Despite its considerable achievements in the past few decades, empirical evidence evaluating the performance and efficiency of the Islamic finance industry is still at its infancy. Zaki Khateeb sought to tackle this issue by conducting a study on conventional and Islamic banks in the GCC. His findings show Islamic banks are as efficient as conventional banks. Here, he summarises his key findings.
In the modern age, globalisation, the interconnectedness of the financial services industry and the wide-scale liberalisation of the financial markets have added pressure on Islamic banks to maintain their competitiveness in a highly competitive environment. They are required to compete with their conventional counterparts and also with Islamic financial windows and subsidiaries of eminent banks such as BNP Paribas Najmah, Citi Islamic, Standard Chartered Saadiq, HSBC Amanah and many more.
Despite its considerable achievements in the past few decades, empirical evidence evaluating the performance of the Islamic finance industry is still at its in- fancy. Furthermore, studies on Islamic banks have generally focused on theoretical issues and empirical works have relied on the analysis of descriptive statistics rather than rigorous statistical estimation. Studies have well documented the need to study bank efficiency and performance in order to assess the behaviour of Islamic banks. Thus, the inherent fragility of the banking systems, especially in emerging markets, pronounces the need for such kind of information to be available in today’s buoyant industry.
Therefore, investigating the efficiency levels and performance of Islamic banks would be beneficial to making a stronger evaluation of Islamic banks. For one thing, practical evidence grants us insight to the day-to-day successes or failures of Islamic banks. Specifically of interest to this present article is the efficiency of banking sectors of the GCC countries.
Overview of the GCC banking industry
Based on high oil prices and a more diversified economic structure, the members of the Gulf Cooperation Council currently witness some of the highest GDP growth rates worldwide with concomitant development of domestic financial markets. Meanwhile, a growing population has caused a boom in local real estate and consumer markets, and multi-billion infrastructure investments are sought after. From heavy industries, transport, power plants, water desalination and waste treatment, there is hardly a sector that does not require an increased amount of financing, financial services and insurance. Despite these issues, the capital markets of the member states are still underdeveloped and underutilised. The major source of financing in this region is dominated by bank assets. Currently, according to recent data from Bankscope, the GCC houses 191 banks with an aggregate asset size of USD 2,018.3 Billion, an increase of 7.3% or USD 137.1 Billion over 2010.
Over the past few years, the size and sophistication of the banking industry has grown to remarkable levels in the GCC. The stringent entry laws in place confine foreign banks to establish themselves and thus most banks are locally owned. Apart from banks, non-banking financial institutions have a rather limited presence in the GCC with very few exceptions. By far the financial sector in the GCC is dominated by the banking sector. Islamic banks represent approximately 24 per cent of the region’s banking system’s assets according to recent figures from Bankscope. Prolonged government spending sprees coupled with surpluses created as a result of the petroleum exports acted as a platform to further launch the cause of Islamic finance in the GCC. At the same time, financial innovation has contributed to facilitating the supply of financial products and services, from retail products, like housing or car financing pro- grams, to more sophisticated products like sukuk or mutual funds. With several banks introducing their Islamic windows over the years, Islamic banking has grown at astonishing rates. According to a study conducted by Standard & Poor’s (2010) “the growth of Islamic banking assets has out-stripped that of conventional banking assets.” The report further adds that “conventional banking assets nearly tripled between 2003 and 2008, while Islamic banking assets have been multiplied by seven, albeit starting from a much lower base.”
| Country | Rank | Inefficient Banks | Efficient Banks | Average Efficiency Score |
| Qatar | 1 | 2 | 2 | 99.76% |
| Kuwait | 2 | 4 | 0 | 96.33% |
| Bahrain | 3 | 16 | 1 | 95.61% |
| Saudi Arabia | 4 | 3 | 1 | 95.30% |
| UAE | 5 | 8 | 0 | 94.85% |
| Country | Rank | Inefficient Banks | Efficient Banks | Average Efficiency Score |
| Kuwait | 1 | 18 | 0 | 95.20 |
| Bahrain | 2 | 37 | 1 | 95.11% |
| UAE | 3 | 28 | 1 | 95.07% |
| Oman | 4 | 8 | 1 | 93.58% |
| Qatar | 5 | 13 | 0 | 93.32% |
| Saudi Arabia | 6 | 13 | 0 | 92.29% |
The GCC banks significantly relied on the budget surpluses, high oil prices and the ever-booming real estate markets in these countries. However, this halcyon period has been halted as a result of the financial crisis that crippled the equity market, deflated oil prices, and pierced the real estate bubble bringing an end to the investment boom in the GCC. Fortunately, the GCC banks did not suffer as much as their Western
counterparts. Crucially, GCC banks maintained a sound financial position thanks to the accumulated liquidity during the investment boom. To support the financial health of these banks, the intervention by the governments of these countries inthe wake of the crisis included a number of measures such as deposit guarantees, capital injections, slashed interest rates etc. This comforted the banks and enhanced them operationally.
Analysing Islamic banks
The Islamic banking concept has a relatively short history. The financial crisis of 2007 has ushered
in a new dawn for the Islamic finance industry. Its risk averseness and socially responsible mandate haveattracted Muslims and non-Muslims alike. However, research on the efficiency of Islamic banks is fewer in number due to the lack of significant data and the fact that the market is relatively new.
In order to study the efficiency of Islamic banks, I analysed a total of 120 banks consisting of 37 Islamic banks and 83 Conventional banks. My study aimed at establishing a correlation of efficiency of both conventional and Islamic banks with respect to their size and age. Although there are quite a number of studies out there that have studied the effects of size and age on the efficiency of the banks, there are very few that have documented the cost, revenue and profit efficiency of Islamic banks against conventional banks.
In line with previous studies of a
similar calibre, I selected a range of financial ratios that captured the performance of the banks in the sample as per their cost, revenue and profit. The data for the study was mainly obtained from the balance sheets and income statements of the banks in the sample. I also conducted Data Envelopment Analysis, which measures thetechnical efficiencies of banks. Technical efficiency can be defined as the manner and extent re- sources are used to achieve maximum out- put. Institutions that have less than 100% efficiency will not be using their resources in the most efficient way possible and leave room for improvement.
Findings From my study, and from previous studies, Islamic banks have performed financially as well as conventional banks de- spite having a very short history. Islamic banks have a carefully structured regime which is gradually developing and adapt- ing to the requirements of their customers, the vicissitudes of the markets and the evolution of Islamic legal thinking. The Islamic banking industry has certainly benefited from the large Muslim customer base. Muslims form over a billion-strong community, worldwide, and stretches across the globe. It is surprising that this pool, in general, has to yet create sufficient uptake of Islamic banking services. Notwithstanding this, the success of Islamic banking owes itself to developing products that up- hold their values, culture and most importantly faith.
Perhaps one of the most important of factors for the financial success of Islamic banks is the nature of the Islamic banking industry. Islamic banks completely avoid speculative markets and interest-based products. This has to a great d extent, kept them safe and well protected from the fouls of financial markets, thereby contributing to their rapid growth despite the financial crises.
Comparing the efficiency of Islamic banks and conventional banks Using the Data Envelopment Analysis (DEA) method of analysing efficiency, which attempts to quantify efficiency, we are able to compare Islamic banks and conventional banks.
According to Table 1, Qatar has the most efficient Islamic banking system in the region followed by Kuwait and Bahrain. Comparing the results of this study to previous studies shows us that Islamic banks are more efficient than conventional banks. However, it is important to understand this conclusion cannot be justified completely because the analyses were made entirely with banks belonging to either group.
According to Table 2, Kuwait topped the table with the most efficient banking system closely followed by Bahrain and UAE. Saudi Arabia ranked last with an average efficiency score of 92.29%. Despite the score, the top 3 countries were found to have the highest number of banks with improvement potential. 28 out of 37 banks in Bahrain experienced slacks that could be overcome, which would increase their output remarkably. UAE also had 16 out of 28 banks that were underproducing given the amount of input that was being employed. Results also show that Kuwait houses 16 banks that have serious improvement potential.
According to the results of my study exclusively, there is hardly any difference in the average efficiency of Islamic banks as compared to conventional banks. This differs from several previous studies, which conclude that Islamic banks are more efficient than conventional banks. Although, it is important to understand that this distinction is rather small and does not define in any way that an Islamic bank will generate extraordinary profits compared to its counterparts.
Breaking efficiency down
Breaking efficiency down to cost, profit and revenue efficiency and utilising financial ratios as opposed to DEA, we can see differences between conventional and Islamic banks. In terms of cost efficiency, conventional banks are more cost efficient than Islamic banks. One of the most important reasons for this conclusion is the fact that over a period of time, an Islamic bank tends to dispose of more cash than its conventional counterparts in order to produce similar results. Shari’a boards compromise a significant proportion of the costs. In addition, the complexity of the Islamic products and the legal ramifications for their compliance involves expert legal opinion which incurs substantial costs that further add to its cost inefficiency status.
In terms of revenue efficiency, Islamic banks fared better than conventional banks. I believe the reason for this is the fact that Islamic banks function on a profit and loss system. Keeping this in mind, one must understand that in most Islamic banking transactions, those structured under the principles of mudaraba, the loss is only borne by the Rab-ul-Mal and thus there is no pay-out as such if the bank is the Rab-ul-Mal. This has led to higher Non Interest Margins for Islamic banks as compared to conventional banks.
On the other hand, conventional banks are more profit efficient than Islamic banks. This is expected considering conventional banks are far superior to Islamic banks in generating profits due to the economies of scale and scope as well as the access to a larger market than that available to Islamic banks. Having said that, Islamic banks have a short history and with the progress of time, it is expected the gap between the two banking systems will close. As Islamic banks grow in size, they are becoming more efficient in their operations and are adopting regulatory standards and products to achieve a stronger position in the financial services market.
Conclusion
Islamic banks were found to be as efficient as conventional banks. The efficiency results of my study is generally consistent with the extant literature available though a conclusive answer to which system is more efficient cannot be made as of yet. However, the good news for Islamic banks is that efficiency measures are not impeded by transactions being in line with Shari’a principles; and that both banking systems suffer from similar imperfections. Results derived from my analysis reveal that there is huge potential for both banking systems to become more efficient by curtailing costs and exhausting the possibilities to generate more profits. Nonetheless, bank efficiencies are subject to endogenous and exogenous factors that are always evolving with time. The current results are only valid for a selected sample and may well have disparate results subject to changes in the sample. Additionally, the financial crisis had an effect on efficiency. It has been found that even countries like Sudan and Iran, which follow Islamic banking principles, have not been able to completely avert the recent crises. This paints a picture that Islamic banking, in itself, is not the answer to a stable economic environment. Having said that, it should be noted that though Islamic banking has made a huge impact on the financial services industry in a short span of time and will never be able to completely replace the capitalistic conventional banking system though it continues to make waves, feeding the growing interest from the west for a more socially responsible banking model.
