Journal of Economic Cooperation 27, 2 (2006) 37-70 EFFICIENCY OF ISLAMIC BANKING IN MALAYSIA: A STOCHASTIC FRONTIER APPROACH Hamim S. Ahmad Mokhtar 1 , Naziruddin Abdullah 2 , Syed M. Al-Habshi 3 This study empirically investigates the efficiency of the full-fledged Islamic banks, Islamic windows and conventional banks in Malaysia. It finds that the Malaysian Islamic banking industry has, in terms of assets, deposits and financing base, grown very rapidly over the 1997-2003 period. The study then measures the technical and cost efficiency of these banks using the Stochastic Frontier Approach. The findings show that, on average, the efficiency of the overall Islamic banking industry has increased during the period of study while that of conventional banks remained stable over time. However, the efficiency level of Islamic banking is still lower than that of conventional banks. The study also reveals that full-fledged Islamic banks are more efficient than Islamic windows, while Islamic windows of foreign banks tend to be more efficient than those of domestic banks. 1. INTRODUCTION Islamic banks today exist in all parts of the world and are looked upon as a viable alternative system which has many things to offer. While it was initially developed to fulfil the needs of Muslims, Islamic banking has now gained universal acceptance. In Malaysia, the first Islamic bank, Bank Islam Malaysia Berhad (BIMB), operated as the only Islamic bank for 10 years since July 1983 before the government allowed other conventional banks to offer Islamic banking services using their existing infrastructure and branches in 1993 [Bank Negara Malaysia (BNM), 1994 and 1999]. The government decided to allow the conventional banking institutions to offer Islamic banking services or “Islamic windows” because this was thought to be the most effective and efficient mode of increasing the number of institutions offering Islamic banking services at the lowest cost and within the shortest time frame (BNM, 1 Senior Bank Officer at the Central Bank of Malaysia. 2 Associate Professor at AlHosn University, United Arab Emirates. 3 Associate Professor at Universiti Tun Abdul Razak, Malaysia.