Efficiency and total factor productivity change of Malaysian commercial banks

Abstract

This paper analyses the efficiency of Malaysian commercial banks between 1996 and 2002 and finds that while the East Asian financial crisis caused a short-term increase in efficiency in 1998 primarily due to cost-cutting, increases in non-performing loans after the crisis caused a more sustained decline in bank efficiency. It is also found that mergers, fully Islamic banks, and conventional banks operating Islamic banking windows are all associated with lower efficiency. The paper estimates suggest mild decreasing returns to scale, and an average productivity change of 2.37% that is primarily attributable to technical change, which has nonetheless declined over time. Finally, while Islamic banks have been moderately successful in developing new products and technologies, the results suggest that the potential for Islamic banks to overcome their relative inefficiency is limited.

Keywords:

• Malaysian banking
• bank efficiency
• bank productivity
• Islamic banking

Notes

Any gambling or game of chance, which has something valuable (money and/or material goods) at stake. However, a game with nothing is really at risk for any participants are permissible.

Under the Islamic Bank Act (1983), an Islamic bank is allowed to operate based on equity participation such as musharaka (partnership), which is similar to the activity of merchant banks and debt-like financing such as murabaha (sale at cost plus margin of profit) and ijarah (leasing), which are similar to the activities of commercial banks.

Foreign banks also have minority shares in some local banking institutions (Detragiache & Gupta, 2006).

Danaharta which has unwound in 2005 was set-up to purchase NPLs from banking institution over 1998–2001 to ensure that NPLs of the banking system are under control and to reduce the burden of banking institutions in managing NPLs (Central Bank of Malaysia, 1999).

CDRC is a facilitator in bringing creditors and debtors to the negotiating table in sorting out an agreeable and workable loan restructuring exercise. Some cases have been transferred to Danaharta. For certain industries, besides financial restructuring, CDRC also facilitates corporate restructuring such as changing the management of the companies and the sale of the non-core assets of borrower (Ariff et al., 2001). It ceased operation in August 2002.

In the literature, the translog function is preferred in estimating a parametric distance function because it is flexible, easy to calculate and permits the imposition of homogeneity (Fuentes, Grifell-Tatjé, & Perelman, 2001).

Mergers 1, 2, 3 refer to mergers between Oriental Bank and EON Bank, between Chung Khiaw Bank and UOB Bank, and between the International Bank Malaysia, Sabah Bank, and Multi-Purpose Bank, respectively.

Higher input requirements as reflected in higher average gross efficiency estimates for IBS banks are also observed for domestic banks, foreign banks, merged banks, and unmerged banks categories, thereby supporting this conclusion. However, the difference is marginal within the domestic bank category, which is consistent with the finding regarding the statistical insignificance of the Z ₉ variable.

High interest rates prevailed at the end of 1997 as the Malaysian government tried to reduce capital outflows. This contributed to a decline in credit growth from an annual average of 30–26.5% at the end of 1997 (Lindgren et al., 1999). The relative small size of this negative output effect may also help explain why there is no statistical evidence for a systematic effect of the financial crisis by inclusion of a 1997 year dummy.

Dummy variables for 1996, 1997, all post-crisis years, as well as individual dummy variables for each of the years after 1998 were tested but were found to be statistically insignificant.

Interest rates, which were very high to refrain capital outflow, were reduced in the third quarter of 1998 to support the economic recovery plan.

Yudistira (2004) found that small- and medium-sized Islamic banks in most countries have diseconomies of scale but Alshammari (2003) found that the bank type has no effect of economies of scale in Gulf Cooperation Council (GCC) countries.

This result is similar to findings by Orea (2002) on Spanish banks, Isik and Hassan (2003) for Turkish banks, and Casu, Girardone, and Molyneux (2004) on Spanish and Italian banks where technological progress is the main determinant of productivity change. Krishnasamy, Ridzwa, and Perumal (2004) found productivity improvement in 10 Malaysian commercial banks was also primarily determined by TC during the 2000–2001 period.

Sufian and Ibrahim (2005) reported average total productivity growth for post-merger Malaysian banks of −1.3% for the period 2001–2003.

The result is consistent with Orea's (2002) research who finds that the average rate of productivity change of merging banks is lower than non-merging banks, and Berger and Mester (2003) who found that productivity deterioration is greater for merging banks than non-merging banks.

Moderate productivity growth is found in Islamic banks for most countries (Hassan, 2005) but productivity loss is found for Islamic banks in Sudan, Iran, and Pakistan (Hassan, 2003).

This is consistent with Hassan (2003, 2005) who also found that the productivity change of Islamic banks is driven by TC.