Measurement of Bank Efficiency: Analytical Methods

This chapter aims to provide a review of various analytical methods which are being used by the researchers to measure bank efficiency. We note that the frontier efficiency measurement methods made the traditional financial accounting ratios’ analysis completely obsolete and out-dated. The careful analysis of literature on frontier approaches of bank efficiency highlights that Data Envelopment Analysis (DEA) and stochastic frontier analysis (SFA) are the predominant approaches that have attracted many empirical studies. Both the approaches have their distinct advantages and disadvantages. DEA has an advantage of computing efficiency scores in multiple-inputs and multiple-outputs production setting without specifying any functional form and distribution of the inefficiency term, but makes no room for noise and lacks hypothesis testing. On the other hand, though the efficiency estimates from SFA accommodate the noise, yet these estimates are very sensitive to the choice of functional form and distribution of the inefficiency term. However, no agreement has been reached on the superiority of one method over the others, and choice of a particular method is primarily guided by the data considerations and an individual preference.