¶ … Malaysia is characterized by the World Bank as being a middle-income country. Modeled after the Anglo-American system, Malaysian banks are restricted in their operation to accepting deposits, granting loans and other specified activities, and they are kept at an arm's length from corporate governance and management; however, beginning in the 1970s, the soundness of the Malaysian banking system was increasingly compromised by the political leadership's policy that used financial policy as an instrument for inter-ethnic income redistribution. Since 1970, though, the nation has transformed itself from a producer of raw materials into an emerging multi-sector economy with much of the credit for the progress to date being attributed to the country's recent political leadership. An efficient banking system plays an important role in the economic development of any country. Commercial banks, which are the main component of the banking system, have to be efficient otherwise they will create maladjustments and impediments in the process of development in any economy. The purpose of this study was to identify the optimum approach and metrics for measuring the efficiency of Malaysian banks and to analyze archival financial performance data using the optimum approach for measuring the efficiency of Malaysian banks to determine historic efficiency levels in an effort to identify opportunities for improvement in the future.
Table of Contents
1.0
Chapter 1: Introduction
1.1
Problem Statement
1.2
Purpose of the Study
1.3
Importance of the Study
1.4
Rationale of the Study
1.5
Overview of the Study
Chapter 2: Literature Review
2.1. Introduction
2.2 Overview of the Malaysian banking system
2.3. SFA in Malaysia
2.4. SFA in Other Countries
2.5. DFA in Malaysia
2.6. DFA in Other Countries
2.7. DEA in Malaysia
2.8. DEA in Other Countries
2.9. NBIFs Research
2.10 BFIs Research
2.11. Other Research
2.12. Conclusion
Chapter 3: Methodology
3.1. Introduction
3.2. Description of the Study Approach
3.3. Data-gathering Method
3.4. Research Method and Database of Study
3.5. Research Variables
3.6. Research Hypothesis
3.7. Conclusion
4.0. Data Analysis
5.0. Summary and Conclusion
An Analysis of the Efficiency of Malaysian Banks
1.0 Introduction
The past two centuries have been fateful ones for Malaysia. After the United Kingdom established colonies and protectorates in what is modern Malaysia during the 18th and 19th centuries, the mid-20th century witnessed these regions being occupied by Japan during World War II, only to revert to British control after the war (Malaysia 2010). By 1948, other events swept across what is now modern Malaysia when the territories under British control, including Singapore, established the Federation of Malaya until 1957 when they achieved their independence (Malaysia 2010). The modern country of Malaysia was created in 1963, but the country's early history was far from uneventful as well, with fundamental changes in organization taking place that culminated in Singapore's withdrawal from the confederation in 1965 (Malaysia 2010). More recently, a series of economic reforms and an emphasis on diversifying the nation's economic base have succeeded in providing a number of value-added industries for Malaysia that have included manufacturing and services industries, and increasingly, the travel and tourism trade (Malaysia 2010).
Today, Malaysia is characterized by the World Bank as being a middle-income country that has transformed itself from a producer of raw materials into an emerging multi-sector economy with much of the credit for the progress to date being attributed to the country's political leadership. For example, following his accession to office in 2003, former Prime Minister Abdullah attempted to transform the Malaysian economy by introducing initiatives designed to improve the value-added production chain through increased investments in high technology industries, medical technology, and pharmaceuticals; these initiatives have been continued under the nation's current Prime Minister Najib, as well (Malaysia, 2010). The Najib administration has continued to implement initiatives that are intended to increase foreign demand for Malaysian products while increasing the self-sufficiency of the country to reduce the need for high levels of imported goods (Malaysia 2010).
On the one hand, the central bank in Malaysia continues to enjoy solid foreign exchange reserves and the nation's mature regulatory system has reduced Malaysia's exposure to higher-risk financial instruments as well as the lingering global economic downturn (Malaysia 2010). On the other hand, though, the country has not been immune to these economic forces and demand for Malaysia's products in the international community has hampered economic growth for the past two years or so (Malaysia 2010). There are signs, though, that the worst is over and that Malaysian exports and economic growth are on the rebound today. These trends were further amplified most recently in June 2010 when Prime Minister Najib launched the Tenth Malaysia Plan that contained further economic reforms, several of which have already been implemented in order to attract new sources of foreign direct investment in response to a lull in recent years (Malaysia, 2010).
In his book, Financial Liberalization and the Economic Crisis in Asia, Lee (2003) states that compared with other developing countries, Malaysia has a highly developed financial system with its history dating back to the 18th and 19th century British colonial era. Not surprisingly, being one of the legacies of the country's colonial era, the modern Malaysian financial system follows the Anglo-American system in which Malaysian banking operations are limited to accepting deposits, issues loans and other financial services activities that are characteristic of the Anglo-American model (Lee 2003), but this traditional role has expanded in recent years. According to Rao and Tiwari, "Since the process of liberalization and reform of the financial sector were set in motion in 1991, banking has undergone significant changes. The underlying objectives of these were to make the system more competitive, efficient and profitable" (2008:73).
Although there remains a dearth of relevant studies concerning the efficiency of Malaysian banks per se, an earlier study by Katib found that Malaysian banks during the period 1989 to 1995 were not operating efficiently to combine their inputs and on average, technical efficiency languished at just 68 per cent to 80 per cent. Moreover, Katib also determined that banks that had elevated levels of technical efficiency were characterized by lower labor costs, suggesting that efficient Malaysian banks are more conscious of controlling costs than those which are not. Further complicating the analysis of efficiency in Malaysian banks has been their changing role in Malaysian society. For instance, according to Katib and Matthews, "While maintaining its traditional role in financial intermediation, offering the basic banking products and services, banks have been moving towards offering more and more nonbanking financial services" (89). There have been also some signs that political imperatives have adversely affected the ability of the Malaysia banking industry to operate efficiently (Lee 2003), an issue that directly relates to the problem to be considered in this study which is discussed further below.
1.1
Problem Statement
Given the importance of an efficient banking system to a country economic development, it is not surprising that the topic has received a great deal of attention in recent years. For example, according to Katib and Matthews, "Efficiency in the banking sector has the subject of numerous investigations" (89). Moreover, Dietsch and Vivas emphasize that there is a basic lack of research devoted to this issue: "There appears to be only six studies in the efficiency the effects of the expected literature that attempts to determine and compare banking performances differences across-countries" (1996: 3).
Since that writing, though, there have been a number of other analyses concerning how best to define and analyze the efficiency of banks in different countries. For example, in their recent study, "Evaluating Efficiency of Malaysian Banks Using Data Envelopment Analysis," Tahir, Bakar and Haron (2009) emphasize that an efficient banking system is an essential element for the economic development of any country. According to these authorities, "Commercial banks, which are the main component of the banking system, have to be efficient otherwise they will create maladjustments and impediments in the process of development in any economy" (Tahir et al. 2009:96). Since the late 20th century, there have been a number of forces at work that have made efficiency in the commercial banking sector more important than ever, but also more challenging. In this regard, Tahir and his associates emphasize that, "Technological advancements and globalisation have added to the pressure on the part of the banks to maintain market shares so as to survive and remain competitive. Competition from foreign banks as well from domestic banks themselves creates greater pressure" (2009:96). This point is also made by Alam who emphasizes that, "The banking sector is constantly and rapidly evolving; the last two decades, in particular, represent a substantial metamorphosis for banking sectors in countries around the world" (2001:121).
The banking sector in Malaysia has certainly not been immune to these forces as well. Consequently, commercial banks are increasingly being required to remain profitable while simultaneously becoming more efficient in the delivery of banking products and services in an increasingly globalized environment that is characterized by competition from domestic and international sources (Tahir et al. 2009). While all organizations seek to become more efficient in order to improve their performance and therefore their profitability, the importance of an efficient banking system also relates to the need to minimize the spreads between lending and deposit rates that can stimulate increased demands for industrial development loans as well as improved mobilization of financial savings through the banking sector (Ikhide 2000).
1.2
Purpose of the Study
The purpose of this study is two-fold as follows:
1. To identify the optimum approach and metrics for measuring the efficiency of Malaysian banks;
2. To analyze archival financial performance data using the optimum approach for measuring the efficiency of Malaysian banks to determine historic efficiency levels in an effort to identify opportunities for improvement in the future.
1.3
Importance of the Study
The importance of the study directly relates to the need to identify effective ways to measure the efficiency of Malaysian banks. The evaluation of bank efficiency, though, introduces a number of constraints that are related to the nature and function of financial intermediaries, particularly in view of the fact that banks provide products and services that are dissimilar to those found elsewhere. As a result, one of the most important issues involving the investigation the efficiency of the banking sector concerning the specification of discrete bank inputs and outputs, but there remains an ongoing controversy concerning precisely what banks produce (Tahir et al., 2009). In this regard, Kaparakis, Miller and Noulas report that, "Little agreement exists as to what a bank produces or how to measure output" (1994:875). Generally speaking, there have been two conventional approaches used to analyze the banking industry: the production and intermediation approaches. According to Kaparakis and his associates, "The production approach measures outputs by the number of accounts and considers only operating costs. The intermediation approach asserts that banks collect deposits and purchased funds, with the assistance, of course, of labor and capital, and intermediate these funds into loans and other assets" (1994:876). On balance, these authorities suggest that the intermediation approach represents a superior alternative: "It measures outputs by the dollar value of accounts and considers both operating and interest costs. Conceptually, the latter approach seems more appropriate when the sample contains large banks, which fund a larger share of their assets from nondeposit sources" (1994:876). In their study of the efficiency of Islamic banks, Mohamad, Hassan and Bader also weigh in on the production approach. In this regard, Mohamad and his colleagues advise, "In the production approach, banking activities are described as the production of services to depositors and borrowers. Traditional production factors, land, labour and capital, are used as inputs to produce desired outputs. The production approach views banks as producers of loan and deposit services using capital and labour. However, majority of the recent empirical research of banking efficiency are based on the intermediation approach" (2006:107).
Whichever approach is used to identify a bank's products, there remains a need to determine how efficiently it is producing them. Therefore, the importance of the study also relates to the need for an informed approach to banking regulation to maintain the economic recovery that is taking place in Malaysia. In this regard, Karim emphasizes that, "How the increased competitive pressures will affect banks depends in part on their ability to adapt and operate efficiently in the new environment. Banks that fail to do so will be driven off the market by the more efficient ones. That is, the most efficient banks will have a competitive advantage" (2001:289).
1.4
Rationale of the Study
Today, Malaysia stands at an important juncture in its economic development. For example, a study by Desa (2003) points out that, "The message is clear, which is even louder after the recent financial crisis of the banking sector in 1997. Commercial banks in Malaysia will have to review the way they have been doing business in the past and . . . understand the internal and external factors which influence their profitability performance" (p. iv). On the one hand, the World Bank's most recent analysis of the Malaysian economy found that it has been experiencing a solid recovery with economic growth projected to reach a respectable 5.7 per cent in 2010 as a result of increased domestic private consumption and investment (Schellekens, 2010). On the other hand, though, the ability of the country to continue this pattern of growth during a period of global economic downturn represents one of the primary near-term risks (Schellekens, 2010).
Other issues are also at work that make the study of banking efficiency an important issue today. For instance, Katib and Matthews emphasize that, "In this changing environment, the measurement of efficiency in the banking sector becomes pivotal and more complex. For the banking institutions themselves, efficiency analysis helps to appraise their performance" (2003:89). Likewise, Schellekens emphasizes that for Malaysian banks, another issue "is whether private sources of growth can lead the recovery once fiscal and monetary policy support unwinds. The medium-term growth outlook is favorable, with growth at 5.3 per cent in 2011 and 5.6 per cent in 2012. These forecasts price in gradual structural reform implementation as well as fierce external competition for trade, talent, and foreign direct investment" (2010:3). Taken together, the foregoing issues create an environment in which the investigation and analysis of the efficiency of Malaysian banks represents a timely and valuable enterprise and the organization of the study that will achieve these goals is discussed further below.
1.5
Overview of the Study
The study used a five-chapter format to achieve the above-stated research purpose. Chapter one was used to introduce the topic under consideration, including a statement of the problem, the purpose and importance of the study, as well as its supporting rationale. Chapter two was used to provide a critical review of the relevant and peer-reviewed literature concerning banking efficiency in general and the efficiency of Malaysian banks in particular, and chapter three presents the study's methodology, a description of the study approach, the data-gathering method and the database of study consulted. Chapter four consists of an analysis of the data developed during the research process and chapter five was used to present the study's conclusions, as well as a summary of the research.
2.0 Literature Review
2.1.
Introduction
This chapter delivers a review of the related literature to provide an overview of the Malaysian banking industry, and a discussion concerning the stochastic frontier approach that has been used to evaluate the efficiency of banks in Malaysia and other countries. The foregoing is followed by a similar analysis concerning the distribution-free approach and data envelopment approach for banks in Malaysia and other countries. A discussion concerning the non-bank financial institution research that has been conducted in Malaysia in recent years is followed by a summary of other research that has been conducted in this area. Finally, a summary of the literature review is provided in the chapter conclusion.
2.2
Overview of the modern Malaysian banking industry
Unlike the so-called "Asian Tigers" that suffered greatly during the Asian monetary crisis during the 1990s, the commercial banking industry in Malaysia managed to avoid many of the problems its neighbors in the region experienced and has enjoyed significant growth in recent years. In this regard, Stewart reports that, "Malaysia was markedly less afflicted by the regional economic crisis than Thailand and Indonesia. However, the paper wealth of the country had been halved, some companies, mainly in the service industries, were shedding staff, civil servants faced restrictions on overseas travel and bonus payments to workers were on hold" (2003:44). After the completion of the consolidation program by Bank Negara Malaysia following the Asian monetary crisis and the elimination of merchant banks from the Malaysian banking sector, the commercial banking industry in Malaysia currently consists of 22 financial institutions; nine of these institutions (or about 41 per cent) are domestically-owned and 13 (or about 59 per cent) are foreign-owned as shown in Table 1 below.
Table 1
List of commercial banks currently competing in Malaysia
Bank Name
Ownership
Affin Bank Berhad
Domestic
Alliance Bank Malaysia Berhad
Domestic
AmBank (M) Berhad
Domestic
Bangkok Bank Berhad
Foreign
Bank of America Malaysia Berhad
Foreign
Bank of China (Malaysia) Berhad
Foreign
Bank of Tokyo-Mitsubishi UFJ (Malaysia) Berhad
Foreign
CIMB Bank Berhad
Domestic
Citibank Berhad
Foreign
Deutsche Bank (Malaysia) Berhad
Foreign
EON Bank Berhad
Domestic
Hong Leong Bank Berhad
Domestic
HSBC Bank Malaysia Berhad
Foreign
J.P. Morgan Chase Bank Berhad
Foreign
Malayan Banking Berhad
Domestic
OCBC Bank (Malaysia) Berhad
Foreign
Public Bank Berhad
Domestic
RHB Bank Berhad
Domestic
Standard Chartered Bank Malaysia Berhad
Foreign
The Bank of Nova Scotia Berhad
Foreign
The Royal Bank of Scotland Berhad
Foreign
United Overseas Bank (Malaysia) Berhad
Foreign
Source: Monthly Statistical Bulletin, Bank Negara Malaysia, July 2009
According to Elyor (2009), the fact that a majority of the commercial banks that are competing in Malaysia today has some important positive as well as negative consequences for the industry in general. In this regard, Elyor notes that, "The presence of foreign banks in a domestic financial landscape has positive as well as negative implications, particularly for a developing economy. [F]oreign banks' presence contributes positively in the development of a strong and stable domestic banking industry" (2009:15). In addition, the foreign banks that are operating in the Malaysian banking sector today provide the impetus for domestic banks to improve their efficiency in order to remain competitive. As Elyor concludes, "The comparatively more efficient foreign banks which adopt cutting-edge technology in their banking services create competitive pressure on the domestic banks, resulting in positive spill-over effects on the banking industry in general" (Elyor 2009:16). Consequently, the banking industry in Malaysia was in a relatively solid position when the Asian monetary crisis struck the region, but it is also worthwhile emphasizing at the outset as well that Malaysia's experience differs in several ways from those of other East Asian economies that were most severely affected by the Asian monetary crisis during the closing decade of the 20th century (Lee 2003).
According to Lee, although administrative constraints adversely affected the financial liberalization process in Malaysia over the past two decades, the economic problems that were confronting Malaysia during the Asian monetary crisis were not considered to be as severe as in other parts of the region (Lee 2003). Likewise, notwithstanding the fact that the Malaysian banking system was responsible for facilitating the level of price inflation at the time through the issuance of property loans and share purchases, Malaysian banks and enterprises did not enjoy the same level of access to foreign capital as their counterparts in other countries in the region that were more adversely affected by the crisis (Lee 2003). Moreover, foreign bank loans did not play as significant a role in the Malaysian crisis as elsewhere in the region; rather, capital market flows, particularly those into and out of the stock market, were more discernible (Lee 2003). The penultimate reason the Asian monetary crisis was not felt as severely in Malaysia as elsewhere in the region was a result of its minimal exposure to private foreign bank capital and Malaysia was not required to petition the International Monetary Fund (IMF) or other international financial services organizations to obtain emergency international credit facilities (Lee 2003). Finally, during the period from late 1997 and once again from mid-1998, authorities in Malaysia intentionally opted for what Lee describes as "unconventional measures in response to the deteriorating situation, with rather mixed results" (2003, p. 106).
As shown in Table 2 below, Malaysian banks tend to be conservative, primarily extending loans on the basis of collateral rather than the viability of a given project (Hing 1987).
Table 2
Distribution of Malaysian bank credit for select purposes, 1966-96 (per centage)
Years
Manufacturing
Property*
Shares
Agriculture
1966-1970
2.6
8.8
-9.2
1971-1975
8.5
17.0
8.6
1976-1980
18.8
22.5
1.8
7.1
1986-1990
21.1
32.0
1.8
6.5
1991-1996
22.6
30.5
3.8
2.9
*Note: Property includes loans for building, construction, real estate and housing.
Figure 1. Distribution of Malaysian bank credit for manufacturing, 1966-96 (per centage)
Figure 2. Distribution of Malaysian bank credit for property, 1966-96 (per centage)
Figure 3. Distribution of Malaysian bank credit for shares, 1966-96 (per centage)
Figure 4. Distribution of Malaysian bank credit for manufacturing, 1966-96 (per centage)
Source: BNM Quarterly Economic Bulletin and Annual Report, various issues cited in Lee 2003: 111
As shown in the series of figures above, the emphasis on the security of loans has meant that Malaysian banks have preferred to extend loans to the real property sector as well as for share purchases and consumption instead of production during periods in which the property and stock markets have been upward moving. In fact, only about 25 per cent of Malaysian commercial bank loans were extended to agriculture, manufacturing and other industries that produced outputs (Griffith-Jones, Gottschalk & Cailloux 2003). According to these authors, "This modest share for productive investments is likely to be even smaller for foreign borrowings, most of which have been collateralized with assets such as real property and stocks" (Griffith-Jones et al. 2003:113).
The dearth of motivational factors to compel the Malaysian banking industry to prefer long-term lending for productive investments represents an important factor that has contributed to the relatively limited development of the Malaysian manufacturing sector, particular in non-resource-based export-oriented industries that are primarily controlled by foreign investors (Griffith-Jones et al. 2003). Citing the results of a study by Chin and Jomo (2003) that determined that export-oriented manufacturing represents a miniscule proportion of the overall total outstanding loans that have been made by commercial banks in Malaysia, Griffith-Jones and her associates emphasize that, "With the exception of export credit and some relatively minor financial institutions, there is little evidence that the government has used financial policy as an instrument for promoting industry" (2003:113).
According to Lee, an analysis of private investment trends in Malaysia by Bank Negara Malaysia determined that the unavailability of bank credit for the Malaysian manufacturing sector resulted in this sector increasingly depending on funds that were generated internally. The Bank Negara Malaysia study determined that, "On average, surveyed firms financed 52 to 66 per cent of their capital expenditure from internally generated funds during 1986-90, while bank financing accounted for only about 10-14 per cent. Although banks still provided a larger share of external finance than the capital market (ranging from 1 to 8 per cent), this probably reflected the less-developed state of the capital market relative to the banking system at that time" (Lee 2003:112).
In addition, the analysis by Lee also determined that the size of the company was also found to be an important factor concerning whether a company was able to obtain credit from Malaysian banks, and on average, larger enterprises were able to secure loans at lower credit costs. In this regard, "This could be due to the fact that financial institutions imposed less stringent requirements for loans to larger companies since they had better track records and reputations than did smaller companies (Zainal et al. 1994: 313 cited in Lee at 112). Although these findings have not extended to more recent studies, the recessionary period under investigation by Zainal et al. (1985-1986) showed that this tendency was more pronounced and the "average cost of credit for large companies was almost 11 per cent lower compared to that charged for small and medium-sized companies, if they were able to secure credit at all (Lee 2003).
These findings as well as other studies into the efficiency of commercial banks clearly indicate that there are a wide range of factors that must be taken into account in determining the efficiency of the banking sector and what impact varying levels of efficiency has on the larger society in which they compete. According to Katib and Matthews, "Research in [the efficiency of the banking sector] has developed in two separate directions, namely the parametric approach using econometric techniques and the nonparametric approach which utilizes the linear programming method" (2003:89). These methods are described further below as they apply to other countries in general and Malaysia in particular.
2.2.
Stochastic frontier approach in Malaysia
Despite its importance to the economic development of countries, there remains a paucity of research using the stochastic frontier approach to gauge the efficiency of Malaysian banks (Mokhtar, Abdullah & Al-Habshi 2006). One notable study by Okuda, Hashimoto and Murakami, though, used the stochastic frontier approach in order to estimate the cost function of the Malaysian commercial banks for the period 1991 to 1997 as well as its effect on bank restructuring. These researchers found economies of scale within the Malaysian banking sector for this time period; however, they did not identify economies of scope and maintained that domestic banks in Malaysian were engaging in unproductive capital investments (Okuda et al. 2003). It should be noted, though, that a study by Vennet found that, "Economies of scale exist if, assuming a constant product mix, a bank faces declining average costs as its size expands. Pure scale economies cannot be invoked as a reason for the formation of financial conglomerates, but since conglomerates and universal banks tend to be relatively large institutions, the scale argument has intuitive appeal as an explanation for growth" (2002:254). Furthermore, technological innovations may represent an important point of departure for banks seeking to increase their size. According to Vennet, "Economies of scope capture the effect of a change in a bank's product mix on aggregate costs. If an expanded set of products and services is produced in a more efficient way by financial conglomerates, costs may be lowered. The sharing of inputs such as labor, technology, and information across multiple outputs constitutes the major source of such potential cost savings. The presence of economies of scale and scope in banking remains a controversial subject" (2002:254).
Another study by Mokktar, Abdullah and Al-Habshi that investigated the efficiency of Malaysian banks during the period from 1997 to 2003 used the stochastic frontier approach. These researchers determined that generally speaking, the efficiency of Malaysian banks increased for domestic banks but these banks remain less efficient than their foreign-operated counterparts (Mahktar et al. 2006). Yet another study by Majid et al. analyzed the cost efficiency of Malaysian banks during the period 1993 to 2000 using the stochastic frontier approach in order to compare the efficiency of banks prior to and following the Asian financial crisis. The results of this study found that the efficiency of Malaysian banks did not differ in any substantial way before or after the financial crisis (Majid et al. 2003).
2.3.
Stochastic frontier approach in other countries.
Although there are a number of ways to examine the relative efficiency of banks, Fried, Lovell and Schmidt (1993) suggest that the stochastic frontier approach has some distinct advantages compared to other techniques. For instance, Fried and his associates report that, "The stochastic frontier approach has a number of virtues, notably its internal consistency and its ease of implementation. For single-equation, cross-sectional analysis, with modern computer software, the stochastic frontier model is not appreciably more complex than a linear regression model" (1993:115). These authorities are quick to point out, though, that, "The number of parameters to be estimated may become a problem in the stochastic frontier approach, however, especially in cases where there are large numbers of inputs and outputs. Specification of the error structure in the stochastic frontier approach is not straightforward, indeed, such specification introduces another potential source of error" (Fried et al. 1993:190). In this regard, Altunbas, Evans and Molyneux note that, "The stochastic-frontier approach labels a bank as inefficient if its costs are higher, or profits lower, than those predicted for an efficient bank producing the same input/output combination and the difference cannot be explained by statistical noise" (2001:926).
According to Gardener and Versluijs (2001), a number of studies of the European banking sector have documented that inefficiency measures for banks can be estimated using the stochastic frontier approach as introduced by Aigner, Lovell and Schmit (1977). It should be noted, though, that based on their research using the stochastic frontier approach to analyze the efficiency of the banking sector in Europe, Artis, Weber and Hennessy suggest that, "The choices made concerning efficiency measurement make very little difference to the empirical findings, in terms of either average industry efficiency or ranking of individual banks" (2000:149).
Furthermore, based on their analysis of the efficacy of the stochastic frontier approach compared to other analytical techniques in determining the efficiency of the banking industry in developing and transition economies in Europe, Balling, Lierman and Mullineux report that, "The SFA has the advantage that it performs well in small and 'noisy samples.' For that reason it is often chosen for analysis of transition economies' banking systems. The main disadvantage of this approach is that a specific functional form for the production frontier has to be assumed" (2004:231). Finally, Hasan and Marton (2003) examined the profit and cost efficiency of Hungarian banks and the factors that were related to their performance using the SFA approach and found that the overall profit and cost inefficiency was estimated to be 28.76 and 34.50 respectively.
A study by Fecher and Pestieu (1993) used a stochastic production frontier approach to analysis the technical efficiency of the financial services sectors for eleven Organization for Economic Co-operation and Development countries. These researchers used aggregate value-added, net of indirect taxes, as a metric for the respective country's financial services sector output, as well as employment in the financial services sector and capital (estimated by the perpetual inventory model) as their inputs (Fecher & Pestieu 1993). Based on their SFA approach, Fecher and Pestieu determined that Japan enjoys the most efficient financial services and that Denmark has the least efficient financial services. In addition, Fecher and Pestieu identified a trend towards harmonizing changes in multifactor productivity that is congruent with that of the development of the larger European Community.
A study conducted by Akhigbe and McNulty used the stochastic frontier approach to capture each bank's divergence from the best-practice frontier in their analysis of banking efficiency in the United States. According to these researchers, "The stochastic frontier approach assumes that deviations from the frontier include inefficiencies (profit inefficiencies in our study) and random errors. Inefficiencies are assumed to follow an asymmetric, half normal distribution, and the random errors follow a symmetric normal distribution. We estimate the inefficiency term as the expected value of profit inefficiency, conditional on the residuals from each year's profit function" (2005:289). Based on their analysis, Akhigbe and McNulty concluded that, "the difference between small and large is more than 10 basis points, which is economically (and statistically) quite significant" (2005:290). These researchers also concluded that there are several ways that different sized banks can improve their profit efficiency: "Small banks can attain high profit efficiency by being older, by operating in markets with low default rates, by being independent of a holding company, by generating high fee income, by operating in a concentrated market, and by having more of their assets in loans as opposed to securities. Large banks that have high profit efficiency do so primarily by using more leverage since none of the other variables are significant" (Akhigbe & McNulty 2005:290).
A study by Stavarek and Sulganova estimated the efficiency of the Slovak commercial banks during the period 2001-2005 using data obtained from annual reports of 13 Slovak banking institutions. According to these researchers, "For the practical estimation we applied the parametric Stochastic Frontier Approach and Cobb-Douglas production function. The results suggest that the initial hypothesis was confirmed as the average efficiency increased. This is also evident in results of individual banks as 11 banks recorded increase in efficiency. The results point out a better ability of Slovak banks to use the inputs in the production process" (Stavarek and Sulganova 2009:37).
A study by Mohamad, Hassan and Bader measured and compared the cost and profit efficiency of 80 banks in 21 of Organisation of Islamic Conference (OIC) countries: comprising of 37 conventional banks and 43 Islamic banks by employing the stochastic frontier approach. This study also measured the efficiency of these banks relative to their size, age, and region. According to these researchers, "The findings suggest that there are no significant differences between the overall efficiency results of conventional vs. Islamic banks. However, there is substantial room for improvement in cost minimization and profit maximizations in both banking systems" (2007:107). Beyond the foregoing conclusions, the results of the stochastic frontier analysis also showed that there was "no significance difference in average efficiency scores between big vs. small and new vs. old banks in both banking streams. This implies that size and age did not affect the performance of banks in both streams. Overall, the results are in favour of the more recent Islamic banking system" (Mohamad et al. 2007:107)..
Likewise, Allen and Rai used a stochastic cost frontier approach to compare cost inefficiency across fifteen developed countries grouped into either universal or separated banking countries (1996). These researchers estimated the respective inefficiency levels of these groups of banks and subsequently regressed this data compared to various bank and market characteristics. The Allen and Rai study employed two outputs (i.e., traditional banking assets such as loans and investment assets) and three inputs (i.e., labor, capital, and borrowed funds). Based on their analysis, Allen and Rai concluded that large banks in separated banking countries demonstrated the largest measure of cost inefficiency, representing 27.5 per cent of costs as well as significant levels of diseconomies of scale; by contrast, these researchers found that other banks experienced significantly lower cost inefficiency measures, in the range of 15 per cent of total costs with financial institutions in Japan, Australia, Austria, Germany, Sweden, and Canada being the most efficient while financial institutions in France, Italy, the United Kingdom, and the United States are the least efficient (Allen & Rai 1996).
According to Karim, the results of these and other studies of banking efficiency using the stochastic frontier approach indicate that there are a number of conclusions that can be drawn as follows:
1. None of the studies on comparing bank efficiency across countries involved the developing countries;
2. The relationship between bank size and efficiency is mixed depending on the country studied; and,
3. Whether a country's banking sector is more efficient than the others varies from study to study. For example, the study by Pastor, Perez, and Quesada (1997) indicates that Austria and Germany are less efficient than France, whilst the study by Allen and Rai (1996) indicates otherwise. However, the U.K. banks are found to be relatively inefficient in all the studies (Karim 2001).
2.4.
Distribution-free approach in Malaysia
Despite an exhaustive search of the literature and available studies, there were no relevant investigations of the efficiency of Malaysia banks using the distribution-free approach. However, According to Tahir et al., "In the distribution-free approach (DFA), a functional form for the frontier is also specified but inefficiencies are separated from random error in a different way. Unlike the SFA, the DFA makes no strong assumptions regarding the specific distributions of the inefficiencies or the random errors" (2009:97). The distribution-free approach has been used to analyze the efficiency of the banking sector in other countries, and these studies are discussed further below.
2.5.
Distribution-free approach in other countries
According to Balling and his associates, "The distribution-free approach requires a constant level of efficiency over time that, in the case of transition economies, is difficult to assume" (2004:231). Despite these constraints, the distribution-free approach (DFA) to analyzing the efficiency of banks was used by Berger (1993) in an assessment of the banking industry in the United States. In the Berger study, it was determined that frequency distribution of inefficiencies was likely closer to the shape of symmetric normal distribution than an asymmetric half-normal distribution. A subsequent study by Berger and Mester (1997) also used the distribution-free approach in combination with the stochastic frontier approach for both the translog and the Fourier specification of the cost and profit function of the banks being analyzed and determined that the empirical findings in terms of either average industry efficiency or ranking of individual banks are similar across methods. Similarly, Taci (2000) examined the cost efficiency of the Czech financial sector relative to the ownership structure, size, and performance status of banks using the distribution-free approach in a cross-sectional estimation and fixed effects approach in panel data estimation.
2.6.
Data envelopment analysis in Malaysia
As with the other analytical approaches to determining the efficiency of the banking industry, the use of the data envelopment method has received far less attention than the importance of the subject matter would indicate. In this regard, Leong, Dollery, and Coelli note that, "Over the past two decades, the measurement of financial institution efficiency using nonparametric frontier models has received considerable attention. However, while the literature on the application of data envelopment analysis (DEA) to the area of bank efficiency measurement is burgeoning, research on the salient properties of efficiency scores as a tool of policy is comparatively rare" (2003:195). This absence can be attributed, in some part, to the recent introduction of the methodology itself. For instance, according to Katib and Matthews, "The early development of the use of linear programming to examine efficiency measures was that of Charnes, Cooper and Rhodes (1978-1981). Their approach, properly known as data envelopment analysis (DEA) was developed initially to evaluate efficiencies in public sector agencies and nonprofit organizations" (2003:92). This point is also made by Tahir et al. who note, "DEA is based on the concept of efficiency that has been widely used in engineering and the natural sciences to measure the amount of work performed by a machine in relation to the amount of energy consumed in the process. The concept of DEA is similar to that of technical efficiency in the microeconomic theory of production" (2009:11).
The primary difference relates to the fact that the DEA production frontier is not developed through the use of a specific equation; rather, the DEA production frontier is developed using the actual data that can be located for the banks being studied. Consequently, Tahir et al. point out that, "The DEA efficiency score for a specific firm is defined not by an absolute standard but is relative to the other firms under consideration. This feature differentiates DEA from parametric approaches which require a specific functional form. DEA also assumes that all firms face the same unspecified technology, which defines their production possibility set" (2009:11).
While the variables used in this approach differ from study to study, the primary goal of a DEA analysis is to identify which banks are functioning on their efficient frontier and those that are failing to do so (Tahir et al. 2009). According to these authorities, "If the firm's input-output combination lies on the DEA frontier, the firm is considered efficient; and the firm is considered inefficient if the firm's input-output combination lies inside the frontier" (Tahir et al. 2009:12).
According to Jayadev and Sensarma, "The two important issues examined by several academic studies relating to bank mergers are: first, the impact of mergers on operating performance and efficiency of banks and second, analysis of the impact of mergers on market value of equity of both bidder and target banks" (2007:21). To this end, a study by Sufian (2004) used the non-parametric frontier approach, data envelopment analysis, to analyze the efficiency of domestic banks operating in Malaysia during the merger year as well as during pre- and post-merger periods. This researcher determined that for the period under investigation, 1998-2003, Malaysian banks demonstrated an impressive overall efficiency level of 95.9 per cent, reflecting a minimal waste of inputs of just 4.1 per cent. According to Sufian, these findings "suggest that the merger programme was successful, particularly for the small and medium sized banks, which have benefited the most from the merger and expansion via economies of scale" (2004:53). However, Sufian also points out that these findings "suggest that the larger banks should shrink to benefit from scale advantages. Decision-makers hence ought to be more cautious in promoting mergers as a means to enjoying efficiency gains" (2004:53).
2.7.
Data envelopment analysis in other countries
A cross-country study of Islamic banks operating in 35 different countries using the data envelopment approach that was conducted by Brown and Skully (2003) found that on average, the most cost-efficient banks were competing in the Middle East region. Another study by Lin used the data envelopment analysis of the non-parametric approach to examine the efficiency of banks in Taiwan because this analytical approach "is not subject to fixed function patterns and huge sample limitations and capable of measuring the diversified input and output items, hence it is very convenient for empirical studies. Banks have diversified inputs and outputs, hence the DEA was used to measure the operating efficiency of banks" (2002:334).
The data envelopment analysis approach was used by Berg, Forsund, Hjalmarssonc and Suominen to study the efficiency of the banking sector in Norway, Sweden, and Finland. According to Berg and his colleagues, "The analysis produces a detailed account of how well banks from different countries and different sizes may be prepared to meet the more intense competition of a common European banking market" (1993:371). These researchers used three outputs (i.e., total loans, total deposits, and number of branches) and two inputs (i.e., labor, measured in man-hours per year, and capital, measured by book values of machinery and equipment). Berg et al. also used Malmquist indices to describe the regional productivity differences. The results of the Berg et al. analysis found that the most efficient Swedish banks were the largest ones, and they concluded that these larger institutions were in a better position to expand in the future (Berg et al. 1993).
A study by Pastor, Perez, and Quesada (1997) used the data envelopment method to analyze the productivity, efficiency, and differences in technology of various European and U.S. banking systems. To accomplish their DEA analysis, Pastor and his associates employed loans, deposits, and short-term as well as equity investments as their outputs and non-interest expenses, besides personnel expenses, as their inputs. The results of the Pastor et al. analysis found that France, Spain, and Belgium enjoyed the most efficient banking systems, while the United Kingdom, Austria, and Germany experienced the least efficient banking systems (Pastor et al. 1997). From a productivity perspective, the Malmquist indices showed that banks in Austria, Italy, Germany, and Belgium were more productive compared with those in the United States, the United Kingdom, France, and Spain (Pastor et al. 1997).
A study by Casu and Molyneux (2003) used the data envelopment approach to analysis the productivity efficiency of European banking systems in an effort to determine whether the sector had improved and converged towards a common European frontier during the period 1993 through 1997. The countries used in this analysis were France, Germany, Italy, Spain and the United Kingdom. All data were reported in ECU as the reference currency (Casu & Molyneux 2003). The results of this DEA analysis found relatively low average efficiency levels, but the researchers suggested that it was possible to discern a slight improvement in the average efficiency scores over the period of analysis for almost all banking systems in the sample, with the single exception of Italy (Casu & Molyneux 2003).
A study by Fernandez, Gascon and Gonzalez analyzed the economic efficiency of 142 financial intermediaries from eighteen countries over the period 1989-1998 and the relationship between efficiency, productivity change and shareholders' wealth maximization (2002). These researchers used the data envelopment approach to estimate the relative efficiency of commercial banks of different geographical areas (i.e., North America, Japan and Europe); the European banks studied by Fernandez and his associates were located in Austria, Belgium, Denmark, Finland, Germany, Ireland, Italy, Luxemburg, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom (Fernandez et al. 2002). In their use of the DEA model, Fernandez et al. used three preferred outputs (i.e., total investments, total loans, and non-interest income plus other operating income); the four input variables used in this study were property, salaries, other operating expenses and total deposits (Fernandez et al. 2002). The values for all of these variables were expressed in terms of billions of U.S. dollars. The results of the Fernandez et al. analysis found that commercial bank productivity in the countries studied had significantly increase (19.6 per cent) during the period from 1989 to 1998. The researcher attributed this increased productivity primarily to relative efficiency improvement, with technological innovations having just a moderate impact (Fernandez et al. 2002).
A summary of the key findings from numerous studies of banking efficiency in different European countries using the different analytical methods reviewed above is provided by Weill (2002) which are recapitulated in Table 3 below.
Table 3
Summary of banking efficiency studies for five European countries
Methodology/No. Of Banks/Time Period
Findings
France
DFA, cost efficiency, 375 banks, 1988-92
Mean cost efficiency 40.6 per cent-70.7 per cent
DEA, technical efficiency, 93 banks, 1994
Mean technical efficiency 78-91 per cent. No clear relation with size. Cooperative and savings banks more efficient than commercial banks.
DFA, cost efficiency, 223 banks, 1988-92
Mean cost efficiency 88 per cent.
DEA, technical efficiency, 38 banks, 1994-97
Mean technical efficiency: 89-95 per cent
SFA and DFA, cost efficiency, 32 banks, 1988-92.
Mean cost efficiency 73.4 per cent (small banks)
and 84.3 per cent (large banks)
DEA, technical efficiency, 67 banks, 1992
Mean technical efficiency 95 per cent
SFA and DFA, cost and profit efficiency, 190 banks, 1993-97.
Mean cost efficiency 82.36 per cent, mean profit efficiency 88.38 per cent
Germany
SFA, cost efficiency, 1425 banks, 1989-92
Mean cost efficiency 90 per cent. Lower efficiency for commercial banks
SFA and DFA, cost and profit efficiency, 7539 bank observations, 1989-96
Mean cost efficiency: 81.3-86.6 per cent
Mean profit efficiency: 78.1-82.1 per cent
Higher cost efficiency for cooperative and savings banks than for commercial banks
SFA and DFA, cost efficiency, 38 banks, 1988-92
Mean cost efficiency 87.6 per cent (small banks)
and 87.7 per cent (large banks)
DEA, technical efficiency, 22 banks, 1992
Mean technical efficiency 65 per cent
SFA and DFA, cost and profit efficiency, 1052 banks, 1993-97
Mean cost efficiency 84.2 per cent, mean profit
efficiency 95.91 per cent
Italy
SFA and DEA, cost efficiency, 270 banks, 1988-92.
SFA: mean cost efficiency 69.6 per cent, negative relation with size. DEA: mean cost efficiency 68.2 per cent, relation with size: positive if variable returns-to-scale, no significant if constant returns-to-scale.
SFA and DFA, cost efficiency, 85 banks, 1988-92.
Mean cost efficiency 84.9 per cent (small banks) and 79.9 per cent (large banks).
SFA and DFA, cost efficiency, 85 banks, 1988-92.
Mean cost efficiency 84.9 per cent (small banks) and 79.9 per cent (large banks).
DEA, technical efficiency, 31 banks, 1992
Mean technical efficiency 77.3 per cent.
SFA and DFA, cost and profit efficiency, 178 banks, 1993-97
Mean cost efficiency 88.73 per cent, mean profit
efficiency 64.73 per cent
Spain
TFA, profit efficiency, 54 savings banks, 1986-91
Mean profit efficiency 72 per cent.
DEA, Malmquist productivity index, 77 savings banks, 1986-91
Mean technical efficiency 75-80 per cent
DFA, cost efficiency, 101 banks, 1988-92
Mean cost efficiency 88 per cent
SFA and DFA, cost efficiency, 52 banks, 1988-92
Mean cost efficiency 79.8 per cent (small banks) and 85.5 per cent (large banks)
DEA, technical efficiency, 59 banks, 1992.
Mean technical efficiency 82.2 per cent
Switzerland
SFA and DEA, cost efficiency, 477 banks, 1987-91.
SFA: mean cost efficiency 3.9 per cent, negative relation with size. DEA: mean cost efficiency 56 per cent, positive relation with size.
SFA and DFA, cost efficiency, 53 banks, 1988-92.
Mean cost efficiency 83.4 per cent (small banks) and 87 per cent (large banks)
Source: Weill 2002:4
As can be seen in Table 3 above, the results of these studies of European banking efficiency differed in their analytical approach but arrived at comparable results, particularly as they related to the effect of size on a given bank's profit and technical efficiency.
2.8.
Non-bank financial institutions research.
According to Tahir and his colleagues, there are some important reasons for analyzing non-bank financial institutions as follows:
1. Banks offer assets (deposits) that claim to be capital certain. If this promise is to be honored, then there must be limits to the range and nature of assets that a bank can reasonably take on to its balance sheets. Notwithstanding the existence of universal banking in many parts of the world (i.e., banks also engaged in securities market activities), this consideration implies that bank-based financial system will tend to have a smaller range of equity-type assets than those with a more broadly-based structure including a wide range of NBFIs. More generally, NBFIs play range of roles that are not suitable for banks and through their provision of liquidity, divisibility, informational efficiencies, and risk pooling services, they broaden the spectrum of risks available to investors. In this way, they encourage and improve the efficiency of investment and savings. Through the provision of a broader range of financial instruments, they are able to foster a risk management culture by attracting customers who are least able to bear risks and fill the gaps in financial services that otherwise occur in bank-based financial systems.
2. From the view of financial stability, in a financial sector in which NBFIs are comparatively undeveloped, banks will inevitably be required to assume risks that otherwise might be borne by the stock market, collective investment schemes or insurance companies. However, there is basic incompatibility between the kinds of financial contracts offered by the banks and those offered by the financial institutions. Thus, banks are more likely to fail as a result (2009:10).
Because the Malaysian banking sector has been characterized by an amplification of the types of services it offers in recent years, NBFIs represent a potential safety valve that can help minimize the consolidation of risky accounting practices that can result in skewed perceptions of the viability of banks. In this regard, Tahir and his associates conclude that, "One way of minimizing financial fragility in the developing economies may be to encourage a diversity of financial markets and institutions, where investors are able to assume a variety of risks outside the banking system itself. Without this diversity, there is a tendency for all risks to be bundled within the balance sheet of the banking system, which may lead to severe financial crises more likely" (2009:10).
2.9.
Other research
Although the foregoing analytical approaches to determining the efficiency of banks are the most common for the reasons specified, there are other approaches available as well. For instance, Balling, Lierman and Mullinax report that, "A growing number of international comparative studies use banking system efficiency scores for various countries, including transition economies, to derive policy recommendations and analyze different aspects of financial structure architecture or performance" (2004:232). These authors also note that whatever analytical approach is used, there remains a lack of consensus concerning what types of input and output variables are most effective for determining efficiency in the banking sector (Balling et al. 2004). According to Balling and his associates, "Inputs and outputs in banking can be specified using either the assets (or intermediation) approach, the user-cost approach or the value-added (or production) approach" (2004:233). There has been a growing tendency among many researches to employ the intermediation approach that treats deposits as inputs and defines loans and investments as outputs; researchers using this approach regard interest on deposits as being part of total costs (Balling et al. 2004).
According to Finneran, yet another approach to measuring the efficiency of the banking sector is to use the efficiency ratio. In this regard, Finneran notes that, "The efficiency ratio is the traditional measure for bank productivity. At its simplest, it is the cost required to generate each dollar of revenue. Its simplicity is an advantage, but the ratio always needs a business context, and consideration of the complicating factors" (2006:2). There are two approaches available for calculating a bank's efficiency ratio. The first and most commonly used is the cost to revenue ratio. As Finneran puts it, "This measures non-interest expenses as a proportion of operating revenue. Costs include salaries, technology, buildings, supplies, and administrative expenses. Revenue includes net interest income (interest revenue less interest expenses) plus fee income" (2006:3). The second approach is to use the cash efficiency ratio that is calculated by deducting the amortization of intangible assets from noninterest expenses before calculating the efficiency ratio described above (Finneran 2006). Following this step, the efficiency ratio must be interpreted. According to Finneran, "A bank's non-interest expense level reflects its efficiency in converting inputs into revenue. A cost to revenue ratio of 50 per cent, or below, is admired. A less efficient bank will have a higher efficiency ratio, say, 70 per cent and above. So, all other things being equal, a low efficiency ratio is good" (2006:4). Similarly, Allen and Gale report that, "The large literature on the efficiency of the banking industry is mostly concerned with the cost- and profit-efficiency of retail banking. For example, [researchers] summarize the evidence as suggesting that the average bank operates at a cost level that is 10 per cent or 20 per cent above the best-practices level. This is just one (probably small) part of the total costs of deviations from perfect competition. Unfortunately, the total costs of a deviation from perfect competition have not been documented as carefully as the costs of financial instability" (2004:454).
In his book, Financial Intermediation in the 21st Century, Mikdashi also notes that a significant number of studies have sought to measure standard returns to scale or scope in banking in recent years; by and large, these studies "have concluded that they are exhausted at a relatively small scale and are not the source of a very large cost advantage. Specifically, most studies have failed to find evidence of scale economies for banks above $25 billion in asset size and they have generally found differences in unit costs attributable to sizes smaller than 10 per cent" (Mikdashi 2001:213).
A study by Mahesh and Rajeez determined that the effect of deregulation on various sectors of the banking industry as it relates to their efficiency has been found to be highly varied in different countries. According to these authors, "While in countries like Australia, Spain, Turkey and Norway, financial liberalisation has positively affected the efficiency and productivity of commercial banks; for Italy, the United States and others, banking efficiency was relatively unchanged after deregulation. Surprisingly, in Korea, productivity of the banking sector has declined after deregulation" (2008:7). In addition, an analysis of 130 studies conducted by Berger and Humphrey (2000) of financial institutions in 21 countries found that the overall effect of deregulation on the efficiency of banks has been mixed. This issue was also examined by Gupta and Lensink in their text, Financial Liberalization and Investment, wherein the authors report that, "Another important issue with respect to the effects of financial deregulation relates to the effects of changes in banking efficiency on private investment. It has been argued that a high spread between deposit and lending rates reflects high cost of financial intermediation and, therefore, lower banking efficiency" (1996:6).
A study of banking efficiency by Evanoff and Ors used as its primary measure of bank performance the cost X-efficiency which is obtained through an analysis of empirical estimates of a minimum-cost frontier for the population of banks under investigation. According to these researchers, "X-efficiency analysis, a standard benchmarking tool in empirical industrial economics, has been used in a large number of studies that examine the banking industry. The X-efficiency benchmark is our preferred method because it encompasses both technological and allocative efficiencies at the firm level. A technologically efficient bank would produce with minimum amounts of inputs given the level of outputs, or, equivalently, would produce the maximum amount of outputs for the given level of inputs" (2008:897). Banks with allocative efficiency would use an appropriate mix of inputs and outputs based on the prices it encounters in its respective market. Consequently, Evanoff and Ors conclude that, "The empirical cost X-efficiency measure accounts for differences in the prices of inputs that the banks (which are price takers operating in competitive markets) face in their local markets, differences in the levels of outputs that they choose to produce, and differences in the fixed-netputs (such as different forms of capital) that banks can only change in the long-term" (2008:898). An alternative approach to the foregoing is to simply employ accounting ratios for the efficiency analysis; accounting ratios, though, Evanoff and Ors caution, "presume that all else (i.e., input prices, output, and fixed-netput levels) is equal across banks when, in fact, they are not. This could result in significant benchmarking errors" (2008:898).
In his study of banking efficiency in Europe, Vennet (2002) notes that a significant amount of research has been devoted to the measurement of X-efficiency of financial institutions in recent years. For example, Vennet cites the Berger and Humphrey (1997) survey of 130 studies concerning efficiency that employed data from 21 different countries across a number of time periods, from different types of financial institutions including banks, savings institutions, and insurance companies, and that employed various efficiency concepts and measurement methods. The results of this comprehensive survey of financial institutions found that by and large, the average inefficiency in banking is placed between 20-25 per cent of total costs. Citing research by Berger, Hancock, and Humphrey (1993), Vennet also notes that larger banks tend to be more efficient; because there is a wide range of disparities between banks of similar size, though, these researchers also caution that the manner in which individual banks are operated is much more salient to an efficiency analysis than their respective types of organization or size, as such. It should also be pointed out that these data were derived primarily from banks in the United States and did not making any explicit distinction between universal and nonuniversal banks (Vennet 2002). In sum, Vennet concludes that, "The data on economies of scale and scope and X-efficiency indicate some advantage for universal banks over specialized banks. However, considering that specialized banks are able to survive in direct competition with universal banks, the author concedes that the efficiency advantages of neither form of banking appear to be overwhelming. Clearly, a more direct assessment of efficiency in universal vs. nonuniversal banks is needed" (2002:255).
Finally, Rutherford states that the efficiency of a bank is "a measure of a bank's effectiveness in using the money available to it. This can be assessed by the 'mark-up' between interest rates, i.e. either the ninety-day bank time deposit day rate minus the prime rate of interest or the bank demand deposit rate minus the bank prime rate. Mark-ups are similar within one country but differ between countries" (1995:30).
2.10.
Conclusion
The research showed that the efficiency of banks can be measured in a number of different ways but the results of these analyses depend in large part on the accuracy of the data inputs that are used for these measurements. In some cases, accurate and timely data are either unavailable or remain proprietary, making the efficiency analysis problematic. Furthermore, identifying appropriate inputs and outputs remains an area of controversy among researchers interested in determining the efficiency of banks. Moreover, all of the analytical methods reviewed in this chapter were marred by different types of constraints or weaknesses compared to others, while each had its own respective strengths. The selection of an appropriate analytical approach, then, depends in large part on what timely and accurate information is available and these issues are discussed further in chapter three below.
3.0
Methodology
3.1.
Introduction
This chapter describes more fully the study approach to be used in this study, the data-gathering method that will be used, the research method and database of study to be consulted, and the research variables that will be used. The study's guiding research hypothesis is also presented, following by a chapter conclusion.
3.2.
Description of the Study Approach
As noted in chapter two above, there are numerous ways to evaluate the efficiency of the banking sector in a country, but no one approach appears to be the absolute best for all purposes and settings. In fact, all of the methodologies reviewed had their own respective strengths and weaknesses, and researchers have arrived at starkly different results even using the same analytical approaches for the same banking sectors. This diversity of findings suggests that measuring bank efficiency must proceed with caution and the results interpreted based on the best available information. According to Sathye, "It is usual to measure the performance of banks using financial ratios. The major demerit of this approach is its reliance on benchmark ratios. These benchmarks could be arbitrary and may mislead an analyst. Further, financial ratios do not capture the long-term performance, and aggregate many aspects of performance such as operations, marketing and financing" (2000:6). As noted in the preceding chapter, there has been a growing trend towards studying bank performance and efficiency through the use of one of the frontier analysis methods. In this regard, Sathye notes that, "In frontier analysis, the institutions that perform better relative to a particular standard are separated from those that perform poorly. Such separation is done either by applying a non-parametric or parametric frontier analysis to firms within the financial services industry. The parametric approach includes stochastic frontier analysis, the free disposal hull, thick frontier and the Distribution Free Approaches (DFA), while the non-parametric approach is Data Envelopment Analysis (DEA)" (2000:6). In this regard, Sengupta reports that, "In a relatively short period of time Data Envelopment Analysis (DEA) has grown into a powerful quantitative, analytical tool for measuring and evaluating performance. It has been successfully applied to a host of different entities engaged in a wide variety of activities in many contexts worldwide" (2005:xi). Likewise, Data Envelopment Analysis (DEA) is an increasingly popular management tool. DEA is commonly used to evaluate the efficiency of a number of producers. A typical statistical approach is characterized as a central tendency approach and it evaluates producers relative to an average producer. The efficiency is simply the ratio of the inputs to the outputs" (Data Envelopment Analysis 2003: 147).
Based on its perceived advantages, the study approach that was used in this study employed the data envelopment analytical approach. The use of the data envelopment analytical approach has several advantages over other approaches for determining the efficiency of banks. For example, in his book, Modern Methods for Business Research, Marcoulides reports that, "Data Envelopment Analysis (DEA), can be successfully applied to assess performance of units utilizing multiple inputs to produce multiple outputs. DEA can also be applied when the input-output transformation is not known, or when accounting and financial ratios are of little value, and it enjoys a number of advantages over the traditional ratio analysis approach and other parametric approaches to assessing performance" (1998:122).
Furthermore, Marcoulides emphasizes that this methodology has become increasingly popular in recent years. According to Marcoulides, "A plethora of methodological enhancements to DEA have been made over the last few years by researchers in North America, Europe, and elsewhere. As a result, DEA applications were soon widely spread in different industries such as banking" (1998:122). Likewise, Banker and Morey note that, "Data Envelopment Analysis has now been extensively applied in a range of empirical settings to identify relative inefficiencies, and provide targets for improvements. It accomplishes this by developing peer groups for each unit being operated. The use of categorical variables is an important extension which can improve the peer group construction process and incorporate 'on-off' characteristics, e.g., presence of drive-in window or not in a banking network" (1986:1613). The data envelopment approach also significantly strengthens the credibility of the findings derived from such analyses (Banker & Morey 1986).
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