Financial efficiency of Islamic rural banks in Indonesia: A two-stage DEA approach

Abstract

The operational effectiveness of Islamic Rural Banks in Indonesia is essential because inefficient financial intermediaries impede inclusive growth, restrict access to credit that complies with Shariah, and erode public confidence. The study's objectives are to assess the Islamic Rural Banks’ financial performance in West Java, Indonesia, and examine how efficiency levels influence specific financial performance measures. The methodology comprises two phases. The first phase measures efficiency using multiple inputs, including, operating expenses, fixed assets, inventory, total deposits, and total assets, alongside outputs such as profit-sharing financing, receivables, fund distribution income, and other operating income. The second phase employs Tobit regression to evaluate the impact of key financial ratios Non-Performing Financing (NPF), Return on Assets (ROA), Operating Expenses to Operating Income Ratio (BOPO), and Financing to Deposit Ratio (FDR) on efficiency scores. Findings indicate that seven of ten Islamic Rural Banks consistently achieved optimal efficiency (DEA score = 1), while three institutions exhibited persistent inefficiencies across various inputs and outputs. Tobit analysis reveals that ROA, BOPO, and FDR have significant positive effects on efficiency, whereas NPF is not statistically significant. The results highlight the importance of cost control and effective fund intermediation in enhancing performance. The study advances the application of Financial Intermediation Theory in Sharia-compliant rural banking by integrating ethical considerations into technical efficiency measurement. Limitations include geographic focus, data quality variability, and the exclusion of qualitative performance measures.