Efficiency and stability of Islamic vs. conventional banking models: a meta frontier analysis

ABSTRACT

This paper aims to compare the efficiency, technological gap, and stability of Islamic and conventional banks in the GCC region. We estimate group-specific cost frontiers for each banking type, and a Meta cost frontier for all banks to draw insights on the technological heterogeneity between the GCC Islamic and conventional banks. In the second stage analysis, we use the Generalized Method of Moments (GMM) to highlight the major determinants of bank efficiency in GCC countries. We also investigate the differences, if any, in the stability of Islamic and conventional banks against the 2007–08 global financial crisis. A panel dataset of 72 banks over the period 2005–2011 that covers the crucial period of the global financial crisis is used for the analysis. The results show that there is no statistically significant difference in mean efficiency between Islamic and conventional banks when efficiency is measured relative to the group frontier. But, Meta Frontier Analysis that accounts for the differences in the modalities of the two banking systems reveals that Islamic banking technology is not at par with the industry’s standard. The decomposition of the efficiency scores indicates that the pure technical efficiency of Islamic banks is significantly higher than that of conventional banks, but Islamic banks are posed to higher dis-economies of scale. The analysis further reveals that the 2007–08 financial turmoil has moderately affected the GCC banking sector; we found no evidence of statistically significant differences in the resilience levels of Islamic and conventional banks against the financial crises.

KEYWORDS:

• Banking sector
• Islamic banking
• conventional banking
• efficiency
• data envelopment analysis
• meta frontier analysis
• financial crisis
• GMM
• GCC region

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 There are around 1,400 Islamic banking and financial institutions operating across 80 countries (Reuters 2018). The total market worth of the ‘global Islamic finance including Islamic banking, Islamic bonds, Islamic insurance and Shariah capital market (Islamic funds) was estimated at USD 2.19 trillion in 2018, marking a 6.9% growth in assets in USD terms from the preceding year (IFSB 2019).

2 Islamic banks are posed to specific risks unique to their business model such as ‘displaced commercial risk’ (DCR), arising from Islamic banks undertaking of the management of assets on behalf of investment account holders, ‘equity investment risk (EIR)’ that originates from some profit and loss sharing contracts unique to Islamic banking, and ‘Shariah compliance risk (SCR)’ that arises when the instruments used by an Islamic bank are not in full compliance with the principles of Shariah (Ali and Azmi 2017).

3 Under diminishing Musharakah, if the market value of the property decreases, both the parties will suffer losses based on their share on the property; the whole burden is not shifted to one party alone like the case of US housing bubble.

4 For instance, suppose an Islamic bank and its customer purchase a house on partnership base. The bank usually contributes more. The bank then divides its total share in small units and client gradually purchases those units where for purchasing each unit the client pays a rent to the bank. The number of units and therefore, the amount of rent to be paid gradually decreases.