1 t t
o ðx ; y Þ

reflects the technical change (Techch) component i.e.:

" #1=2
D to ðx tþ1 ; y tþ1 Þ D to ðx t ; y t Þ
Techch ¼ £ : ð6Þ
Dtþ1
o ðx
tþ1 ; y tþ1 Þ D tþ1 t t
o ðx ; y Þ

Thus, equation (4) can also be written as:

Tfpch ¼ Effch £ Techch: ð6aÞ

Tfpch is the total factor productivity change. Productivity growth takes place when
Mo(†) . 1. By the same token, efficiency improves when Effch . 1 and technical
advancement happens when Techch . 1. Based on the convictions of Färe et al. (1994),
the efficiency change (Effch) component can be written as the product of the two
constituents: the pure efficiency change (Pech) and scale efficiency change (Sech).
 The equations for the Pech and Sech could be written as follows: Are Saudi banks
D tþ1 tþ1 tþ1 productive and
o ðx ; y jVRSÞ
Pech ¼ t ð7Þ efficient?
D o ðx ; y t jVRSÞ
t

and:
" #1=2 103
D to ðx t ; y t jVRSÞ D tþ1 ðx tþ1 ; y tþ1 Þ
Sech ¼ t £ tþ1o : ð8Þ
D o ðx t ; y t Þ D o ðx tþ1 ; y tþ1 jVRSÞ

In equation (8) above, Do(†jVRS) shows the distance functions calculated under the
assumption of VRS. A value of Sech . 1 indicates that the operating unit has become
more scale efficient. Thus, equation (5) can also be interpreted as:
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Effch ¼ Pech £ Sech: ð8aÞ

The MPI at equation (4) is calculated by solving four linear programming (LP) problems,
each corresponding to each of the four distance functions. These are:
Dto ðx t ; y t Þ; D to ðx tþ1 ; y tþ1 Þ; D tþ1 t t
o ðx ; y Þ, and D o ðx
tþ1 tþ1 tþ1
; y Þ. As per Färe et al.
(1994), these distance functions are calculated by using the fact that the output distance
function is reciprocal to output-based measurement of TE by Farrell (1957), assuming
a constant return to scale. Seiford and Thrall (1990), Färe and Grosskopf (1996),
and among others, offer a good literature review on this subject. The distance function
D to ðx t ; y t Þ for each k0 ¼ 1, . . . , K and can be calculated through a LP problem, shown
as below:

0 0
21 0
D to ðx k ;t ; y k ;t Þ ¼ max u k ; ð9Þ

Subject to:
0 0
X
K
0
uk y m
k ;t
# z k;t y km ;t m ¼ 1; . . . ; M ;
k¼1

X
K
0
z k;t xk;t k ;t
n # xn n ¼ 1; . . . ; N ;
k¼1

z k;t $ 0 k ¼ 1; . . . ; K;
where k ¼ 1, . . . , K banks producing m ¼ 1, . . . , M outputs, y k;t m , at each time period
t ¼ 1, . . . , T. These outputs result from the use of n ¼ 1, . . . , N inputs, x k;t
n , and z
k;t

reflects the level to which a particular bank is utilized in production. By the same
analogy, the other three distance functions are calculated by substituting the
appropriate index, based on t or t þ 1. In order to ascertain the decomposition of the
efficiency change (Effch) Component 5 into the pure efficiency change (Pech) Component
7 and the scale efficiency change (Sech) Component (8), the calculation of two more
distance functions is needed. These include: D to ðx t ; y t jVRSÞ and D tþ1
o ðx
tþ1 tþ1
; y jVRSÞ
which need to be calculated under theP VRS technology as reflected by the functions. This
can be obtained when the restriction K k¼1 z
k;t
¼ 1 is added to the LP problem in Model 9.
 IMEFM 4.3. Technical efficiency
3,2 TE reflects the ability to transform multiple resources into multiple financial services
(Sathye, 2001). Being technically efficient means to minimize inputs at a given level
of outputs, or maximize outputs at a given level of inputs. TE can be split into PTE and
SCE. PTE exhibits improvements in productivity solely resulting from managerial and
organizational skills at banks leading to an efficient use of inputs. SCE is the ratio of
104 TE calculated under the assumption of CRS to TE calculated under the assumption
of VRS (Färe et al., 1985). It reflects how close an industry is to the most productive scale
size. A firm may be scale inefficient if it exceeds or is lagging behind the most productive
scale size. TE estimates 0
of Saudi
0
banks are based on Model 9. As per Coelli et al. (1998),
the expression D to ðx k ;t ; y k ;t Þ represents the output-oriented TE measure that varies
between zero and one; where one represents efficient bank and zero otherwise.
The assumption of CRS technology in Model 9 is relaxed to those PK ofk;tVRS and
non-increasing
PK k;t returns to scale (NIRS) by allowing the restrictions of k¼1 z ¼ 1 and
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k¼1 z #
0
1, 0
respectively. These 0
result 0
into two more efficiency measures based
on D to ðx k ;t ; y k ;t jVRSÞ and D to ðx k; t ; y k; t jNIRSÞ, where the former represents PTE.
The SCE estimate is described below:

0 0
D to ðx k ;t ; y k ;t Þ
SCEk 0 ¼ ; ð10Þ
D to ðx k 0 ;t ; y k0 ;t jVRSÞ

0 0 0 0 0 0
Dto ðx k ;t ; y k; t Þ # D to ðx k; t ; y k; t jNIRSÞ # D to ðx k; t ; y k; t jVRSÞ # 1, signifying that the
SCEk 0 # 1. However, if SCEk 0 , 1, bank k 0 is scale inefficient due to either decreasing
t k; 0 t k ;0 t t k; 0 t k; 0 t
returns0 to scale 0
(DRS) like D0 o
ðx 0
; y jNIRSÞ ¼ D o ðx ; y jVRSÞ or IRS since
D to ðx k; t ; y k; t jNIRSÞ , D to ðx k; t ; y k; t jVRSÞ:

4.4. Model specification and data

To conduct efficiency and productivity analysis in banking, inputs and outputs
need to be specified since the nature of banking inputs and outputs is different from
those of manufacturing firms. As a result, defining a production function for banking
organizations is more mechanical than that of their manufacturing counterparts. There
exist two approaches to measure the flow of services provided by banks; the production
approach and the intermediation approach. The production approach considers banks
as production units utilizing their inputs like labor and capital for providing various
financial services to their customers. Studies by Sherman and Gold (1985), Ferrier and
Lovell (1990), and Fried et al. (1993) have adopted this approach in their studies. As
per intermediation approach, banks are regarded as financial intermediaries, which
convert deposits into loans and investments. Studies by Berger and Humphrey (1991),
Jackson et al. (1998), Avkiran (1999), Sathye (2001), and Sturm and Williams (2004) have
taken up this approach. From the viewpoint of the present study, a production
perspective is a complement to the intermediary function of banks. The performance of
banks on the intermediary front reflects the performance from a production perspective
as the former is a by-product of the latter. Based on this conviction, this study adopts the
intermediation approach where financial institutions like banks are perceived to be
manufacturing units, employing inputs such as interest and non-interest expenses,
to produce the outputs of net interest income and non-interest income.
 The study is based on a sample of nine out of 11 local commercial banks[4] operating Are Saudi banks
in Saudi Arabia during the period of 2000-2006[5]. Some new banks[6] have also entered productive and
the banking sector during recent years but for data constraints, these were not included
in the study. Although some foreign banks do exist in the country, their scope of efficient?
operation is limited to branch-level only. For such reasons, these banks were not
included in the study. Data for the study were obtained from the annual reports of these
banks and from SAMA, which is the regulator of commercial banks in the Kingdom. 105
The inputs employed in the model are:
.
interest expenses; and
.
non-interest expenses (which are, in fact, operating expenses).
while:
.
net interest income; and
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.
non-interest income are used as outputs.

Thus, the study is an attempt to estimate the efficiency of banks in converting costs
into revenues.
Both interest and non-interest expenses are important determinants of bank
efficiency and productivity. A relatively lower level of non-interest expenses to total
expenses is likely to result in an efficient and productive banking system. Similarly,
ability to generate more and more income from interest and non-interest sources is
expected to strengthen such drive of the banks. Based on these theoretical strands and
extant literature on bank efficiency and productivity, the choice of inputs and outputs
was determined. Table III exhibits descriptive statistics for variables used as inputs and
outputs[7].

5. Empirical results
5.1. Technical efficiency
TE measures are calculated for each bank in each year of the period 2000-2006 based on
the DEA model. Table IV exhibits the average levels of TE, PTE, and SCE measures. As
proposed by Sturm and Williams (2004), the SCEs are calculated through converting IRS
values by 2 minus the original scores while leaving the scores for decreasing and CRS
as unchanged. Hence, the average SCE score of . 1 is expected to reflect an IRS on
average, , 1 would exhibit decreasing returns to scale on average and ¼ 1 would show
a CRS on average.

Variables Mean SD Minimum Maximum

Output variables
Net interest income 12,21,003 10,17,497 0 43,00,962
Non-interest income 12,69,334 17,69,141 64,790 95,09,898
Input variables Table III.
Interest expenses 8,62,152 7,63,187 0 29,54,768 Descriptive statistics of
Non-interest expenses 10,00,685 6,39,257 73,290 23,49,331 variables used in the
study for the period
Notes: SD, standard deviation; variables used are in thousands Saudi riyals 2001-2006
 IMEFM Looking at results of the model, it appears that the banks are operating below optimal
3,2 levels of TE and its components, i.e. PTE and SCE. This signals the fact that Saudi banks
are less efficient in their drive for converting costs into revenues. One of the causes for
this phenomenon could be the higher levels of initial costs on technology and other
infrastructure by banks during these years. Results on TE reveal that the average output
levels could have been increased by 47 percent while still using the same levels of inputs.
106 In terms of technical inefficiency statistics, the average level of TE for banks in the
Kingdom stands at 88.7 percent[8], a substandard performance on the efficiency fronts.
Similarly, the inefficiency levels of PTE and SCE are more pronounced in terms of their
levels. Thus, the SCE component represents a larger source of average technical
inefficiency (49.3 percent) compared to the pure technical inefficiency level (44.2 percent)
on average. These findings are on the contrast with the findings of Grigorian and Manole
(2005) for banks on Bahrain.
The TE and its components exhibit lower levels in the year 2001. This might be due
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to the receding oil prices and the contraction of OPEC quotas for oil production during
the period 2000-2002. The profitability indicators (return on equity (ROE) and return on
assets (ROA)) in Table II replicate the same trend. The revenue-focused model also
reflects the effects of an economic slowdown in the Saudi economy emerging out of
volatility across the hydrocarbon sector. The effect of oil price reduction appears to be
instantaneous on levels of TE and its components in the model. This can be considered
as logical since banks, on average, appear to be earning higher income from non-interest
revenues (Table III) part of which stems from trade finance. Effects of oil price decline are
also dominant among results for the years 2004 and 2006. Since Saudi Arabia is an
oil-based economy, the relationship between oil prices and income generating activities
of banks cannot be ignored. However, it would be naı̈ve to associate the inefficiency of
the banking system solely with the oil price trends. Factors like input prices, high levels
of initial capital outlays, decreasing returns to scale, and regulation also need to be taken
into account. Although banks appear to be profitable in their operations as disclosed by
the profitability indicators in Table II yet making efficient use of inputs, e.g. interest and
non-interest expenses, still stands as an unfulfilled dream for them.

5.2. Productivity change

This section presents results on changes in total factor productivity as measured by the
Malmquist index. The change in total factor productivity (Tfpch) can be attributed
either to an efficiency change (Effch) or technological change (Techch) or even both.
An efficiency change is further associated with a change in pure efficiency (Pech) or scale
efficiency change (Sech) or both. The average annual values of Effch, Techch, Pech,

Year TE PTE SCE

2001 0.28 0.48 0.43

2002 0.46 0.71 0.59
2003 0.68 0.82 0.80
Table IV. 2004 0.45 0.62 0.62
Average DEA efficiency 2005 0.74 0.82 0.87
scores for the period 2006 0.54 0.73 0.69
2001-2006 Period average 0.53 0.69 0.67
 Sech, and Tfpch for the years 2001-2006 are reported in Table V. All these indices are Are Saudi banks
relative to the preceding year. For example, results for the year 2001 are based on data for productive and
the year 2000 and so on.
Viewed from the perspective of converting costs into revenues, growth in average efficient?
productivity emerged at 33 percent during the period 2001-2006. Both efficiency (catching
up) and technological changes shifted out the efficiency frontier leading to an increase in
productivity. The technological change supported the average growth in productivity by a 107
much larger degree (205 percent) compared to the efficiency change. This reflects that
computerization and automation of financial transactions, has significantly increased the
productivity of banking industry in the Kingdom. The average efficiency change of 60
percent surfaced out of both the changes in Pech and Sech in the model. These findings are
in line with those by Penny (2004) for Australian banks.
The banks managed to increase their productivity by 55 percent in the year 2001,
where contribution from technological change was immense even with an efficiency
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regress of 88 percent. This might be attributed to the swift embrace of new technology
by Saudi banks in the new millennium. The adoption of new technology allowed the
banks to increase their productivity but the occurrence of large adjustment outlays,
related to the new technology adoption, resulted in a deterioration of TE. Between
the years 2003 and 2006, productivity change was subject to swings, the same being the
case with TE levels in Table IV. The swings in efficiency and productivity can be linked
to a number of reasons. First, to structural attributes of the economy in terms of its
pervasive dependence on the hydrocarbon sector. Second, such swings might ensue in
a situation where pioneer banks tend to adopt the technology at a faster pace, while those
taking a cautious approach might lag behind. Third, the occurrence of technological
progress, might have shifted the existing efficiency frontiers rightward, leaving banks
as technically inefficient on average, even though the average productivity did increase.
Results on TE and productivity growth for individual banks[9] (not reported here)
revealed that the smallest bank (ranked in terms of assets) appeared as the most efficient
with a simultaneous increase in productivity too. This alludes to the fact that smaller
banks demonstrate superior efficiency and productivity patterns. This is consistent
with the findings by Al-Muharrami (2008) for GCC banks, and Galagedera and
Edirisuriya (2004) for Indian banks but is in contrast to the study by Demir et al. (2005).
However, this result needs to be viewed with caution since the sample size of the study
is limited.

Year Effch Techch Pech Sech Tfpch

2001 0.12 12.93 0.20 0.58 1.55

2002 4.86 0.37 3.89 1.25 1.80
2003 2.11 0.46 1.22 1.73 0.97
2004 0.61 0.72 0.89 0.69 0.44
2005 1.50 1.51 1.02 1.47 2.27
2006 0.40 2.33 0.46 0.86 0.93
Period average 1.60 3.05 1.28 1.10 1.33
Table V.
Notes: Effch, efficiency change; Techch, technological change; Pech, pure efficiency change; Sech, Malmquist indices
scale efficiency change; Tfpch, total factor productivity change (annual averages)
 IMEFM 6. Policy implications and conclusions
3,2 This paper has investigated the DEA efficiency and productivity of banks in an
economy that is heavily dependant on the hydrocarbon sector. The DEA results indicate
that both the scale and pure technical inefficiencies are leading to technical inefficiency.
The results of MPI reflect an improvement in the average productivity of banks
resulting from both the efficiency and technological changes. However, the contribution
108 of technological change to productivity gains was higher than that by the efficiency
change. This reveals the fact that banks in the Kingdom have not only succeeded to catch
up with the best performance, but have also exploited the technological advancements.
The results of the study also indicate that for TE (Table IV) and for components of MPI
(Table V), there is a definite randomness between 2001 and 2006 with TE and
productivity increasing in some years while decreasing in other years. This might be
more likely an outcome of changes in oil prices and production quotas.
The study leads to some useful policy implications for the countries with heavy
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dependence on a single revenue-generator like the hydrocarbon sector in the Kingdom.

First, the lower scores on TE and swings across productivity in Tables IV and V call for
an improvement towards input utilization and operational scales of banks in the
Kingdom. Although the banks are making an enhanced and proficient use of technology,
and seem to be catching up with the best practices, they fail to line up across the frontiers.
Second, banks in the Kingdom need to broaden their investment horizons and enrich
their service portfolios to minimize their risks and maximize returns. Third, the banks
need to adopt a global perspective that would lead them towards superior investment
strategies, advanced managerial techniques, and provision of better quality and
extended services to their clients. This would enable them to reach efficiency frontiers
while keeping productivity growth intact. Fourth, countries like Saudi Arabia need to
diversify their sources of GDP both nationally and internationally. This would enable
them to avoid the effects of swings stemming from the changes in oil prices and quotas.
Finally, there remains a need to adopt a shift in the paradigm of existing monopolistic
type of banking sector to a competitive one that would enable the banks to look for
optimality and competitiveness. Changes taking place both at national and international
levels demand for a competitive and efficient banking sector in the Kingdom. These
include factors like new technology adoption by commercial banks and the joining of the
World Trade Organization by the Kingdom. Results on TE suggest that there exists a
great room for improvement by banks to reach the efficiency frontiers. Positive changes
on catching up and technological advancements augur well for the sector.
The study managed to explore the critical issues of TE and productivity change
across the banking sector in the Kingdom. The question, whether small banks are more
productive and efficient vis-à-vis large banks, remains unanswered. Likewise, to what
extent the changes in oil prices and revenues affect the efficiency and productivity of
banks, a second-stage regression of efficiency on oil prices and revenues along with
other variables would help in calculating the degree of impact. However, these are the
agenda for future research.

Notes
1. By the end of year 2008, the total number of commercial banks in Saudi Arabia stood at 12,
excluding foreign banks with a branch status only (SAMA, 2008).
 2. These include mainly the services fee, income from exchange, trading, dividends and Are Saudi banks
realized gains on investments, etc.
productive and
3. These represent mainly the salaries and employees benefits, rents, depreciations, general
and administrative expenses and provision for credit losses, etc. efficient?
4. These banks were selected based on availability of consistent data for the whole period of
analysis.
5. At time of start of this research, the latest available data for the banks in Saudi Arabia was
109
until the year 2006.
6. These include Bank Albilad and Alinma Bank, which started their operations in the year
2005 and 2008, respectively, making the total number of local commercial banks as 12 in the
year 2008.
7. Since Islamic banks in the Kingdom do not enter into interest-based activities, as a result, the
minimum values for data across net interest income and interest expenses appear as zero.
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8. This is determined by dividing the optimum level of 1 with the TE level achieved by the
banks, i.e. 88.7 percent ¼ 1/0.53.
9. Can be had from the author on request.

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 IMEFM About the author
Mohammad Hanif Akhtar earned his PhD in the area of international business from the University
3,2 of Leeds, UK. His research interests mainly fall in the area of international business and bank
management. Akhtar is currently leading the Department of Finance and Accounting at Prince
Sultan University, Riyadh, KSA. He is handling courses in areas of insurance, real estate and
financial markets. His teaching experience is stretched over a period of 19 years across Pakistan,
UK, and Saudi Arabia. He has also availed a fellowship at Leeds University Business School
112 (LUBS) of the University of Leeds, UK under the Charles Wallace Trust/British Council fellowship
scheme. He is a fellow at LUBS, University of Leeds, UK. Mohammad Hanif Akhtar can be
contacted at: mhakhtar@fnm.psu.edu.sa
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