Problem Loans and Cost Efficiency in Commercial Banks

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: The primary cause of problem loans and bank failures Determining the most important supervisory focus for promoting safety and soundness at banks Deciding how to estimate the cost efficiency of financial institutions. The authors test four hypotheses bad luck, bad management, skimping, and moral hazard using Granger-causality analysis. The bad luck hypotheses posits that exogenous events can cause nonperforming loans to increase, and that after time passes the extra expenses associated with these loans will be reflected in lower measured cost efficiency. The bad management hypothesis posits that poorly run banks do bad jobs at both cost control and at loan underwriting and monitoring, and that after time passes this slack leads to increases in problem loans as borrowers fall behind on their loan repayments. The skimping hypothesis posits that banks might achieve low costs by under-spending on loan underwriting and monitoring in the short run, and after time passes this slack results in increases in problem loans. The authors test the moral hazard hypothesis by testing whether equity capital negatively Granger-causes nonperforming loans. The authors results suggest that the inter-temporal relationships between loan quality and cost efficiency run in both directions. Increases in nonperforming loans tend to be followed by decreases in measured cost efficiency, suggesting that problem loans cause banks to increase spending on monitoring, working out, or selling off problem loans. The data favor the bad management hypothesis over the skimping hypothesis decreases in measured cost efficiency are generally followed by increases in nonperforming loans, evidence that bad management practice are manifested not only in excess expenditures, but also in subpar underwriting and monitoring practices that eventually lead to nonperforming loans. For a subset of banks that are consistently efficient, however, increases in measured cost efficiency precede increases in nonperforming loans, consistent with the skimping hypothesis that banks trade short-run expense reductions for long-run reductions in loan quality. Finally, decreases in bank captial ratios precede increases in nonperforming loans for banks with low captial ratios, evidence that thinly capitalized banks may respond to moral hazard incentives by taking increased portfolio risks. The authors suggest that if these results can be confirmed by future research, their findings have research and policy implications. The inter-temporal relationships revealed by Granger-causality techniques are indicative of which among the alternative hypotheses are consistent with the data. Future research might use other statistical techniques to reveal the inter-temporal relationships between loan quality and productive efficiency in financial institutions; attempt to decompose the determinants of loan quality into internal versus exogenous factors; or focus on the empirical consequences of controlling for loan quality when estimate efficiency.