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Problem loans and cost efficiency in commercial banks

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  • Berger, Allen N.
  • DeYoung, Robert

Abstract

The authors suggest that what is largely missing from the research literature related to the field of financial institutions is an analysis of the relationships between problem loans and cost efficiency. Recent empirical literature suggests at least three significant links between these two topics. First, a number of researchers have found that failing banks tend to be very cost inefficient, that is, located far from the best-practice frontiers. Cost-inefficient banks may tend to have loan performance problems for a number of reasons, For example, banks with poor senior management may have problems in monitoring both their cost and their loan customers, with the losses of capital generated by both these phenomena potentially leading to failure. The authors refer to this as the "bad management" hypothesis. Alternatively, loan quality problems may be caused by an event exogenous to the bank, such as unanticipated regional economic downturns. The expenses associated with the nonperforming loans that results can crate the appearance, if not the reality, of low cost efficiency. The authors refer to this as the "bad luck" hypothesis. The second empirical link between problem loans and productive efficiency appears in studies that use supervisory examination data. A relationship between asset quality and cost is consistent with the failed bank data, and suggests that the negative relationship between problem loans and cost efficiency holds for the population of banks as a whole as well as for failing banks. Third, some recent studies of bank efficiency have directly included measures of nonperforming loans in cost or production relationships. Whether this procedure improves or hinders the estimation of cost efficiency depends upon the underlying reason for the relationship between costs and nonperforming loans. Thus, important policy and research issues rest on identifying the underlying relationship between problem loans and measured cost efficiency: T

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 21 (1997)
Issue (Month): 6 (June)
Pages: 849-870

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Handle: RePEc:eee:jbfina:v:21:y:1997:i:6:p:849-870

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Web page: http://www.elsevier.com/locate/jbf

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References

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  1. Berger, Allen N. & DeYoung, Robert, 1997. "Problem loans and cost efficiency in commercial banks," Journal of Banking & Finance, Elsevier, vol. 21(6), pages 849-870, June.
  2. Allen N. Berger, 1994. "The relationship between capital and earnings in banking," Finance and Economics Discussion Series 94-2, Board of Governors of the Federal Reserve System (U.S.).
  3. Robert B. Avery & Allen N. Berger, 1990. "Risk-based capital and deposit insurance reform," Working Paper 9101, Federal Reserve Bank of Cleveland.
  4. Cordell, Lawrence R. & King, Kathleen Kuester, 1995. "A market evaluation of the risk-based capital standards for the U.S. financial system," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 531-562, June.
  5. Simon H. Kwan & Robert A. Eisenbeis, 1995. "An analysis of inefficiencies in banking: a stochastic cost frontier approach," Working Papers in Applied Economic Theory 95-12, Federal Reserve Bank of San Francisco.
  6. Joseph P. Hughes & Loretta J. Mester, 1991. "A quality and risk-adjusted cost function for banks: evidence on the " too-big-to-fail" doctrine," Working Papers 91-21, Federal Reserve Bank of Philadelphia.
  7. Gerald R. Faulhaber, 1995. "Banking Markets: Productivity, Risk, and Customer Satisfaction," Center for Financial Institutions Working Papers 95-14, Wharton School Center for Financial Institutions, University of Pennsylvania.
  8. Bauer, Paul W., 1990. "Recent developments in the econometric estimation of frontiers," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 39-56.
  9. David C. Wheelock & Paul W. Wilson, 1993. "Explaining bank failures: deposit insurance, regulation, and efficiency," Working Papers 1993-002, Federal Reserve Bank of St. Louis.
  10. Allen N. Berger & David B. Humphrey, 1992. "Measurement and Efficiency Issues in Commercial Banking," NBER Chapters, in: Output Measurement in the Service Sectors, pages 245-300 National Bureau of Economic Research, Inc.
  11. Allen Berger & John Leusner & John Mingo, 1994. "The Efficiency of Bank Branches," Center for Financial Institutions Working Papers 94-27, Wharton School Center for Financial Institutions, University of Pennsylvania.
  12. McAllister, Patrick H. & McManus, Douglas, 1993. "Resolving the scale efficiency puzzle in banking," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 389-405, April.
  13. Stevenson, Rodney E., 1980. "Likelihood functions for generalized stochastic frontier estimation," Journal of Econometrics, Elsevier, vol. 13(1), pages 57-66, May.
  14. Asli Demirgüç-Kunt, 1989. "Deposit-institution failures: a review of empirical literature," Economic Review, Federal Reserve Bank of Cleveland, issue Q IV, pages 2-18.
  15. Berger, Allen N. & Hunter, William C. & Timme, Stephen G., 1993. "The efficiency of financial institutions: A review and preview of research past, present and future," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 221-249, April.
  16. Gary Whalen, 1991. "A proportional hazards model of bank failure: an examination of its usefulness as an early warning tool," Economic Review, Federal Reserve Bank of Cleveland, issue Q I, pages 21-31.
  17. Allen N. Berger & David B. Humphrey, 1990. "The dominance of inefficiencies over scale and product mix economies in banking," Finance and Economics Discussion Series 107, Board of Governors of the Federal Reserve System (U.S.).
  18. Mitchell, Karlyn & Onvural, Nur M, 1996. "Economies of Scale and Scope at Large Commercial Banks: Evidence from the Fourier Flexible Functional Form," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(2), pages 178-99, May.
  19. Jones, David S. & King, Kathleen Kuester, 1995. "The implementation of prompt corrective action: An assessment," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 491-510, June.
  20. Richard S. Barr & Thomas F. Siems, 1994. "Predicting bank failure using DEA to quantify management quality," Financial Industry Studies Working Paper 94-1, Federal Reserve Bank of Dallas.
  21. Keane, Michael P & Runkle, David E, 1992. "On the Estimation of Panel-Data Models with Serial Correlation When Instruments Are Not Strictly Exogenous," Journal of Business & Economic Statistics, American Statistical Association, vol. 10(1), pages 1-9, January.
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