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Reconsidering the degree of inefficiency of financial institutions

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Author Info
David Becher
George Deltas
George Pinteris

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Abstract

There is an extensive existing literature on the cost efficiency of banking institutions that estimates cost inefficiencies of the order of 15 to 30%. The persistence of such staggering inefficiencies is surprising given the competitive nature of the industry. Using a novel estimation framework that complements traditional cost function estimation with a revenue analysis, we find that much of what the prior literature classified as inefficiency is actually productive expenditure. This expenditure effectively increases the quality of the banking institution’s products and results in higher revenues. True “waste” is much lower, and averages only 9-12% of mean costs. By using broader measures of bank output we document that much of the unobserved product quality reflects omitted output. Our estimates of bank inefficiency are robust to the inclusion of these broader measures of bank output, while the inefficiency estimates that are based on the existing approaches are not robust. This robustness of our approach to variations in output definition forms a test of its internal validity, since our approach is designed to account for productive expenditures that are not directly attributed to observed output.

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Article provided by Federal Reserve Bank of Chicago in its journal Proceedings.

Volume (Year): (2006)
Issue (Month): ()
Pages: 223-240
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Handle: RePEc:fip:fedhpr:y:2006:p:223-240

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Keywords: Financial institutions;

References listed on IDEAS
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  1. Allen N. Berger & Loretta J. Mester, 1997. "Inside the Black Box: What Explains Differences in the Efficiencies of Financial Institutions?," Center for Financial Institutions Working Papers 97-04, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
    Other versions:
  2. Massimo Filippini & Marika Zola, 2005. "Economies of scale and cost efficiency in the postal services: empirical evidence from Switzerland," Applied Economics Letters, Taylor and Francis Journals, vol. 12(7), pages 437-441, June. [Downloadable!] (restricted)
  3. Allen N. Berger & David B. Humphrey, 1997. "Efficiency of financial institutions: international survey and directions for future research," Finance and Economics Discussion Series 1997-11, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  4. Altunbas, Y. & Chakravarty, S. P., 2001. "Frontier cost functions and bank efficiency," Economics Letters, Elsevier, vol. 72(2), pages 233-240, August. [Downloadable!] (restricted)
  5. Steven B. Caudill, 2003. "Estimating a mixture of stochastic frontier regression models via the em algorithm: A multiproduct cost function application," Empirical Economics, Springer, vol. 28(3), pages 581-598, July. [Downloadable!] (restricted)
  6. Mitchell A. Petersen & Raghuram G. Rajan, 2002. "Does Distance Still Matter? The Information Revolution in Small Business Lending," Journal of Finance, American Finance Association, vol. 57(6), pages 2533-2570, December. [Downloadable!] (restricted)
    Other versions:
  7. Allen Berger & Robert DeYoung, 2001. "The Effects of Geographic Expansion on Bank Efficiency," Journal of Financial Services Research, Springer, vol. 19(2), pages 163-184, April. [Downloadable!] (restricted)
    Other versions:
  8. Berger, Allen N. & Hancock, Diana & Humphrey, David B., 1993. "Bank efficiency derived from the profit function," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 317-347, April. [Downloadable!] (restricted)
  9. Aigner, Dennis & Lovell, C. A. Knox & Schmidt, Peter, 1977. "Formulation and estimation of stochastic frontier production function models," Journal of Econometrics, Elsevier, vol. 6(1), pages 21-37, July. [Downloadable!] (restricted)
  10. Greene, William, 2005. "Reconsidering heterogeneity in panel data estimators of the stochastic frontier model," Journal of Econometrics, Elsevier, vol. 126(2), pages 269-303, June. [Downloadable!] (restricted)
  11. Jaume Puig & Vicente Ortún, 2003. "Cost Efficiency in Primary Care Contracting: A Stochastic Frontier Cost Function Approach," Working Papers, Research Center on Health and Economics 719, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
    Other versions:
  12. Getu Hailu & Scott Jeffrey & James Unterschultz, 2005. "Cost Efficiency for Alberta and Ontario Dairy Farms: An Interregional Comparison," Canadian Journal of Agricultural Economics/Revue canadienne d'agroeconomie, Canadian Agricultural Economics Society/Societe canadienne d'agroeconomie, vol. 53(2-3), pages 141-160, 06. [Downloadable!] (restricted)
  13. Jaume Puig-Junoy & Vicente Ortún, 2004. "Cost efficiency in primary care contracting: a stochastic frontier cost function approach," Health Economics, John Wiley & Sons, Ltd., vol. 13(12), pages 1149-1165. [Downloadable!]
  14. 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. [Downloadable!] (restricted)
  15. Luis Orea & Subal C. Kumbhakar, 2004. "Efficiency measurement using a latent class stochastic frontier model," Empirical Economics, Springer, vol. 29(1), pages 169-183, January. [Downloadable!] (restricted)
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