Operational Efficiencies In Banking Studies Arena Education Essay

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The empirical literatures theory and reviews background are been outlined in this chapter which deals with the operational efficiencies in the banking studies arena which is mainly focused on the economies of scope and scale and also X-efficiency. The second section deals with the literature views of the banks in the framework of te firms theory and the studies of the banking sector efficiency's significance of all the parties who are participating in the financial system of the country. In the third section the various types of inputs and outputs of the banks production process are been discussed. The next sections deals with the data collection, methodology and also the characteristics of the one-way ANNOVA is been discussed. The different variables used in this study is also been discussed.


The operational efficiency have been focused more and it became more important among the managers, shareholders, regulators and the researches of the financial institution and even among the policy makers. The banking systems performance was been impacted due to many policies which are implemented in the financial system. Hence there would be many policies created in the banking system by the policy makers and regulators as the efficiency of the banks are been understood. An example of this is that the studies conducted in 1994 by Berger and Humphrey was really helpful to review that to what extent the deregulation have helped to improve the banks efficiency by removing restrictions as to improve the performance, by increasing the competition in the market as competitive market prices are created and the trimming of down waste of the resources as to generate social gains.

The studies conducted to understand the profitability of the banks and the operational efficiency due to market forces are considered to be important by the regulators for the performance as well as the market structure( Berger,1995; Molyneux et al. 1996). There are two ways the banking sector can improve its efficiency , they are the first one testing the marketing power hypothesis by creating products and services which makes high profit for the banking sector but this is unfavourable to the customers and second way is by is the efficient structure hypothesis that is by creating products which are favourable for the customers and also increase the market shares and profits by competitive prices. This also makes way for regulatory reforms in the banking industry.

The performance efficiency of the banks is lined with the capital level which are strong which was found out by many studies conducted. The studies conducted by Mester 1996, Berger and Humphrey, 1992 and by Hermalin and Wallace, 1994 in all these studies it was argued that by improving the solvency base can improve the profits and even generate higher profits and the banks efficiency is inversely related to the loan losses of the bank.

The banks ranking is based on their performance efficiency and this ranking accuracy is increased by the efficiency studies which helps us to find the best and the worst practice by the banks. It was argued by Berger and Humphery, 1997 that the policies set by the policy makers are to improve the performance of the worst and also encourages the good practice.

The out put side that is the marketing strategies and the pricing strategies helps to improve the profit efficiency and the input side that helps to improve the cost efficiency by adopting the latest information technology, good practices which are managerial and also ensuring proper capital. This two sides have to be seen as to improve the efficiency and the managers should find the reason and should bne determinant to do that. This shows the important part of the managers leading to efficiency studies.

After mention the managers part in the effieciency and the importance of these studeis, and now to mention the Shareholders part as they are the ones who appoint the managers and give them the control to run the instituttion properly and effectively. Mangers work effectively and make a efficient profit , this can only happen with the interest of the shareholders.

We can say that the studies which aree conducted on the efficiency of banks are helpfull for getting a improved results . these results are can be in great interest of the shareholders, managers, policy makers and also academic researchers. The resource usage by the banks, the power of the market, safety of the system, and profitablitiy of the banks in the country.


Acoording to the traditional theory it is said that banks convert the input resources into output resources as a finacial firm. Even though this was there the bank handling is very hard under this theory as these theories have no consensus of the banks prodution. In the study by Sealey and Lindley,1977,p1251 it was found that by judging the firms decisions on the economy the output an the input of the firm can be seperated and sorted. There are lot of problems to really consider what is the output or input for the bank production even though there is nop consensus as to consider the deposits in the bank to be input or output.

The inputs and outputs are given in the banks blaance sheet. The inputs from the liablity side and the output is from the assets side. The argument of Berger and Humphret,1990,p.247 is that, "[v]irtually all observers would agree that bank liabilities have some charecteristics of inputs, ecause they provide the raw material of investable funds, and that bank assets have some characteristics of outputs as they are ultimate use of funds that generate the bulk of revenue that bank earns." But there is no proper agreement that the bank balance sheets categorization of the inputs and outputs in the assets and liabilities can be used to explain the process of the bank even though there is a potential insight of the inpouts and outs of the bank in the banks balance sheet.

Deposits one of the item n the balance sheet is the crucial value to seperate the inputs and outputs of the bank. This is considered to be a important issue as to decide it as a input or as an output. The time deposits are considered to be the inputs and the demand deposits are considered to be th outputs in the studies conducted by HUges and Mester(1993) and Bauer et al.,(1993) in the view of interest paid. But here was other studies conducted as whether to treat deposits as inputs or outputs were attempted by Hughes and Mester, 1993,and Favero and Papi, 1995. These test main idea was that using some inputs is increasing and the expense of the other inputs has to decrease. In these studies it was found that the other inputs is inversly propostional to the deposits as for the given outputs, which shows that the deposit is better considered as a input rather considered to be output.

Humphrey, 1985; Berger and Humphrey, 1990, in their literatures regarding banking was clearly said about the two approaches of defining the inouts and outputs of the banks . the two approaches are the production approach and the internediation approach. In these approaches it is clearly said how the deposit is treated.

In the banking production process it is clearly noted that the inputs used are the labour and physical capital, this is the concept agreed by both the internediation and production aprroaches. But in these two approaches the main differance is considered to the way the inputs and outputs are treated and the how the deposits are viewed to measure. In the argument of Sealy and Lindley, 1977 that the deposit is treated as the input in the intermediation process as the deposits are consider to produce earning assets such as loans and this leads to the decision making if the banking firm. On the other hand in the study conducted by Bauer et all, 1993; Berger et al,. 1997; Resti, 1997 , the deposits are considered to be the output in the production approach as it is been using the resources of the banks like the labour and the capital as to provide a value added output for the customers like security services, book keeping and the shape of clearing.

In the intermediation approach the operating and the interest cost are used as the measurements of outputs and inputs where as in the production apporach the physical quantities are used as the output, they are the total deposit accounts, loan lent, current accounts and the cost for operation is considered and measured.

As these two approachs are used in the banking industry for calcualtating the efficiency of the banks performance, in real only the one process is practices that is intermediation approach. This approach is adoped in the studoies conducted by Berger and Mester, 1997; Altunbas et al. 2000; Allen and Rai, 1996.

According to the microeconomic theory of intermediation , it was firstly suggested in the studies conducted berger et al., 1987; Ferrier and Lovell, 1990, thats the deposited funds by the depositers are intermediated with the cost which is minimum to the lenders.

Secondly, the intermediation apporach is the best way to calculate the bank efficiency said by Karparakis et al., 1994, if the banks which are large are included in the study as sample as these banks from their non-deposit sources they fund their assets.

Thirdly , when we see the production approach when calculating the banks efficiency it is hard to get datas on the details of the accounts as they are all private and owned by one person. In the studies conducted by Berger and Humphery, 1997, in that it was argued that the financial institutions efficiency and its branches efficiency is calculated using the production approach as these institutions have the deatails of the customer records and they process as a whole. But the decisions like the investment and funding does not involve the manager of these branches much.

Form the above we can say that the production of the banks is mainly focused on the approach of defining the inputs and outputs of the bank in the microeconomic aspect. Debate still presites for the mesure ment of the outputs and inputs of the banks and also defining them. From the literature that are available it is found that the intermediation approach is the best wayh to clculate the efficiecny of the banks .


Reserve Bank of India is the regulators of the Indian banking sector. The data for the study is taken from the website of the RBI (www.rbi.org.in) . The data is collected as per the availability in the website. But the certain banks are not considered for the studies are there are no data available.


While calculating the efficiency of the banks the banks financial ratios are used in common. But in the study by Yeh 1996, it was argued that the as these ratios are independent and dependents mainly on the arbitrary bench mark ratios, so the analyst will have difficulties calculating the efficiency of the banks. Sherman and Gold (1985) added arguments to this view that the long term performance of the banks are not been captured by these ratios. For measuring the banks performance the method is used frontier analysis was said by Sathye(2002). According to this method the poor performing banks are separated from the banks that are performing better. Non parametric frontier analysis and the parametric frontier analysis is used to separate these banks. The stochastic frontier analysis, distribution free approaches, thick frontier and the free disposal hull are the various parametric approaches and the Data Envelopment Analysis (DEA) (Molyneux et al, 1996) is one of the approaches of non parametric approach. DEA approach is used by many people in calculating the performance of the banks. It was also used by Sathye(2002) in his study for calculating the efficiency of the banks in the developing countries: the case of India. In the studies by Seiford and Thrall (1990) it was found that the other methods procedure is completely different and is not as much robust as the DEA mathematical programming procedure. There was lots of empirical analysis after the coining of the term DEA by Charnes et al., (1978) and it was almost accurate (Coelli, 1996). The technical efficiency is associated with the performance of the bank studies according to Bhattacharya et al., (1997). The ability for converting into the multiple financial services can be done by technical efficiency from multiple resources according to Sathye 2003. The calculation of the efficiency of the banks are been calculated by the DEA methodology using the variable returns to scale input oriented model. There are two models considered that is model A and model B which has two inputs and two output variables in each as to measure the success of the management in cost controlling and revenues generation. The variables used as the inputs in model A are interest and non interest expenses and the net interest and non interest income are used are the output variables in model A. Deposits and the number of staffs are used as inputs in model B and the output variables are net loans adn non interest are used to analysis model B. But when compared with model A, the model B has less direct approach. The deposits are been substituted with interest expense and the number of staffs can be substituted with the non interest expenses. The net interest income are been replaced by the net loans. Sathye (2003) in his studies has used the above mentioned method. This study with the use of two models are to see the difference in the efficiency if the variables are been changed. Even though there is a debate among the researchers about the variables input and output in both intermediation and the production process, we are going to carry out the intermediation approach where there are only certain variables are used and the banks act like the financial intermediaries. In the analysis method DEA, the variable selection should be absolute as this method is sensitive to the variables selected and so it gives banks better idea for selecting the variables as to have a better efficiency. There was a study about the Australian banks by Avkiran (1999) which is a similar study like this.


DEA was invented to calculate the performance efficiency of the non profitable branches and organisation in the public sector by Charnes et al (1978). This method was first used in the banking sector by Sherman and Gold (1985). Using this method various decision making units (DMUs) can be compared and evaluated in a taken sample. Decision making unit in this study are the banks. Efficiency of Each bank is evaluated and compared with each other's efficiency levels. Using this method the better performers are been noted and the also helps to find the possible peers and this method is more efficient then the other methods. The weaker DMU is been identified and the inefficiency is also identified with the stronger DMUs, this is the important strength of this method. But in the other methods the performance is evaluated by using the statistical averages of the banks.


Charnes et al (1978) who developed the DEA has described the characteristic of this method well. DMU is considered to be the units and it of N numbers, which in turn converts to J number of outputs using I number of inputs. Here J can be greater or smaller or even equal to I. The ratio proposed by Charnes et al that is the weighted outputs to the weighted inputs for a unit , are considered for the other DMUs valuation and this can be equal or less to one another. That is,


∑ u0jy0j

Max e0 =j=1 equation (1)


∑ v0ix0i

i =1

Subject to


∑ u0jynj

j=1 ≤ 1; n = 1... N,


∑ v0ixni

i =1

vi0, uj0 ≥ 0; i=1 ...I; j =1... J.

Where yjn are considered as the positive input of the nth DMU.

  • xjn are considered to be the positive outputs of the nth DMU.

  • vi0and uj0 are the weighted variables used to solve the equation 1

The index 0 represents the DMU which is measured as the base DMU. The maximum score assigned t the DMU0 which is the score of the efficiency given by the problem is e0. The DMU0 is considered to be efficient only if the e0 = 1 otherwise it is considered to be in efficient.

The first equation objective is non linear and fractional function so it was difficult to solve this equation , so as to overcome this there was the second equation was formed by transforming the first equation by Charnes et al. The transformed equation is as follows:

Max h0 = ∑J u0jy0j equation (2)


Subject to


∑ v0ix0i=1,



∑ u0jy 0j _ ∑ v0ixni = 0;

j=1 i=1

n=1,......N, v0i ≥ ε, u0j ≥ ε i=1,....,I,

j = 1,....,J

the second equation has the same variable like the first equation. But in the second equation e is added which is the arbitrarily very small positive number, so as to make all the values of the inputs and the outputs positive and also when calculating the efficiency scores in the DEA for the DMUs there should not be any problem given in the equation due to the values given by the slack variables. Same like the equation 1 that the DMU0 is considered efficient only when h0 = 1 otherwise it is considered to be inefficient.

By using this method the researchers can change their variables and select the proper variable for the study as per the requirement of the management. This is a big advantage of this method. This method also helps management to focus on the areas where it will improve the performance according to the result. There is no need to standardize the units in the variables in this method. The results cannot be found out with precision and confidence if the data's integrity are debased. The DEA is restricted as the performance scores of the base DMU is compared with the other samples in the study. In the process of analysing the efficient values are compared with the values of the organisations which are inefficient, this helps the researchers to understand the inefficiency of the banks and according to that allocate the resources as to improve the performance. For evaluating the banks performance in various countries and in various studies DEA is used. It has been used by researchers like Sathye (2001), Yue (1992); Miller and Noulas (1996); Resti (1997); Berg et al. (1993); Mester (1996); Favero and Papi (1995); and Wheelock and Wilson (1995)

In this study we are going to analyse the banking performance of the different types of banks like the pulic, private and the foreign banking sector for different year. The main years that we are concentrating are 1969, 80, 91 and 2006.


The variables that are used as the banks inputs and the outputs which are used in the study are explained below.


When the borrower gets the money from the lender, he gives some price for the depositor for the use of the lenders money and this is called the Interest expenses. In the banking industry this is considered to be the charge for the depositors whose investments and deposits are maintained by the bank. This can be otherwise called as the payment of the interest to all the depositors of the bank.


The operating expenses are considered to be the non interest expenses which include like the salaries to the employees, benefits for them, occupancy, etc. Majority of this is the salaries and the benefits given to the employee which was considered to be 50% of the total noninterest expenses. The other operating expenses are considered to be standard and fixed.


All the organisations have balance sheets and they are divided into two categories, they are the assets and liabilities. In the banking field the liabilities are consider to have the deposits of the customers and the asset compress of the different types of loans and the securities. The difference between the money got from the asset and the cost spent for the services for the liabilities is considered to be the net interest income (NII). These two types of cash payments are the non interest payments. We also say that difference between the interest that are paid to the bank on the given loans and the bank paying customers interest for the deposits that they have made is NII.


The banks have some income which has no interest on them; these services are like planning for the finance, services through computer, brokerage, and others. Even the fiduciary services are also considered to be the non interest income. These services are like the transfer of stocks in the corporate side, safekeeping of the securities, and others. These are incomes which are off balance sheet items like the swapping of the interest rate contracts.


These are nothing but the money put in the bank by the customers as deposits in their current account and this can be put in and withdrawn anytime by the account holder. There are banks which have this service as free and there are banks which charge interest for this service.


This is nothing but the number of total employees of the bank working at the particular given time.


This is the total loans lend to the customers for different purposes like housing. Personal loan, etc. And which has to be paid with the interest at the given date.