IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this paper

Problem Loans and Cost Efficiency in Commercial Banks

Listed author(s):
  • Allen N. Berger
  • Robert DeYoung

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.

To our knowledge, this item is not available for download. To find whether it is available, there are three options:
1. Check below under "Related research" whether another version of this item is available online.
2. Check on the provider's web page whether it is in fact available.
3. Perform a search for a similarly titled item that would be available.

Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-01.

in new window

Date of creation: Nov 1995
Handle: RePEc:wop:pennin:96-01
Note: This paper is only available in hard copy
Contact details of provider: Postal:
3301 Steinberg Hall-Dietrich Hall, 3620 Locust Walk, Philadelphia, PA 19104.6367

Phone: 215.898.1279
Fax: 215.573.8757
Web page:

More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

in new window

  1. 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.
  2. 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.
  3. 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.
  4. Stevenson, Rodney E., 1980. "Likelihood functions for generalized stochastic frontier estimation," Journal of Econometrics, Elsevier, vol. 13(1), pages 57-66, May.
  5. Joseph P. Hughes & Loretta J. Mester, "undated". "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.
  6. 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 178-199, May.
  7. Simon H. Kwan & Robert A. Eisenbeis, 1996. "An analysis of inefficiencies in banking: a stochastic cost frontier approach," Economic Review, Federal Reserve Bank of San Francisco, pages 16-26.
  8. Allen N. Berger & John H. Leusner & John J. Mingo, 1994. "The efficiency of bank branches," Finance and Economics Discussion Series 94-26, Board of Governors of the Federal Reserve System (U.S.).
  9. Bauer, Paul W., 1990. "Recent developments in the econometric estimation of frontiers," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 39-56.
  10. Wheelock, David C & Wilson, Paul W, 1995. "Explaining Bank Failures: Deposit Insurance, Regulation, and Efficiency," The Review of Economics and Statistics, MIT Press, vol. 77(4), pages 689-700, November.
  11. 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.
  12. 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.
  13. 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.
  14. 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.
  15. 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.).
  16. 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.
  17. 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.
  18. 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.
  19. Avery, Robert B. & Berger, Allen N., 1991. "Risk-based capital and deposit insurance reform," Journal of Banking & Finance, Elsevier, vol. 15(4-5), pages 847-874, September.
  20. 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.
  21. 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.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:wop:pennin:96-01. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Thomas Krichel)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.