The Financial Review 37 (2002) 257--280

Cost and Profit Efficiency of the

Turkish Banking Industry:
An Empirical Investigation
Ihsan Isik
Rowan University

M. Kabir Hassan∗
University of New Orleans

Abstract

By employing a stochastic frontier approach, we examine the effect of bank size, corporate
control, and governance, as well as ownership, on the cost (input) and alternative profit (input-
output) efficiencies of Turkish banks. We find that the average profit efficiency is 84% for
Turkish banks. The oligopolistic nature of the Turkish banking industry has contributed to
less than optimal competition in the loan market and deposit markets. Our results indicate that
the degree of linkage between cost and profit efficiency is significantly low. This suggests
that high profit efficiency does not require greater cost efficiency in Turkey, and that cost
inefficient banks can continue to survive in this imperfect market, where profit opportunities
are abundant for all types and sizes of banks. Accordingly, our results indicate that the different
sizes of banks have capitalized these opportunities equivalently.
Keywords: efficiency, Turkish banks, governance and control, stochastic frontier approach
JEL Classifications: G21/G28

1. Introduction
Until the 1980s, the banking industry in Turkey was a regional, heavily regu-
lated, and protected business, resulting in a closed and uncompetitive bank sector

∗ Corresponding author: Department of Economics and Finance, University of New Orleans, New Orleans,
LA 70148; Phone: (504) 280-6163; Fax: (504) 280-6397; E-mail: mhassan@uno.edu.

257
258 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

enjoying a “quiet life” (in Hick’s words). However, in recent years the industry has
taken steps toward becoming more competitive, dynamic, and open, while facilitating
the integration of the industry with the world. The 1980s witnessed strong structural,
institutional, and legal changes in the Turkish financial markets. The deepening of the
financial system was significant due to substantial new entries from both inside and
outside (in banking, leasing, brokerage, investment funds, factoring, and insurance),
the foundation of new financial markets (Istanbul Stock Exchange, Interbank Money
Market, Foreign Exchange and Foreign Banknote Markets, and Gold Exchange) and
the introduction of new financial products (consumer credits, asset backed securi-
ties, consulting services, interest and currency forwards and swaps). In addition to
the fundamental transformation in the financial environment, the mixed economy
of the country, where all sizes and types of banks (public or private, domestic or
foreign) compete with each other, makes the Turkish banking sector an important
case for measuring and comparing the efficiency differences of different forms of
banks.
Employing a parametric method, stochastic frontier approach (SFA), we ana-
lyze both cost and profit efficiencies of the Turkish commercial banks between 1988
and 1996. The type of profit efficiency method employed in this study is the non-
standard profit efficiency model, which is the latest development in the literature
(Berger and Mester, 1997; DeYoung and Hasan, 1998; Khumbakar et al., 2001). This
inter-temporal study will be the first study that investigates the profit (output) ineffi-
ciency of the Turkish banks in comparison with cost (input) inefficiency. While output
inefficiency stems from producing sub-optimal output levels and/or sub-optimal com-
bination of outputs, input inefficiency results from employing a sub-optimal input
mix and/or failure to effectively utilize the inputs employed.
Earlier studies on Turkish banking efficiency invariably focused on input saving
(cost) inefficiency of the sector. Utilizing the non-stochastic DEA method, Oral and
Yolalan (1990) measure operating efficiency of branch offices of a major domestic
commercial bank, Yapi ve Kredi Bankasi. Their findings complement and mostly
comply with the traditional performance analysis of the bank. Using a stochastic
cost technique, Altunbas, Molyneux, and Murphy (1994) dwell particularly on the
performance difference between public and private banks, and reported no statis-
tically significant inefficiency difference between public and private banks, justi-
fying the privatization of the public banks on efficiency grounds. Employing the
non-parametric DEA approach, Zaim (1995) finds that Turkish banks experienced
improved efficiency in a more liberalized banking environment, as evidenced by
increased technical and allocative efficiencies between 1981 and 1990.
Despite the substantial efforts in the 1980s to increase competition in the fi-
nancial sector, the Turkish banking industry still carries the typical characteristics of
an oligopolistic market (Altunbas and Sarisu, 1996). First of all, by any standard,
banking is a highly concentrated business in Turkey. As of 1990, while the five-bank
concentration ratio was about 53% in Turkey, it was 28% in the United Kingdom,
27% in Germany, and 38% in Spain (Gual and Neven, 1993). Before the 1980s, the
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 259

Turkish government had imposed a ceiling on the interest rate that banks could pay
depositors in order to prevent “excessive competition” for deposits, thereby provid-
ing rents to banks. In doing so, the regulators simply wished to augment the safety
and soundness of banks by increasing their profitability. Such rents that increased
the franchise value of banks before the 1980s were unavailable once interest rates
were deregulated in the early 1980s. Supra-profits should not have been sustainable
in the more liberal and competitive environments since then. However, the evidence
suggests the contrary. Evidently, the profitability of the Turkish banking sector was
five times higher than the OECD average in 1990 (Denizer, 1997), and two and
a half times greater than the Turkish manufacturing sector average in 1989 (Zaim,
1995).
Profit efficiency analysis of the Turkish banks is thus a critical concern for
both research and public policy. The greater demand for banking services might have
allowed more profit efficient productions in the short run, especially in a highly
concentrated market such as Turkey’s. Consequently, until more competitors emerge,
a greater demand for banking services might permit less cost efficient production
and provide more opportunities to make profits. Therefore, one may expect to see
increasing profit efficiency in Turkish banks over time. However, because some
banks may have market power and/or talents developed over a long time horizon,
only certain banks may have capitalized such opportunities. Hence, the impact of
the profit opportunities may be uneven across banks, making some banks fall behind
in the race, which may result in a decrease in average profit efficiency over time.
In addition, it is important to investigate whether higher profit efficiency in banks
results from higher cost efficiency.
Each efficiency concept provides distinct valuable information with which man-
agement can trace the sources of inefficiency. Such analysis helps banks enhance their
likelihood of survival in competitive markets. One step in this analysis is to determine
whether operational errors are concentrated on the input (cost inefficiency) or output
(profit/revenue inefficiency) sides. Another, more important, step in this analysis is
to explore the impact of certain bank factors on their profit and cost efficiencies.
As mentioned earlier, Altunbas, Evans and Molyneux (1994) examine the impact of
ownership on cost efficiency. However, to our knowledge no study has yet explored
the impact of size, organizational control, and governance on Turkish bank efficiency
(cost or profit) and the effect of ownership on the profit efficiency of Turkish banks.
In this study, we examine the relationship between organizational form and profit
efficiency in Turkish banking.
In the following section, we present a short discussion of the structure of Turkish
banking market. We discuss the methodology utilized in constructing the cost and
profit efficiency indices in the third section. We then discuss the data and define the
inputs and outputs for banks and justify these specifications in the fourth section. In the
fifth section, we present and analyze our results in both general terms and according
to several banking forms operating in the country. We provide our concluding remarks
in the sixth section.
260 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

Table 1
Market shares of Turkish commercial banks in total assets, loans, and deposits

% Share of Total Assets % Share of Total Loans % Share of Total Deposits

Years State Private Foreign State Private Foreign State Private Foreign
1988 44.9 52.0 3.1 52.2 45.0 2.8 41.8 54.8 3.4
1992 44.8 52.0 3.2 47.8 49.4 2.8 48.2 50.5 1.3
1996 40.7 56.1 3.3 38.9 59.1 2.0 44.1 53.4 2.5

2. A short overview of the Turkish banking industry

By the end of 1996, 70 banks were operating in Turkey, including the Central
Bank of Turkey. Of the 69 banks active in the system, 56 were commercial banks
while 13 were investment and development banks. Of the 56 commercial banks,
5 were state-owned and 51 were privately owned (33 domestic and 18 foreign).
Further, of the 13 investment and development banks, 3 were state-owned and 10
were privately owned (7 domestic and 3 foreign). Table 1 provides the group shares of
state, private, and foreign-owned commercial banks in total assets, loans, and deposits
of the banking sector. As can be seen, the state, aside from its regulatory power and
interference in the system, also occupied an important position in the Turkish banking
system. The number of state-owned banks (in both commercial and investment and
development banking) in 1988, 1992, and 1996 was 12, 9, and 8, respectively. Despite
the privatization and restructuring trend in state banking, evidenced by the shrinkage
of their market share and by the fall of the number of state-owned banks over time,
the state controlled about 41% of the assets of the commercial banking industry by
1996. Although still strong, the dominance of the state in commercial banking tended
to decrease over time. It seems that private domestic banks have largely filled the
resultant gap.
Even though the number of foreign banks increased considerably in the post-
liberalization era (from 6 in 1981 to 23 in 1990), they account for only 3.3% of all
commercial banking assets in 1996. However small, their share in total assets has
increased slightly, from 3.1% in 1988 to 3.3% in 1996. Due to increased country risk
in the 1990s, foreign banks have reduced their loan offers to the Turkish market.1
Likewise, the share of foreign banks in total deposits fell during the early 1990s. In
spite of their limited presence, foreign banks have triggered an undeniable momentum
in the system by introducing new concepts and practices to the traditional banking
business, which has been under the state’s protection for so long.
During the 1980s, the abolition of interest rate ceilings, reductions in reserve
and liquidity requirements, financial taxes, and restrictions on foreign exchange

1 As such, Moody’s and Standard and Poor’s degraded the credit rating of Turkey in January 1994.
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 261

operations, as well as barriers to entry and exit, provided a more liberal and contestable
financial environment. The number of banks operating in Turkey has increased con-
siderably over time, mainly due to these liberal policies. The upward trend in the
number of banks in the system indicates that the existing traditional banks have faced
an increasing level of competition from both inside and outside of the country. For
instance, the number of commercial banks increased notably from 42 in 1981 to 56
in 1996. While there were only 6 foreign banks operating in the market in 1981, the
number increased to 21 by the end of 1996. Foreign banks have entered the market
either by establishing a branch or subsidiary or by entering into a joint venture with
a bank established or about to be established in Turkey. Of the 21 foreign banks, 10
were founded in Turkey with foreign capital as joint-stock companies, while 11 are
simply branch offices of foreign banks abroad.

3. Methodology
While analyzing the performance of production units, researchers should decide
on which economic efficiency concept to use. Actually, this basic decision is mostly
dependent upon the purpose of the study or the question being investigated. There are
two main efficiency concepts: cost and profit efficiencies.2

3.1. Parametric cost efficiency

Cost efficiency is defined as a measure of how far a bank’s cost is from the
best practice bank’s cost if both were to produce the same output under the same
environmental conditions. One can obtain the cost efficiency of a bank by employing
either nonparametric or parametric approaches. Nonparametric (non-stochastic) cost
efficiency is calculated by employing linear mathematical programming techniques.
On the other hand, parametric (stochastic) cost efficiency is derived from a cost func-
tion in which variable costs depend on the input prices, quantities of variable outputs,
random error, and inefficiency. Duality theory maintains that under certain condi-
tions (e.g., exogenous prices and optimal behavior of the producer), the properties of
the production function (e.g., scale and scope economies, i.e., sub-addivity) can be
inferred indirectly either by utilizing cost or profit functions. Accordingly, Aigner,
Lovell, and Schmidt (1977) and Meeusen and Broeck (1977) define a firm’s cost
function as follows:

Cb = C(yi , pk , εb ), b = 1, . . . , n (1)

2 Although revenue efficiency can be added to the list, profit efficiency is conceptually superior to revenue
efficiency in reflecting the goal of the production units. Thus, addition of the revenue efficiency could be
redundant.
262 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

where Cb stands for the bank’s total operational costs, yi represents the vector of
quantities of the bank’s variable outputs, pk is the vector of prices of the bank’s
variable inputs, and εb is a composite error term, through which the cost function
varies stochastically. The cost function provides an indirect representation of the
feasible technology because it is mainly a specification for the minimum cost of
producing the output vector, y, given the cost drivers, such as price vector, p, in the
input market, managerial inefficiency, some exogenous economic factors, or just pure
luck.
The term εb can be partitioned into two parts as follows:
ε b = u b + eb (2)
where u b refers to endogenous factors and eb refers to exogenous factors that im-
pact the cost of the bank production. Thus the term u b denotes a rise in the cost of
bank production due to the inefficiency factor that may result from the mistakes of
management, such as non-optimal employment of the quantity or mix of inputs given
their prices. On the other hand, eb represents a temporary rise or fall in the bank’s
costs due to the random factor that may stem from a data or measurement error, or
unexpected or uncontrollable factors (such as weather, luck, labor strikes, war, etc.)
that cannot be changed by the management.
To facilitate the measurement, u b and eb are assumed to be multiplicatively
separable from the rest of the cost function and both sides of the equation (1) are
represented in natural logs:
εb
  
ln Cb = f (yi , pk ) + ln u b + ln eb (3)
where f is a functional form and εb = ln u b + ln eb is the composite error term. Para-
metric and non-parametric efficiency techniques differ in how they disentangle the
composed error term, εb . Non-parametric techniques assume that there is no error and
attribute any deviation from the best practice bank’s cost to inefficiency. On the other
hand, parametric techniques assume that the inefficiencies follow an asymmetric dis-
tribution, mostly the half-normal, and random errors follow a symmetric distribution,
mostly the standard normal. In other words, random factors, eb , are assumed to be
identically distributed as normal variates and the value of the error term in the cost
function is equal to zero on the average. Thus, inefficiency scores are derived from a
normal distribution,N (0, σu2 ), but truncated below zero. The underlying reason for the
truncated normal distribution assumption is that inefficiencies cannot be negative.3

3In estimating our profit and cost in-efficiency scores, we assume that they are distributed as half normal
distribution because inefficiencies cannot be negative. The reason is that you cannot waste more than
100% of the resources you are currently using. Nonetheless, this assumption is less than perfect for profit
efficiencies, because a bank can throw away more than 100% of its potential profits; thus the profit
efficiency score, unlike the cost efficiency score for a bank, can be negative. Nevertheless, the assumption
of half normal distribution has been standard in the literature.
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 263

According to Jondrow, Lovell, Materov, and Schmidt (1982), the relative effi-
ciency of a firm can be estimated by means of the ratio, λ = σσue . If the inefficiency
factor, which is under the control of management, dominates the random factor, which
is beyond the control of management, the λ attains large values. The u b (inefficiency
measure) of a firm can be formulated as follows:

u b = [σ λ/(1 + λ2 )][−φ(εb λ/σ )/(εb λ/σ ) + (εb λ/σ )] (4)

where, σ = [σu + σe ]2 , φ is the standard normal density function,  is the cumulative

normal density function, and the rest of the terms are as defined above.
We first need to specify a relationship (function) between bank production and
bank cost in order to estimate the inefficiency, u b , and random, eb , factors of the
composite error term, εb . To that end, we specify banks as multi-product and multi-
input firms and estimate the following translog cost function:

4
14 
4 
3
ln Cb = α0 + βi ln yi + βi j ln yi ln y j + γk ln pk
i
2 i j k

13 
3 
4 
3
+ γlm ln pl ln pm + ρik ln yi ln pk + εb (5)
2 l m i k

where, ln is natural logarithm, Cb is the bth bank’s total (interest and noninterest)
costs; yi is the ith output; p is the kth input price, and εb is the composite error term.
Cost and prices are written using p2 (price of physical capital) as numeraire. Cost
efficiency score attains values over (0,1]. A score of 0.6 for a bank implies that it is
about 60% cost efficient, i.e., it wastes about 40% of its costs relative to a bank on
the frontier facing similar conditions. Therefore, 1 refers to the “best practice” while
0 refers to the “worst practice” observed in the sample.

3.2. Alternative (non-standard) profit efficiency

Apart from examining the cost saving efficiency, banks are also examined for
their output generating, i.e., revenue efficiency. Indeed, the profit efficiency concept
serves both purposes. Profit efficiency accounts for errors on the output side as
well as those on the input side. As evidence to date suggests, inefficiencies on the
output side might be as large or larger than those on the input side (Berger, Hancock
and Humphrey, 1993). The cost efficiency models, be they stochastic (parametric)
or nonstochastic (nonparametric), assume that banks take present input prices and
output quantities as given, and then try to minimize costs by employing the optimal
level of inputs. According to these models, cost inefficiencies can arise exclusively
due either to hiring an excess amount of inputs (technical inefficiencies) or to having
a sub-optimal mix of inputs (allocative inefficiencies). Nevertheless, a bank can be
inefficient if it produces too few, or a nonoptimal, mix of outputs given the inputs
264 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

it uses and the prices that it faces. In other words, not only input (cost) inefficient,
a bank might also be output (revenue) inefficient. Cost efficiency models ignore
this possibility and thus can misrepresent the nature and extent of inefficiency of
banks (DeYoung and Nolle, 1996). For instance, production of high quality financial
products and services requires extra costs. If the quality of the output produced is not
accounted for in efficiency estimations, cost based models will probably label such
banks as cost inefficient. However cost inefficient, quality producers may actually
be profit efficient because customers tend to pay more for higher quality services.
If this is the case, these banks will earn extra revenues large enough to offset their
relatively high expenses.
Overall, profit efficiency implies that managers should not only pay attention to
reducing a marginal dollar of costs, but also to raising a marginal dollar of revenue.
Since its requirement to be efficient is based on the more accepted economic goal of
profit maximization, profit efficiency has become a favorite model among researchers
for evaluating the overall performance of banks in recent years. It must be noted that
there are different versions of the profit efficiency concept applied in practice. The
standard profit (SP) efficiency, (e.g., Berger, Hancock, and Humphrey, 1993; DeY-
oung and Nolle, 1996; Akhavein, 1997a, 1997b; Berger and Mester, 1997) estimates
how close a bank is to producing the maximum possible profit given a particular level
of input prices and output prices. Unlike the cost function from which the cost efficien-
cies are derived, the profit function from which profit efficiencies are obtained does
not hold all output quantities statistically fixed at their observed, possibly inefficient,
levels. Thus, in contrast to the cost efficiency, standard profit efficiency indicates
performance based on the ability to generate revenues by varying outputs as well as in-
puts. As an extension, Hughes and Moon (1995) and Hughes, Lang, Mester, and Moon
(1996) estimate a profit efficient frontier taking the risk of earnings into consideration.
They define a bank as profit inefficient if it has too little expected profit as compared
to the amount of risk it is taking. They report that profit efficiency of an average bank
relative to the one on the risk-expected return efficient frontier was around 85%.
On the other hand, there is a new development in the efficiency estimation,
popularized as the alternative or nonstandard profit (AP) efficiency concept (e.g.;
Humphrey and Pulley, 1997; Berger and Mester, 1997; DeYoung and Hasan, 1998).
Alternative profit efficiency measures how close a bank is to generating maximum
profits given its output levels instead of output prices, unlike in the standard profit
efficiency concept. Berger and Mester (1997) and DeYoung and Hasan (1998) provide
a number of conditions in which this alternative way of measuring efficiency is
superior to both the cost and the standard efficiency methods:
(1) If the quality of the financial products and services rendered differs sub-
stantially across banks, so that high-quality producers will not be penalized
unlike in cost efficiency,
(2) If output quantities vary across banks more than output prices, so that output
prices can explain a large portion of the variation in the dependent variable,
either profit or cost,
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 265

(3) If banks are not sole price-takers, so that they have some market power over
the prices they charge,
(4) If output prices are hard to measure, so that inaccurate measurement may
result in poor estimation of opportunities for banks to earn revenues and
profits in the standard profit function,
(5) In relation to (4), if the availability of data impedes one to come up with an
accurate market or accounting price for some important bank outputs, such
as for transaction deposits, if specified as output, and off balance sheet items,
so that the standard profit function cannot be appropriately estimated.4
Apparently, some of the above conditions apply to the Turkish banking sector.
There are divergent banking groups producing various financial services with highly
differing qualities (for instance, foreign banks are “quality” producers, whereas state
banks are “mass” producers). Concentration of the banking assets in the market is very
high (five banks account for about 50% of the total bank assets) and thus tacit collusion
and exercising market power in pricing is occasional rather than exceptional (Denizer,
1997). Off-balance sheet activities surpass on balance sheet activities by at least a
factor of two in notional values (Banks Association of Turkey, 1996), and pricing them
would be imperfect, if not impossible, given the format of financial statement reports
in Turkey. Therefore, we employ alternative profit efficiency instead of standard profit
efficiency in estimating profit efficiencies of Turkish commercial banks. There has
been an expressed concern among Turkish banks in controlling costs, especially in
the increasingly competitive environment following the financial reforms introduced
in the 1980s. Thus, we also estimate the cost efficiencies of the banks and compare
banks’ profit efficiencies with cost efficiencies.
While the standard function is specified in terms of input prices and output
prices, the alternative profit function is specified in terms of input prices and output
quantities. In log form, alternative profit function can be written as follows:
επ b
  
ln(π + a)b = f (yi , pk ) + ln u π b + ln eπ b (6)
As a matter of fact, the alternative profit function employs the same independent
variables as the cost function, as shown below:

4
14 
4 
3
ln(π + a)b = α0 + βi ln yi + βi j ln yi ln y j + γk ln pk
i
2 i j k

13 
3 
4 
3
+ γlm ln pl ln pm + ρik ln yi ln pk + επ b (7)
2 l m i k

4 Please see Berger and Mester (1997) for further justification of the conditions in which the alterna-
tive profit efficiency can be superior to both cost and standard profit efficiencies in measuring bank
performance.
266 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

where π represents net profits of the bank b; a represents a constant that was added to
every bank’s profit so that natural log is taken of a positive number since the minimum
profits are typically negative; and all other variables are as explained previously in
equation (5). A 70% profit efficiency score for a bank suggests that it would earn
about 30% more profits than what it is making now if it were operating on the efficient
frontier.

4. Data and definition of variables

We obtained the annual accounting data of the Turkish commercial banks from
the 1988, 1992, and 1996 “Banks in Turkey” series published by Banks Association of
Turkey (BAT). The financial reports of the banks have become much more transparent,
reliable, and informative in recent years. After the establishment of the Istanbul Stock
Exchange (ISE) in 1986, external auditors have been required to audit banks along
with other firms whose shares are traded on the ISE. The Capital Market Board
also began to force banks to publish their audited financial statements periodically.
Aside from the auditors from within the bank, the Treasury and Undersecretariat
of Foreign Trade (TUFT) and Central Bank (CB), independent external auditors
have started to audit banks in accordance with internationally-accepted principles
of accounting since 1987. Moreover, unified accounting principles and a standard
reporting system were adopted in 1987, further fostering the reliability of bank data in
Turkey.
Our sample covers the universe of the commercial banks, which operated in
Turkey between 1988 and 1996.5 However, as a result of the data filtering process,
a few bank observations were eliminated from the sample. For instance, it was im-
possible to come up with an input price for some banks because either the input or
the expenditure on the input was reported as zero.6 Consequently, having removed 4
observations in 1988, 4 in 1992, and 3 in 1996, our sample consists of a total of 139
observations.
As Table 2 demonstrates, we modeled Turkish commercial banks as multi-
product, 4-output and 3-input, firms according to the intermediation approach (Sealey

5 Commercial banks are not actually perfectly homogenous within themselves. It may be questionable
to combine foreign, domestic private, and state commercial banks into one sample, because these forms
of banks may be facing different regulatory and market conditions, although they operate in the same
environment. In order to examine this, like Aly, Grabowski, Pasurka, and Rangan (1990), we tested whether
the efficiency scores relative to a separate (group-specific) frontier, rather than to a common (pooled)
frontier, should be used. Our parametric and nonparametric tests uniformly showed that foreign and
domestic banks operate in similar environments and thus the selection of either separate or common
frontier is not material. Thus, our results rest on a common efficient frontier and the rest of the study keeps
on with the efficiency scores obtained assessing all kinds of banks in the sample to this common frontier.
6 At times, even if we were able to construct the input prices for those banks, they were unrealistically
high or low (above or below the mean by 2.5 standard deviations). Moreover, one bank, namely Caybank
(formerly Derbank) did not report to the BAT in 1988.
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 267

Table 2
Definition of cost and profit function variables

Variable Variable name Definition

C Total cost Total of interest and non-interest operating costs
π Net Income Total revenue − total cost − tax
y1 Short-term commercial loans Loans with less than a year maturity
y2 Long-term commercial loans Loans with more than a year maturity
y3 Risk adjusted off balance sheet items Sum of risk adjusted guarantees, commitments,
interest and foreign exchange transactions,
repos, and other items
y4 Other earning assets Sum of investment securities, inter-bank funds sold
and loans to special sectors (directed lending)
p1 Price of labor Total expenditures on employees divided by the
total number of employees in the bank
p2 Price of capital Total expenditures on premises and fixed assets
divided by the sum of physical capital
and premises
p3 Price of funds Total interest expenditures on deposit and non-
deposit funds divided by those funds

and Lindley, 1977). Accordingly, all variables except for the input factor labor are
measured in millions of U.S. dollars. Table 2 shows the definition of outputs, in-
puts, and input prices for Turkish commercial banks. The input vector consists of the
following three inputs: (1) labor, x1 ; (2) capital, x2 ; and (3) loanable funds, x3 . We
measure the quantity of labor by the number of full-time employees on the payroll,
capital by the book value of premises and fixed assets, and loanable funds by the sum
of deposit (demand and time) and non-deposit funds as of the end of the respective
year. Hence, the total banking costs include both interest expense and operating costs
and are proxied by the sum of labor, capital, and loanable funds expenditures. Ex-
penditures on these inputs are used as the dependent variable in the cost equation (5).
Obviously, all input prices are proxied as flows over the year divided by these stocks:
(1) price of labor, p1 : total expenditures on employees such as salaries, employee
benefits, and reserves for retirement pay, divided by the total number of employees,
(2) price of capital, p2 : total expenditures on premises and fixed assets divided by the
book value of premises and fixed assets, and (3) interest rate on loanable funds, p3 :
total interest expenses in deposit and non-deposit funds divided by loanable funds.
The output vector, on the other hand, includes the following four outputs, which we
assume represent the ‘true’ portfolio mix of the financial products and services gener-
ated by the Turkish commercial banks: (1) short-term loans (y1 ), (2) long-term loans
(y2 ), (3) risk-adjusted off-balance sheet items (y3 ), and (4) other earning assets, such
as investment securities, specialized and directed loans, and inter-bank loans (y4 ). The
revenues created by these outputs, after accounting for the expenses in their produc-
tion, make up the dependent variable in our profit function. In other words, net income
268 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

(interest and non-interest income) after operating expenses (interest and non-interest
expense) and taxes is used as a proxy for the regressand in the profit equation (7).
Earlier empirical studies on Turkish banking efficiency did not account for di-
rected lending, as they drew no distinction between directed lending and other lending
(Isik and Hassan, 2001). According to the 1996 Banks Association of Turkey reports,
82% of the banks’ securities portfolio consisted of public sector securities, such as
treasury bills and government bonds, by the end of 1995.7 Thus, the exclusion of
security investments could create biases for the whole sector in general and for cer-
tain banks in particular, especially for small banks, whose operations mostly revolve
around the management of such portfolios of government securities. The inclusion
of the very short-term loans (inter-bank loans) in the bank output set is equally crit-
ical, as these became widespread among banks to meet temporary liquidity needs.
Other off-balance sheet activities contain various types of guaranties, mostly regard-
ing foreign-trade, foreign currency, and interest rate transactions, in addition to loan
commitments. In notional values, these activities have altogether surpassed the on
balance sheet items by as high as a factor of three in Turkey. Taking off-balance sheet
items into account will be an advance over both Turkish banking and general banking
literature, because as Berger and Mester (1997) reported, most frontier studies, either
parametric or nonparametric, did not account for these items, although they were
comparable to loans in terms of risk and revenue.
Table 3 presents sample statistics for the variables. A few observations are worthy
of discussion. It is apparent that due to the inflationary pressures that have been a part
of Turkey’s financial life in recent years, most loans have concentrated on the short
term. This is also a reflection of rational behavior by banks attempting to manage their
maturity gap (interest rate risk), because, like loans, deposits have been concentrated
in the very short term, mostly in the 3-month period (BAT, 1996). Expressively, off-
balance sheet activities account for a large part of the output portfolio in the Turkish
banking sector, exceeding the sum of all types of loans each year. The degree of
involvement in such non-traditional activities is not uniform across different groups of
banks, implying that exclusion of such bulky bank output could cause underestimation
of efficiency scores for all banks, but in varying magnitudes and degrees. This is
simply because such items make up a higher fraction of the operations for foreign
and small private banks than for the state banks. A close examination of input prices
suggests that the most expensive factor of production in the input market is capital,
which is typical for a developing country. Also, it is apparent that foreign banks pay
much higher wages and salaries to their employees and invest more in expensive
high-tech capital than domestic banks do, justifying the common belief in the sector

7 All state banks and some private banks make subsidized loans and omitting these activities could produce
underestimated efficiency and productivity measures for such banks. Investment in marketable securities
has been very profitable in Turkey in recent years. For example, in the $ U.S. basis, the average real interest
rate in the 3–6 month and 6–9 month T-bills and government bonds were 9% and 27% and 43% in 1995
and 9%, 18% and 15% in 1996, respectively.
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 269

Table 3
Sample statistics of variables ($ millions of US)1
1 Labor is measured in terms of number of employees by the end of the respective year. 2 Panel A summarizes

dependent variables (total cost and net profit) as well as independent variables (outputs and input prices)
to estimate the cost and profit functions for the Turkish commercial banks. Dependent variables: Total
cost, C: sum of interest and non-interest expenses; Net profit, π : Total revenues after total cost and tax.
Independent variables: Outputs: (1) Short-term loans, y1 , and (2) Long-term loans, y2 , comprise the loans
with less than and more than a year maturity, respectively; (3) Risk-adjusted off-balance sheet items,
y3 , include guarantees and warranties (letters of guarantee, bank acceptance, letters of credit, guaranteed
pre-financing, endorsements, and others), commitments, foreign exchange and interest rate transactions
as well as other off-balance sheet activities; (4) Other earning assets, y4 , consist of loans to special sectors
and investment securities (treasury bills, government bonds and other securities). Inputs: (1) Price of labor,
p1 , total expenditures on employees such as salaries, employee benefits, and reserves for retirement pay
divided by the total number of employees; (2) Price of capital, p2 , total expenditures on premises and fixed
assets divided by book value of premises and fixed assets; (3) Price of loanable funds, p3 , total interest
expenses in deposit and non-deposit funds divided by loanable funds. 3 Panel B and C detail the input prices
and size according to four banking groups: (1) State banks that are owned predominantly by the Turkish
taxpayers and voters; (2) private banks whose more than 50% of shares is owned by the Turkish residents;
(3) foreign banks founded in Turkey in which more than 50% of shares are owned by the residents of
foreign countries; (4) foreign banks’ branches operating in Turkey.

Years → 1988 1992 1996

Variables ↓ Mean Std Error Mean Std Error Mean Std Error
Panel A
Dependent Variables:
C 169.942 335.572 223.810 553.111 333.335 769.745
π 23.661 36.662 31.249 101.076 40.778 76.258
Independent Variables:
OUTPUTS
y1 187.707 306.901 296.970 441.760 410.072 580.706
y2 35.412 86.895 29.289 83.315 44.834 109.379
y3 337.186 454.883 389.357 551.884 863.020 1,114.739
y4 220.090 625.692 273.235 881.615 386.456 1,263.475
INPUT PRICES
p1 0.008 0.004 0.019 0.008 0.017 0.009
p2 0.194 0.174 0.270 0.237 0.271 0.270
p3 0.161 0.052 0.133 0.084 0.174 0.104
Panel B
p1
State Banks 0.004 0.002 0.010 0.002 0.008 0.003
Private Banks 0.007 0.003 0.016 0.006 0.014 0.006
Foreign Subsidiaries 0.010 0.003 0.025 0.007 0.021 0.008
Foreign Branches 0.012 0.005 0.025 0.008 0.028 0.010
p2
State Banks 0.052 0.028 0.065 0.043 0.048 0.047
Private Banks 0.173 0.145 0.228 0.170 0.272 0.237
Foreign Subsidiaries 0.375 0.267 0.320 0.260 0.320 0.436
Foreign Branches 0.264 0.174 0.429 0.333 0.35 0.316
270 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

Table 3 (continued)
Sample statistics of variables ($ millions of US)1

Years → 1988 1992 1996

Variables ↓ Mean Std Error Mean Std Error Mean Std Error
p3
State Banks 0.194 0.038 0.207 0.051 0.249 0.147
Private Banks 0.158 0.050 0.138 0.086 0.165 0.093
Foreign Subsidiaries 0.136 0.074 0.133 0.106 0.143 0.083
Foreign Branches 0.158 0.056 0.090 0.410 0.185 0.121
Panel C
GROSS ASSETS
State Banks 2,925.242 2,476.829 6,146.119 3,917.786 6,379.214 5,470.071
Private Banks 770.306 1,189.30 1,031.521 1,442.258 1,330.377 1,356.315
Foreign Subsidiaries 183.205 175.331 168.325 142.438 283.377 343.189
Foreign Branches 43.561 25.534 90.107 96.837 86.067 86.077

that foreign banks have boosted the quality of human resources in the banking sector.
However, as suggested by the standard deviations, the pay by foreign banks is quite
volatile, perhaps because of differences in the origins of the banks. The pay by state
banks is quite stable, perhaps due to the equal payment system in public services.
Foreign banks are mostly wholesale banks with a small base in retail banking; they
do not operate many branch offices. Accordingly, their size is much smaller than the
domestic banks, state or private, that have a strong network of branch offices scattered
all around the country. However, having being shaken up by the 1994 crisis, foreign
banks have adopted policies to penetrate into the local market to collect deposit funds.
Core deposits are less expensive and less risky, and thus more dependable and more
stable than the purchased funds that foreign banks extensively use in funding their
clients’ projects.

5. Analysis of results
5.1. First-stage analysis of the efficiency estimates
In this section, we present and discuss the efficiency results obtained indirectly
from a functional form on cost and profit behaviors of the banking firms. Table 4
reports the stochastic translog cost and profit frontier parameter estimates from the ML
model. The parameter estimates for price of capital ( p2 ), numeraire, are not shown, but
can be computed from the restrictions for linear homogeneity and cost exhaustion put
on the functions. The values in the table suggest that long term loans and off-balance
sheet items are the most cost incentive outputs. Long-term loans have been sporadic
financial products in Turkey because of the high inflation experienced in recent years.
Thus, the production cost per dollar of such loans looks quite high. Off-balance sheet
activities may be costly to produce mainly due to the know-how required, as they are
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 271

Table 4
The ML cost and profit frontier parameter estimates for Turkish commercial banks (1988–96)1
1 Log likelihood in 1988, 1992, and 1996 are 23.075, 8.944, and 16.777 for the cost function; and −6.753,
−5.742, and 4.830 for the profit function, respectively. The adjusted R2 ’s in 1988, 1992, and 1996 are
98.9%, 98.6%, and 97.1% for the cost function; 53.9%, 85.9%, and 67.8% for the profit function, respec-
tively.

C(.): Cost function π (.): Profit function

Coefficient 1988 1992 1996 1988 1992 1996

α0 5.665∗ 4.052∗∗∗ 1.314∗∗∗ 0.334 2.201∗ 1.753
β y1 −0.766 −0.273 0.572 −3.276 −0.728 −0.123
β y2 0.159 0.776∗∗ 1.336 −0.840 0.640 1.665∗∗∗
β y3 −0.792 0.265 −0.392 1.921 0.539 −0.062
β y4 1.373∗ −0.093 −0.333 1.408 −0.314 −0.406
γ p1 0.829 1.085∗ −0.835 −1.592 0.095 −0.923
γ p2 1.684 −0.265 0.271 2.292 −0.700 −0.045
β y1, y1 −0.773 0.025 0.306∗ −0.626 −0.308 −0.137
β y2, y2 0.128 0.090 −0.011 −0.106 −0.175 −0.049
β y3, y3 −0.444 −0.006 0.281 0.341 −0.064 0.263∗∗
β y4, y4 0.187 −0.057 0.202 −0.322 −0.125 −0.156
β y1, y2 −0.066 −0.085 −0.108 0.210 0.146 0.182
β y1, y3 0.922∗ 0.086 −0.141 0.159 0.130 −0.077
β y1, y4 0.062 0.080 −0.054 0.512 0.378 0.205
β y2, y3 −0.105 −0.081 −0.035 −0.335 −0.174 −0.239∗∗
β y2, y4 −0.034 0.030 0.006 0.162 0.141 0.000
β y3, y4 −0.306 −0.028 −0.069 −0.344 −0.165 −0.023
γ p1, p1 0.065 0.424∗ −0.117∗∗ −0.458 −0.244 −0.328
γ p3, p3 0.176 0.336∗∗∗ 0.453∗∗ 0.767 −0.129 0.131
γ p1, p3 −0.074 −0.321∗∗∗ −0.346 0.082 0.005 −0.051
ρ y1, p1 0.013 −0.094 0.093∗ −1.062 0.002 −0.190
ρ y1, p3 0.076 −0.007 −0.171 0.063 −0.045 0.072
ρ y2, p1 −0.204 0.058 0.143 −0.510 0.400∗∗ 0.399∗∗
ρ y2, p3 0.199∗ −0.071 0.127 0.406 −0.203∗ −0.244∗
ρ y3, p1 −0.184 0.150 0.039 0.868 −0.149 0.240
ρ y3, p3 −0.344 0.023 0.114 −0.549 0.246 −0.278∗∗
ρ y4, p1 0.167 −0.121 −0.130 0.272 −0.030 −0.118
ρ y4, p3 0.019 0.119 −0.069 −0.152 −0.142 0.268∗

relatively sophisticated financial products. The production of non-traditional bank

services such as off-balance sheet items might necessitate employment of a high-
quality staff, which is naturally expensive to get. Our independent variables, which
are common to both profit and cost functions, are able to explain more of the cost
variations than the profit variations across banks. The adjusted R 2 s for the profit and
cost OLS models are around 70% and 90%, respectively.8

8However, it must be noted that our frontier estimations are far from perfect in the sense that we do not
have much freedom left for fair estimations because we have few observations relative to the number of
272 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

Table 5
Summary statistics for the stochastic cost and profit efficiencies of the Turkish commercial banks

Cost Efficiency (CE) Profit Efficiency (PE)

Years → 1988 1992 1996 All 1988 1992 1996 All

Mean 0.936 0.943 0.822 0.895 0.864 0.874 0.784 0.837
Std. Dev. 0.019 0.009 0.239 0.158 0.037 0.040 0.272 0.175
Minimum 0.878 0.919 0.153 0.153 0.762 0.689 0.146 0.146
Maximum 0.969 0.962 0.991 0.991 0.923 0.941 0.992 0.992
# of Banks 36 50 53 139 36 50 53 139

As Denizer (1997) pointed out, most of the new entries to the banking sector
were small in size and scope with a limited impact on competition. Those new banks
mostly concentrated on corporate finance and government securities with no interest
in retail banking. Hence, there are two possible causes of the high profitability in
banking in the post-liberalization era. The first cause may be the high concentration
and excess demand for bank resources by the state that runs large budget deficits, or the
growing economy that requires a substantial amount of funds to finance investments.9
Alternatively, it could be argued that management shake-ups after liberalization have
induced banks to cut their operational costs by quitting unprofitable ventures, reducing
the number of bank branches or downsizing by laying off redundant employees.
Better control of operational costs (thus higher cost efficiency) along with profitable
opportunities in the new environment may have added to the bottom line of banks
(thus higher profit efficiency).
Table 5 summarizes the stochastic cost and profit efficiency scores of the Turkish
banks for the years 1988, 1992, and 1996.10 The average cost and profit efficiencies
over the years studied are about 90% and 84%, respectively. This implies that during
the period, Turkish banks would have needed only 90% of the resources they used
to produce the services they generated, while earning only 84% of their potential
profits on average. It seems that Turkish banks are relatively better at controlling
costs than generating profits. However, as compared to the banking sectors in other
countries, the Turkish banking sector has recorded higher profit efficiency results.
On average, profit efficiency is found to be only 64% for U.S. banks (Berger and

parameters to be predicted. The selection of the size of the sample is not a preference or option, but is
imposed upon us by the data. Given that we included the universe of the Turkish banks in our sample, there
is not much one can do other than be aware of the problem and interpret the results accordingly.
9 The Turkish economy has grown impressively in recent years (e.g., 8.1% in 1995 and 7.9% in 1996).
This high growth has fueled the demand for banking services and products, as evidenced by the impressive
real growth rate in banking assets (e.g., 32% in 1995, and 22% in 1996).
10We convert the inefficiency estimates (IE) into efficiency scores (E) by first taking the anti-logs of
inefficiencies and then using the following transformation: E = 1/(1 + IE).
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 273

Humphrey, 1997) and 72% for Spanish banks (Lozano, 1995b). There may be several
reasons for this wide profit efficiency differential. Unlike their North American and
Western European peers, the Turkish banks do not face influential competition from
non-bank institutions because most of these are affiliated with banks in one way or
another under a holding company structure. In addition, the disintermediation process
that has caused a decline in banking in developed countries has not threatened banks
yet in Turkey because of underdeveloped capital markets for corporate bonds and
stocks. Furthermore, the correlation coefficient between cost and profit efficiency of
the Turkish banks is 0.19, which is statistically insignificant. This suggests that cost
inefficient banks can become highly profit efficient at the same time in a concentrated
market like Turkey. Regulatory distortions in the form of excess demand for bank funds
by the state may have weakened competitive forces, which allowed cost inefficient
firms to continue to prosper.
The inter-temporal comparison of the scores suggests that although cost and
profit efficiencies of the banks were practically stable between 1988 and 1992, they
dramatically fell between 1992 and 1996. Results indicate that efficiencies in 1996
were much less than those in 1988 and 1992. This occurred in parallel with adverse
developments in the banking business in Turkey in the 1990s: an increased cost
of funding, due to strong competition among banks to collect scarce deposits, and
a short-term concentration of bank deposits, due to strong inflationary pressures.
The variation in both cost and profit efficiencies seems to have climbed over time,
indicating that the efficiency gap between the best practice banks and worst practice
banks is getting wider. While the average difference between the most and least cost
efficient banks was about 4% in 1992, it jumped drastically, to 84%, in 1996. Likewise,
the average profit efficiency gap between best practice and worst practice banks
increased dramatically between 1992 and 1996, from 25% to 84%. This may have
resulted from the failure of some banks to catch up with advances in the technology
stimulated by efficient banks in the sector. The results suggest that efficiency in
Turkish banking has worsened in the 1990s, despite efforts of the regulators over two
decades to promote efficiency and productivity in the sector.

5.2. Second-stage analysis of the efficiency estimates

In the second stage, we investigated whether the performance, as proxied by our
cost and profit efficiencies, varies across banking groups even though they operate
in the same market. Table 6 provides the average efficiencies for banks as grouped
by size, control and governance, and ownership categories.
Size can be an important factor that drives the variation in efficiency across
banks. In order to operate optimally by obtaining scale and scope related economies,
firms should posses a certain degree of size. Also, the markets where large and small
banks are concentrated might be different, affecting their performance. For instance,
in the United States small banks operate in the suburban or rural areas where competi-
tion is relatively weak, whereas large banks typically operate in the large metropolitan
274 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

Table 6
Comparison of the performance across different banking groups (1988–1996)

Banking forms Cost Efficiency (CE) Profit Efficiency (PE)

Size Variables
Small Banks (40) 0.882 0.894
Medium Banks (58) 0.843 0.829
Large Banks (41) 0.817 0.793
Control and Governance Variables
Banks where the CEO and chairman 0.891 0.828
of the board are the same person (51)
Banks where the CEO and chairman 0.901 0.843
of the board are not the same person (88)
Banks whose shares are publicly traded 0.905 0.829
in the Istanbul Stock Exchange (23)
Banks whose shares are not publicly traded 0.893 0.839
in the Istanbul Stock Exchange (116)
Ownership Variables
Domestic Banks
State Banks (14) 0.844 0.769
Private Banks (82) 0.898 0.845
Foreign Banks
Foreign Subsidiaries (17) 0.855 0.872
Foreign Branches (26) 0.907 0.866

areas where competition is relatively stiff. Thus, high competitive pressures might
induce more incentives for large banks to be efficient. In this respect, some studies
examined the efficiency differential between different sizes of banks. The results
are ambiguous, with some banks reporting a significantly positive relationship (e.g.,
Berger, Hancock and Humphrey, 1993; Miller and Noulas, 1996) and others reporting
a significantly negative relationship (e.g., Hermalin and Wallace, 1994; Kaparakis,
Miller, and Noulos, 1994; DeYoung and Nolle, 1996) between bank size and effi-
ciency. Some studies did not find any efficiency advantage significantly different
from zero accruing to large banks (e.g., Aly, Grabowski, Pasurka, and Rangan, 1990;
Cebenoyan, Cooperman, and Register, 1993; Pi and Timme, 1993; Berger and Mester,
1997). However, most of these studies measure efficiency relative to the best practice
in saving input quantities and thus/or input costs. However, if banks produce certain
products that add more to the revenues than to their costs, then an increase in pro-
duction costs is financially justifiable. The studies that take the errors on the output
side as well as on the input side reported some efficiency gains pertaining to large
banks (e.g., Berger, Hancock, and Humphrey, 1993). As banks get larger they develop
better means and opportunities for risk diversification, thus the structure of their asset
portfolio changes significantly by size, shifting from less risky (thus less profitable)
investment securities to riskier (but more profitable) business and individual loans. A
recent merger and acquisition (M&A) wave among banks experienced in the United
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 275

States is partly explained by this proposition (Berger and Humphrey, 1997). Previous
studies generally could not find any cost advantage accruing to the acquiring bank
after the merger. On the other hand, the conditions in which small and large banks
operate in Turkey are quite different from those prevailing in the United States. In
Turkey there are no local markets segmented by geographical restrictions or governed
by distinct laws. In this sense, all banks are “national” banks, allowing them to operate
and open branches any where across the country. Small banks operating in Turkey
are typically domestic and foreign private banks, professional banks specializing in
wholesale and corporate financing, and not in need of extensive and expensive branch
networking.
In order to examine the impact of bank size on performance, we divided the
banks into three groups: small, medium, and large, according to gross total assets.
Our results suggest that both average cost and profit efficiencies fall systematically
and monotonically as size increases. There may be a number of plausible reasons for
this efficiency differential among the various sizes of banks. The cost per capita and
branch is very high, and business is limited in scale and scope in rural places due to
the high concentration of the economy in the western part of the country. For instance,
Istanbul, the largest city and center of business in the country, accounts for more than
25% of the national income alone. For this and other reasons, small banks do not
extend their business beyond the three largest cities of the country, Istanbul, Ankara,
and Izmir. Small banks’ overhead cost is relatively low because they often operate
as a single branch. Hence small banks may posses some operational advantages that
bring about higher efficiencies. These banks also extend loans to corporations; by
their nature, such loans are few in number but large in amount. In contrast, large
banks make all types of loans, but typically in great numbers and small amounts.
Thus, originating, serving, and monitoring costs per dollar of loan might be higher
for large banks than small banks.
The study of Pi and Timme (1993) is among the first studies in the financial
institutions literature that tried to link efficiency with the agency cost theory. They
investigated whether the concentration of decision management and control in one
hand brings about any deterioration in the estimated efficiency measures. They found
that the efficiency of the banks whose CEO and chairman of the board is the same
person is significantly lower than that possessed by banks without a similar gover-
nance structure. To explore this proposition, we grouped banks according to CEO and
chairman affiliations. Our results from cost and profit efficiency estimates confirm
the finding of Pi and Timme (1993), indicating that there is a strong link between
management structure and efficiency.
We also investigated whether intense public scrutiny exerts enough market dis-
cipline on banks whose shares are publicly traded, leading to improved efficiencies
for these banks. Berger and Mester (1997) found that publicly traded U.S. banks tend
to have both higher cost and profit efficiencies. Our results concerning the cost effi-
ciency of Turkish commercial banks provide an international support to the finding
of Berger and Mester (1997). On the other hand, the results of the profit efficiency
276 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280

measures from Turkish banks do not support this assertion: although publicly traded,
Turkish banks that tend to have a higher cost efficiency seem to be unable to transform
this cost advantage into earnings.
From Table 6, we also see that the cost and profit efficiencies for the private
banks are 90% and 83%, respectively, whereas for state banks the efficiencies are
only 84% and 77%, respectively. The results suggest that domestic private banks are
operating much more efficiently than state banks. Public banks may become subject
to the whims of the controlling politicians. Political desires may sometimes lead to
inefficient decisions in these banks such as employment of redundant employees and
subsidized lending to special sectors, factors that can be converted into votes, “political
currency,” at the time of elections. One state-owned bank alone, T.C. Ziraat Bankasi,
employs about 25% of the all bank personnel in the country. This bank also makes
subsidized loans to agriculture and is sometimes ordered by the state to write off these
loans or postpone the service or the principal payments on them to support farmers at
bad times. State banks operate in all parts of the country, and some of them are required
by law to exist in certain areas even though economic activities in these areas do not
justify the continuity of operations. Therefore, socially desirable goals may conflict
with economically desirable goals. In other words, state banks might not necessarily
pursue profits. Yet under the successive governments of the late Prime Minister Turgut
Ozal, the prime architect of the liberal reforms of the 1980s, the professional managers
with international business experience have run the Turkish state banks. During this
time interval, state banks have been operating with an increased professional business
mentality, pursuing profitable opportunities in international markets while relying on
their size and network inside and outside of the country. For example, in several years
during the period, the publicly owned T.C. Ziraat Bankasi has been the most profitable
commercial bank in the country. Therefore, performance comparison based on profit
maximization and cost minimization across private banks and state banks is less
problematic during this time interval, to which the period of our study corresponds.
In parallel with recent globalization and integration efforts all over the world,
banks have crossed borders, either to follow their customers at home when they ex-
pand to other markets, or to seek opportunities in other markets simply for the virtue
of profits. Studies from the United States show that foreign banks have usually traded
market expansion for efficiency. Foreign banks seeking to expand their business may
have to rely mostly on purchased funds, which are more expensive and less depend-
able types of deposits because they do not have a strong standing in local deposit
markets. The results from the U.S. studies show that foreign banks have significantly
lower cost and profit efficiencies than domestic banks. However, our results imply
that foreign banks, both in subsidiary and branch forms, have higher cost and profit
efficiencies than their domestic peers, but the difference in profit efficiency is much
more pronounced. This can be attributed to their being small in size but large in amount
of business. Also, foreign banks have modern techniques and business practices and
possess more astute management, attracting both foreign and domestic firms operat-
ing in Turkey to these banks. Bhattacharya, Lovell, and Sahay (1997) also reported
 I. Isik and M. K. Hassan/The Financial Review 37 (2002) 257–280 277

that foreign banks operating in India are more efficient than domestic banks. This
finding along with ours suggests that the context in which foreign banks operate is
important.

6. Conclusion
In this paper, we studied the impact of some independent bank characteristics on
the performance of Turkish commercial banks between 1988 and 1996 by employing
modern stochastic cost and alternative profit efficiency techniques. It is strongly
argued in the finance literature (Berger and Mester, 1997; DeYoung and Hasan, 1998)
that profit efficiency is superior to the cost efficiency concept because according to
profit efficiency banks are punished not only when they employ more costly inputs
to produce the same amount of outputs but also when they generate less earnings by
using the same amount of inputs. All earlier efficiency studies on Turkish banking
investigated input saving efficiencies, but none of them analyzed the profit efficiency
of the sector. In this regard, this study is the first to focus on output side inefficiency
along with input side inefficiency in Turkish banking, using the so-called stochastic
frontier approach.
Among other interesting results, we found that Turkish banks are highly profit-
efficient, a quality that, surprisingly, is not driven by higher cost efficiency. It seems
that the supra profits recorded by Turkish banks in recent years may be a result of reg-
ulatory distortions. In a highly profitable and concentrated market such as Turkey’s,
as a result of the limited number of banks in the system and excess demand for bank
resources from public sector, it seems that banks do not feel the pressure to oper-
ate very cost efficiently to remain in business. This long-observed fact necessitates
a balanced budget by the state and the continuation of financial reforms to foster
competition among banks.

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