Determinants of Cost Efficiency of Islamic Banks of Pakistan

Efficient utilization of the resources as trust of the depositors is the first and foremost responsibility of the Islamic bank, as directed in Al-Quran (17:29). Efficiency in managing the cost of the bank is only aspect that bank can control which can lead to increase in income of bank and depositors. There is a vast literature on theoretical models of business cost minimization but in reality the situation is not promising. This paper aims to measure and compare the real cost efficiency of full-fledged Islamic banks operating in Pakistan between the years of 2003 to 2015, using the Panel Stochastic Frontier Approach (SFA). The results revealed that surprisingly the Islamic banks in Pakistan area only 36% cost efficient, which can be contributed to the challenges faced because of parallel Islamic & conventional banking system and the nature of support from the regulatory and economic system. While determining the factors for efficiency for banking, fixed effect estimates revealed that operating efficiency, asset utilization has a positive effect while profit margin has a negative effect on cost efficiency. This study concludes that Islamic banks are facing issues of excess liquidity, inadequate support from regulatory authorities and competition from the conventional banking system which are causing inefficacy in cost management.