Little microeconomic analysis of the banking business in Malaysia has been conducted. The only known serious academic research in this area is by Katib et al. (2000). This paper contributes to the expansion of the results of the empirical study by Katib et al.. (2000)., in two respects. Firstly, different form Katib et al.. (2000) using Data Envelop Analysis (DEA) based on a non-parametric approach. in this paper, we have estimated the cost function of Malaysian commercial banks with respect to almost the same analysis period, availing ourselves of SEA analysis based on a parametric approach. The second contribution of this paper is that the estimation also factors in the existence of bad debts, which is ignored by Katib et al.. (2000). The difference in the quality of finance reflecting the difference in the management policies adopted is hard to discern when the economy is in good shape. However, as the economic situation deteriorates, bad debts come to the surface and the profitability of banks that have engaged in dubious financing deteriorates as debt arrears. In this paper, we have assumed a set of several different amounts of sound credit for individual banks, and made an estimation of the cost function for each case. In our analysis, neither economies of scale nor economies of scope, which are said to be intrinsic to the banking industry, were observed for commercial banks in Malaysia. If the view that economies of scale and economies of scope are observed in efficient bank management is correct, then it is safe to assume that the management of domestic banks in Malaysia must be inefficient. Moreover, no technological progress was observed in that cost declined over time despite the fact that the capital equipment ratio increased and labor productivity rose in the first half of the 1990s. In studies on developed countries, a decline in cost is observed over time in a competitive market, as is progress in labor saving technology due to investment in modernization. Our observation results suggest that Malaysian domestic banks were making unproductive capital investment. No essential changes occurred in the analysis even when it was conducted assuming several different amounts of sound credit, i.e. factoring in the quality of credit. Moreover, on comparing our results with those of the earlier study by Katib et al.. (2000)., based on DEA, we have found no inconsistency between the two.
