Page 324 - Contributed Paper Session (CPS) - Volume 4

CPS2245 Azrie Tamjis
duplicated branch networks, managing staff redundancy, synchronising
technology with the acquiring partner and implementation of internet banking
services had resulted in decreasing cost efficiency during the first phase of the
FSMP (Sufian, 2004).
During the FSMP’s second phase (2004–2007), BNM introduced a new
interest rate framework (NIRF) that aimed to facilitate more efficient pricing of
financial products. Following the removal of BNM’s intervention rate, the
banking institutions were given the flexibility to determine their BLR based on
their own cost structure and lending strategies. The deregulation of interest
rates was intended to increase efficiency, productivity, innovation and
profitability in the banking system (Leightner and Lovell, 1998; Berger and
Mester, 2003). As a result of the deregulation of interest rates, banks were
forced to adjust their inputs and outputs to remain competitive (Hao et al.,
3
2001). With the introduction of NIRF, Malaysian banks were able to price their
funding costs and revenues based on their own cost structure and compete
4
for customers using their own interest pricing structure. There was a slight
increase in cost efficiency scores in 2005, following the liberalisation of BLR,
indicating some increasing level of competition in terms of pricing among
Malaysian banks. Towards the end of the second phase of the FSMP, the cost
efficiency scores dropped marginally due to a significant loss faced by full-
fledged Islamic banks and the inception of new foreign Islamic banks. The
overall average cost efficiency scores worsened because these new or de-novo
foreign Islamic banks inherently faced higher operational costs during their
early phase of operations.
In the third phase of the FSMP (2008–2011), the Malaysian banks were not
affected at the initial stage of the subprime crisis in the US. Malaysian banks
were prudent in their investments, particularly relating to derivatives products
originated in the US and Europe: only a small portion of these instruments
were held by them. However, in 2008, as the global economy deteriorated,
demand for Malaysian exports declined, which affected the real sector.
Malaysian GDP contracted by 1.7% in 2009. The NPLs of banks increased
slightly in 2009, reflecting the contraction experienced by the economy.
Therefore, the declining trend of cost efficiency scores is driven by greater
operating costs when managing excess liquidity from large inflows of foreign

3 In terms of adjustments made to inputs and outputs, Humphrey and Pulley (1997) found that
during the deregulation of interest rate, banks tend to respond in three ways. First, to offset
higher deposit interest cost with higher explicit and implicit for small deposits. Second, to
transfer the higher funding cost to borrowers. And third, to invest in risky assets to obtain higher
yield.
4 The interest rate deregulation program generally increases competitive pressure in the market
and forced banks to reduce their cost (Mester, 1993).

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