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There are now more than 300 Islamic financial institutions spread across 70 countries – including five Islamic banks in the UK, and 19 Islamic financial institutions in the USA.

An important factor in their growth has been the effect of the recent financial crisis on changing attitudes to risk given that Islamic banks were largely insulated from the crisis. Highly regulated operational environments, guided by Shariah principles, prohibited investment in the type of financial products which affected conventional banks and prompted the crisis. Western investors, disillusioned with the banking practices of conventional banks in the wake of the global financial crisis, have seen the potential for a safe harbour.

islamic bank managers are levelling the playing field in the competition with conventional banking
islamic bank managers are levelling the playing field in the competition with conventional banking

At the same time, the constraints imposed by regulation might hinder the efficiency with which banks can operate. The strict application of Shariah rules can increase operational costs since many Islamic banking products are bespoke. Furthermore, Islamic banks are typically small compared to conventional banks, and evidence suggests that technical efficiency increases with size in the banking industry. In addition, Islamic banks are often domestically owned and previous work indicates that foreign-owned banks are more technically efficient than domestically owned ones.

The rapid increase in Islamic banking internationally, and the importance of the sector for the economies of some countries (for example, Malaysia, Bahrain and the United Arab Emirates) make it important to have a greater understanding of the performance of Islamic financial institutions. Previous studies of  performance in Islamic banks relative to conventional banks have been inconclusive. In our research we compare conventional and Islamic banks in terms of efficiency and also what the underlying reasons might be. We focus on countries with a substantial (at least 60%) Muslim population and where there are both Islamic and conventional banks in operation, comparing the efficiency of 45 Islamic banks with 207 conventional banks across 18 countries over the period 2004–2009 (a period covering the start of the global financial crisis). We use an approach that breaks down overall efficiency into two components: one looking at the ‘modus operandi’ of the operation (we call this ‘type efficiency’), and the other at managerial competence at converting inputs into outputs (which we label ‘net efficiency’).

In taking this approach we gain new insights. First of all, we find that there is no significant difference in average overall efficiency between conventional and Islamic banks – which is in line with some previous findings. But this result conceals some important differences. The modus operandi in Islamic banking (measured by type efficiency) appears to be a less efficient system on average than the conventional one. Managers of Islamic banks, however, make up for this, as average levels of net efficiency in Islamic banks are higher than in conventional banks. So essentially, the apparent inefficiency of the system is counterbalanced by the efficiency of the managers.

Each type of banking could learn from the other. Islamic banks need to look at the conventional banking system for ideas on how to make their own system more efficient. An obvious possibility would be to standardize their portfolio of products as in conventional and the larger Islamic banks. Conventional banks need to examine the managerial side of Islamic banking for ideas on how to improve the efficiency of their own managers. If there is little difference in the inherent ability or the training of managers in each type of bank, then other aspects, such as the remuneration systems and project viability might hold the key.

Managers should also take note of the beneficial effects on efficiency of prudent behaviour in terms of holding reserves relative to non-performing loans. In a period of financial turmoil, the banks in this sample have typically suffered falls in their overall efficiency relative to the start of the period. The year 2008 had a particularly bad impact on overall efficiency, but there has been a limited recovery in 2009. An examination of the components of overall efficiency indicates, however, that the managers of Islamic banks have coped with the crisis better than those of conventional banks (based on the results for net efficiency), but that the gap between the conventional and Islamic frontiers has widened during this same period (based on results for type efficiency).This implies that the efficiency advantage of the conventional over the Islamic operating system has increased during the period of financial turmoil, suggesting that a shift to a more standardized process would help Islamic banks to maintain efficiency in the face of future crises.

We need to know more about why managers of Islamic banks appear to perform more efficiently than those of conventional banks – as a way of complementing the econometric analyses of bank level data – these findings are nevertheless important and relevant to both policy-makers and regulators, and the development of a secure and efficient banking system.

Dr Jill Johnes, Lancaster University Management School, www.lums.lancs.ac.uk