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Conventional
Competition between and Islamic
conventional and Islamic banks in banks in
Malaysia
Malaysia revisited
Rafik Harkati, Syed Musa Alhabshi and Salina Kassim
IIUM Institute of Islamic Banking and Finance,
International Islamic University Malaysia, Kuala Lumpur, Malaysia Received 10 September 2019
Revised 1 November 2019
3 February 2020
20 April 2020
Accepted 27 April 2020
Abstract
Purpose – This paper aims to assess the nature of competition between conventional and Islamic banks
operating in Malaysia. It is an effort to enrich the existing literature by offering an empirical compromise on
the differences in the results of studies related to competition between the two types of banks.
Design/methodology/approach – Secondary data on all banks operating in Malaysia’s diversified
banking sector is collected from the FitchConnect database for the period 2011-2017. A non-structural
measure of competition (H-statistic) as informed by Panzar–Rosse is used to measure the competition between
conventional and Islamic banks. Panel data analysis techniques are used to estimate H-statistic. Wald test for
the market structure of perfect competition/monopoly is used to affirm the validity and consistency of the
results.
Findings – The findings of this study signify that the Malaysian banking sector operated under
monopolistic competition during the period of study. The long-run equilibrium condition holds for the
Malaysian banking sector. Competition among conventional banks is more intense than that among Islamic
banks. Financial reform endeavours of Bank Negara Malaysia (BNM) along with the liberalisation wave of the
financial system were successful in promoting competition, rendering the financial system contestable,
resilient and dynamic.
Practical implications – Regulators and policymakers may find the results beneficial in terms of
rethinking the number of banks operating in the Islamic sector. The number of banks, however, is not the only
determinant of competition in the banking sector. Implications of competition change for stability and risk-
taking behaviour of banks should be considered.
Originality/value – Within the context of Malaysia’s diversified banking system, given the contradictory
results reported in studies on competition, this study is an effort to provide a plausible middle ground. It
suggests a possible answer as to why competition nature has not changed since the policy change initiatives
of BNM, namely, banks merger, expansion of Islamic banking operation scope and liberalisation process.
Keywords Competition, Panzar–Rosse, Islamic banks, Conventional banks, Diversified banking system
Paper type Research paper

1. Introduction
Structural change takes place when firms change their business operations because of
changing economic conditions. The implications of the structural changes for bank
operations depend on the degree of competition within the banking market. Malaysia’s
banking system is a diversified banking system that has undergone several
transformations. Structurally, the Malaysian banking market has experienced four major
structural-change processes, namely, the application of the Islamic banking system (Husain,

Journal of Islamic Accounting and

Business Research
We would like to extend our gratitude to the three anonymous reviewers for their highly appreciated © Emerald Publishing Limited
1759-0817
insightful comments and suggestions that helped improve and clarify this manuscript. DOI 10.1108/JIABR-09-2019-0176
JIABR 2002), consolidation process (Abdul Majid and Sufian, 2007), liberalisation and globalisation
(Mokhtar et al., 2008) and technological advancement (Bank Negara Malaysia, 1999).
These processes exposed Malaysian banks to greater competition from foreign and non-
bank financial intermediaries. The changes in market competition are a result of many
structural changes, which led to a transformation in the number and type of financial
institutions and their range of operations/activities. The market structure has changed
significantly as a result of liberalisation that facilitated the entry of foreign banks into the
Malaysian banking sector, which in turn, intensified competition among banks at the local and
global levels. The implementation of advanced technology, in turn, paved the way for banks to
extend their range of operations in the market, especially in terms of services. Banks that adopt
advanced technology have a greater capacity to compete, retain or increase their market share.
Accordingly, the present study assesses the competition in Malaysia’s diverse banking sector
within and between conventional and Islamic banks. The study sheds light on whether
competition among Islamic banks has improved compared to competition among conventional
banks. This study enriches the studies that focused on the conventional sector (Casu and
Girardone, 2006; Abdul Majid and Sufian, 2007; Sharma and Bal, 2010). Nonetheless, two very
recent studies on the diversified banking system of Malaysia reported contradicting results
despite the fact that the sample and period of study are the same. Ibrahim et al. (2019) and
Mohammed et al. (2018) examined competition between conventional and Islamic commercial
banks over the same period, namely, 1997-2016 and 1997-2015, respectively. However, they
reported contradicting results. Ibrahim et al. (2019) provided evidence that conventional
commercial banks, to a certain extent, are more competitive than Islamic banks. By contrast,
Mohammed et al. (2018) maintained that competition among Islamic commercial banks is more
intense than that among conventional banks. Unlike these two studies, this study considers all
banks operating in the Malaysian banking industry, regardless of their type. This is an effort to
meet these researchers halfway in terms of their empirical results. In addition, the study
investigates the most elastic input prices (sensitive to outputs) that contribute to competition for
both Islamic and conventional banks. It contributes to the literature by assessing competition
within and between the two types of banks by extending the sample considering all banks
operating in Malaysia.
The remainder of the paper is arranged as follows. Section 2 presents the changes that have
transpired in the Malaysian Islamic banking sector. Section 3 reviews the literature relevant to
competition in the banking sector and its measures. Section 4 details the data collection methods
and analytical tools. Section 5 provides a comprehensive discussion of competition estimates as
well as empirical comparison of competition condition between and within Islamic and
conventional banking sectors. Section 6 concludes the study and includes policy implications.

2. Literature review
Fundamentally, this study focuses on competition within a diversified banking system. The
literature is limited to the context of Malaysia’s banking system. It sheds light on the
structural changes the banking system has undergone and presents the approach widely
used to measure competition.

2.1 Structural changes in the Malaysian banking sector

The banking industry in Malaysia has undergone accelerated liberalisation resulting in a
rapid expansion in business reflected in the immense increase in the portfolio of loans and
operations. Given the robust principles and local demand within Malaysia’s banking sector,
Malaysian banks have expanded their operations to foreign markets despite the negative
indirect effects of the US subprime crisis (Saiti et al., 2016).
 A promising initiative to motivate mergers of small-sized local banks, a two-tier banking Conventional
system was introduced by Bank Negara Malaysia (BNM) in the 1990s. This marked the onset and Islamic
of the consolidation process in the Malaysian banking sector (Bank Negara Malaysia, 1999).
Nevertheless, this initiative was unsuccessful as very few mergers were carried out[1] to
banks in
capitalise on the advantages of the tier-one banking group status (Sufian, 2007). Only three Malaysia
banking mergers were awarded the tier-1 status. Sufian (2007) stated that the smaller banks
with the tier-2 status had increased their capital to qualify for tier-1 status. Further, to
guarantee sufficient return on capital, banks with considerable tier-2 have been lending
unwisely and, as a result, endured significant losses during the Asian financial crisis (Sufian,
2007). In the aftermath of the 1997 Asian financial crisis, and to scale down the likely effects of
systemic banks upon the banking sector, tight measures were adopted to compel incorporated
local banks to merge (Bank Negara Malaysia, 1999). Consequently, a further merger plan was
introduced, where local banking institutions were required to merge and appoint a leader (Bank
Negara Malaysia, 1999). In response to this plan, ten domestic banking groups were merged.
Despite this, BNM stated that it would still take part directly to single out partners if banks do
not manage to accomplish the mergers. Ten anchor banks were chosen, and each bank
possessed a minimum shareholders’ fund of RM 2bn and an asset base of at least RM 25bn
(Bank Negara Malaysia, 1999). The number of local banks declined considerably as a result of
the formation of these 10 banking groups to only 29 banking institutions. The result was ten
finance companies, ten commercial banks and nine merchant banks.
Malaysia’s banking sector witnessed considerable changes in market structure in the
aftermath of the consolidation process. In this regard, the consolidation process was marked
as a structural amendment of the local banking sector. The number of banks dropped after
the consolidation process, and the market became more concentrated. Horizontal mergers
among banks characterised the Malaysian banking sector’s consolidation, which caused
overlapped market partition, leading to the creation of many chief banks and/or financial
holding companies, and hence a broad distribution of bank size.
The financial landscape in Malaysia has witnessed dramatic changes. Malaysia has
successfully implemented a diversified banking system. Malaysia’s Islamic banking is
unique because of it being horizontally and vertically institutionalised into social, economic
and political institutions. The width and depth of integration are parallel to that of
conventional banking. Islamic banking has gained its importance and has been on an
advanced upward trend. As of 2000, the Islamic banking industry has experienced annual
growth at an average rate of 19% in terms of assets (Abdul Majid and Sufian, 2007). Based
on Table 1, the number of institutions in the Malaysian banking system landscape has
changed. The commercial banks decreased from 27 to 22 in 2006, then it remained constant
until the year 2010 where it increased to 23 participants, 25 in the year 2011, and from 2012
to 2017 the number was stable at 27 commercial banks. For investment banks, they
witnessed the entry of five participants, after that they decreased to ten participants. Islamic
banks increased from 6 participants in the year 2005 to 17 by the year 2017. This increase in
the number of Islamic banks was because of the introduction of Islamic banking
subsidiaries as well as allowing foreign banks to participate in the Malaysian
banking system. This signifies that the market share of Islamic banks in the Malaysian
banking system has increased, which has implications for competition and concentration.

2.2 Panzar–Rosse approach: theory and evidence

The Panzar–Rosse (P-R) approach is used in this study to measure competition. The P-R
technique depends on the presumption that banks will use distinguished pricing strategies
in response to changes in input prices (e.g. cost of funds [PF], cost of labour [PL] and cost of
JIABR capital [PK]) according to the market structure in which they operate. Hence, whether a bank
operates in a competitive environment or practices monopoly power can be deducted from
the analysis of that bank’s total revenue as it reacts to changes in input prices. The test is
extracted from an inclusive banking market model. It specifies equilibrium output and the
equilibrium number of banks by maximising profits at both industry and bank levels. Two
crucial suggestions are identified for this equilibrium model. Firstly, at the bank level, profit
is maximised where marginal revenue is equal to marginal cost:
Ril ðyi ; k; y i Þ  Cil ðyi ; fi ; qi Þ ¼ 0
Ril is the marginal revenue function; Cil is the marginal cost function; yli is the output of bank
i; k is the number of banks; y i and qi composed of exogenous variables that shift the bank’s
revenue and cost functions, respectively; and fi is a vector of bank i’s factor input prices. The
second suggestion is that the zero-profit constraint holds at the industry level:

Ri ðy ; k ; y i Þ  Ci ðy ; f ; qÞ ¼ 0

According to several studies (Claessens and Laeven, 2004; Yildirim and Philippatos, 2007;
Agoraki et al., 2011; Schaeck and Cihak, 2012; Hamza and Kachtouli, 2014), the proxy most
commonly used to evaluate the banking sector competing at the bank level is the P-R model,
which uses the H-statistic index. It was constructed by Rosse and Panzar (1977) and Panzar
and Rosse (1987). H-statistic is the addition of the input price elasticities of the reduced-form
revenue equation, which discloses the market contestability circumstances of the banking
sector. The input price elasticities represent the linkage between the returns and the input
prices. Therefore, it is possible to use these elasticities to examine how alterations in returns
appear when input prices change, and the estimation of the sum of these elasticities is
representative of the contestable behaviour within the banking sector. Casu and Girardone
(2006) stated that the test should be termed H-statistic given that it is calculated from a
reduced-form revenue equation and measures the total elasticity of revenue of the firm
regarding the firm’s factor prices that can be formulated as follows:
X
m
@R wki
i

k¼1
@wki Ri*

where Ri is the returns of the bank (income) i, wki is the input price for bank i and @Ri and
@wki are the changes in revenue and input prices, respectively. The variables marked with a

Year Islamic banks Commercial banks Merchant/investment banks Total number of institutions

2005-2006 6-10 27-22 10 43-42

2007-2008 11-17 22 14-15 47-54
2009-2010 17 22-23 15 54-55
Table 1. 2011-2012 16 25-27 15-13 56
2013-2014 16 27 12-11 55-54
Number of 2015-2016 16 27 11 54
institutions in the 2017 17 27 10 54
Malaysia banking
sector Source: Bank Negara Malaysia (2016)
star are the equilibrium values for these variables (Panzar and Rosse, 1987; Shaffer and Conventional
DiSalvo, 1994; Vesala, 1995; Bikker and Haaf, 2002). and Islamic
As shown in Table 2, the size of the H-statistic provides information on the contestable
behaviour of the market in question (Panzar and Rosse, 1987). When H # 0, it indicates that
banks in
the market is in a monopoly condition or a short-run conjectural variation oligopoly because Malaysia
an increase in input prices increases the marginal costs of the bank. This, in turn, reduces
the equilibrium output level and overall revenue (Panzar and Rosse, 1987; Vesala, 1995;
Shaffer, 1983). If the H-statistic value ranges between zero and one, i.e. 0 < H < 1, then the
market is running under monopolistic contestability conditions. Under these conditions, the
income experiences less increase proportionally to factor prices alterations as the demand is
not elastic (Panzar and Rosse, 1987). Eventually, for perfect contestability, the H-statistic is
equivalent to one, i.e. H = 1. Under this circumstance, an increase in input prices brings
about the exit of some banks from the market. This phenomenon takes place when an
increase in the average and marginal costs experienced by banks will not bring forth
alterations in the optimum output levels of individual banks as the demand is perfectly
elastic. The reduction in the number of banks in the industry results in a rise in demand and
output prices, and hence revenue and costs increase evenly, while the sector remains in a
long-run equilibrium (Panzar and Rosse, 1987).
Applying the P-R method necessitates that observations should be in long-run
equilibrium. Investigating the long-run equilibrium is based on the estimation of H-statistic
in a reduced form equation where revenues (dependent variable) are substituted with return
on assets (ROA) or return on equity (ROE). The generated H-statistics is anticipated to equal
zero in the long-run equilibrium, and negative otherwise. This supposition has been
vindicated in practice, that is, when risk-adjusted return rates are uncorrelated with input
prices in equilibrium. Nonetheless, the entry and exit of firms could be critical for
equilibrium validation. Therefore, equilibrium within this method is considered a serious
issue (Gutiérrez de Rozas, 2007). On the other hand, the long-run competitive assessment
necessitates increasing the marginal cost. This is a technical constraint on the presence of
long-run competitive equilibrium, rather than a shortcoming of the P-R method (Bikker et al.,
2012). Generally, this method is considered a useful approach when assessing conditions in
the markets as revenues are more likely to be observed compared to prices of output. In
addition, given that, presently, data availability is no longer a serious concern, all necessary
information used in the P-R model is obtainable from financial statements and various
databases, thereby rendering the approach more successful on the ground (Gutiérrez de
Rozas, 2007).

Parameter zone Contestable environment test

H#0 Market structure in this range is featured with either monopoly or perfectly colluding
oligopoly, as under these two situations the input prices (PL, PF and PK) increase lead to
increase in marginal costs, lessen equilibrium output and thereby scale down total firm
revenue
0 < H <1 Monopolistic competition
H=1 Contestability at its perfect stage, any rise in input prices give rise to both marginal and
average costs without changing the optimal output of any individual firm. It also means
natural monopoly in a perfectly competitive market or sales maximizing firm subject to
a breakeven barrier Table 2.
H=0 Equilibrium Interpreting the H-
H<0 Disequilibrium statistics of P-R
JIABR Even though the number of empirical studies on competition in the banking sector has seen
an increasing trend, it is still relatively scarce, particularly in countries that adopt a
diversified banking system. To this end, this study investigates competition in Malaysia’s
diversified banking system to provide evidence on two banking systems coexisting in the
same environment. Especially after the Islamic banking sector has seen considerable growth
and development in Malaysia, where it has been gaining more market power in the face of
the fierce competitive conventional sector. This approach differs between the studies (Abdul
Majid and Sufian, 2007; Fah and Ariff, 2017; Ibrahim et al., 2019) that investigated
competition, either at the banking sector level, focusing on commercial banks only, or by
using the ten largest banks in the banking sector. In addition, studies have focused on one
sector only, i.e. Islamic sector (Abdul Majid and Sufian, 2007; Mohammed et al., 2015) or
conventional sector (Gajurel and Pradhan, 2012; Sharma and Bal, 2010). Although, Hakim
and Chkir (2014) used concentration measures to measure competition, and Uddin and
Suzuki (2014) examined both banking systems, the study of both banking streams is still
limited, particularly for an emerging economy like Malaysia. Mohammed et al. (2018)
sampled all banks operating in the Malaysian banking system over the period from 1997 to
2013. Similarly, our study considers all Islamic and conventional banks operating in the
Malaysian banking sector for a comprehensive comparative analysis of both sectors over
the period from 2011 to 2017.
Four recent studies have addressed the topic of competition in the Malaysian banking
sector as a comprehensive comparative study between Islamic and conventional sectors.
The first study by Ibrahim et al. (2019) used 21 conventional and 16 Islamic commercial
banks for the period from 1997 to 2015. The Lerner index was used to measure competition.
Essentially, the Lerner index reflects the ability of banks to set their prices above the
marginal cost. In other words, it is the difference between output prices and marginal costs.
It is also used to detect technical changes in the cost function. They concluded that the
consolidation wave has not curbed the competitiveness capacity of banks. The competition-
stability view holds, especially for commercial banks. In other words, competition is a
strengthening mechanism for the stability of the banking sector. The Lerner index of the
Islamic banking sector was below that of its conventional counterpart, that is, Islamic
commercial banks are less contestable than their conventional counterparts. It is worth
mentioning that conventional banks reflect the competitiveness of the entire banking sector
because of their dominance over the sector in both size and number. Finally, both Islamic
and conventional banks experienced monopolistic completion during the study period.
The second study by Mohammed et al. (2018) is similar to Ibrahim et al. (2019) where the
period 1997-2016 was investigated. Both studies sampled commercial banks. However,
Mohammed et al. (2018) used the P-R method as a non-structural test. The dependent variables
used in estimating the P-R model are total revenues and income generated out of interest or
financing activities. The second dependent variable was used to check for robustness. The
study assessed the degree of competition in the Malaysian banking industry. It investigated
Islamic banks’ capability to cope with the fierce competition from their well-established
conventional counterparts. It was concluded that, in general, Islamic and conventional banking
sectors experienced monopolistic competition. Competition in the Islamic banking sector was
slightly higher than that in the conventional sector as compared to Ibrahim et al. (2019) where
the opposite was found. Throughout the study period, competition ranged between 0.253 and
0.931 for Islamic banks and between 0.153 and 0.871 for conventional banks. Regardless of
using different measuring techniques in assessing completion and given that the sample and
the study period are the same for both studies, it is surprising that the results are contradictory
in terms of competition level within the Islamic and conventional banking sectors. The results
are contradicting, yet still lend support to the monopolistic competition feature characterising Conventional
the Islamic and conventional sectors. and Islamic
The third study by Fah and Ariff (2017) is unlike the aforementioned two studies in sample
and period; only the largest 11 banks in the Malaysian banking industry were used in the study
banks in
covering the period 2006-2014. However, it used both techniques in assessing competition, Malaysia
namely, the P-R model non-structural test and Lerner Index. They argue that, as these 11 banks
make up 87% of the industry, investigating them is equivalent to investigating the entire
sector. Discordantly, the study concluded that neither perfect nor monopolistic competition was
prevailing during the study period. Competition appeared to be like a cartel with low H-
statistic. The Lerner index, which is a measure over time, indicates slowly increasing
competition perhaps owing to the learning effect from adjusting to post-consolidation realities.
The study argued that consolidation might lead to shape a cartel-like structure which is not
favourable because of misuse of market power in the name of stability.
The fourth study by Wahid (2017) used a sample of 37 banks, comprising 17 Islamic and 21
conventional banks. The P-R method was used to estimate competition. For the entire period,
both types of banks experienced monopolistic competition. Islamic banks were operating in a
more competitive environment compared to their conventional partners. When considering the
2008 financial crisis, Islamic banks were operating in a monopoly environment during the pre-
crisis period; however, their conventional counterparts were operating under monopolistic
competition. Therefore, conventional banks were experiencing a more competitive environment
compared to Islamic banks. On the other hand, during the crisis period, Islamic banks
approached perfect competition, whereas conventional banks continued to earn profit under
monopolistic competition. This indicates the superior competitiveness of the Islamic sector.
During the post-crisis period (2010-2013), conventional banks appeared to be operating in a
more competitive environment compared to Islamic banks.

3. Data and methodology

Annual bank-level data on all Malaysian banks covering the period from 2011 to 2017 is
collected from the FitchConnect database. The overall number of banks operating in the
Malaysian banking sector during the study period is 54, comprising 17 Islamic and 37
conventional banks. This gives a total of 362 yearly observations. Three banks are excluded
from the sample because of data unavailability.
The P-R model is applied to estimate contestability in the banking sector at three levels,
namely, industry, Islamic and conventional sectors. Unlike Bikker and Haaf (2002),
Claessens and Laeven (2004) and Shaffer (1982), who used the P-R model revenue test, we
use total income in estimating contestability. We do so because Islamic banks do not
generate profit from interest-based activities. The method is to gauge the impact of factor
prices on the observed equilibrium values of total income (TINC). TINC is the operating and
non-operating income and input prices are PF, PL and PK. Total loans to total assets (TA),
non-performing loans to TA, equity to TA and TA are used as bank-specific factors.
Following Sarkar and Sensarma (2016) and Maji and Hazarika (2018), we estimate
equation (1) to obtain the P-R H-statistic:
   
lnðTINCit Þ ¼ a þ b 1 lnðw1;it Þþ b 2 lnðw2;it Þþ b 3 ln ðw3;it Þ þ g 1 ln Y1;it þ g 2 ln Y2;it
   
þ g 3 ln Y3;it þ g 4 ln Y4;it þ « it : (1)
Where:
TINC = total income (operating þ non-operating income);
W1 = PL (personal expenses/TA);
JIABR W2 = PK (other operating expenditure/total asset);
W3 = PF (interest expenses/total deposit);
Y1 = degree of intermediation (total loans/TA);
Y2 = bank-specific risk (non-performing loans/TA);
Y3 = capital structure (equity/TA); and
Y4 = size/economies of scale (TA).
To conclude, the above analysis related to H-statistics based on both ordinary least squares
(OLS) and generalized least squares (GLS) is valid; equilibrium condition should be observed
in the long run. The logic behind this is that, in equilibrium, the dependent variable should
be uncorrelated with the input prices.
   
lnð ROAit Þ ¼ a þ b 1 lnðw1;it Þþ b 2 lnðw2;it Þþ b 3 lnðw3;it Þ þ g 1 ln Y1;it þ g 2 ln Y2;it
   
þ g 3 ln Y3;it þ g 4 ln Y4;it þ « it : (2)

Equilibrium condition in the banking sector is evaluated through the estimation of

equation (2) where ROA is used as the dependent variable. As ROA can take negative
values, we calculate the dependent variable as ROA = ln(ROA þ1). Equilibrium E-statistics
equals to b 1 þ b 2 þ b 3. It should be tested if E = 0 based on F-test. If the test rejects the
null, the market deviates from equilibrium. The notion underlying this test is that in the
equilibrium position, risk-adjusted rates of return should be equal across banks, and values
of ROA should be uncorrelated with the input prices.

4. Findings, analysis and discussion

4.1 H-statistics estimation results
Table 3 reports the descriptive statistics for all variables used in estimating H-statistics for
the three categories. At the sector level, the dependent variable, total income, shows a mean
of 1,469.80 and a standard deviation of 3,113.04 for all banks, which is considered very high;
this implies the disparity of the generated income across banks.
With regard to independent variables, it is apparent from the table that the high level of
disparity between banks as the standard deviation exceeds the mean. On the other hand, the
dependent variable shows a mean and standard deviation of 1,858.666 and 3,670.643, and
623.8638 and 674.3962 for conventional and Islamic banks, respectively. The disparity of
income for Islamic banks is lower than the conventional banks. This is attributed to the fact
that the number of conventional banks in the sample is considerably greater than the
Islamic banks, or because of the fact that conventional banks generate more income
compared to Islamic banks owing to their size and differences in the nature of business
activities. In addition, the high level of disparity between conventional banks in comparison
with Islamic banks is apparent from the table. Again, this is because of size, the number of
banks in each sector and nature of business.
Table 4 reports the estimated H-statistics for Islamic and conventional banks[2]. H-
statistics ranging between 0 and 1 implies a monopolistic competition. For the industry,
Islamic and conventional banks’ H-statistics values are found to be 0.66, 0.23 and 0.71,
respectively, in the OLS model. This denotes that for three categories, competition is
monopolistic. Islamic banks have a lower market power than conventional. The same result
is detected in the fixed effect model with H-statistics of 0.473, 0.5092 and 0.5798 for the
Islamic and conventional banks, respectively. Our findings are supported by previous
studies (Claessens and Laeven, 2004; Perera et al., 2006; Mensi, 2010; Sufian and Shah
Habibullah, 2013). The lower competition among Islamic banks is attributed to the different
Variable Mean Std dev. Min Max Obs
Conventional
and Islamic
Total income banks in
Banking sector 1,469.806 3,113.041 0 23,098.7 362
Islamic 623.8638 674.3962 5.39 3,752.3 114 Malaysia
Conventional 1,858.666 3,670.643 0 23,098.7 248
Personal expenses
Banking sector 368.8297 844.1257 0.27 6,128 362
Islamic 76.34675 108.4654 4.88 569.3 114
Conventional 503.2775 989.1421 0.27 6,128 248
Other operating expenditure
Banking sector 314.2639 626.8961 78.3 5,229.1 362
Islamic 208.5059 228.4533 2.27 1,234.9 114
Conventional 362.8785 736.8655 78.3 5,229.1 248
Interest expenses
Banking sector 1,079.29 2,141.363 0 14,954.1 362
Islamic 666.4056 840.977 4.71 4,995.1 114
Conventional 1,269.083 2,502.676 0 14,954.1 248
Total equity
Banking sector 4,572.643 9,657.897 22.1 75,183.6 362
Islamic 1,906.334 1,770.535 88.35 9,311.4 114
Conventional 5,798.286 11,406.2 22.1 75,183.6 248
NPL
Banking sector 2.70674 6.198685 0 66.23 362
Islamic 3.302895 7.620589 0 66.23 114
Conventional 2.432702 5.417592 0 47.45 248
Total loans
Banking sector 34,879.64 73,685.63 0 493,845.1 362
Islamic 20,805.02 29,712.5 47.51 163,555.1 114
Conventional 41,349.42 86,012.7 0 493,845.1 248
Total deposits
Banking sector 43,074.17 86,591.87 0 574,252 362
Islamic 25,354.44 31,856.08 115.05 182,691 114
Conventional 51,219.52 101,405.3 0 574,252 248
Total assets Table 3.
Banking sector 53,059.72 109,747.4 22.22 765,301.8 362
Islamic 28,531.9 34,696.93 212.84 202,495.1 114
Summary statistics
Conventional 64,334.6 129,024.9 22.22 765,301.8 248 of variables used in
P-R model for each
Note: Numbers are in 000,000; NPL = non-performing loans type of banks

religious and economic incentives. Islamic banks ought to consider and maintain Islamic
norms of behaviour such as the obligation to charge fair prices. Being conscientious and
submissive to Islamic principles, they are not restricted to charge burdensome prices.
Moreover, Islamic banks have incentives to deal with loans based on certain Shariah
principles compared to conventional banks and, hence face higher exposure to Shariah-
compliant and the moral hazard of borrowers. For multicollinearity and correlation matrix
of variables used in the P-R model, refer to Tables A1 and A3.
Total income is used as the dependent variable in the estimation[3]. The three
independent variables used in our study are input prices, namely, PL, PK and PF, which
JIABR Variable Whole sample Islamic Conventional

lnPL 0.2212*** 0.0912*** 0.5993***

lnPK 0.2734*** 0.4504*** 0.0313
lnPF 0.1611*** 0.3102*** 0.0868**
lnEQ/TA 0.0713 0.0542 0.0526
lnNPL/TA 0.0254*** 0.0249 0.0149**
lnTL/TA 0.0262* 0.0731 0.0214**
lnTA 1.0567*** 1.0171*** 1.0459***
Constant 1.0118*** 2.2565*** 0.5959***
Table 4. R2 0.9711 0.9836 0.9834
Results of panel data F-statistic 2,533.95*** 905.96*** 2,028.95***
H-statistics 0.6557*** 0.2315*** 0.7173***
analysis for H-
No. of obs 362 114 248
statistics (dependent
variable: total income Notes: ***, ** and * indicate significance level at 1, 5 and 10%, respectively; all variables are subject to
[OLS model]) Ln = natural logarithm

show a positive sign except for PF at the Islamic level. This implies that the increased costs
are associated with increased total income (output).
At all levels, all factor costs are statistically significant with two exceptions. Firstly, at
the conventional level where PK is not significant; and secondly, PF at the Islamic level is
the second main contributor to Islamic H-statistics with a negative impact of 0.31. The
major contributor to H-statistics for all banks comes from all input prices with slight
differences. For Islamic banks, the major contribution (of a high elasticity) comes from PK
with a coefficient of 0.45. In contrast, at the conventional level, the major contributor to H-
statistics stems from PL with a coefficient of 0.60. For Islamic banks, this is because Islamic
banks’ total income is very responsive to change in PK (capital for Islamic banks is
embodied in equity). For conventional banks, this is because of the fact that total income is
very sensitive to PL. It is likely owing to the reason that fee-based income demands a higher
level of talented labour. The same result was reported by Fah and Ariff (2017).
The impact of equity/TA on total income is positive but non-significant in the OLS model
at the three levels. However, at the banking sector level, in the fixed effect model (Table 5), it
indicates a significant positive sign at the 5% level. It is not only statistically significant but
also economically significant as the value of 0.1856 is the second-highest value among the
variables. This confirms theory prediction about well-capitalised banks having a lower cost
of bankruptcy owing to their ability to generate more income. On the other hand, in both
OLS and fixed-effect models, Islamic banks’ capitalisation is not significant. This is because
Islamic banks are not well-capitalised. For conventional banks, it shows significance at 10%
with a positive coefficient of 0.14. This confirms the superiority of conventional banks over
Islamic banks in terms of capitalisation contribution to competition.
Our results concur with previous studies. For example, Fah and Ariff (2017), where only
the 11 major banks are used in their study; Ibrahim et al. (2019), where only conventional
and Islamic commercial banks were considered; and Kadir et al. (2014), where only
commercial banks were used for the period from 1996 to 2009. These three studies reported a
positive association between total income and input prices. This present study is
distinguished from previous studies in a way that it considers all banks, and therefore
provides a comprehensive picture of competition in Malaysia. In addition, it investigates
how competition differs between Islamic and conventional banks regardless of the products
not being homogeneous across banks.
Variable Whole sample Islamic Conventional
Conventional
and Islamic
lnPL 0.316*** 0.0456 0.5069*** banks in
lnPK 0.088 0.6154*** 0.0054
lnPF 0.0685*** 0.1122 0.0675 Malaysia
lnEQ/TA 0.1856** 0.0261 0.14*
lnNPL/TA 0.0201*** 0.0589 0.0176
lnTL/TA 0.122*** 0.1571 0.1028**
lnTA 0.964*** 0.898*** 0.9674***
Constant 0.466 0.0349 0.1403
R2 0.80 0.766 0.8416
Breuch Pag 322.08*** 45.57*** 140.66*** Table 5.
Hausman 75.64*** 20.01*** 29.68*** Results of panel data
F-statistic 171.98*** 15.93*** 164.43***
H-statistics 0.473*** 0.5092*** 0.5798***
analysis for H-
No. of obs 362 114 248 statistics (dependent
variable: total income
Notes: ***, ** and * indicate significance level at 1, 5 and 10%, respectively; all variables are subject to Ln [fixed-effect model])

For non-performing loans that represent risk inclination, the coefficient signs for the three
categories are negative and very small with the exception of being insignificant for Islamic
banks. This suggests that the loan portfolio of banks is not risky. In addition, it suggests
that conventional banks do not engage in risky provisions. For Islamic banks, it is very clear
as it is prohibited to engage in extending loans on interest. For this reason, the coefficient is
small and insignificant.
The coefficients for TA are positive and statistically significant. It shows a very high
value for the three categories as TA are potentially the pillar of generating income.
Furthermore, it suggests that the size of banks is critical in terms of income generation.
Moreover, this implies that banks are efficient in using their assets to generate income.
Lastly, this gives further insights that banks in Malaysia are experiencing economies of
scale.
Finally, for the ratio of loans to TA, the coefficient shows a significant positive sign at all-
bank levels and conventional level. In contrast, for Islamic banks, the coefficient shows a
positive but insignificant sign. This implies that loans share in interest income to total
revenues, especially for conventional banks.
To sum up, during the study period, the Islamic banking market and conventional
market generated income under monopolistic competition. The estimated values of H-
statistic for the three categories indicate that competition among conventional banks is
higher compared to that among Islamic banks.
Based on Table 6 and Figure 1, the mean H-statistics value, which is an indicator of
banks’ reaction to changes in input prices, showed an increase in the first year, from 2011 to
2012, for all banks and conventional banks. It then increased slightly and steadily for the
remainder of the period. On the other hand, competition in the Islamic banking sector
decreased sharply along the period of study. This could be attributed to the size of Islamic
banks, the generated profit or external factors such as identical pricing strategies followed
by banks or economic conditions. In addition, Meslier et al. (2017) stated that Islamic banks’
competition is encountered by conventional banks via setting higher deposit rates,
especially when their market power is lower. They also adopt lower interest rates when their
market power is strong. These could have been some of the critical reasons behind the
decrease in Islamic banks’ competition.
JIABR Islamic and conventional banks in Malaysia were operating under monopolistic
competition. It is noteworthy that the market power of conventional banks is far higher than
that of Islamic banks. This result is supported by Ibrahim et al. (2019).
For the validation of our competition estimation, Kadir et al. (2014), using a sample of
Islamic and conventional commercial banks, stated an H-statistic of 0.27 for a study period
of 14 years (1997-2016). For Islamic banks, this result is a bit higher than our result (0.23)
because of the sample period and sample composition as we consider all banks regardless of
their core business. For conventional banks, H-statistics was reported to be 0.77 for the same
period. This differs slightly from our result (0.72) and might be attributed to the sample
period. However, both results do not differ much and still lend support to the condition of
monopolistic competition within both sectors.

5. Equilibrium condition in the Malaysian banking sector

Table 7 reports the equilibrium condition in the banking sector. It is evaluated through the
estimation of equation (2), where ROA is used as the dependent variable. As ROA can take
negative values, we calculate the dependent variable as ROA’ = ln(ROA þ1). We set
equilibrium E-statistics as being equal to b 1 þ b 2 þ b 3. We test if E = 0 based on F-test. If
the test rejects the null, the market is supposed to deviate from equilibrium. The notion
underlying this test is that, in the equilibrium position, risk-adjusted rates of return should
be equal across banks, and values of ROA should be uncorrelated with the input prices.
This method for examining if the observations are in long-run equilibrium condition is
already set in the literature (Shaffer, 1982; Molyneux et al., 1996; Claessens and Laeven,
2004; Schaeck et al., 2009). Table 7 presents the outcomes of regression and test. Based on
the Wald x 2 test value, we fail to reject the null hypothesis that H = 0, as to whether the
market is in equilibrium. Hence, as we fail to reject the null hypothesis, we conclude that
the Malaysian banking sector is in equilibrium in the long run, thereby supporting the
consistency and validity of our results. Further, the equilibrium condition holds when ROE
is used instead of ROA (see results in Table A2).

Sector 2011 2012 2013 2014 2015 2016 2017

Table 6. Banking sector 0.4471 0.5953 0.6245 0.6313 0.6406 0.649 0.6557
H-statistics (P-R Islamic 0.5191 0.5114 0.5086 0.4327 0.3137 0.2818 0.2315
model) Conventional 0.6090 0.705 0.7202 0.7281 0.7220 0.7181 0.7173

0.8
0.7
0.6
0.5
0.4
0.3
0.2
Figure 1. 0.1
Plots of H-statistic for 0
banks in Malaysia by 2011 2012 2013 2014 2015 2016 2017
category
H-stat BS H-stat Isl H-stat Con
Variable OLS Fixed Random
Conventional
and Islamic
lnPL 0.003* 0.004 0.002 banks in
lnPK 0.003 0.005 0.006
lnPF 0.02 0.03 0.03 Malaysia
lnEQ/TA 0.007 0.012 0.11
lnNPL/TA 0.002* 0.008 0.004
lnTL/TA 0.001 0.001 0.002
lnTA 0.001 0.020 0.001
Constant 0.13 0.44 0.18
R2 0.15 0.34 0.30 Table 7.
F-statistic/Wald test 2.27** (0.01) 0.50 (0.83) 6.45 (0.45) Panel regression
Hausman test 76.61 (p-value = 0.0000)
H-statistics 0.02 0.039 0.034
results for
No. of obs 362 362 362 equilibrium condition
for the Malaysian
Notes: * and ** indicate significance level at 1 and 5%, respectively; all variables are subject to Ln banking sector

6. Conclusion
Given the considerable structural changes the Malaysian banking sector has undergone, the
degree of competition at the industry, conventional and Islamic banking sector levels have
changed. This study investigates and compares competition within and between Islamic
and conventional banks over the period from 2011 to 2017. Equilibrium test is also
conducted to validate the equilibrium condition in the long run during the study period, and
therefore the consistency of the results. To this end, the P-R approach is applied using OLS
and GLS techniques.
The findings of the study revealed that the PL is a major contributor to competition
within the conventional sector, with a positive impact of 0.60. In contrast, within the Islamic
banking sector, PK and PF are found to be the main contributors to competition with 0.45
and 0.31 impact, respectively. In other words, these input prices signify higher elasticity to
total income. The values of H-statistic provided evidence of monopolistic competition
condition across the banking system. This is the case within both Islamic and conventional
sectors. The degree of competition within the conventional banking sector is higher and
therefore denoting a lower concentration within this sector.
These results concur with those of Weill (2011) who conducted a comparative study of
market power of both banking systems in 17 countries where both operate in the same
environment and found that conventional banks possess more market power than Islamic
banks. On the other hand, competition in the Islamic banking sector is lower than that of the
conventional, hence providing evidence that Islamic banking sector is still experiencing a
higher degree of concentration. The results are also in line with those reported by Ibrahim
et al. (2019). One possible explanation as to why monopolistic competition has remained is
that, in the long-run, new banks are attracted into the industry as a result of fewer barriers to
entry, in addition to good knowledge and an opportunity to differentiate. In addition, banks
in Malaysia are the price makers instead of price takers. In other words, the price elasticity
of demand is high. However, banks’ ability is ultimately offset as the demand for products is
facing high price elasticity. This implies that to increase their prices, banks need to be
efficiently able to distinguish their products from their rivals in terms of quality. Another
possible explanation is that, to some degree, the financial sector rent for incubating Islamic
banks in Malaysia might have been provided under a protective financial policy or
customary practices in pricing.
JIABR The findings of this study concur with those of Basri (2020) where he investigated the
impact of competition on concentration for Islamic banks in Malaysia. His study consisted of
16 Islamic banks covering the period between 2008 and 2015. Using P-R model, with total
revenues as a dependent variable, his results revealed that Islamic banks operated under
monopolistic competition conditions with a moderately concentrated market structure. It
also showed that the introduction of foreign Islamic banks stimulated competition along
with a decrease of concentration. Accordingly, financial reform endeavours of BNM along
with the liberalisation wave of the financial system were successful in promoting
competition, rendering the entire financial system contestable, resilient and dynamic.
The findings of this study have several important implications at the policy level. Firstly,
competition in the Islamic market needs to be promoted further, thereby paving the way to a
more competitive environment where banks will be more efficient and profitable in the face
of their conventional counterparts [“competition is the gymnastics of banks” (Padoa-
Schioppa, 2001)]. Accordingly, regulators and authorities may find the results beneficial in
terms of rethinking the number of banks operating in the Islamic sector. Secondly, the
number of banks is not the only factor that determines competition in the banking sector.
Entry and exit from the sector have been detected in the literature to be of considerable
importance in determining the degree of competition. BNM should consider the implications
of this change in competition which could have been brought about at the expense of other
banking characteristics. This structural change is anticipated to have implications for the
stability and risk-taking behaviour of banks. This puts forward, for future research, the
need to investigate the impact of this structural change on the stability and risk-taking
behaviour of conventional and Islamic banks.
Future research is encouraged to be undertaken on the entry restrictions and their impact
on competition. In addition, constraints on activities that banks can embark on, in turn, play
an important role in the decrease or increase of competition. Therefore, regulators and
policymakers may consider several factors when aiming at encouraging or discouraging
competition in the banking sector, as the case may be. Reasonable competition is beneficial
for banks in terms of investment and performance. However, extreme competition may
decrease generated profits, thereby leading to adverse consequences. Accordingly,
competition can be improved through effective and prudent merger and acquisition
strategies, improving operational cost efficiency, profit efficiency and diversification of
assets and liabilities, in addition to alleviating non-interest revenue. Researchers are
encouraged to investigate further the level of competition within and between Islamic and
conventional banks in Malaysia based on financing and deposit products.

Notes
1. There were only three banking mergers given the tier-1 institutions status: DCB Bank with
Kwong Yik Bank, DCB Finance with Kwong Yik Finance and United Overseas Bank with Chung
Khiaw Bank, resulting in both DCB Bank and Kwong Yik Bank being granted the tier-1
institutions status. Rashid Hussain Bank resulted out of a merger that took place between DCB
Bank and Kwong Yik Bank as the second largest bank, and later agreed to buy Sime Bank,
which underwent huge losses during the second half of 1997. By of the end of 1997, ten
commercial banks were given the tier-1 status.
2. The model does not suffer from multicollinearity issue as variance inflation factor (VIF) values
are less than 4 (Table A1).
3. Please see Table A3 for the correlation matrix.
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JIABR Appendix

Variable VIF 1/VIF

PL 1.80 0.56
PK 1.49 0.67
PF 1.03 0.97
EQTA 3.41 0.29
TA 2.58 0.387
Table A1. TLTA 1.21 0.83
Multicollinearity test NPLTA 1.19 0.84
using VIF Mean VIF 1.82

Variable OLS Fixed Random

lnPL 0.002 0.009 0.005

lnPK 0.00003 0.0002 0.004
lnPF 0.031 0.05 0.04
lnEQ/TA 0.41*** 0.06 0.11**
lnNPL/TA 0.006** 0.01 0.008
lnTL/TA 0.006*** 0.0008 0.006
lnTA 0.014*** 0.015 0.01**
Table A2. Constant 0.27 0.52 0.35
Panel regression R2 0.32 0.32 0.31
results for F-statistic/Wald test 29.78*** (0.000) 0.87 (0.54) 7.23 (0.41)
Hausman test 33.61 (p-value = 0.0000)
equilibrium condition H-statistics 0.02 0.058 0.038
for the Malaysian No. of obs 362 362 362
banking sector using
ROE Notes: *** and ** indicate significance level at 1 and 5%, respectively; all variables are subject to Ln

TI/TA pl pk pf eq/ta npl/ta tl//ta

pl 0.18*** 1.0000
pk 0.1508*** 0.4696*** 1.0000
pf 0.0368 0.1073** 0.0795 1.0000
eq/ta 0.5621*** 0.5926*** 0.4149*** 0.0404 1.0000
npl/lta 0.2634*** 0.0669 0.1917*** 0.0046 0.2065*** 1.0000
Table A3. tl/ta 0.3338*** 0.1866*** 0.0142 0.1005* 0.3326*** 0.0866 1.0000
Correlation matrix of ta 0.9503*** 0.3966*** 0.3606*** 0.0390 0.7657*** 0.1810*** 0.3564***
the variables used in
P-R model Note: ***, ** and * indicate significance level at 1, 5 10%, respectively; and all variables are in Ln
About the authors Conventional
Rafik Harkati is a PhD candidate at the International Islamic University Malaysia, Institute of Islamic and Islamic
Banking and Finance. His areas of interest include finance and Islamic finance. Rafik Harkati is the
corresponding author and can be contacted at: rafikharkati@gmail.com banks in
Syed Musa Alhabshi is an Associate Professor at the International Islamic University Malaysia, Malaysia
Institute of Islamic Banking and Finance. His areas of specialisation include accounting, finance, risk
and governance of Islamic financial institutions.
Salina Kassim is an Associate Professor at the International Islamic University Malaysia, Institute
of Islamic Banking and Finance. Her areas of specialisation include financial economics and Islamic
finance.

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