The Competitiveness Comparison Between Islamic Banks and Conventional Banks : Case of Indonesian Banking System

Presenter: Cupian (G1211025)

Supervisor : Dr. Muhammad Abduh

Ph.D Colloquium

Institute of Islamic Banking and Finance

International Islamic University Malaysia

November 2nd-3rd, 2014

Outline

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Introduction

Problem Statement

Research Objective

Significance of the Study

Theoretical Framework

Methodology

Expected results/findings

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Banking competition has escalated over the past couple decades.Large financial institutions are strategically penetrating new marketsand try to offer a diverse spectrum of products and services tostrengthen their existence and boost their profitability. Among suchdevelopments is the expansion of Islamic banking since seventies,and its growing recognition as a viable mode of financing.

The recent global financial crisis severely hits the banking system ofseveral countries in the world and forces government to intervene inthe financial sector. All these events can bring a change inconcentration and competition in the banking systems.

The competitive environment of the banking system in Indonesia hasexperienced several changes in recent decades. The deregulation offinancial services in Indonesia allows banks to freely establishbranches and provide financial services throughout this country.

INTRODUCTION

Problem Statement 9 Ap

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The deregulation of financial services in Indonesiaallowing banks to freely establish branches and providefinancial services can bring a change in concentration andcompetition in the banking systems.

the recent global financial crisis has severely hit theIndonesian banking system forces government tointervene in the financial sector and it could have animpact on the competitiveness of the system

Research Objectives 9 A

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Empirically assessment of the competitive structure of the Indonesia banking system, both Islamic and conventional.

Investigation on an implication of the deregulation of financial services in Indonesia and the recent global financial crisis on the competitiveness of Indonesian banking system.

Research Questions

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Q1:

What are the competitive structure of the Indonesia banking system both conventional and Islamic over the period 2006-2013?

What are the impact of input prices of deposit, physical capital and labor on the revenue of Islamic and conventional banks?

Q2:

Research Questions

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What are the impact of total asset and equity ratio on the revenue of Islamic and conventional banks?

Q3:

What are the impact of efficiency on performance increases as the market becomes more competitive?

Q4:

What are the impact of total asset and equity ratio on the revenue of Islamic and conventional banks?

Q5:

Significance of the study

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the results of this study may help bank managers determine the key success (or failure) factors of Islamic and conventional banks in the competitive market .

Knowledge gained from the study will provide government with information about how to make a financial policy which can create a competitive market in the banking sector.

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Market Structure

Monopoly

Oligopoly

Monopolistic Competition and

Perfect Competition.

Dual Banking Sector

Islamic Banks

Conventional Banks

Banking System Stability

The empirical analysis of the link between competition

and profitability of the banking system

Assessment the competitive structure of the

Indonesia banking system

the impact of input prices of deposit, physical

capital and labor on the revenue of Islamic

and conventional banks

Financial Deregulation and Financial

Crisis and Technological advance

1. H statistic of the Panzar-Rosse model

2. ordinary least square (OLS) and fixed effects(FE)

estimators

The deregulation of financial services in Indonesia, technological

advancement and the recent global financial crisis on the

competitiveness of the system.

the estimation of the Boone indicator pre and post financial

crisis

identify a change in the degree of competition

Market concentration and competition

1

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Efficiency

Profitability

Performance

Boone indicator

translog total cost function

seemingly unrelated regression

The overall Research Framework

Literature Review

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Differences between Islamic and conventional bank

SCP and ES Theory

Studies on banking using Panzar Rosse Model

Studies on banking using Boone Indicator Model

Studies on banking in Indonesian Banking System

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The conventional bank operation is to purchase transactionsdeposits from the depositors at a low interest rate, then allocatethose funds to the households and firms at a higher interest rate,earning an interest spread based on its competitive advantage.Meanwhile, Islamic banking considered as a different bankingstream as it prohibits interest and replaces with a profit share.Moreover, another principle of an Islamic bank is the avoidanceof economic activities involving oppression.

(Santos ,2000)

Differences between Islamic and Conventional Bank

The structure-conduct-performance (SCP) hypothesis and the efficient-structure (ES) hypothesis 9 A

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The SCP paradigm assumes that in concentrated markets, banks caneasily arrange collusive agreement and exercise market power.Empirically, a positive relationship between profitability and marketconcentration indicates that the market is less competitive. The EShypothesis on the other hand asserts that the positive relationshipbetween profit and concentration in concentrated markets could resultfrom the banks efficiency gains (cost advantage) contrary to thecollusive behavior. (Demsetz, 1974)

Under the ES hypothesis the positive statistical relation betweenprofitability and industry concentration could be explained by efficiencygains of banks. Empirical evidences support both hypotheses. Smirlock(1985) finds evidence in favour of the ES hypothesis using U.S. banks.Berger (1995) also finds that the ES hypothesis holds in the U.S.banking system. In contrast, Goddard et al. (2001) find evidence infavour of the SCP paradigm for European banking systems.

Authors Countries Periods Results

Shaffer (1982) New York (USA) monopolistic competition

Casu and Girardone (2006) European Union countries 1997-2003. monopolistic competition

Molyneux et al. (1994) EU countries 1986-1989 Banks in France,

Germany, Spain and the

UK operate under

monopolistic competition

and the monopoly for

Italy.

Nathan and Neave (1989) Canada 1982-1984 perfect competition for

1982 and monopolistic

competition for 1983 and

1984

Vesala (1995) Finland 1985-1992 monopolistic competition

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Studies on banking using Panzar Rosse Model

Studies on banking using Boone Indicator Model

Authors Countries Periods Results

Leuvensteijn et al.

(2007)

France, Germany, Italy,

the Netherlands, Spain,

the UK, the U.S. and

Japan.

1994-2004 U.S. has the most competitive loan market.

In the EU, German and Spain were found to have a competitive loan market.

commercial banks to operate under a more competitive environment than savings banks.

Tabak et al. (2011) 10 Latin American

countries banking

systems

Schaeck and Cihak

(2008, 2010)

European countries and

rural U.S. banks

Leuvensteijn et al.

(2008)

eight European countries

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Authors Periods Method Results

Gamaginta, Rokhim, (2010) 2004 - 2009 Z-score

indicator. Using

the parametric

statistical t-test,

The Islamic banks in

general have a lower

degree of stability

compared to

conventional ones the

Widyastuti,

Armanto, (2012)

2001 - 2006 Panzar and

Rosse

The competition in

banking

decreased after the

introduction of API,

with a large tendency to

monopoly or collusive

oligopoly

Studies on banking in Indonesian Banking System

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Scope and Limitation Study

This study focuses on the Islamic and Conventional banking sector in Indonesia with the observation period of 2006 -2013. The number of commercial banks was 88 commercial banks including 75 conventional banks and 13 Islamic banks which are treated equally as individual bank separated from their holding.

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Methodology

The non-structural approach

The Panzar-Rosse Model

Relative Profit Differences (The Boone Indicator)

Data analysis

variables

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The Panzer-Rosse model

The method attempts to infer the competitive

structure of a market by observing the response of a

banks equilibrium revenues to changes in cost of production.

The PR approach introduces H-Statistic, which is the sum of the elasticities ofbank revenue function with

respect to input prices

The method attempts to infer the competitive structure of a market by observing the response of a banks equilibrium revenues to changes in cost of production. The PR approach introduces H-Statistic, which is the sum of the elasticities ofbank revenue function with respect to input prices

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The rejection of the null hypothesis H < 0 rules out

the monopoly market structure

the rejection of both H < 0 and H = 1 the (but not

the H < 1 ) hypothesis indicates monopolistic

competition.

the rejection the H < 1 hypothesis, it indicates

perfect competition.

This interpretation is valid under the assumption that the

observations are in the long-run equilibrium (Nathan & Neave,

1989).

Empirical Application

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In the econometric analysis this paper estimates the H-statistic from the following log-linear reduced-form bank revenue equation for a panel dataset:

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Variable Definition

Total Revenue (TR) Total interest and dividend income plus non-interest operating income.

Total Cost (TC) Total operating expenses. It includes interest expenses, personnel expenses, and other operating

expenses.

Gross Interest Income (GII) *

)

Interest income on loans, other interest income, and dividend income.

Return on Assets (ROA) The ratio of before-tax profit to total assets. It captures all sources of income.

Price of deposits (W1) Ratio of interest expenses to total deposit and short-term funding (Current accounts, saving accounts,

time deposits, interbank deposits and alternative funding sources such as securities). It is a proxy for

the unit price of borrowing funds.

Price of physical capital (W2) Ratio of depreciation expenses and administrative expenses to total assets. Administrative expenses

include such as advertisement, security, information technology, and insurance expenses. The

variable is used as a proxy for the unit price of physical capital.

Price of labor (W3) Ratio of personnel expenses to total assets. Personnel expenses include wages and salaries, and other

staff-related expenses. It is used as a proxy for the unit price of labor.

Marginal cost (MC) It is the cost of producing one more unit of output. It is calculated by estimating a separate cost

function (7).

Loans ratio (Z1) Ratio of net loans to total assets. Net loan is calculated as gross loans minus provision for non-

performing loans. The variable is used to capture risk preference.

Total assets (Z2) It is the sum of the value of equity and liability. The variable is used to capture possible scale

economy.

Equity ratio (Z3) Ratio of equity to total assets. It captures the impact of leverage.

Output (q) It is the total earning assets. It includes loans, securities, insurance assets and investments in property.

The variable is used as a proxy for bank level output

*) For Islamic banks, the category of loans is substituted by financing activities and interest revenues are called financing revenues. Similarly, the interest expense item is labeled financing expenses.

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Data Analysis

The research methodology will be started by collecting the required data from Central Bank of Indonesia database. The data are publicly available in the quartally published Balance Sheet accounts and Income Statements of individual banks. The sample consists of 88 commercial banks including 75 conventional banks and 13 Islamic banks operating in Indonesia and they are treated equally as individual bank separated from their holding.

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Collecting Secondary Data

Data of Islamic Banks and Conventional Banks

being separated

Process by Regression Model

analyzed using the Panzar-Rosse (PR)

model and

the Boone indicator model

Summary

Procedure

References

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Bikker, J.A., Haaf, K. (2002): Measures of competition and concentration in the banking industry: A review of the literature, Economic and Financial

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Boone, J. (2008): A new way to measure competition,Economic Journal, Vol. 118, 1245-1261.

Brissimis, S.N., and Delis, M.D. (2011): Bank-level estimates of market power,European Journal of Operational Research, 212, 508517.

Casu, B., and Girardone, C. (2006): Bank competition, concentration and efficiency in the single European Market, The Manchester Scholl, Vol. 74, 4,

441-468.

Leuvensteijn, M., Bikker, J.A., van Rixtel, A. & Kok-Sorensen, C. (2007): A new approach to measuring competition in the loan markets of the euro area,

Working Paper No. 0768.

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Leuvensteijn, M., Bikker, J.A., van Rixtel, A. & Kok-Sorensen, C. (2008): Impact

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Molyneux, P., Lioyd-Willimas, D. M. and Thornton, J. (1994): Market structure

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