Int. J. Monetary Economics and Finance, Vol. 11, No.

4, 2018 363

Price efficiency on Islamic banks vs. conventional

banks in Bahrain, UAE, Kuwait, Oman, Qatar and
Saudi Arabia: impact of country governance

Fakarudin Kamarudin*
Faculty of Economics and Management,
Universiti Putra Malaysia,
43400 Serdang, Selangor Darul Ehsan, Malaysia
Email: fakarudinkamarudin@gmail.com
Email: fakarudin@upm.edu.my
*Corresponding author

Fadzlan Sufian
Universiti Islam Malaysia,
Blok I, Bangunan MKN Embassy Techzone,
Jalan Teknokrat 2, 63000 Cyberjaya,
Selangor Darul Ehsan, Malaysia
Email: fadzlan.sufian@uim.edu.my

Annuar Md. Nassir

Faculty of Economics and Management,
Universiti Putra Malaysia,
43400 Serdang, Selangor Darul Ehsan, Malaysia
Email: annuar@upm.edu.my

Nazratul Aina Mohamad Anwar

and Nur Ainna Ramli
Faculty of Economics and Muamalat,
Universiti Sains Islam Malaysia,
Bandar Baru Nilai, Nilai,
71800, Negeri Sembilan, Malaysia
Email: nazratulaina@usim.edu.my
Email: nurainna.ramli@usim.edu.my

Khar Mang Tan

Faculty of Economics and Management,
Universiti Putra Malaysia,
43400 Serdang, Selangor Darul Ehsan, Malaysia
Email: carmen_5328@yahoo.com

Copyright © 2018 Inderscience Enterprises Ltd.

364 F. Kamarudin et al.

Hafezali Iqbal Hussain

Universiti Kuala Lumpur Business School,
Level 8, Bangunan Yayasan Selangor,
74, Jalan Raja Muda Abdul Aziz,
Kg Baru, 50300 Kuala Lumpur, Malaysia
Email: hafezali@unikl.edu.my

Abstract: This research investigate the impact of six dimensions of country

governance to the price efficiency of Islamic and conventional banks. The
empirical analysis is focused on the Islamic and conventional banks operating
in the Bahrain, UAE, Kuwait, Oman, Qatar and Saudi Arabia countries.
The data envelopment analysis (DEA) method applied to compute the revenue
efficiency of Islamic and conventional banks. Then used the Multivariate Panel
Regression Analysis with the Ordinary Least Square as an estimation method to
investigate the potential determinants and the effect of country governance on
the revenue efficiency. The empirical findings indicate that greater voice and
accountability, political stability, regulatory quality, rule of law and control of
corruption enhance the revenue efficiency of both Islamic and conventional
banks. The dimension of government effectiveness exerts positive sign
relationship with the banks revenue efficiency only on conventional banks.

Keywords: revenue efficiency; DEA; data envelopment analysis; ordinary least

square; country governance.

Reference to this paper should be made as follows: Kamarudin, F., Sufian, F.,
Nassir, A.M., Anwar, N.A.M., Ramli, N.A., Tan, K.M. and Hussain, H.I.
(2018) ‘Price efficiency on Islamic banks vs. conventional banks in Bahrain,
UAE, Kuwait, Oman, Qatar and Saudi Arabia: impact of country governance’,
Int. J. Monetary Economics and Finance, Vol. 11, No. 4, pp.363–383.

Biographical notes: Fakarudin Kamarudin is a Senior Lecturer at the Faculty

of Economics and Management, Universiti Putra Malaysia (UPM). He obtained
his PhD majoring in Finance from UPM in 2015. He has a Master of Science
(MSc) in Finance in 2010 from the same university.

Fadzlan Sufian is a Professor at Universiti Islam Malaysia. He holds a PhD in

Economics (Financial Economics) from Universiti Putra Malaysia. His papers
have appeared in more than 100 local and international journals. His research
concerns performance banking and financial sector performance measurement.

Annuar Md. Nassir is a Professor at Universiti Putra Malaysia (UPM).

He completed his PhD degree in 1991 at UPM. He was promoted to Associate
Professor in 1993 and subsequently to Full Professor in 2000. He has published
over 80 research local and international papers. His specialisation is in finance
and investment analysis.

Nazratul Aina Mohamad Anwar is the Senior Lecturer at the Faculty of

Economics and Muamalat, Universiti Sains Islam Malaysia (USIM). She
obtained her PhD majoring in Accounting from UPM in 2016. She completed
her Master of Science (MSc) in Accounting in 2009 from the same university.
She currently conducts lectures on Public Sector Accounting.
 Price efficiency on Islamic banks vs. conventional banks 365

Nur Ainna Ramli is the Senior Lecturer at the Faculty of Economics and
Muamalat, Universiti Sains Islam Malaysia (USIM). She obtained her PhD
majoring in Finance in 2014 from Lincoln University and completed her
Master of Science (MSc) in Finance from Stirling University in 2009.
Her research interest is in corporate finance, capital structure and portfolio.

Khar Mang Tan is currently a Doctor of Philosophy (PhD) in Business

Economics student at the Department of Accounting and Finance, Faculty of
Economics and Management, Universiti Putra Malaysia. She has a Master of
Science (MSc) in Finance at the Putra Business School, University Putra
Malaysia in 2014. She has working experience as a researcher, research
assistant and a part-time lecturer. She holds a Bachelor of Finance with Honour
qualification from University Utara Malaysia.

Hafezali Iqbal Hussain is a Senior Lecturer at Universiti Kuala Lumpur,

Malaysia. Formerly a chartered accountant at Citigroup, his work has appeared
in several peer-reviewed finance, management, education and scientific
journals and has presented at various conferences.

This paper is a revised and expanded version of a paper entitled

‘Price efficiency on Islamic banks vs. conventional banks in Bahrain, UAE,
Kuwait, Oman, Qatar & Saudi Arabia: impact of country governance analysis
using DEA, OLS & GMM’ presented at SIBR-RDINRRU Conference on
Interdisciplinary Business and Economics Research, Vibe Hotel Sydney,
Australia, 15–16 April, 2017.

1 Introduction

The objective of the present paper is to build on the earlier contributions on the
performance of Islamic and conventional banks operating in the Bahrain, UAE, Kuwait,
Oman, Qatar and Saudi Arabia countries banking sectors and to establish new empirical
evidence on the impact of country governance. Country governance as a set of traditions
and institutions by which authority in a country is exercised (Kaufmann et al., 2010). The
country governance comprised of three main dimensions with two different measures
corresponding to each of the three different dimensions. The first dimension is the
process whereby the citizens select, monitor, and replace governments measured by voice
and accountability (VA) and political stability and absence of violence (PV). The second
dimension is the capability to effectively formulate and implement policies by the
government measured by government effectiveness (GE) and regulatory quality (RQ).
The final dimension concerns respectable institutions governing economic and social
interaction among citizens and state measured by (RL) and Control of Corruption (CC).
As noted earlier, empirical evidence on the impact of country governance on
Islamic banks is completely missing from the literature. The paper also investigates to
what extent internal (i.e., bank-specific characteristics) and external factors (i.e.,
macroeconomic conditions) influence the performance of Islamic banks while controlling
for the impact of country governance. To do so, we collect and analyse data on both
Islamic and conventional banks operating in the Bahrain, UAE, Kuwait, Oman, Qatar and
Saudi Arabia countries banking sectors over the period of 2007 to 2016. The analysis
comprises of two main stages. In the first stage, we compute the revenue, cost, and profit
366 F. Kamarudin et al.

efficiencies of individual Islamic and conventional banks by employing the data

envelopment analysis (DEA) method. We then employ panel regression analysis to
examine the impact of country governance on the revenue efficiency of both Islamic and
conventional banks.

2 Literature review

Since its introduction by Charnes et al. (1978), researchers have welcomed the DEA as a
methodology for performance evaluation. Numerous researchers employed DEA to
measure the efficiency on decision-making units not limited to firms and financial
institutions (Sufian and Habibullah, 2009; Barth et al., 2013; Sufian, 2013; Won and Ryu,
2017; Degl’Innocenti et al., 2017).
Sufian and Habibullah (2009) investigate the efficiency of China banking sector with
the impact of non-traditional activities over the years 2000–2005. The results revealed the
technical efficiency of State Owned Commercial Banks are higher due to the
improvement in scale efficiency while pure technical efficiency attribute the higher
technical efficiency for the Joint Stock Commercial Banks.
A study by Barth et al. (2013) examines the bank efficiency with the impact of
regulation, supervision and monitoring from 72 countries over the period 1999–2007.
This study employed DEA to measure bank efficiency. Empirical findings suggest that
tighter restrictions impede the bank efficiency. Meanwhile, greater capital regulation
stringency, strengthening of official supervisory power, experienced supervisory and
more financial transparency monitoring are positively associated with bank efficiency.
Sufian (2013) investigates the impact of economic freedom on Indonesian banks
efficiency. This study applied the DEA to analyse the level of banks efficiency during
1999 to 2008. The empirical findings suggest an increasing level of efficiency in the
Indonesian banks. The study also asserts a positive relationship between capitalisation
and liquidity and bank efficiency. However, negative relationship between credit risk and
overhead expenses and bank efficiency. The results indicate a positive relationship
between business and monetary freedoms and bank efficiency, while the relationship
between technical efficiency and financial freedom seems to be negative.
Other studies by Won and Ryu (2017) explore the operational efficiency of the
ownership structure in the Korean manufacturing firms for 2002–2013. They also used
DEA to measure the efficiency of the firms. The results documented that operational
efficiency was higher during after economic crisis then before the crisis. They also find
that largest shareholder and board members positively influence firms efficiency.
Degl’Innocenti et al. (2017) study the bank productivity growth and integration
process for the 28 EU countries over the years 2007 to 2012. They divided the period
study into three main phases of the financial crisis,
1 US subprime crisis (2007–2008)
2 global financial crisis (2009–2010)
3 sovereign debt crisis (2010–2012).
 Price efficiency on Islamic banks vs. conventional banks 367

The DEA method used in this study to examine the bank productivity. The results
indicate that bank productivity growth during U.S. subprime crisis but decrease during
the global financial crisis.
Studies by Johnes et al. (2014), and Maghyereh and Awartani (2014) are among the
most notable empirical research performed to examine the efficiency of the Gulf
Cooperation Council (GCC) countries banking sectors. Zeitun et al. (2013) employ the
DEA method to explore the relative efficiency of 65 conventional and Islamic banks in
the (GCC) region during the period of 2002 to 2010. The empirical results suggest that
Islamic banks are significantly less efficient than conventional banks in three out of five
DEA models.
Most of these studies focus on the technical, pure technical, and scale efficiency
concepts. On the other hand, studies which investigate the revenue efficiency concept and
its cost and profit efficiency components are scarce. This limitation is somewhat
surprising given the fact that revenue inefficiency has been found to be the main problem
resulting in lower profit efficiency levels (Kamarudin et al., 2014a, 2014b).
In essence, banks may experience revenue inefficiency when they produce too few
outputs given a set of inputs. Likewise, banks may also be revenue inefficient if they
respond poorly to changes in prices and produces marginal high priced but too many low
priced outputs. Therefore, within the banking sector context, it would be more
meaningful to compare profit with cost efficiency to identify the existence of revenue
efficiency since revenue efficiency may directly influence the overall performance and
profitability of banks.
In regard to the impact of governance on the efficiency of Islamic banks, empirical
evidence to date have mainly focused on the micro dimension of governance or
governance within banking institutions. Although governance quality may exert a
positive influence on efficiency levels (Meon and Weill, 2005), the empirical findings by
Bukhari et al. (2013), Darmadi (2013), and Ginena (2014) remain inconclusive at best.
This could be due to difficulties in evaluating the indicators of quality in governance due
to its subjective evaluation. Usually, such evaluation is based on experts ratings indices
produced by private risk rating agencies (e.g., Internal Country Risk Guide or Business
Environmental Risk Intelligence). However, these indicators are not always inclusive,
with limited availability, and biased (Kaufmann et al., 2010). By allowing the elimination
of the individual indices and providing the overall countries’ aggregate indices, the
country governance (macro governance) indicators are capable to avoid these
deficiencies.
Noticeably absent is empirical evidence on the impact of country governance on the
performance of Islamic banks. The present study, therefore, attempts to fill in a
demanding gap in the literature by providing new empirical evidence on the impact of
country governance on the efficiency of Islamic and conventional banks operating in the
Bahrain, UAE, Kuwait, Oman, Qatar and Saudi Arabia countries banking sectors.

3 Hypotheses development

The contextual variables used to explain the efficiency of banks, in this study, are
grouped into three main categories. The first represents bank-specific attributes, the
second encompasses economic and market conditions and the third comprises the country
governance dimension. The bank-specific variables included in the regression models are,
368 F. Kamarudin et al.

lnTA (log of total assets), lnLLRGL (log of loans loss reserves divided by gross loans),
lnETA (log of equity divided by total assets), lnNIITA (log of non-interest income
divided by total assets), lnNIETA (log of non-interest expenses divided by total assets)
and lnLOANSTA (log of total loans divided by total assets).
The lnTA variable is included in the regression models as a proxy of size to capture
for possible cost advantages associated with size (economies of scale). In the literature,
mixed relationships are observed between size and profitability, while some studies
suggest a U-shaped relationship. LNTA is also used to control for cost differences
relating to bank size and the ability of large banks to diversify. In essence, LNTA may
lead to a positive effect on bank efficiency if economies of scale are observed. On the
other hand, if increased diversification leads to higher risks, the variable may exhibit
negative effects.
H1a: Bank size has a significant influence on Islamic banks’ revenue efficiency.
H1b: Bank size has a significant influence on conventional banks’ revenue efficiency.
The lnLLRGL variable is incorporated as an independent variable in the regression
analysis as a proxy for credit risk. The coefficient of LLP/TL is expected to take a
negative sign because bad loans reduce bank profitability and consequently is expected to
exert a negative influence on bank profit efficiency. Greater financial institutions
exposure towards high-risk loans, the higher would be the accumulation of unpaid loans
resulting in a lower profitability.
H2a: Credit risk has a significant influence on Islamic banks’ revenue efficiency.
H2b: Credit risk has a significant influence on conventional banks’ revenue
efficiency.
The lnETA variable is included in the regression models to examine the relationship
between efficiency and bank capitalisation. The strong capital structure is essential for
banks in developing economies, since it provides additional strength to withstand
financial crises and increased safety for depositors during unstable macroeconomic
conditions. Furthermore, lower capital ratios in banking imply higher leverage and risk,
and therefore greater borrowing costs. Thus, relatively better-capitalised banks should
exhibit higher efficiency levels.
H3a: Capitalisation has a significant influence on Islamic banks’ revenue efficiency.
H3b: Capitalisation has a significant influence on conventional banks’ revenue
efficiency.
To recognise that financial institutions in recent years have been generating income from
‘off-balance sheet’ business and fee income, the lnNIITA variable is entered in the
regression models as a proxy measure of bank diversification into non-traditional
activities. Non-interest income consists of the commission, service charges, and fees,
guarantee fees, net profit from the sale of investment securities, and foreign exchange
profit. The variable is expected to exhibit a positive relationship with bank efficiency.
H4a: Bank diversification has a significant influence on Islamic banks’ revenue
efficiency.
 Price efficiency on Islamic banks vs. conventional banks 369

H4b: Bank diversification has a significant influence on conventional banks’ revenue

efficiency.
The lnNIETA variable is used to provide information on the variation of management
efficiency on bank operating costs. The variable represents the total amount of wages and
salaries, as well as costs of running branch office facilities. The relationship between this
variable and bank profit efficiency levels may be negative, because the more efficient
banks should keep their operating costs low. Furthermore, the usage of new electronic
technology, like ATMs and other automated means of delivering services, may have
caused expenses on wages to fall (as capital is substituted for labour).
H5a: Management efficiency has a significant influence on Islamic banks’ revenue
efficiency.
H5b: Management efficiency has a significant influence on conventional banks’
revenue efficiency.
lnLOANSTA as a proxy of bank’s loans intensity is expected to affect bank efficiency
positively. However, the loan-performance relationship depends significantly on the
expected change of the economy. During a strong economy, only a small percentage of
loans will default and bank profitability would increase. On the other hand, the bank
could adversely be affected during a weak economy, because borrowers are likely to
default on their loans. Ideally, banks should capitalise on favourable economic conditions
and insulate themselves during adverse conditions.
H6a: Bank’s loans intensity has a significant influence on Islamic banks’ revenue
efficiency.
H6b: Bank’s loans intensity has a significant influence on conventional banks’
revenue efficiency.
To measure the relationship between economic conditions and bank efficiency, we
include lnGDP (log of Gross Domestic Products), lnINFL (log of the consumer price
index) and in the regression models. The economic growth variable is measured (lnGDP)
and the coefficient is expected to have a positive or negative sign. Factors related to the
supply and demand for loans and deposits could be influenced by economic growth.
Plummeting bank returns can be due to economic growth which slows down particularly
during recessions, where, credit quality deteriorates and defaults intensify. Results
indicate that economic growth has a significant and positive impact on the performance
of banks. However, the coefficient may also be negative which spell out a negative
relationship between economic growth and bank efficiency. This result may be due to the
volatile economic growth that drives banks to suffer from lower demand for their
financial services, increased loan defaults and thus lower output.
H7a: Economic growth has a significant influence on Islamic banks’ revenue
efficiency.
H7b: Economic growth has a significant influence on conventional banks’ revenue
efficiency.
370 F. Kamarudin et al.

The coefficient lnINF is expected to be negative or positive towards bank efficiency.

Unanticipated inflation can be defined as the rate of inflation which has not been
predicted by economists and comes as a surprise to business people, governments and
workers. Under this unanticipated inflation, there will be a negative relationship between
inflation and bank efficiency. On the other hand, in anticipated inflation, the interest rates
are adjusted accordingly to gain revenues which increase faster than costs. This will
provide a positive impact on profitability.
H8a: Inflation has a significant influence on Islamic banks’ revenue efficiency.
H8b: Inflation has a significant influence on conventional banks’ revenue efficiency.
We include lnCR3 variable (log of the three banks concentration ratio) to control for the
impact of competition on the efficiency of banks operating. The structure-conduct-
performance (SCP) theory posits that banks in a highly concentrated market tend to
collude and therefore earn monopoly profits, while a positive impact is expected under
both the collusion and efficiency views.
H9a: Market concentration has a significant influence on Islamic banks’ revenue
efficiency.
H9b: Market concentration has a significant influence on conventional banks’
revenue efficiency.
Country governance is the macro governance that may significantly influence the
profitability and efficiency of the banks. Eventually, there are three areas that comprise
country governance. The first area is the process whereby the citizens select, monitor, and
replace governments measured by dimensions of voice and accountability (lnVA) and
political stability and absence of violence (lnPV). VA is defined as the capabilities of
citizens to participate in selecting their government, freedom of expression, freedom of
association, and a free media. PV is the stability in politics since there is the likelihood
that a government could be destabilised or overthrown by unconstitutional or violent
means, including politically motivated violence and terrorism. These two dimensions
may have positive or negative relationship with bank efficiency.
H10a: Voice and Accountability have a significant influence on Islamic banks’
revenue efficiency.
H10b: Voice and Accountability have a significant influence on conventional banks’
revenue efficiency.
H11a: Political Stability and Absence of Violence have a significant influence on
Islamic banks’ revenue efficiency.
H11b: Political Stability and Absence of Violence have a significant influence on
conventional banks’ revenue efficiency.
The second area is the capability to effectively formulate and implement policies by the
government measured by dimensions of government effectiveness (lnGE) and regulatory
quality (lnRQ). Both measures assess the credibility and ability of a government towards
its commitment to formulate and implement sound policies and regulations that permit
and promote private sector development. The coefficient of lnGE and lnRG may
significantly influence positively or negatively to the efficiency of banks.
 Price efficiency on Islamic banks vs. conventional banks 371

H12a: Government Effectiveness has a significant influence on Islamic banks’

revenue efficiency.
H12b: Government Effectiveness has a significant influence on conventional banks’
revenue efficiency.
H13a: Regulatory Quality has a significant influence on Islamic banks’ revenue
efficiency.
H13b: Regulatory Quality has a significant influence on conventional banks’ revenue
efficiency.
The final area concerns respectable institutions governing economic and social
interaction among citizens and state measured by dimensions of RL and CC. RL refers to
agents who have confidence in and abide by the rules of society particularly the quality of
contract enforcements, property rights, the police, and the courts. While, CC measures
which public power is exercised for private gain, including both small and large forms of
corruption. These variables may have a positive or negative relationship with bank
efficiency.
H14a: Rule of Law has a significant influence on Islamic banks’ revenue efficiency.
H14b: Rule of Law has a significant influence on conventional banks’ revenue
efficiency.
H15a: Control of Corruption has a significant influence on Islamic banks’ revenue
efficiency.
H15b: Control of Corruption has a significant influence on conventional banks’
revenue efficiency.

4 Data and methodology

The present study gathered data on 74 banks comprising of 47 conventional and

27 Islamic banks) operating in the Bahrain, UAE, Kuwait, Oman, Qatar and Saudi Arabia
countries banking sectors during the period of 2007 to 2016. The primary source of
financial data is the Bank Scope database. We gather the country governance data from
the world governance indicator (WGI) database. The macroeconomic variables are
retrieved from the IMF financial statistics (IFS) and the World Bank world development
indicator (WDI) databases. This study computes the revenue, cost, and profit efficiency
to obtain robust results and to enable us to observe and compare different efficiency
measures of Islamic and conventional banks operating in the Bahrain, UAE, Kuwait,
Oman, Qatar and Saudi Arabia banking sectors. The DEA Excel Solver developed by
Zhu (2009) under the VRS model used to solve the revenue, cost, and profit efficiency
problem. The revenue, cost, and profit efficiency models are given in equations (1)–(3)
below. As can be seen, the revenue, cost, and profit efficiency scores are bounded within
the 0 and 1 range.
372 F. Kamarudin et al.

Revenue, cost, and, profit efficiency models equations:

Revenue efficiency Cost efficiency Profit efficiency
(Equation (1)) (Equation (2)) (Equation (3))
s m s m
max ∑q o
r y ro min ∑ pio xi o max ∑ qro y r o − ∑ pio xi o
r =1 i =1 r =1 i =1

subject to subject to subject to

n n n

∑λ x j ij ≤ xio i = 1, 2,..., m; ∑λ j xi j ≤ xio i =1, 2,..., m; ∑λ x

j =1
j ij ≤ xi o i =1, 2,..., m;
j =1 j =1
n n

∑λ y ≥ y ro r = 1, 2,..., s; ∑λ yr j ≥ yr o r =1, 2,..., s; n

∑λ
j rj j
j =1 j =1 j yr j ≥ y r o r =1, 2,..., s;
j =1
λ j y ro ≥ 0 λ j , xi o ≥ 0
n n xi o ≤ xi o , y r o ≥ yr o
∑
j =1
λj = 1 ∑
j =1
λ j=1
λj ≥ 0
n

∑
j =1
λ j =1

Source: Zhu (2009)

S is the output observation, m is the input observation, r is the sth output, i is the mth
input, qro is the unit price of output r of DMU0, pio is the unit price of input i of DMU0,
y ro is the rth output that maximises revenue for DMU0, xio is the ith input that minimise
cost for DMU0, yro is the rth output for DMU0, xio is the ith input for DMU0, n is the
DMU observation, j is the nth DMU, λj is the non-negative scalars, yrj is the sth output for
nth DMU, xij is the mth input for nth DMU.
There are six reasons why this study adopts DEA method. Firstly, each DMU is
assigned a single efficiency score that allows ranking amongst the DMUs in the sample.
Secondly, DEA highlights the areas of improvement for every single DMU such as either
the input has been excessively used, or output has been underproduced by the DMU (so
they could improve on efficiency). Thirdly, there is a possibility of making inferences on
the DMU’s general profile. DEA allows the comparison between the production
performances of each DMU to a set of efficient DMUs (called reference set). Thus, the
owner of the DMUs may be interested to know which DMU frequently appears in this
set. A DMU that appears more than others in this set is called the global leader.
Apparently, DMU owner may obtain a huge benefit from this information especially in
positioning its entity in the market. Fourthly, several studies suggest that DEA does not
require a preconceived structure or specific functional form to be imposed on the data in
identifying and determining the efficient frontier, error and inefficiency structures of the
DMUs. Fifthly, DEA does not need for standardisation and this allows the researchers to
choose any kind of input and output of managerial interest (arbitrary), regardless of the
different measurement units. Finally, DEA is suitable with a small sample.
The present study adopts the intermediation approach since this the most preferred
approach on the efficiency of banking sectors. Besides that financial institutions normally
employ labour, physical capital, and deposits as their inputs to produce earning assets
which show the suitability of this approach (Sufian et al., 2013b; Sufian and Kamarudin,
2014a, 2014b). Accordingly, two inputs, two input prices, two outputs, and two output
prices variables are chosen. The two input vector variables consist of x1: Deposits and x2:
 Price efficiency on Islamic banks vs. conventional banks 373

Labour. The input prices consist of w1: Price of Deposit and w2: Price of Labour. The two
output vector variables are y1: Loans and y2: Income while, the two output prices consist
of r1: Price of Loans and r2: Price of Income. The selection of the input and output
variables are based on other major studies on the efficiency of banking sectors
(e.g., Sufian et al., 2012; Sufian et al., 2013a; Kamarudin et al., 2013).
Then, the Ordinary Least Square (OLS) regression method applied in the second
stage regression analysis to examine the relationship between bank efficiency and
other potential internal and external determinants (bank-specific characteristics and
macroeconomic conditions). By using the revenue efficiency scores as the dependent
variable, we estimate the following baseline regression model:
6 3
Efficiencyi ,t = β1 ∑ BankCharacteristicsi ,t + β 2 ∑ Macroeconomicst
n = 74 n = 74
3
(4)
+ β 3 ∑ CountryGovernancet + η i + ε i ,t
n = 74

We include six bank-specific [total assets (lnTA), loan loss reserve over gross loan
(lnLLRGL), earning over total assets (lnETA), non-interest income over total assets
(lnNIITA), non-interest expense over total assets (lnNIETA), total loan over total assets
(lnLOANSTA)] and three macroeconomic [economic growth (lnGDP), consumer price
index (lnINFL), concentration ratio of the three largest banks (lnCR3)] determinant
variables in the panel regression models. To address the issue whether country
governance matters for bank efficiency, we re-estimate equation (4) to include the six
dimensions of country governance indicators. The country governance indicators are
measured by scores ranging between –2.5 and 2.5, where a higher value indicates better
country governance.

5 Empirical results and hypothesis analysis

An analysis based on levels may be biased by a few observations. Accordingly, in the

preceding section, we perform a series of parametric (t-test) and non-parametric (Mann-
Whitney (Wilcoxon) and Kruskall-Wallis) tests to examine the difference in revenue,
cost, and profit efficiency of Islamic and conventional banks operating in the Bahrain,
UAE, Kuwait, Oman, Qatar and Saudi Arabia countries banking sectors. Table 1 presents
the results. The results from the parametric t-test suggest that Islamic banks
have exhibited a lower mean revenue efficiency (0.535 < 0.753), cost efficiency
(0.409 < 0.781), and profit efficiency (0.553 < 0.702) compared to their conventional
bank peers (statistically significantly different at the 1% level in all cases). The results
from the parametric t-test are further confirmed by the non-parametric Mann-Whitney
(Wilcoxon) and Kruskall-Wallis tests.
Tables 2 and 3 present regression results focusing on the relationship between
revenue efficiency and the contextual variables for Islamic and conventional banks
respectively. Referring to the impact of bank size, the empirical findings indicate a
positive relationship between size (lnTA) and revenue efficiency for both Islamic and
conventional banks. The results imply that the larger (smaller) size banks tend to exhibit
higher (lower) revenue efficiency providing support to the argument that large bank may
benefit from economies of scale which enables them to generate higher revenues.
374 F. Kamarudin et al.

Therefore, we reject the null hypotheses of H1a and H2a (supported H1a and H1b) With
regards to the relationship between credit risk (lnLLRGL) and revenue efficiency, the
result shows that the coefficient for credit risk has a negative sign only for conventional
banks. A higher credit risk means that banks may deal with a higher possibility that its
loans will become non-performing (supported H2b only).
Concerning the impact of capitalisation on revenue efficiency, the coefficient of the
lnETA variable exhibits a positive sign. The results imply that the relatively better
capitalised Islamic and conventional banks tend to report higher revenue efficiency levels
(supported H3a and H3b). The coefficient of lnNIITA has a negative sign (statistically
significant in all regression models at the 5% to 1% level in both banks). The results
imply that banks which derived a higher proportion of its income from bank’s
diversification towards non-interest sources such as fee-based services tend to be
relatively less efficient in their intermediation function (supported H4a and H4b).
Likewise, the coefficient of lnNIETA has a positive relationship with efficiency for both
types of banks. This indicates that higher profit earned by banks that are more
management efficient may be appropriated in the form of higher payroll expenditures
paid to the more productive human capital (supported H5a and H5b). Referring to the
impact of bank’s loan intensity or liquidity, we find that lnLOANSTA is negatively
related to the revenue efficiency of Islamic and conventional banks. The negative sign
indicates the bank’s profitability could be affected in a weak economy because borrowers
are likely to default on their loans. Ideally, the bank should capitalise on favourable
economic conditions and insulate themselves during adverse conditions (supported H6a
and H6b).

Table 1 Summary of parametric and non-parametric tests

Test groups
Parametric test Non-parametric test
Individual tests t-test Mann-Whitney Kruskall-Wallis
[Wilcoxon Rank-Sum] test Equality of Populations test
Hypothesis MedianIslamic =
MedianConventional
Test statistics t(Prb > t) z(Prb > z) X² (Prb > X²)
Mean t Mean Rank z Mean Rank X²
Revenue Efficiency
Islamic banks 0.535 8.029*** 236.483 –6.299*** 236.483 39.683***
Conventional bank 0.753 329.857 329.857
Cost Efficiency
Islamic banks 0.409 12.096*** 212.448 –8.758*** 212.448 76.700***
Conventional bank 0.781 342.304 342.304
Profit Efficiency
Islamic banks 0.553 5.084*** 257.039 –4.219*** 257.039 17.802***
Conventional bank 0.702 319.212 319.212

*Correlation is significant at the 0.1 level (2-tailed), **Correlation is significant at the

0.05 level (2-tailed), ***Correlation is significant at the 0.01 level (2-tailed).
 Price efficiency on Islamic banks vs. conventional banks 375

Table 2 Panel OLS regression results – Islamic banks

376 F. Kamarudin et al.

Table 2 Panel OLS regression results – Islamic banks (continued)

 Price efficiency on Islamic banks vs. conventional banks 377

Table 3 Panel OLS regression results – conventional banks

378 F. Kamarudin et al.

Table 3 Panel OLS regression results – conventional banks (continued)

 Price efficiency on Islamic banks vs. conventional banks 379

The empirical findings in Tables 2 and 3 show a mix finding (supported H7a and H7b).
The negative relationship between economic growth (lnGDP) and revenue efficiency of
the conventional banks. A plausible reason could be due to the volatile economic growth
in the Bahrain, UAE, Kuwait, Oman, Qatar and Saudi Arabia countries resulting in banks
to suffer from lower demand for their financial services, increase loan defaults, and lower
outputs. On the other hands, the positive sign of lnGDP in Islamic banks signifies that the
favourable economic conditions during the study period have fuelled higher demand for
Islamic banking products and services, reducing default loan probabilities and thus
increasing the profitability of the Islamic banks. High economic growth motivates Islamic
banks to serve more loans and improve the quality of their assets. Furthermore, the
coefficient of lnINF shows significantly negative to revenue efficiency of Islamic and
conventional banks. This indicates that the borrowers will react negatively to the increase
in inflation as they believe the rate of inflation may be reduced in the future. In the
unanticipated case, banks may be slow to adjust their interest rates resulting in a faster
increase of bank costs compared to bank revenues, and consequently negative effects on
bank profitability (supported H8a and H8b).The coefficient of the lnCR3 that measure
market concentration has a positive sign only in conventional banks providing support to
the SCP hypothesis. Therefore, we reject the null hypothesis of H9a (supported H9a) but
failed to reject the null hypothesis of H9b (not supported H9b).
As observed, the empirical findings in column 3 of Tables 2 and 3 indicate that
the coefficient of the voice and accountability (lnVA) variable has consistently exhibited
a positive sign. A plausible reason could be attributed to the fact that voice and
accountability promote democracy and eradicate poverty through the role of citizens and
state institutions which could consequently lead to higher revenue efficiency for both
Islamic and conventional banks (supported H10a and H10b). Furthermore, the positive
coefficient of lnPV indicates that the stability of politics and free from any violence and
terrorism contribute to a higher revenue efficiency of the Islamic and conventional banks.
The empirical findings to a certain extent support the fact that politicians in these
countries fully exercise their power to optimise social welfare rather than their own
private interest. Political stability may help banks reduce transaction costs and remove
asymmetric information which allow banks to receive deposits and provide loans
efficiently (supported H11a and H11b).
The lnRQ variable exhibits a positive sign. The results clearly imply that better
governance in the form of regulatory quality enhances the revenue efficiency of Islamic
and conventional banks. The empirical findings to a certain extent lend support to the fact
that governments in these countries have formulated and implemented sound policies and
regulations which encourage positive development within banking sector (supported
H13a and H13b). The positive variable of rule of law (lnRL) indicates that better rule of
law contributes to a higher revenue efficiency of Islamic and conventional banks.
The Rule of Law in country governance is the respect for order and law, effectiveness of
the judiciary system, and enforceability of contracts. In essence, Rule of Law measures
the efficiency of the legal system. It would be reasonable to assume that efficient judicial
institutions helped reduce uncertainty and risk for conducting and starting businesses
subsequently boost investments by the private sector, reduce transaction costs for
consumers, and strengthens the market (supported H14a and H14b).
380 F. Kamarudin et al.

The empirical findings indicate a positive relationship of the impact of (lnCC)

implying that greater Control on Corruption enhances the revenue efficiency of both
banks. The findings seem to suggest that supervisory agencies have been successful to
contain corruption which helps enhance the revenue efficiency of the Islamic and
conventional banks (supported H15a and H15b). Concerning the impact of government
effectiveness (lnGE), the empirical findings given in column 5 of Tables 3 shows a
positive coefficient of the lnGE variable only to conventional banks revenue efficiency.
The results imply that the greater the credibility of a government towards its commitment
to formulate and implement sound private sector development policies and regulations
positively influence the revenue efficiency of conventional banks. Therefore, we failed to
reject the null hypothesis of H12a (not supported H12a) but reject the null hypothesis of
H12b (supported H12b).

6 Conclusions and policy implications

The present study provides new empirical evidence on the impact of country governance
on the revenue efficiency of Islamic and conventional banks. The empirical analysis is
confined to Islamic and conventional banks operating in the Bahrain, UAE, Kuwait,
Oman, Qatar and Saudi Arabia countries banking sectors during the period of 2007 to
2016. We find that Islamic banks have been relatively less efficient compared to their
conventional bank counterparts on all three different efficiency measures. The results
suggest a positive impact of bank size, capitalisation, management efficiency on the
revenue efficiency of both Islamic and conventional banks, while a negative relationship
is observed on bank’s diversification, bank’s loan intensity and inflation. The factor of
credit risk negatively influences the conventional bank revenue efficiency, while market
concentration has a positive impact on the Islamic banks revenue efficiency. Likewise,
we find mixed evidence on the impact of economic growth on the revenue efficiency of
Islamic and conventional banks.
Examining the impact of country governance, we find that greater voice and
accountability, political stability, regulatory quality, rule of law and control of corruption
have a positive impact on the revenue efficiency of Islamic and conventional. The
empirical findings seem to suggest that government effectiveness has a positive impact
on the revenue efficiency only on conventional banks but not so in the case of the Islamic
banks.
The empirical findings from this study could be useful and may have significant
implications for regulators, bankers, investors, and academicians in the Bahrain, UAE,
Kuwait, Oman, Qatar and Saudi Arabia countries. The regulators or policy makers could
find mechanisms to improve the revenue efficiency and subsequently result in a higher
profitability of Islamic and conventional banks operating in these countries banking
sectors. Furthermore, the empirical findings could serve as guidance to regulators and
decision makers in designing new policies and regulation for a sustainable and
competitive banking sector.
Several new policy measures may be introduced to enhance the revenue efficiency of
both Islamic and conventional banks. Among others, these new policies should allow for
greater freedom of expression by citizens and free media in the system. A higher level of
media independence may help increase the information quality on local developments
and provide benefits to both Islamic and conventional banks. The more developed and
 Price efficiency on Islamic banks vs. conventional banks 381

democratic system could promote greater transparency and credibility of the banking
sector, which in turn could enhance revenue efficiency in the banking sectors, and
subsequently spur economic growth and developments in these countries.
Although policymakers are encouraged to consider introducing new measures which
could promote higher revenue generating activities among the Islamic banks, strong
regulatory quality is vital to ensure that Islamic banks do not assume excessive risks.
On the other hand, the empirical findings from this study clearly indicate that
policymakers may help boost the revenue efficiency of the conventional banks by
implementing policies capable to oversee politicians’ discipline in order to avoid them
from mixing public with private welfare and effective policies in controlling corruption to
further promote activities among the conventional banks.
The results also provide useful insights and guidance to the bank managements. Since
different principals are practised by Islamic and conventional banks (Syari’ah and non-
Syari’ah compliance), therefore, different strategies need to be taken to improve their
revenue efficiency levels. Accordingly, both Islamic and conventional banks should
revise or improved on their existing governance strategy so as to be aligned with the
country governance if improvement in revenue efficiency levels is to be expected.
Nevertheless, the empirical findings may also provide useful insights to investors as
they may be able to assess the performance of Islamic and conventional banks operating
in these countries banking sectors. Investors are able to predict the future of Islamic and
conventional banks revenue efficiency level if all the potential determinants and the
specific dimension of country governance have been taken seriously by banks and
regulators. Therefore, the empirical findings from this study may help investors plan and
strategise their investment portfolio performance.
Finally, this study provides a new area of research for academicians to explore where
more interesting and new findings could be obtained. Although studies examining the
performance of Islamic banks have expanded rapidly in recent times, most of these
studies have examined the concept of technical efficiency. On the other hand, empirical
studies on the revenue efficiency concept are relatively scarce, while empirical evidence
on the impact of country governance on the efficiency of Islamic banks is completely
missing from the literature.

Acknowledgements

We would like to thanks the editors and the anonymous referees of the journal for
constructive comments and suggestions, which have significantly helped to improve the
contents of the paper. Furthermore, special thanks to: 1) Fundamental Research Grant
Scheme (FRGS) Vot No. 5524716 sponsored by Malaysian Ministry of Higher
Education; 2) Universiti Putra Malaysia Grant IPM Vot No. 9473700 sponsored
by Universiti Putra Malaysia; 3) University Grant Phase 1/2017 research code
(PPP/FEM/0117/051000/11917) sponsored by Universiti Sains Islam Malaysia and 4)
University Grant Phase 2/2017 research code (PPP/FEM/0217/051000/10218) sponsored
by Universiti Sains Islam Malaysia as an organisations that funded my research. The
usual caveats apply.
382 F. Kamarudin et al.

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