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Banks have a pivotal role in growth and development of an economy where it ensures prudent allocation of capital resources and their efficient utilization; whereas it is implausible to work smoothly in modern time without a robust banking system. Recently, the developing countries have focused on performance and efficiency of banking sector given the crucial role of commercial banks as leading financial institutions. Performance evaluation of banking is significant to investors, proprietors, potential depositors and to the policy makers as banks play a major role in the formation and execution of monetary policy.
Traditionally, activities of banking sector were restricted to conventional banking (Con. Banking), but recently Islamic banking (Isl. Banking) has emerged as an alternative. Con. Banking is based on interest earnings and Isl. Banking is based on profit and loss sharing. The remarkable growth of Islamic banking in the developed and developing economies (covering 70 countries) in addition to the Muslim world contributes to its significant expansion and enhanced acceptability. Even many international conventional institutions such as Standard Chartered Bank, Citibank, HSBS, Deutsche Bank, etc, responded to this growth by establishing separate Windows and providing Islamic financial services to their customer. The main difference between both banking systems is that conventional banks are based on interest-based system, whereas the Islamic use the interest-free system and based on profit and loss sharing (PLS) principles. The four different categories used as substitute of interest based financing are; sale method financing, investment financing, rent financing and service financing. Profit and loss sharing is fundamental to Isl. banking.
Habib Bank is the only con banking institution which is working in Pakistan since independence 1947. Historically the role of banking in Pakistan was restricted to Con. Banking but later on it adopted emerging practices in the form of Isl. Banking. The first Islamic bank in Pakistan was formed in 2002 when Meezan Bank converted its operations from conventional banking to Islamic banking. According to State Bank of Pakistan (SBP) report on Islamic banking, Islamic banking sector experienced phenomenal growth in the world including Pakistan since 2002. In Pakistan, Islamic banking assets are worth Rs147 billion (SBP) with market share of 12.3% in the overall banking industry and It has the largest market for ISLAMIC PRIVATE DEBT SECURITIES (IPDS). The percentage of Sukuk bonds outstanding was 56.1% out of total outstanding bonds at 31st March 2008.
Despite significant development in the Isl. Banking, majority of the studies emphasized on profitability and size, whereas a few focused on its efficiency. Efficiency in the banking system is necessary as it accounts for number of advantages such as improved profitability, better utilization of resources, compatible prices and improved service quality and opposite relates to inefficient banks. Banks efficiency can be determined using various approaches. Berger and Humphrey analyzed various studies using diverse analysis of frontier efficiency for different countries. Previously banks efficiency was measured using ratio analysis while the critics on this technique reported a number of limitations. As mentioned by Oral and Yolalan the ratio analysis does not take into account actions of the management and their investment decisions which may hamper the performance. Mukherjee, et al. reported that financial ratios provide an incomplete, restricted position of the process and also fail to provide interactions of the different factors, subsequently leading to contradictory results. Efficiency measurement through frontier approach is preferable over the ratios analysis as it involves various types of input and output required for function and other factors that affect the performance Iqbal and Molyneux.
Farrell was the first to provide the concept of efficiency and defined it as actual results obtained are equivalent to optimal results. The two types of efficiency discussed in banking literature are Scale and X efficiency. Leibenstein first introduced the X efficiency and defined it as lowest cost of production for the given amount of output. X-efficiency is imperative as x-inefficiencies explain about more than 20 % of the banking cost Berger, et al. . The notion of the x-efficiency has two further types; technical efficiency where firm tries to obtain optimum output for the given amount of input and the allocative efficiency, where firm’s inputs are utilized in optimal way. Both, the parametric and nonparametric techniques are available to execute the x efficiency approach to measure operational, technical and allocational efficiency. This study uses frontier non parametric technique named data envelopment analysis (DEA) to investigate x efficiency of overall banking sector. We further apply this technique to check the differences of efficiency of the Con. and Isl. Banks.