The Efficiency of Islamic Banking Industry: a Non-parametric Analysis with Non-discretionary Input Variable

This paper investigates the performance of Malaysian Islamic banking sector during the period of 2001-2005. Several efficiency estimates of individual banks are evaluated using non-parametric Data Envelopment Analysis (DEA). Two different approaches have been employed to differentiate how efficiency scores vary with changes in inputs and outputs. To examine the impact of risk factor on Islamic bank efficiency, we have incorporated problem loans as a nondiscretionary input variable in our analysis. The findings suggest that during the period of study, scale inefficiency dominates pure technical inefficiency in the Malaysian Islamic banking sector. We found that foreign banks have exhibited higher technical efficiency compared to their domestic peers. The inclusion of risk factors has mixed impact on Malaysian Islamic banks’ efficiency. The results seems to suggest that while potential economies of scale may be overestimated when risk factors are excluded, pure technical efficiency estimates on the other hand, tend to be much more sensitive to the exclusion of risk factors. The empirical results from the Spearman and Pearson tests reinforce these findings.