An analysis of productivity change: Are UAE banks operating efficiently when compared to GCC Banks?

Author:Kashani, Hossein Attar
Position::Gulf Cooperation Council - United Arab Emirates
 
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INTRODUCTION

Efficiency analysis of commercial banks is particularly needed in a region dominated by bank-intermediated finance. A well developed banking sector was found to bear a positive relationship to economic growth (Levine and Zervos, 1998). It was further suggested that the legal environment within which banks operate can significantly affect economic growth through its effect on bank behavior (Levine, 1998).

The economies of the Gulf Cooperation Council (GCC) have gone through periods of peaks and troughs, mainly because of their dependence on oil revenues and the volatility of oil prices. After a period of economic slump due to declining oil prices during most of the 1990s, GCC countries have been witnessing breathtaking growth thanks to skyrocketing oil prices since 2000. The surge in oil revenues has led to a lifting of the region's economy and the accumulation of large amount of liquidity. This has stimulated an unprecedented investment boom, especially in the property market, and increasing demand for bank services. The question becomes whether banks are well poised to meet the challenges and take advantage of the new opportunities presented to them.

Banks in the region are generally small in size, preventing them from participating fully in the financing of energy-related and other local infrastructure projects. They have long benefited from the protectionist policies of the local governments. Entry and branching restrictions have limited the ability of foreign banks to capture a material share of the local loan and deposit market, even when outnumbering the local ones.

Bank regulators, however, have expressed intentions to, or starts of, changes, which, once completely implemented, would confront the banks--specially the local ones--with serious challenges. To start with, all the GCC member countries are signatories of the WTO agreement, which should result in further liberalization of their economies, in general, and the financial sector in particular. Indeed, most of these six countries have already revised, or are in the process of revising, their "company and investment laws" to allow for higher level of foreign ownership of banks and presence of foreign investors in the local stock markets. It is these changes that made Kuwait, Oman and Saudi Arabia extend new licenses to foreign banks in 2004. The UAE recently indicated its intention to adopt a reciprocal treatment to foreign banking presence when issuing new banking licenses.

Further, the GCC countries are envisioning a monetary union by the year 2010. This not only assumes the removal of all barriers towards the flow of capital between the member countries. It may also lead, through mergers and acquisition, to a wave of consolidation that would unveil hidden inefficiencies that were only made viable because of government protectionist policies. One salient feature common to all GCC countries is the emergence of Islamic banking and finance. It all started with the establishment of Dubai Islamic Bank which was able to bring about a marriage of faith and finance that many thought could not coexist in modern times. While the Islamic finance sector has been growing at a faster rate than its conventional counterpart, it still is far from capturing a sizable market share of the banking industry. During 2001-2005, the UAE Islamic Banks outperformed their GCC counterparts in terms of growth of their asset base (20.5%), loan portfolio (21.6%), and deposit mix (21.2%) compared to GCC's growth rates of 7%, 6% and 4% respectively. Islamic banks in Bahrain lead in terms of market share: viz., 38% of the country's banking sector real assets, 28% of real loans, and 36% of real deposits in 2005 compared with 12.4%, 16.1% and 13.6% respectively in the UAE.

With these scenarios, the efficiency and/or over-the-time efficiency gain of each bank in the system would play a major role in their competitiveness and survival as an independent entity, for the less efficient firms have traditionally been the prime target of well-functioning competitors. On a cross-country basis, on the other hand, the possibility of a monetary union between the member countries would suggest homogenous banking system in each and every GCC countries. Without this homogeneity cross-country mergers and acquisitions are possibilities that could not be ignored. Once again the efficiency of banks and their over-the-time efficiency gain play major role in provoking a take-over initiation.

This study is, therefore, important for bankers as a higher efficiency means higher profit and increased chance of survival in an increasingly deregulated and competitive market. Higher efficiency could also lead to a higher customer satisfaction as efficient banks are better positioned to offer quality and new services at competitive prices. The study is also important for the policy makers. An awareness of efficiency features is important to help them formulate policies that affect the banking industry as a whole and the local banks in particular.

This study aims to examine the overall cost efficiency of the banks in all six GCC member countries of the GCC over the period of 2000-2005 and the comparative efficiency between Islamic banks (IBs) and conventional banks (CBs). We measure the efficiency of each bank and the average efficiency of the banks in each country and for each specialization (IBs vs CBs) in each year of the operation within the time period in question. We proceed by investigating the efficiency gain/loss of each bank during the mentioned period to shed some lights on overall performance of the banking industry in the GCC countries.

We also test whether there has been a significant improvement in their efficiency over time. Given the protectionist environment in which they operate, the high level of government ownership in the sector, the low level of financial deepening of the GCC economies and the most recent oil bonanza, banks may have had little incentive to strive towards improving their productive efficiency, and accordingly, achieve little efficiency gains.

The remainder of this study is organized as follows. The next section looks at some of the existing works on the issue. This will be followed by discussing the methodologies used in this study. We will see how data envelopment analysis can be used to measure the relative efficiency of the banks and how we can apply the Malmquist productivity index (MPI) technique to break down the efficiency changes in various components and how it could be used to measure the efficiency changes of the banks over time. To measure the efficiency of the banks, we need the input and output data. Section four discusses the variables we use in this study. We then proceed to introduce the results. The study comes to its end with a summary and some concluding remarks.

LITERATURE

The literature focusing on the efficiency of the financial sectors of various countries, in general, and the banking sector, in particular, is vast. To mention only a few of the literature during the last 10 years we can name: Sufian and Abdul Majid (2007) discusses the relationship between X-efficiency and share prices in the Singaporean banking sector; Sufian (2007) evaluates the efficiency of domestic and foreign Islamic banks active in Malaysia; Barros and Garcia (2006) use DEA to evaluate the performance of Portuguese pension funds from 1994 to 2003; Lozano-Vivas and Pastor (2006) relate macro-economic efficiency of fifteen OECD countries over a period of eighteen years to the financial efficiency of the countries; Grigorian and Manole (2006) use DEA to estimate indicators of commercial bank efficiency to bank-level data from a wide range of transition countries; Brown and Skully (2006) evaluate the cost efficiency of banks in the Asia-Pacific region and test whether the operating performance of banks in poorer economies improves with the inclusion of environmental proxies; Kirkwood and Nahm (2006) investigate the relationship between the Australian banks' efficiency to their stock returns; Lo and Lu (2006) discuss the profitability and marketability benchmark of financial holding companies in Taiwan; Samjeev (2006) evaluates the efficiency of the public sector banks in India to investigate whether there exists any relationship between the efficiency and size of the banks; Camanho and Dyson (2005) use DEA to measure the cost efficiency of a British bank branches in phase 1 to be applied in the analysis of branch network and the production and value-added approaches to have a more comprehensive assessment of bank branch efficiency; Weill (2004) investigates the consistency of efficiency frontier models on some European (France, Germany, Italy, Spain, and Switzerland) banking samples; Krishnasamy, Hanuum Ridzwa, and Perumal (2003) apply Malmquist Productivity Index to discuss the efficiency of the Malaysian banks' post-merger productivity; Sathye (2002) measures the productivity changes in Australian banking sector using DEA and Malmquist Productivity Index; Athanassopoulos and Giokas (2000) use DEA to discuss the efficiency of the banking sector in Greece; Chen and Yeh (2000) measure the bank efficiency and productivity changes in Taiwan banking sector and investigate the impact of ownership on the resulted efficiency scores; Zenios et. al. (1999) use DEA to develop a benchmark on the relative efficiency of the Cyprus banks branches, provide guidelines for improvement to management, and isolate the effects of the environment on branch efficiency; Camanho and Dyson (1999) too use DEA to assess the performance of Portuguese bank branches to complement the profitability measure used by the bank; Ayadi, Adebayo, and Omolehinwa (1998) measure the bank performance of Nigerian banks and conclude that the seeming inefficiency is attributed to the banks' poor management;

Closer to the region under this study, Rao (2005) looks at 35 banks operating in the UAE for the years 1998 and...

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