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Efficiency of Banks in the Third Federal Reserve District

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  • Loretta Mester

Abstract

In recent years banks have had to operate in an increasingly competitive environment. How banks will be affected by the increased competitive pressures depends in part on how efficiently they are run. This paper uses the stochastic econometric cost frontier approach to study efficiency at banks in the Third Federal Reserve District. The paper looks at scale efficiency - whether banks are operating with the efficient level of outputs; scope efficiency - whether banks are operating with the efficient mix of outputs; and x-efficiency - whether banks are using their inputs efficiently. The cost model differs from previous studies in that it explicitly accounts for the quality of banks' assets and the probability of failure, which influences banks' costs in a number of ways. The paper also differs from previous studies in its treatment of financial capital as an input into the production process. In addition to providing a cushion against losses, financial capital can be used to fund loans as a substitute for deposits or borrowed funds. The paper differs in a third way in reporting confidence intervals for the bank- specific measures of efficiency. There do not seem to be many cost efficiency gains made from Third District banks' changing their sizes, and these results are much like those obtained in studies using U.S. samples. The model shows that there is no evidence of either scope economies or diseconomies at the average efficient bank in the Third District, nor at banks in different size categories. While the scope measures suggest there is no cost justification for joint production, the approach leaves open the possibility of revenue benefits. Average x-inefficiency at banks in the Third District is on the order of 6 % to 9 %. In competitive markets not all of this gain would be retained by the bank - the savings would be passed on to customers - increasing overall welfare. When compared to U.S. samples, Third District banks seem to be outperforming U.S. bankers on average in this regard. A simple correlation and regression results indicate that inefficient banks in the District tend to be younger. There is no statistically significant differences in efficiency across the three states. There is no evidence that larger banks are more or less x-efficient than smaller banks. Inefficient banks have a higher percentage of loans in construction and land development, and loans to individuals. One of the more interesting relationships is the negative relationship between inefficiency and the capital-asset ratio. It may indicate that higher capital may prevent moral hazard. In conclusion, inefficient banks may have more to fear from efficient producers than from banks producing particular volume or product mix.

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Bibliographic Info

Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 94-13.

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Date of creation: Dec 1993
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Handle: RePEc:wop:pennin:94-13

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  1. Jeffrey A. Clark, 1988. "Economies of scale and scope at depository financial institutions: a review of the literature," Economic Review, Federal Reserve Bank of Kansas City, issue Sep, pages 16-33.
  2. Loretta J. Mester, 1994. "How efficient are Third District banks?," Business Review, Federal Reserve Bank of Philadelphia, issue Jan, pages 3-18.
  3. Jondrow, James & Knox Lovell, C. A. & Materov, Ivan S. & Schmidt, Peter, 1982. "On the estimation of technical inefficiency in the stochastic frontier production function model," Journal of Econometrics, Elsevier, vol. 19(2-3), pages 233-238, August.
  4. Joseph P. Hughes & Loretta J. Mester, . "A Quality and Risk-Adjusted Cost Function for Banks: Evidence on the "Too-Big-To-Fail" Doctrine," Rodney L. White Center for Financial Research Working Papers 25-92, Wharton School Rodney L. White Center for Financial Research.
  5. Loretta J. Mester, 1987. "Efficient production of financial services: scale and scope economies," Business Review, Federal Reserve Bank of Philadelphia, issue Jan, pages 15-25.
  6. Loretta J. Mester, 1992. "Efficiency in the savings and loan industry," Working Papers 92-14, Federal Reserve Bank of Philadelphia.
  7. Schmidt, Peter & Sickles, Robin C, 1984. "Production Frontiers and Panel Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 2(4), pages 367-74, October.
  8. Berger, Allen N. & Humphrey, David B., 1991. "The dominance of inefficiencies over scale and product mix economies in banking," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 117-148, August.
  9. Saxonhouse, Gary R, 1976. "Estimated Parameters as Dependent Variables," American Economic Review, American Economic Association, vol. 66(1), pages 178-83, March.
  10. Mester, Loretta J., 1991. "Agency costs among savings and loans," Journal of Financial Intermediation, Elsevier, vol. 1(3), pages 257-278, June.
  11. Loretta J. Mester, 1990. "Traditional and nontraditional banking: an information-theoretic approach," Working Papers 90-3, Federal Reserve Bank of Philadelphia.
  12. Douglas D. Evanoff & Philip R. Israilevich, 1991. "Productive efficiency in banking," Economic Perspectives, Federal Reserve Bank of Chicago, issue Jul, pages 11-32.
  13. Stevenson, Rodney E., 1980. "Likelihood functions for generalized stochastic frontier estimation," Journal of Econometrics, Elsevier, vol. 13(1), pages 57-66, May.
  14. Allen N. Berger & David B. Humphrey, 1992. "Megamergers in banking and the use of cost efficiency as an antitrust defense," Finance and Economics Discussion Series 203, Board of Governors of the Federal Reserve System (U.S.).
  15. Greene, William H., 1990. "A Gamma-distributed stochastic frontier model," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 141-163.
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Cited by:
  1. José Manuel Pastor Monsálvez, 1999. "- Credit Risk And Efficiency In The European Banking Systems: A Three-Stage Analysis," Working Papers. Serie EC 1999-18, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  2. Maudos, Joaquin & Pastor, Jose M. & Perez, Francisco & Quesada, Javier, 2002. "Cost and profit efficiency in European banks," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 12(1), pages 33-58, February.
  3. Imed Limam, . "Measuring Technical Efficiency of Kuwait Banks," API-Working Paper Series 0101, Arab Planning Institute - Kuwait, Information Center.
  4. José Manuel Pastor Monsálvez & Lorenzo Serrano Martínez, 2000. "Efficiency, Endogenous And Exogenous Credit Risk In The Banking Systems Of The Euro Area," Working Papers. Serie EC 2000-17, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  5. repec:ebl:ecbull:v:17:y:2005:i:9:p:1-11 is not listed on IDEAS
  6. Haslem, John A. & Scheraga, Carl A. & Bedingfield, James P., 1999. "DEA efficiency profiles of U.S. banks operating internationally," International Review of Economics & Finance, Elsevier, vol. 8(2), pages 165-182, June.

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