Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

EQUITY- BASED FINANCING AND ISLAMIC BANKS EFFICIENCY: STOCHASTIC FRONTIER ANALYSIS Norfaizah Othman Faculty of Economics, Selangor International Islamic University Mariani Abdul Maji and Aisyah Abdul Rahman School of Management, Faculty of Economics and Business, Universiti Kebangsaan Malaysia [email protected]; [email protected]; [email protected] ABSTRACT Using an output distance function and Stochastic Frontier Approach (SFA), this paper analyzed the effect of equity-based financing on efficiency level of Islamic banks in Malaysia and Indonesia for the period of 1996-2012. After controlling ratio of non-performing loan to total financing and ratio of equity to total assets, this study found that that ratio of equity to total assets, GDP growth, ratio of total financing to total deposit, telephone and internet are significant in influencing bank potential output. Then, turning to inefficiency determinants, level of inefficiency decrease when Islamic banks provide more equity – based financing compared to debt –based financing. Moreover, it efficiency level does not affected during the financial crisis. Other than that, size, country risk and economic freedom are significant in affecting inefficiency level of Islamic banks. In overall, Malaysian Islamic banks are more efficient compared to Indonesian Islamic banks after considering other environmental factors such as size, country risk and economic freedom. These findings are relevant to bankers, investors and society by providing empirical evidence on the performance of Islamic banks and their efficiency levels. Keywords: Equity-based financing, Bank efficiency, Stochastic Frontier Approach, Financial crisis

1.

INTRODUCTION

The occurrence of financial crisis has affected both Islamic and conventional banks. However, the salient features of Islamic banking such as prohibition of interest in all transactions, prohibition of maysir, prohibition of illegal activities such as gambling and payment of part of bank profit to benefit society has encouraged economist worldwide to consider Islamic banking as an alternative financial solution (Imam & Kpodar, 2013; Rosman, Wahab, & Zainol, 2014). Furthermore, due to unique characteristics, Islamic banks are safer from the direct effects of global financial crisis (Chazi & Syed, 2010). The direct impact of financial crisis on Islamic

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Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

banking was minimal due to its intrinsic principles such as its asset-based1 and risk sharing nature (Hassan & Dridi, 2010). For instance, in Musharaka financing Islam requires both the financier and the entrepreneur to equitably share the profit as well as the loss. These unique principles of Islamic banking were able to avoid the direct effect of financial crisis and hence it offers greater stability of Islamic banking compared to conventional banking (Turen, 1996). Besides, in Mudarabah financing, the entrepreneur who is given the responsibility to manage the capital should manage it accordingly. The focus of Islamic banking on profitability and rate of return of investments on equity-based and profit sharing mode of financing increase the potential of directing financial resources to the most productive investments, and hence increases the efficiency of the financing process (Kahf et al, 1998). Turning to efficiency level, we found mixed evidence regarding the methodology used. The level of efficiency for Islamic banks increased during global financial crisis. There is no significant difference between Islamic and conventional banks with regard to overhead cost, however Islamic banks have lower cost efficiency with regard to cost to income ratio during local crisis (Beck, Demirgüç-Kunt, & Merrouche, 2013). Meanwhile, there is no significant difference with regard to cost to income ratio during global financial crisis (Bourkhis & Nabi, 2013). However, in practice, as experience shows, some Islamic banks (Al Rajhi bank in Saudi Arabia, Dubai Islamic Bank in UAE and Kuwait finance house in Kuwait) were affected negatively by the crisis and even closed their doors (Zeineb & Mensi, 2014). Due to different evidence on the effect of equity- based financing on financial crisis and efficiency, the present study attempt to fill this gap by analyzing whether equity -based financing affect the efficiency level of Islamic banking. The rapid increases in Islamic banking especially during financial crisis make it important to have greater understanding of efficiency and it drivers.Despite the growing study focusing on an efficiency of the Islamic banking industry (Abdul Majid, 2010; (Kamaruddin, Safa, & Mohd, 2008)Kamaruddin, Safa, & Mohd, 2008; Mokhtar, Abdullah, & Alhabshi, 2008 and Sufian & Haron, 2009), analysis of Islamic banking efficiency at a regional level such as (Noor, Noor, Ahmad, & Sufian, 2011; Saleh & Zeitun, 2007; Viverita, Brown, & Skully, 2007; and Yudistira, 2004) are still at its infancy. As far as the researcher aware of there were no studies focusing on the types of financing contract and efficiency level of Islamic bank. This research is unique because it will analyze whether the types of financing contract affect the efficiency level of Islamic banks. In order to monitor and estimated the impact of equity-based financing and debt-based financing towards bank performance, this study will examine various types of banks specific and countryspecific factors. Besides, this study will use unbalanced panel data of Islamic banks in Malaysia and Indonesia from 1996 – 2012. The current study chooses those countries because due to data availability regarding the types of financing contract for Islamic bank. Moreover, in Malaysia only 0.5 per cent Islamic banks is based on profit and loss sharing principles. Meanwhile 1

Assets-based means that an investment is structured on exchange or ownership of assets, placing Islamic banks closer to the real economy. Asset- based consist of equity-based financing and debt-based financing.

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Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

according to Bank Indonesia (2009), approximately 35.7 per cent are based on equity-based financing by the end of 2008 (Abedifar, Molyneux, & Tarazi, 2012). The report showed that the use of Profit and Loss sharing (PLS) modes of financing in Indonesia is the highest compared to other countries (Abedifar, Molyneux, & Tarazi, 2012)2. Thus, the main objective of this study is to examine whether equity-based financing affect bank efficiency. Furthermore, it salient characteristics such as stable economic growth, political stability, high economic freedom, good infrastructures, abundant natural resources and capital - intensive industries motivate this study to explore the efficiency level towards their Islamic banks. Using an output distance function and Stochastic Frontier Approach (SFA), we found that ratio of total equity to total assets, GDP growth, ratio of total financing to total deposit, telephone and internet are significant in influencing potential output in Malaysia and Indonesian Islamic banks. Turning to inefficiency determinants, total assets, equity – based financing, country risk and economic freedoms are significantly affect inefficiency level of Islamic banks. The rest of the paper is organized as follows: Section 2 review selected studies on efficiency in Islamic banks. Section 3 will explain on methodology undertaken by this study. Section 4 discusses the data and empirical specification, section 5 discusses the result and finally, Section 6 is conclusions. 2. REVIEW OF THE LITERATURE Efficiency evaluation for Islamic banks Studies in this area are divided into two groups. Firstly, studies that evaluate the performance of Islamic banks using traditional financial ratios(Bader, Mohamad, & Ariff, 2007; Hassan & Bashir, 2003; Saleh & Zeitun, 2007; Samad & Hassan, 1999). Some of these studies compared their results with conventional banks. Secondly, studies that focuses on bank efficiency using the frontier analysis approach rather than traditional financial ratios. Studies in this group can be divided into three areas of specialization. First, studies that evaluate the efficiency of Islamic banks(Yudistira, 2004); Abdul-Majid et al., 2005; Bader et al., 2007; Sufian, 2007; Viverita et al., 2007; Kamaruddin et al.; Mokhtar et al., 2008; Noor et al.2011;Dost, Ahmad, & Warraich, 2011; Nai Chiek & Tan, 2012). Second, studies that evaluate the efficiency of conventional bank (Williams, 2004; Bruce Q.Budd, 2010; Abdul-Majid, David, & Battisti, 2011; Chortareas et al., 2011 and Manlagnit, 2011), and third, studies that compare the efficiency of Islamic and conventional bank (Abdul Majid, 2010; Al-Jarrah & Molyneux, 2007; Al-Khasawneh, Bassedat, Akten, & Thapa, 2012; Arslan & Ergec, 2010; Bader et al., 2007; Hassan, Mohamad, & Bader, 2009; Srairi, 2010; Wasiuzzaman & Gunasegavan, 2013; Yahya, Muhammad, & Hadi, 2012)and the recent study conducted by (Saeed, Ali, Adeeb, & Hamid, 2013).

2

Mills and Presley (1999) also claim that PLS is only marginally practiced in Bangladesh, Egypt, Iran, Pakistan, Philippines and Sudan.

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Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

Although the efficiency features of a conventional banking sector have been examined extensively, particularly the United States and European banking markets, the works on Islamic banking remain in their infancy. Based on recent literature that studied efficiency, it appears that most researchers used the Data Envelopment Analysis (DEA) approach (Ahmad & Abdul Rahman; Al-Khasawneh et al.; Nai Chiek & Tan; Yahya et al.,2012; Dost et al.; Noor et al., 2011., Arslan & Ergec; Q.Budd & R.Budd, 2010; Hassan et al., 2009; Kamaruddin et al.; Mokhtar et al. 2008; Sufian; Viverita et al., 2007; and Yudistira, 2004). Meanwhile, only few authors such as (Saeed & Izzeldin, 2014 ; Abdul-Majid et al., 2011; Abdul-Majid; Srairi, 2010; Mohamad et al., 2008; Al-Jarrah & Molyneux, 2007; Abdul-Majid et al. 2005; and Williams, 2004) used the Stochastic Frontier Analysis (SFA) approach. Equity –based financing and Islamic bank efficiency Musharaka and Mudaraba represent the core of Islamic financing. In Musharaka, Islamic banks share financing and management with their clients and the profit is shared based on agreed ratios. As for losses, they are shared based on their initial contribution to the business. On the other hand, in Mudaraba, the owner of capital entrusts his capital with the Mudarib who acts as an entrepreneur to run the business. At the end of the agreed upon period, the Mudarib will return the principal and share of agreed upon profit to the investor. Any losses from the venture are exclusively borne by the capital owner. The Islamic bank may act as a financier or a Mudarib. As a financier, the Islamic bank provides capital to the entrepreneur while as a Mudarib, the Islamic bank manages the funds deposited by its clients. For both cases, profit is distributed based on agreed ratios (Chazi & Syed , 2010).

Furthermore, Murabaha mode of financing requires real assets to underlie financial transactions. This linkage with the real economy helps to reduce leveraging and prevents the exposure of Islamic banks to speculative behaviour, which leads to instability. Islamic banks will channel its investment deposit into profit and loss sharing (PLS) loans such as Mudaraba and Musharaka. Given that neither the principal nor the return of the investment deposits are guaranteed 3, any loss that occurs on the assets side could be absorbed in their entirety on the liability side 4. Thus, the PLS allows Islamic banks to transfer the credit risk from its assets to its liabilities. If the value of assets decreases, then the value of liabilities should also decrease. As a result, an Refer to IFSA 2013-Section 148 ‘Islamic deposit’- “No person shall accept Islamic deposits except under alicence granted under section 10 regardless of whether the transaction is described as a loan, a financing, an advance, an investment, a savings, a sale or a sale and repurchase or by whatever”. 3

4

Depositors ‘accounts comprise non-investment and investment deposits. Non-investment (safe keeping) deposits take the form of current accounts, which are not entitled to any profits nor do they bear any risk of loss as they can be withdrawn by depositors on demand. Investment deposits comprise deposits for unlimited periods, limited periods, and savings accounts. Unlimited investment deposits are initially valid for one year and are automatically renewable for the same period unless notified to the contrary in writing by the investor. Investment deposits for a limited period are initially valid for one year and are renewable only by specific instructions from the depositors concerned. Investment savings accounts are valid for an unlimited period. Investment deposits receive a predefined proportion of profits or bear a share of the losses based on the results of the financial year (Hassan & Dridi, 2010).

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Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

individual bank as well as the entire Islamic banking system is less exposed to bankruptcy (Abdul Rahman ,2012 and Bourkhis & Nabi , 2013). In addition, profit sharing is more stable than the interest based system. It prevents from fluctuation in rates of return. Moreover, it has been pointed out that interest based debt financing is a major factor in causing economic instability in capitalist economies. The focus of Islamic banking on profitability and rate of return of investments on equity and profit sharing mode of financing increase the potential of directing financial resources to the most productive investments, and hence increases the efficiency of the financing process (Chapra ,1992; Kahf ,1982; Siddiqui ,1983; Zarqa ,1983 and Kahf et al, 1998). Determinant for Islamic Bank Inefficiency Focusing on the bank specific variable, size is significant in influencing the efficiency levels of banks (Chortareas et al., 2011; T. Hassan et al., 2009; Mohamad et al., 2008; Al-Jarrah & Molyneux, 2007; and Abdul Majid et al. 2005). Besides, the bigger the size of the conventional commercial banks the higher the technical and scale efficiency score ( Ahmad & Abdul Rahman ,2012). In addition, large banks are better able to utilize more efficient technology with less cost, prepare more specialized staff for the most profitable activities, and provide higher quality output resulting in higher prices. Based on this, they conclude that large banks seem to be more profit efficient than small banks ( Al-Jarrah & Molyneux, 2007).This contrasts with the research of Arslan & Ergec (2010), which found that small size banks in Turkey are more efficient. Furthermore, small banks appeared to be more allocative and technically efficient compared to larger banks, which in turn made small banks more profit efficient (Darrat et al., 2002). In addition, Islamic banks in Malaysia are inefficient due to the comparatively smaller size of Islamic banks. This is a result of a lack of economies of scale, in addition to high cost to income ratios due to an increase in staff cost and overheads. Moreover, Islamic banks in Malaysia incurred high cost in their promotional activities as well as marketing and higher investment in technology (Kamaruddin et al., 2008). Meanwhile, size does not play an important role in determining the level of efficiency. There was no evidence to suggest that small banks are necessarily more cost efficient than large banks (Q.Budd & R.Budd, ,2010) and Isik & Hasan, 2000). In estimating frontier, equity to total asset ratio does not directly influence efficiency but directly influences financial friction. High capital will prevent moral hazard and alleviate informational friction, which will lead to more efficient financial institutions (Chortareas et al., 2011). In addition, banks which have high equity to asset ratio it cost is lower compared to those bank which depend more on deposits (Abdul-Majid et al. 2011). Meanwhile, banks which faced high non-performing loan, it would incur high costs. Banks therefore require more input in order to monitor default loans (Abdul -Majid et al., 2010). A similar finding was reached when AbdulMajid et al. (2011) treated loan quality as an environmental variable. The result significantly showed that high non-performing loans lead to increased cost for banks. This will affect the efficiency level of the bank. These different results show the importance of the impact of the control variable on measuring efficiency. Moreover, it is necessary when judging the relative efficiency of banks. 47

Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

Referring to the cross country analysis, Islamic banks in the Middle East and Turkey scored the highest cost, while African Islamic banks scored the lowest cost efficiency (Mohamad et al., 2008). In addition, Asia was the best region for changes in their productive and technical efficiency while Indonesia and Yemen are the most improved countries in terms of their productive and technical efficiency components (Viverita et al., 2007). Meanwhile, the United Arab Emirates had the best use of inputs and outputs for efficiency change. Malaysia had been expected to be the most efficient and improved country due to its innovation in Islamic products. Their finding is in line with that of Ahmad et al., (2010) which stated that Indonesia is the most efficient among the Asian region, with the mean efficiency score of 92.3%. In conclusion, most of the previous studies choose Africa, Asia, and Middle East such as Jordan, Egypt, Saudi Arabia and Bahrain (Viverita, 2007; Al-Jarrah and Molyneux (2003) as a sample of their research. In short, based on previous literature, there are few methods used to estimate efficiency which are SFA, DEA, ROA and ROE. For estimating efficiency level it is recommended to use Stochastic Frontier Approach because it distinguishes between inefficiency and other stochastic shocks. Furthermore, using this model allows the inclusion of additional control variables such as country-specific variables in the equation of the model compared to the non-parametric technique of DEA. SFA allows the efficiency between country and efficiency between Islamic and conventional banks to be compared. Focusing on inefficiency determinants most of the previous researches include size, non-performing loan, financial crisis and bank dummy as it determinants. Given the asset-based foundation of Islamic banks, none of the previous studies empirically analysed the effect of equity-based financing on the efficiency level of Islamic banks.

3. 3.1

METHODOLOGY Output distance function

Generally, efficiency study estimates a common frontier to compare the performance of banks against the efficient frontier. In 1957, Farrell has developed the technical inefficiency as the maximum possible expansion of an output from given inputs. Moreover, Aigner, et al. (1977), Meeusen and Broeck (1977) suggested taking into account two sources of deviations using parametric SFA. The model estimates a frontier production function under a two-component error term. The error term assumes that deviation from the frontier function is due to either inefficiencies or statistical noise. The two-sided statistical noise has a normal distribution with zero mean and variance . With regard to the inefficiency component of the error term, Aigner et al. (1977) assumed a half-normal distribution that is truncated above at zero . However, Stevenson (1980) used a truncated normal distribution that is truncated above at . In another study, Meeusen and Broeck (1977) employed a single parameter exponential distribution

to separate the two components. Finally, Greene

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Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

(1990) developed a two-parameter gamma distribution statistical noise.

to separate inefficiency from

The current research used truncated distribution to generate bank technical efficiencies. It allow for a wider range of distributional shapes. That is a common frontier in the Malaysia and Indonesia which demonstrates the efficient level of output for given inputs. The output distance function is non-decreasing, positively linearly homogeneous, increasing in Y, decreasing in X, and defined as the maximum feasible expansion of the output vector given the input vector (Fare and Primont 1995).The production possibility set is the area bounded by the production possibility frontier (PPF), which defines the maximum feasible output. If firms produce on the PPF, it indicates technical efficiency. It differ for an inefficient firm operating within the area bounded by the PPF, , indicating the ratio of actual output to potential output. Based on Farrell’s (1957), output-oriented measure of technical efficiency can be represented as: (1) 3.2 The econometric specification By referring to Fare and Primont (1995) and Cuesta and Orea (2002), and allowing for exogeneous factors, the general form of a stochastic output distance function can be shown as: (2) Where , is a vector of outputs, is an input vector, is an exogenous factor vector and is a vector of parameters. Inefficiency is accommodated in the specification of , as is a composed error term comprised of , which represent random uncontrollable error that affects the n-th firm at time t, and is assumed to be attributable to technical inefficiency. Next, in order to estimate this model, the current research will follow the standard practice of imposing homogeneity of degree one in outputs on the distance function, which implies that . By randomly choosing the M-th output, we then can define and write: (3) Which, after assuming rearranging terms yield the general form:

and (7)

Lastly after assuming a standard translog functional form to represent the technology, the output distance can be represented as:

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Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

(4) Where = k = 1,2…….K and s =1, 2……, K are indices for input; m=1,2……M and j=1,2,…….M are indices for output; h=1,2…..H is an index for the total of H environmental Z variable that are included to account for differences in operating environment discussed above, and the Greek letters (except ν and μ)represent unknown parameters to be estimated. Standard symmetry is imposed to the second order parameters by imposing the constraints . By specifying Battese and Coelli (2005)’s truncated normal SFA model with the mean of the truncated distribution made an explicit function of country dummy variables and size differences across banks. is assumed to be normally distributed with zero mean and variance and independently distributed of is assumed to be drawn from a truncation at zero of the normal distribution with mean, and variance where and are parameters to be estimated, f =1, 2…, is an index for countries, C is a country dummy and S is a bank size which measured by total assets. It can be estimated using the maximum likelihood estimation (MLE) techniques. This represented in the following equation: (5) Given the output distance function specification in equation 8, the recent model includes directly the appropriate Z variables in the estimated frontier to controls for country- specific operating characteristics in Islamic banking. Therefore, the estimated inefficiency score are net of the impact of controlled for environmental influences in efficient potential output. The simultaneous estimation in equation 8 and 9 enable one to estimate inefficiency under the assumption that banks operate in an equivalent environment, different countries and different size. Accordingly, if , it implies that the probability of observing higher inefficiency decrease (increase) with bank size by assuming ceteris paribus or other variables is constant. Similarly, if , resulting from the truncated normal inefficiency distribution, ceteris paribus, it shows that the probability of observing higher inefficiencies is lower in Country B than in Country A. In other word, a finding that is statistically significantly less than , therefore, it signal presence higher inefficiency in Country A. Following from equation 5 and given the model assumption, an estimate output distance can be derived as . Therefore, an estimate of output-oriented efficiency is obtained as: (6) Based on equation 10, relies on unobservable inefficiency. Thus, this research will follow the standard approach as describe by Frame and Coelli (2002) and Battese and Coelli (2005) to estimate given the observed value of the overall composed error term, . 50

Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

4.

THE DATA AND EMPIRICAL SPECIFICATION

The data used to estimate the output distance function consists of 17 Islamic banks from Malaysia and 9 from Indonesia. The inputs and outputs were provided by the Annual Report and span the period 1996-2012, giving an unbalanced panel of 169 annual observations. The data are deflated by Gross Domestic Product (GDP) deflators in constant 2000 prices in Local Currency Units (LCU) and are expressed in the U.S. Dollar (USD). The conversion rates and GDP deflators were drawn from the World Bank's World Development Indicators (WDI). Table 1 shows the distribution of 26 Islamic banks for Malaysia and Indonesia. The selection of output and input variables follow the intermediation approach, which has been widely employed in Islamic banks studies (Yudistira, 2004; Abdul Majid et al. 2005; Sufian, 2007; Viverita et al., 2007;Mokhtar et al., 2008; Ahmad et al., 2010). This approach was suggested by Sealey and Lindley (1977) and in fact is complementary to the production approach. Based on this approach, it views bank as an intermediates in collecting funds and transforming these into loans and other assets. The intermediation approach is the most suitable with the concept of Islamic banking in intermediating savers and investors of funds. This is because the nature of Islamic banking that relies on profit sharing contract, which involve equity participation principle with depositors. Banks will intermediate savers and investors by transforming the deposit into earning assets rather than as producers of services and loans. The selection of output and input variables follows the existing literature on Islamic banking study such as ( Yudistira 2004; Viverita et al., Sufian 2007; Mokhtar et al., 2008; Ahmad et al., 2010; Dost and Ahmad, 2011). This research includes two outputs, total financing and other earning assets include investment securities held for trading, investment securities available for sale and investment securities held to maturity, and two inputs total operating expense and total funds which include deposit from customer and other banks. Table 2 presents the average values of total output, total input, total banks asset, total equitybased financing and total debt-based financing. All values are express in thousand international dollars for each country over the 1996–2012 periods. The Column 2 to Column 5 shows Islamic banks total outputs and inputs. Table 2 reveals that there has been a marked decrease in the total fund and other earning assets in Malaysian Islamic banks by 14 and 12.8 per cent from 1997 to 1998. After the imposition of capital control in 1998, it shows a slight increase in total financing in 1999. Meanwhile, during the global financial crisis Malaysian Islamic banks marked decline in other earning assets about 15.3 per cent in 2008. It might be due to decrease in its level of investment. In 2000, Indonesian Islamic banks show a sharp decline (43.42 per cent) in its total financing. After the Indonesian government opts for the assistance from the International Monetary Fund (IMF) in October 1997, it keeps interest rate high and reluctance of many banks to provide new loans for firms and consumers. Besides, banks were already shaky because of excessive property lending, raising amount of non-performing loan, large deposit withdrawal from year 2000 to 51

Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

2001 and finally it caused bank run (Azis, Thorbecke & Thorbeeke, 2001). The IMF program did not succeed. Therefore, in year 2000, new government negotiated a new three - year extended arrangement for about US$ 5 billion with the IMF. The macroeconomic framework seeks to restore an annual growth rate in the vicinity of 5 to 6 percent by 2002, with an annual inflation target of below 5 percent. In addition, the Financial Sector Policy Committee was established with the mandate to provide leadership and direction in banking and corporate restructuring. The main objective in bank restructuring efforts is to capitalize all the banks, including through the provision of public funds, to an 8 percent capital adequacy ratio by end-2001. In 2004, after recover from the Asian financial crisis, it shows sharp increases in it total assets, total financing, other earning assets as well as total fund. However, these gains were eroded due to negative impact of the world oil price hike on the domestic economy in 2005 to 2006 (Ismal, 2013). Furthermore, from 2007-2009, Indonesian Islamic banks experience drop in it total financing and total fund due to global financial crisis. Column 6 shows that the average value of total assets for Malaysian Islamic banks gradual decrease about 5.15 per cent in 1998 due to Asian financial crisis. Then, it continuously increases from year 2000 to 2007. However, during the global financial crisis the average value of total assets show a slight decrease about 1.35 per cent in 2008 and it continuously increases until 2012. For Indonesian Islamic banks it average total assets increase gradually from year 2000 to 2003, but after Indonesian government received financial assistance from the International Monetary Fund it shows a sharp increase in its total assets about 56.5 per cent. However, it shows a huge decrease during the global financial crisis.

Table 1 Sample of Islamic banks, 1996-2012 Category of banks Country Malaysia

Years 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Ownership Domestic 1 1 1 1 2 2 2 2 2 2 2

Foreign 0 0 0 0 0 0 0 0 0 1 2

Subsidiarylocal 0 0 0 0 0 0 0 0 0 2 5

Subsidiaryforeign 0 0 0 0 0 0 0 0 0 0 1

Total 1 1 1 1 2 2 2 2 2 5 10

public 1 1 1 1 2 2 2 2 2 4 7

foreign 0 0 0 0 0 0 0 0 0 1 3 52

Total 1 1 1 1 2 2 2 2 2 5 10

Proceeding of the 2nd International Conference on Management and Muamalah 2015 (2nd ICoMM) 16th – 17th November 2015, e-ISBN: 978-967-0850-25-2

2007 2008 2009 2010 2011 2012

2 2 2 2 2 2

2 2 2 2 2 2

7 9 9 9 8 8

1 4 4 4 4 4

12 17 17 17 16 16

9 11 11 11 10 10

3 6 6 6 6 6

12 17 17 17 16 16

Indonesia 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

1 1 1 1 1 1 1 1 1 1 1 1 1 1

0 0 0 0 0 0 0 0 0 0 0 0 0 0

0 1 1 1 1 1 1 1 1 2 4 7 7 7

0 0 0 0 0 0 0 1 1 1 1 1 1 1

1 2 2 2 2 2 2 3 3 4 6 9 9 9

1 2 2 2 2 2 2 3 3 4 6 9 9 9

0 0 0 0 0 0 0 0 0 0 0 0 0 0

1 2 2 2 2 2 2 3 3 4 6 9 9 9

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Table 2 Average total output, total input, total assets, total equity-based financing and total debt-based financing for Islamic banks, 1996-2012 Malaysia

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Output Other Total Earning Financing Assets 17424.10 10183.30 20447.90 11899.50 21070.80 10377.60 24557.60 20221.00 17436.45 21479.60 22966.35 26518.90 25505.45 31389.15 27035.00 30737.65 28306.75 25816.90 26462.57 25287.80 14390.71 15275.90 18314.24 17258.55 20110.33 14618.67 28567.78 20781.97 32805.94 20748.33 39487.80 24668.97 49475.77 25875.13

Input Operating Expense 619.69 675.93 714.08 766.89 546.87 811.22 945.96 986.47 1012.25 948.75 334.52 527.73 403.86 628.51 759.75 644.36 788.70

Total funds 27834.50 30740.70 26412.50 40431.10 36097.80 45102.65 53504.00 57506.65 51250.75 46811.43 26526.19 29054.80 29687.14 39081.60 39572.24 52242.94 60243.70

Inefficiency Determinants

Total assets 31432.60 36726.00 34833.20 48657.40 42284.65 51445.50 58535.35 62959.10 57523.00 53610.27 31674.58 37016.33 36515.98 50555.88 54792.60 67300.13 85484.38

Total Equitya 347.16 321.74 223.36 284.48 97.60 647.33 809.79 779.16 235.97 116.58 0.43 207.74 118.50 318.36 811.26 1486.23 1410.89

Total Debtb 15890.80 19228.50 20644.40 23260.90 16465.44 20173.70 21859.30 24162.85 25453.25 24027.23 9027.26 11347.93 10572.66 15152.36 17384.54 19397.37 24795.17

Equity to Debt EWS 0.0218 0.0000 0.0167 0.0509 0.0108 0.8006 0.0122 0.0524 0.0046 0.0300 0.0228 0.2184 0.0261 0.1216 0.0218 0.0925 0.0064 0.0535 0.0029 0.0500 0.0000 0.0187 0.0211 0.0058 0.0082 0.0016 0.0763 0.0439 0.0425 0.0022 0.0869 0.0003 0.1154 0.0004

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Indonesia

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Output other total earning financing assets 3283.42 168.60 1857.56 576.79 2435.10 375.79 3464.74 185.41 5057.54 286.54 9395.58 1814.92 9212.55 1721.71 8618.26 541.16 7875.50 727.05 7114.94 1294.33 5497.08 1285.94 3680.88 1916.38 4164.93 1239.86 6481.68 960.06

Input operating expense 112.22 154.35 188.49 230.60 372.25 421.53 607.76 584.26 492.02 357.03 204.81 171.60 296.85 334.57

total funds 2685.82 1796.70 2341.46 429.59 651.97 5442.18 9841.86 8531.56 1185.51 1801.75 1015.03 975.22 1201.53 1249.48

Inefficiency Determinants

total assets 3526.04 3109.52 3506.94 4760.96 7841.86 12270.95 12592.05 11385.25 9135.53 6420.35 6295.77 8416.44 6319.73 7347.39

Total Equitya 1085.96 519.87 578.28 673.06 1349.96 3056.19 3465.69 3661.30 2941.00 1994.42 1802.38 1259.92 1231.00 1962.63

Total Debtb 2197.46 1336.58 1838.07 2554.20 3411.74 6353.48 5333.96 4445.50 3576.20 3915.33 3464.92 2058.81 2425.05 3232.36

Equity to Debt EWS 0.4942 0.6296 0.3092 0.5271 0.2825 0.7431 0.2376 0.0000 0.4034 0.0004 0.5904 0.1411 0.6571 0.1234 0.8310 0.0248 0.6848 0.0024 0.5155 0.1430 0.5092 0.0256 0.5982 0.0186 0.4585 0.0008 1.3275 0.0286

Values are in (thousand Int'l $) a Total equity comprised of Musyarakah and Mudharabah types of financing b Total debt comprised of Bai bi-thaman ajil, Murabaha and Istisna types of financing c total financing comprised of total equity, total debt & others types of financing such as Ijarah, Ijarah muntaha buy al-biltamlik,buy and etc.. 55

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To identify the common frontier, this research will include variables describing distinctive features of the economy, the banking industry and the geography of each country. These variables are grouped into three categories. The first category includes macroeconomics conditions consists of GDP per capita. This variable explains the macro condition under which bank operates. Per capita GDP is used as a proxy for economic development. It also has an impact on demand and supply of deposit and loans. It is expected to be positively associated with the total output. The second category includes banking structure in measuring banking concentration and intermediation ratio. The intermediation ratio is measured by the total loan to total deposit. This variable included in the model because to capture the differences among banks in term of their capacity to covert deposit into loans. It is expected that the higher the intermediation ratio, the higher bank output (Carvallo and Kasman, 2005; (Abdul Majid, 2010) (Srairi, 2010). The third category includes proxies for accessibility of banking service. The proxy variable is telephone line per 100 inhabitants. With an easier access to telephone lines, it is expected to increase potential bank output. Finally higher number of broadband subscribers increases potential bank output. Table 3 describe the average value of those environmental variables for each country from 1996-2012. It was a huge gap for the GDP per capita. This is because Indonesia is a low- middle–income economies while Malaysia upper- middle-income economies5. Furthermore, the banks in Malaysia convert more than half of their deposit into loan while the others convert into investment. In contrast, Islamic bank in Indonesia almost convert all the deposit into loan. Lastly, for the telephone line, Malaysia showed more advance in term of electronic communication used compared to Indonesia. Table 3: Environmental Characteristics by variables (1996-2012) Panel A : Macroeconomics condition GDP growth Panel B: Bank structures Intermediation ratio (%) Financing to Deposit Total Equity to Total Assets Panel C: Accessibility of banking service Telephone lines per 100 inhabitantas Internet (Fixed broadband subscribers per 100 people)

Malaysia

Indonesia

4.64

5.64

0.75 0.087 0.087

5.27 0.139 0.139

16.23 5.26

11.83 0.67

Source: Islamic banks Annual Report, World bank Database, own calculation. 5

Lower-middle-income economies ($1,026 to $4,035), Upper-middle-income economies ($4,036 to $12,475). (source worldbank database).

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Then, focusing on inefficiency specification, the first determinant is size of the banks. It is measured by the total assets of the banks ( Karim,2001; Yudistira, 2004; Abdul Majid et.al ,2005; Al-Jarrah & Molyneux, 2007; Hassan et al., 2009; Srairi, 2010 and Abdul Majid,2010). This variable is expected to have negative sign as increase in total assets, decreases inefficiency. Next, the second variable is the ratio of total equity financing to total debt financing. In Mudaraba financing, the entrepreneur who is given the responsibility to manage the capital should manage it accordingly in order to avoid credit and market risk among others. Based on two different types of financing contracts, namely equity-based financing and debt-based financing, Qureshi (1984) and Naqvi (1981 and 1982) claim that equity-based financing in the Islamic framework will increase the exposure of the Islamic bank to risk. In Islamic banks, credit risk is high under the Mudaraba and Musharaka types of financing contracts (Ariffin, Archer, & Karim, 2009). It is due to asymmetric information problem in which the entrepreneur does not provide sufficient information to the financier on the actual profit of the bank. This form of credit risk is referred to as ‘capital impairment risk’, as the obligor has no contractual obligation to return the financier’s capital intact. However, the consensus among Islamic scholars is that the elimination of interest tends to increase stability (Turen, 1996). The focus of Islamic banking on profitability and rate of return of investments on equity and profit sharing mode of financing increase the potential of directing financial resources to the most productive investments, and hence increases the efficiency of the financing process (Kahf et al, 1998).Therefore, Islamic banks which focus more on equity-based financing is expected to increase its efficiency. The third variable is the interaction between financial crisis and the ratio of equity financing to debt financing. As Islamic banks have intrinsic principles which are asset-based6 and risk sharing nature (Hassan & Dridi, 2010), it enable them to avoid from the direct effect of financial crisis and risk exposure. Considering the effect of financial crisis, Islamic banks which are focus more on equity –based financing are expected to decrease inefficiency. The fourth variable is a dummy variable for public ownership7. This variable is expected to have a positive sign indicating increase in inefficiency. This may be because state-owned banks are usually focusing on direct lending or with specific objectives such as developing certain industries or regions (Berger, George, Cull, Klapper and Udell, 2005). In addition, (William and Nguyen, 2005) state that foreign banks are more efficient because they have superior management practices and technology. The fifth determinant is country risk. Country risk refers to the ‘probability of occurrence of political events that will change the prospects for profitability of a given investment’ (Haendel,

6

Assets-based means that an investment is structured on exchange or ownership of assets, placing Islamic banks closer to the real economy. Asset- based consist of equity-based financing and debt-based financing. 7 Public ownership is referring to banks with more than 50 percent government ownership through its agencies such as the Employees Provident Fund (EPF) and Permodalan Nasional Berhad (PNB)

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West & Meadow, 1975). In 20108., Euromoney assigns a weighting index to seven categories It includes political risk, economic performance, access to bank finance or capital markets, debt in default, credit rating, debt indicator and discount forfaiting. The higher value of the index show better position and less risk. For example in political risk it includes corruption, government nonpayments, government stability, information access, institutional risk, regulatory and policy environment. Firm level corruption affects intertemporal optimization and distorts the government's choice towards more restrictive regulation such as less bank competition. Bank competition can be stimulated easily by granting foreign bank access to the domestic market. High bank competition the most effective tool in fostering efficiency levels (Yildirim and Philippatos, 2007). However, numerous countries9 including Malaysia and Indonesia are actively hampering foreign bank access. The insistence on domestic bank protection is seem inconsistent, since the finance-growth literature emphasizes that efficient financial intermediation fosters growth (Wieneke & Gries, 2011). Therefore, no prior assumption is made for this variable. The final determinant is economic freedom. Economic freedom is an index which capture 10 specific freedoms that are business, monetary, financial, fiscal, corruption, property, government spending, trade and investment. It indices between 0 to 100 scales, where 100 represent the maximum freedom. It is a key for the creation of environment that allows for virtuous cycle of entrepreneurship, innovation and sustained economic growth and development. Overall, one can argue that economic freedom can be used as a significant policy tools in enhancing the efficiency of the banking institutions. When relating economic freedom to bank performance, ( Sufian, & Zulkhibri, 2013 and Sufian & Habibullah, 2010); found that economic freedom has positive and significant impact on profitability of Malaysian banks. Furthermore, the higher the degree of an economy’s financial freedom, the better the banks’ performance is in terms cost advantages and overall efficiency (Chortareas, Girardone, & Ventouri, 2012). However, if government intervention rises beyond the minimal level, it becomes corrosive to freedom and the first freedom affected is economic freedom. Greater direct control by government is a threat to the function of banking system because excessive government interference can introduce inefficiencies and outright corruption (Beach, Kane, 2007). Therefore, this variable is expected to have a negative sign. High degree of economic freedom decreases banking inefficiency.

5.

RESULTS

5.1

The output distance function estimates

8

In 2009, Euromoney assigns a weighting to nine categories including political risk (25% weighting), economic performance (25%), debt indicators (10%), debt in default or rescheduled (10%), credit ratings (10%), access to bank finance (5%), access to short-term finance (5%), access to capital markets (5%), forfaiting (5%). 9

Numerous countries include Ethiopia, Algeria, China, India, Indonesia, Kenya, Pakistan,Sri Lanka, Thailand, Uruguay, Brazil, Egypt, Mexico, Philiphines, Poland, Romania and Rusia.

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The estimated output distance function parameters are reported in Table 4. Model A includes the ratio of non-performing financing to total financing, ratio of equity to total assets, GDP growth, ratio of total financing to total deposit, telephone and internet as describe in table 4. While model B excludes ratio of non-performing financing to total financing which is individually insignificant in Model A. A negative correlation between ratio of total equity to total assets and bank potential output demonstrated that an increased in equity financing involves higher costs relative to increase in deposits. Therefore, its potential output will decrease. Based on Table 4, surprisingly, high growth rate was found to decrease the level of output. For the developing economies, there is a positive relationship between growth and inflation if the annual inflation rates below the threshold level which is 11 to 12 per cent (Khan & Senhadji, 2001). High level of inflation rate affects level of deposit (Han & Melecky, 2013). Most of depositors withdraw their money during the financial stress or crises (Huang & Ratnovski, 2011). Subsequently this also affects investment and productivity growth of a country (Huang & Ratnovski, 2011 and Fischer, 1993). As shown in Model B, the higher the concentration ratio, the lower the potential output. This result may be explained by the fact that high market power lead to increase in cost and subsequently banks may become inefficient in producing output. The negative sign of fixed telephone lines per 100 inhabitants’ indicates that greater availability of telephone lines increases bank outputs. Contrary to expectations, this study did not find a significant difference between fixed broadband subscribe per 100 users and bank output. This inconsistency may be due to Malaysia and Indonesia are developing economies. Whereby the usage of electronic communications such as internet-banking are not fully developed. Therefore, internet usage may raise relative bank costs within the sample of countries. Then, focusing on inefficiency determinants, there is a negative correlation between total assets and inefficiency showed that big size of Islamic banks is more efficient. The present findings seem to be consistent with other research (Karim 2001 and Abdul Majid et al., 2005) which found cost inefficiency decreased with bank size. Large banks enjoy several advantages compared to small banks. For example, big size banks able to utilize more efficient technology with less cost and prepare more specialized staff for the most profitable activities (Al-Jarrah & Molyneux, 2007). Based on the result in Table 4, the level of inefficiency decreased when Islamic banks provide more equity – based financing compared to debt –based financing. In other word, Islamic banks become more efficient if they are focus more on equity-based financing rather than debt-based financing. For example in Mudaraba financing, the entrepreneur who is given the responsibility to manage the capital should manage it accordingly in order to avoid credit and market risk. The focus of Islamic banking on profitability and rate of return of investments on equity and profit sharing mode of financing increase the potential of directing financial resources to the most productive investments, and hence increases the efficiency of the financing process (Kahf et al, 1998). Furthermore, equity lending and direct investment play a much bigger role (Chapra,2008).Islamic banks can contribute more significant to the society by increasing the 59

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quality of low-income people and needy if they employ more equity-based financing (Ismal, 2013). It clearly stated in Table 4 that the level of inefficiency for Islamic banks which provide more equity-based financing compared to debt-based financing are not affected during the financial crisis. As Islamic banks have intrinsic principles which are asset-based and risk sharing nature (Hassan & Dridi, 2010), it enable them to avoid the direct effect of financial crisis and risk exposure. Islamic banks are more stable during the financing crisis (Chazi & Syed, 2010). They able to avoid the direct effect of financial crisis due to their intrinsic principles which are assets based and risk sharing nature (Hassan & Dridi, 2010). Based on Table 4, a positive correlation between country risk and inefficiency explained that the lower the risk level of Islamic banks, the higher the level of inefficiency. Under the political risk, high firm level corruption distorts the government's choice towards more restrictive regulation such as less bank competition (Wieneke & Gries, 2011). Less bank competition indicates high level of inefficiency (Yildrim & Philippatos, 2007). In addition, restriction on capital flow reduces international investment. Reductions in foreign funding and loans to domestic firms destabilize financial and real sectors, especially during crises. Political corruption and government instability caused uncertainty among investors about a crisis. Moreover, they adversely influence investor’s confidence, reduce financing, and finally destabilize external and real sectors (Biglaiser, DeRouen & Archer, 2011). Another important finding was that economic freedom has negative and significant impact on inefficiency level of Islamic banking. It is a key for the creation of environment that allows for virtuous cycle of entrepreneurship, innovation and sustained economic growth and development. Overall, one can argue that economic freedom can be used as a significant policy tools in enhancing the efficiency of the banking institutions. When relating economic freedom to bank performance, ( Sufian, & Zulkhibri, 2013 and Sufian & Habibullah, 2010); found that economic freedom has positive and significant impact on profitability of Malaysian banks. Furthermore, the higher the degree of an economy’s financial freedom, the better the banks’ performance is in terms cost advantages and overall efficiency (Chortareas et al., 2012) .

Table 4: Maximum likelihood estimates for parameter of the output distance function for Islamic banks : 1996-2012 MODEL A MODEL B Estimated Estimated Parameter Coefficient Value SE Value SE ϕ0 α1 α2 λ1 β1

Constant ln X1 ln X2 t ln Y1

0.3812 -0.1064 -0.6299 -0.0288 0.4934

0.1925 0.0327 0.0312 0.0163 0.0332

0.2089 -0.1106 -0.6260 -0.0260 0.4767

0.1780 0.0307 0.0302 0.0158 0.0359 60

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β1,1 Ɵ1,1 Ɵ2,1 α1,2 α1,1 α2,2 λ1,1 Ω1 τ1 τ2 ζ1 ζ2 ζ3 ζ4 ζ5 ζ6 0 1 2 3 4 5 6 σ2 

(ln Y1)2 ln X1 ln Y1 ln X2 ln Y1 ln X1 ln X2 (ln X1)2 (ln X2)2 t2 ln Y1t ln X1 t ln X2 t NON-PERFORMING FINANCING/TOTAL FINANCING EQUTY/TOTAL ASSETS GDPGRWTH TOTAL FINANCING TO TOTAL DEPOSIT TELEFON INTRNET Constant

0.1241 -0.0510 -0.0347 -0.0219 0.1499 0.0318 0.0044 -0.0064 0.0253 -0.0419

0.0235 0.0176 0.0143 0.0109 0.4415 0.0184 0.0027 0.0091 0.0092 0.0067

0.1273 -0.0524 -0.0371 -0.0258 0.3764 0.0425 0.0050 -0.0076 0.0273 -0.0407

0.0225 0.0162 0.0124 0.0110 0.2402 0.0168 0.0026 0.0084 0.0084 0.0067

0.0022 0.5730 0.0103

0.1456 0.2833** 0.0068

0.4591 0.0114

0.2669* 0.0061*

-0.0984 -0.0668 0.0479 1.2947 -0.00x 10-

0.0160*** 0.0122*** 0.0175*** 1.0112

-0.0952 -0.0610 0.0459 1.0926 -0.00x 10-

0.0141*** 0.0119*** 0.0182** 1.0103

0.0000*** 0.2052**

4

-0.4596

0.0000*** 0.0338***

0.9845 0.1267 0.0155*** 0.0212** 0.0330*** 0.0302***

1.1746 -0.1741 0.0380 -0.0437 0.1567 0.9814

0.9907 0.1351 0.0140*** 0.0225** 0.0291*** 0.0146***

4 SIZE EQUITY/DEBT -0.4511 INTERACTION FINANCIAL CRISIS & EQUITY/DEBT 0.9732 PUBLIC-DUMMY -0.1318 COUNTRY RISK 0.0426 ECONOMIC FREEDOM -0.0526 sigma-square 0.1560 lamda 0.9537

Log likelihood

25.98

28.82

a X1 , X2, Y1, Y2, t refer to total operating expense, total fund, total financing, other earning assets and year. b *, **, *** significant at 90%, 95% and 99%

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5.2

Inefficiency Estimates

Table 5 demonstrates the inefficiency estimate for Malaysia and Indonesia. Overall, the estimate inefficiency score for Malaysian Islamic banks is 1.4006 while the estimate inefficiency score for Indonesian Islamic banks is 1.5229. It clearly show that Malaysian Islamic banks are more efficient compared to Indonesian Islamic banks by considering other environmental variables such as economic freedom and country risk. Even though Islamic banks in Indonesia practiced more on equity-based in their financing, it does not give high impact on it efficiency level. From the table, the estimate inefficiency score for Malaysian Islamic banks slightly fluctuate from 2000 to 2012. It showed a sharp increased to 1.9535 from 2007 to 2008 due to financial crisis. But, overall performance inefficiency level declined. Meanwhile, inefficiency level for Indonesian Islamic banks went up and down from 2000 to 2012. During financial crisis it inefficiency level increase drastically from 1.1221 to 1.6582. Then, the trend keep continuously decreased.

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Table 5 : Average inefficiency for all Islamic banks Malaysia

Average Std. Dev Min Max

2000 1.0816 0.0259 1.0632 1.0999

2001 1.3599 0.3794 1.0917 1.6282

2002 1.2700 0.3000 1.0578 1.4821

2003 1.3470 0.4077 1.0587 1.6352

2004 1.3587 0.1828 1.2294 1.4880

2005 1.3035 0.0585 1.2560 1.3688

2006 1.5703 0.3290 1.1450 1.8797

2007 1.4528 0.3843 1.0761 2.3972

2008 1.9535 1.8200 1.0687 8.8964

2009 1.6054 0.4368 1.0281 2.3737

2010 1.3615 0.3547 1.0163 2.3683

2011 1.2215 0.2121 1.0259 1.7181

2012 1.3224 0.2142 1.0341 1.7332

All Years 1.4006 0.3927 1.0885 2.3130

2001 1.6495 0.0477 1.6158 1.6833

2002 1.1215 0.0333 1.0979 1.1450

2003 1.0873 0.0141 1.0774 1.0973

2004 1.4056 0.1653 1.2887 1.5224

2005 1.7875 0.3738 1.5232 2.0519

2006 2.1258 0.3163 1.9021 2.3494

2007 1.1221 0.1278 1.0361 1.2689

2008 1.6582 0.4622 1.2295 2.2682

2009 1.3617 0.2940 1.0444 1.7282

2010 1.2735 0.2018 1.0536 1.6291

2011 2.3154 1.9913 1.1824 6.1079

2012 1.3203 0.2458 1.0355 1.7371

All Years 1.5229 0.3351 1.2768 2.0167

Indonesia

Average Std. Dev Min Max

2000 1.5700 0.0823 1.5118 1.6282

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6.

CONCLUSION

This study employed an output distance function to analyze the effect of equity –based financing on the inefficiency level of Malaysian and Indonesian Islamic banks for the period of 1996-2012. In achieving this objective, this study found that the level of inefficiency decreased when Islamic banks provide more equity – based financing compared to debt –based financing. Furthermore, it efficiency level does not affected during the financial crisis. Focusing on equity-based financing it reduces leveraging and prevents the exposure of Islamic banks to instability especially during crisis. Moreover, it can contribute to the society by increasing the quality of low-income people. Other than that, size, country risk and economic freedom are significant in affecting inefficiency level of Islamic banks. Turning to output distance estimates, this study found that ratio of equity to total assets, GDP growth, ratio of total financing to total deposit, telephone and internet are significant in influencing bank potential output after controlling ratio of non-performing loan to total financing and ratio of equity to total assets. In overall, Malaysian Islamic banks are more efficient compared to Indonesian Islamic banks. Even though Malaysia only offered 5 percent on equitybased financing, other environmental factors such as size, country risk and economic freedom are important in influencing it efficiency level. This study provides a significant contribution to the bankers. Bankers should increase promotion and marketing especially on equity-based products rather than debt-based products. For the investors and society, they will get clear picture on investment opportunities by looking the past performance and current position of Islamic banks. Future studies in this area would benefit from the use of extended data sets by including other countries.

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