A CONCEPTUAL FRAMEWORK FOR AND

SURVEY OF BANKING EFFICIENCY STUDY1

Hamim Syahrum Ahmad Mokhtar

Central Bank of Malaysia, Malaysia
hamimsyahrum@yahoo.co.uk

Syed Musa AlHabshi

International Institute of Islamic Finance Inc., Malaysia
syedmusa@iiif-inc.com

Naziruddin Abdullah
AlHosn University, United Arab Emirates.
n.abdullah@alhosnu.ae, nazirudin@hotmail.com

ABSTRACT

This paper provides a conceptual framework for the banking efficiency study and a survey of the
previous banking efficiency literature. The discussions include the concept of efficiency
measurement, different types of efficiency, methodology as well as the approaches of input and
output variables. The possible bank efficiency determinants or factors that could explain the
differences in efficiency of the bank are also discussed. The findings show that no estimation
techniques dominate over the other with DEA widely used to measure the technical efficiency
while SFA mostly used to measure the cost efficiency. The paper also found that the
intermediation approach is the common approach used to decide the appropriate input and output
variables.

KEYWORDS: Bank Efficiency, Conceptual Framework, Data Envelopment Analysis (DEA) ,

Stochastic Frontier Approach (SFA).

INTRODUCTION

Since the 1990s, studies that were focused on the efficiency of financial institutions have become
an important part of banking literature (Berger & Humphrey, 1997). One of the important aspects of
the banking efficiency studies is that efficiency measures are indicators of success, by which the
performance of individual banks, and the industry as a whole, can be gauged. Greater efficiency
implies that individual banks can adapt better to a different operating environment via their
improved ability to combine and utilise inputs. This development could lead, for example, to
improved financial products and services, a higher shareholder value, a higher volume of funds
intermediated and more economic growth if funds are channelled into more productive
investments.

The efficiency study can also be used to investigate the potential impact of government policies on
banking efficiency. It is of the interest of regulators to know the impact of their policy decision to

1
Parts of this paper have been presented in the 2005 National Conference of Young Scholar, 12-13 December 2005,
Istana Hotel, Kuala Lumpur, Malaysia.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 1

the performance and efficiency of the banks, as they will hugely affect the economy. Berger and
Humphrey (1997) noted, “the information obtained from efficiency studying could be used” (p.175).
1. To inform governments on their policy by assessing the effects of deregulation,
mergers or market structure on efficiency;
2. To address research issues by describing the efficiency of an industry, ranking firms,
or checking how measured efficiency may be related to different efficiency techniques
employed;
3. To improve managerial performance by identifying ‘best practices’ and worst practices’
associated with high and low measured efficiency, respectively, and encouraging the
former practices while discouraging the latter.

The main objective in writing this paper is to discuss the conceptual framework for the bank
efficiency study and survey the previous literature on bank efficiency. The paper is divided into
seven parts. Following this introduction, section two defines the efficiency while section three
explains briefly the concept of efficiency. Section four then proceeds with the framework on bank
efficiency. Section five analyses the previous banking efficiency studies and section six examines
the possible determinants of bank efficiency. Lastly, section seven contains our concluding
remarks.

EFFICIENCY DEFINITION

In general, the efficiency analysis of a production or service unit refers to the comparison between
the outputs and inputs used in the process of producing a product or services. For lucidity, the
process is shown in Figure 1.

Figure 1

The Efficiency Analysis Framework

Environment
Factors

Firm transforms
Inputs inputs into Outputs
outputs

Efficiency

Source: Adapted from Chu & Lim (1998); Ahmad Mokhtar, Abdullah & Alhabshi (2005).

Efficiency measurement is one aspect of a firm’s performance. Efficiency can be measured with
respect to maximization of output, minimization of cost or maximization of profits. In general,
efficiency is divided into two components (Kumbhakar & Lovell, 2003). A firm is regarded as
technically efficient if it is able to obtain maximum outputs from given inputs or minimise inputs
used in the production of given outputs. The objective of producers here is to avoid waste.
According to Koopmans (1951), “a producer is considered technically efficient if, and only if, it is

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 2

impossible to produce more of any output without producing less of some other output or using
more of some input”.

On the other hand, allocative efficiency relates to the optimal combination of inputs and outputs at
a given price. The objective of producers might entail the production of given outputs at minimum
costs or the utilisation of given inputs to maximise the revenue, or the allocation of inputs and
outputs to maximise profit. This is also what we call economic efficiency and the objective of
producers becomes one of attaining a high degree of economic efficiency (cost, revenue or profit
efficiency). According to Berger and Mester (1997), the two most important economic efficiency
concepts are cost and profit efficiency.

THE CONCEPT OF EFFICIENCY

The concept of measuring efficiency was first discussed by Farrell (1957). Drawing inspirations
from Koopmans (1951) and Debreu (1951), Farrell was first to measure the efficiency empirically.
According to Farrell (1957), the concept of efficiency measurement can be divided into two
components, technical efficiency (TE) and allocative efficiency (AE). According to him, technical
efficiency is the firm’s ability to obtain maximal output from a given set of inputs while allocative
efficiency means the firm’s ability to use inputs in optimal proportions, given their respective prices
and production technology.

Figure 2

Overall, Technical & Allocative Efficiency

X2/y

S
.P

R .. Q

.
Q’

S’

O A’ X1/y

Source: Coelli et al. (1998, p.135).

Based on his concept, the combinations of two components will produce overall economic
efficiency (OE). The concept is illustrated in Figure 2. Assuming a firm, ABC, is using only two
inputs, x1 and x2 to produce a single output (y) at point P. SS’ slope shows the possible
combinations of inputs the firm can produce if it is perfectly efficient. The slope AA’ represents the
input price ratio and it shows the various combinations of inputs that require the same level of
expenditure. If the firm’s production is efficient, it should occur at point Q’, which indicates the cost

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 3

minimisation. That is where SS’ and AA’ slope intersect, which means the input combinations Q’ is
both technically and allocatively efficient.

Since the ABC firm produces using the combination of input at point P, two types of inefficiency
arise. First, it is technically inefficient, since by moving to point Q, it could produce the same output
with fewer inputs. In order to measure the magnitude of a firm’s technical efficiency (TE), the ratio
is calculated as OQ/OP, which is equal to one minus QP/OP. Second, it is allocatively inefficient.
Producing at point P shows that the firm made an incorrect choice as to the combination of inputs
at the given prices, therefore incurring more cost than if it had produced at point Q’. To measure
the allocative efficiency (AE), the ratio is calculated as OR/OQ.

Then, we would be able to measure the Overall Efficiency (OE), since we have the ratio calculation
for TE and AE. According to Farrell, OE is TE multiplied by AE.

O E = TE X A E = (O Q /O P ) X (O R /O Q ) (1)

Where, Overall Efficiency (OE) equals to Technical Efficiency (TE) multiplied by Allocative
Efficiency (AE).

Farrell’s original ideas were illustrated in input-oriented measures under the assumption of
constant returns to scale. This input-oriented measure addresses the question of “by how much
can input quantities be proportionally reduced without changing the output quantities produced?”
One could also ask another question; “by how much can output quantities be proportionally
expanded without altering the input quantities used?” This is, according to Coelli (1996), an output-
oriented measure as opposed to the input-oriented measure as discussed by Farrell above.

BANKING EFFICIENCY ANALYSIS FRAMEWORK

The aim of this section is to discuss framework of the bank efficiency study. Figure 3 shows the
conceptual framework of the bank efficiency study. The framework demonstrates what is needed
and what you need to know in analysing the banking efficiency. As shown in the Figure 3, the
conceptual framework is divided into five (F1-F5) steps or stages. In substance, the figure spells
out the steps one has to follow in order to measure the efficiency of a production unit.
In step one (F1), for example, one has to illustrate or identify the main objectives of the study,
which is to examine the efficiency of the bank. The measurement of efficiency would enable us to
know the status of the individual banks’ efficiency and how it is compared among them. It is noted
that while extensive literature has been developed to examine banking efficiency in the US and
Europe (Berger & Humphrey, 1997; Goddard, Molyneux & Wilson, 2001), there is only limited
literature on developing countries (Elzahi Saaid, 2002; Hussein, 2003).

Step two (F2) in Figure 3 shows the type of efficiency used in the frontier efficiency measurement,
which are technical and allocative efficiency. The allocative efficiency can be further divided into
two main types of allocative efficiency: cost and profit efficiency. We reiterate here that a producer
or service provider is considered technically efficient if he/she can produce more outputs from a
given set of inputs or use less input to produce a given level of output (Kumbhakar & Lovell, 2003).
We also note that a producer or service provider is considered cost efficient if he/she is able to
produce a given output at a minimum cost. Similarly, he/she is deemed revenue efficient if he/she
is able to maximise revenue from the utilisation of given inputs. In the same vein, he/she is
regarded as profit efficient if he/she is able to maximise profit from the allocated inputs and
outputs.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 4

 Figure 3

Conceptual Framework of Banking Efficiency

F1 Objective- to measure efficiency of the banks

F2 Type of
efficiency
Technical Allocative/ Economic Efficiency
efficiency (Farell, 1957, Leibenstein, 1966)
(Farell, 1957)

Cost efficiency (Berger Profit efficiency (Berger

& Mester, 1997) & Mester, 1997)

Estimation
F3 Techniques

Parametric Approach Non-Parametric

Approach

SFA (ALS, 1977, DFA (Berger, TFA (Berger &

MVB, 1977)* 1993) Humprey, 1991, 1992)

DEA (Charnes, Cooper FDH (Deprins

& Rhoedes, 1978)* et. al, 1984)
F4 Definition of
input output
variables

Production Approach Intermediation Approach

(Cobb & Douglas, 1928) (Sealey and Lindley, 1977)

Environmental
variables

Regulatory-specific Bank-specific
variables variables

Efficiency results &

F5 Findings Previous Empirical Research

US & Europe (e.g. Berger Asia & Middle East

& Humprey, 1997) (e.g. Abd. Karim, 2001)

* ALS: Aigner, Lovell, and Schmidt (1977); MVB: Meusen and Van Den Broeck (1977).

Next, step 3 (F3) in Figure 3 shows the two general methodologies that are commonly used to
measure efficiency. They are: parametric approach using econometric techniques; and, non-
parametric approach utilising linear programming method. Both differ mainly in how they handle
the random error and their assumptions regarding the shape of the efficient frontier. Each of the
techniques has its own strengths and weaknesses.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 5

The parametric approach has the advantage of allowing noise in the measurement of inefficiency.
However, the approach needs to specify the functional form for the production, cost or profit
function. Non-parametric is simple and easy to calculate since it does not require specification of
functional form (Coelli, 2004). However, it suffers from the drawback that all deviations from the
best-practice frontier are attributed to inefficiency since it does not allow for noise to be taken into
account. Common parametric methods are the Stochastic Frontier Approach (SFA), the Thick
Frontier Approach (TFA) and the Distribution Free Approach (DFA), while the common non-
parametric techniques are the Free Disposal Hull analysis (FDH) and the Data Envelopment
Analysis (DEA).

Berger and Humphrey (1997) found that out of 130 applications, more than half used
nonparametric techniques and 60 were parametric which suggest no approaches dominate the
other. McAllister and McManus (1993), Mitchell and Onvural (1996) and Wheelock and Wilson
(2001) test and reject the translog specification of bank cost functions, and suggest semi-
nonparametric or nonparametric methods for estimating bank costs. In contrast, Bauer et al. (1998)
have found nonparametric techniques do not meet some of their consistency conditions and
therefore some cautions should be taken before using them. The examples of DEA and SFA
models are discussed in the Appendix.

Most of the studies use either non-parametric or parametric techniques in their respective bank
efficiency studies. This might be because both techniques are altogether different in terms of their
approaches in analysing the efficiency. The evidence of consistency between the two techniques
is limited and scarce as only a few studies have been performed to test the robustness of the
results generated by the two frontier techniques apart from the studies by Resti (1997), Bauer et
al. (1998) and Sturm and Williams (2004). It is suggested both parametric and nonparametric
techniques are used in order to strengthen the findings and to make the study more robust (Favero
& Papi, 1995; Intarachote, 2001; Nghia, 2003; Mohamed, 2003). Ideally, if the majority of the
findings from the two different techniques are similar, then one can be sure that the findings are
not being driven by chance or luck.

After the type of efficiency and the measurement techniques, one has to decide the input and
output variables. Specifically, step 4 (F4) in Figure 3 demonstrates the decision that a service
provider has to undertake before measuring the bank’s efficiency. Any decision made, however,
will essentially be subject to banks’ treatment of the money they received from the depositors as
well as the money they extended to the creditors. In relation to this, two main approaches can be
found in the literature. They are: the intermediation approach; and, the production approach

The production approach defines the bank activity as production of services and views the banks
2
as using physical inputs such as labour and capital to provide deposit and loan accounts . While
the intermediation approach views banks as the intermediator of financial services and assumes
that banks collect deposits, using labour and capital, then intermediate those sources of funds into
loans and other earning assets (Sealey & Lindley, 1977). This intermediation approach is argued
to be particularly appropriate for banks where most activities consist of turning large deposits and
3
funds purchased from other financial institutions into loans or financing and investments (Favero
& Papi, 1995).

In practice, the intermediation approach is the most widely used in the banking literature (Kwan,
2002). In choosing the appropriate approach, Berger and Humphrey (1997) suggested that the
intermediation approach is the most appropriate for evaluating the entire bank because it is
inclusive of interest expense (income paid to depositors), which often accounts for one-half to two-
third of total costs. Meanwhile, he recommended that the production approach is more appropriate
for evaluating the efficiency of the bank’s branches because branches process customer
documents for the banks as a whole.

2
Cobb and Douglas (1928) explained about the theory of production.
3
The term financing is for Islamic banks, which is equivalent to the loans for conventional banks.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 6

 Figure 4

Input-output relationship in banking (intermediation approach)

Operation
INPUT Process OUTPUT
VARIABLES VARIABLES

Banking Loans,
Advances &
Labour
Financial Financing
Capital Aspect
Investment &
Deposits Trading
Securities

An example of the intermediation approach is illustrated in Figure 4. In this case, the banking
operation process produces joint-outputs. That is to say, banks produced different outputs from the
same set of inputs. To give but one example, the same staff, office space and deposits and funds
(for brevity, they are called inputs) are used to provide financial assistance to corporate or retail
clients. At the same time they are used to conduct other business dealings like investment and
trade, which generate returns for the banks and subsequently depositors.

Finally, after going through all the process discussed earlier, you will get the efficiency results (step
5 in Figure 3). A value of 1 or 100% indicates full efficiency and operations on the frontier. A value
of less than 1 or 100% reflects operations below the frontier. The wedge between 1 and the value
observed measures the inefficiency.

SURVEY OF THE PREVIOUS BANK EFFICIENCY STUDY

The studies of efficiency using “frontier” approaches on banking did not start until Sherman and
Gold (1985) initiated their study. They applied the frontier approaches to the banking industry by
focussing on operating efficiency of branches of a savings bank. Since then, there have been
extensive studies on bank efficiency done in the US and European countries and most of the
studies focused on conventional banking (Berger & Humphrey, 1997; Goddard et al., 2001).

This paper analysed the previous bank efficiency study to link with the conceptual framework
highlighted in the previous section. The works written on global banks’ efficiency are summarised
in Table 1. Specifically, the table provides an understanding of the frequency, and type of inputs
and outputs used by the studies on banks’ efficiency for the period between 1985 and 2005. All in
4
all, during the period there were 47 bank efficiency studies included .

4
The detail of analysis on the previous studies is available upon request.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 7

 Table 1

Input and Output Variables, its Approaches, and Techniques Used:

Inputs variables Frequency Outputs Variables Frequency

Labour 39 Investment Securities 15
(Physical) Capital 32 Net/ total loans 14
(core) deposits 15 Commercial Loans 13
Interest expense 10 Real Estate Loans 13
Non-interest expense 8 Consumer Loans or Loans
Purchased Funds 6 to individuals 13
Time and Savings Non-interest Income 12
Deposits 6 Other Loans 10
Borrowed Funds/Money 6 Interest Income 7
Operating Expense 5 Demand/savings Deposits 7
Demand Deposits 3 Time Deposits 7
Customer Funds 3 Earning Assets 5
Expenditure on Materials 3 Deposits Placements 5
Financial Capital 3 Securities in Trading 4
Transactions Deposits 2 Commitment &
Non-transactions Contingencies 4
Deposits 2 Short Term Loans 3
Occupancy Costs 2 Long Terms Loans 3
Instalment Loans 2
Total 145 Total 137

Inputs and Outputs Frequency Estimation Techniques Frequency

Approaches
Intermediation 34 DEA 32
Production 5 SFA 23
Value-Added 5 DFA 5
User Cost 3 TFA 2
Asset 2 FDH 1
Total 49 Total 63

Sources: Authors’ own updates.

Note: These results were found to be used in a review of 47 bank efficiency studies. Take note that the
total number of techniques used in the previous studies are more than 47 studies since there are
studies which used more than one technique. The same goes to the other findings.

Based on the analysis in Table 1, one can safely conclude that labour, physical capital, various
kinds of deposits (core deposits, time and savings deposits, demand deposits, purchased funds,
borrowed funds) and interest expenses are the most widely used input variables. Likewise, the
most commonly used outputs are investment securities, different kinds of loans (such as real
estate loans, commercial loans, consumer loans or loans to individuals, total or net loans and other
loans), interest income and non-interest income. It is also obvious from the table that the
intermediation approach, the frequency of which 34 as opposed to value-added (5) and production
(5), is the most frequently employed technique to define the banks’ inputs and outputs.

Table 1 also shows the number of estimation techniques used in bank efficiency studies. Of the
studies conducted over the 1985-2005 period, 32 studies utilised data envelopment approach
(DEA), while 31 others utilised other techniques ranging from stochastic frontier technique with the
frequency of 23 to free disposal hull (FDH) technique with the frequency of 1.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 8

 Table 2

Types of efficiency analysed by different estimation techniques

No. Estimation Type of Efficiency Number of

Techniques Times
1. DEA Technical Efficiency 23
Cost Efficiency 6
Allocative Efficiency 3
2. SFA Technical Efficiency 3
Cost Efficiency 15
Profit Efficiency 4
Revenue Efficiency 1
3. DFA Cost Efficiency 4
Profit Efficiency 1
4. TFA Cost Efficiency 1
Profit Efficiency 1
5. FDH Technical Efficiency 1

Sources: Authors’ own updates. Note: These results were found in a review of 47 bank efficiency
studies.

Meanwhile, Table 2 is the extension of Table 1. It shows the types of efficiency that are analysed
using different estimation techniques. As evident from Table 2, DEA is the most widely used
estimation technique to measure the efficiency of the banks. However, a closer look reveals that
DEA was mostly used to measure the technical efficiency, while SFA was more frequently used to
measure the cost efficiency.

FRAMEWORK ON DETERMINANTS OF BANKING EFFICIENCY

The process of producing outputs from inputs can also be influenced by environmental variables
or explanatory variables such as location, which are often not controllable by producers or service
providers (see Figure 1 and Step 4 of Figure 3). This section commented on possible
environmental or explanatory variables that may explain the differences in efficiency of the bank.
The approach is to take into account both regulatory-specific variables and bank-specific variables
in explaining the variations in bank’s efficiency estimates (Figure 5).

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 9

 Figure 5

Determinants of Banking Efficiency

Regulatory-specific Dependent Bank-specific

variables variable variables

Size (Berger &

Bank Type Mester, 1997).
(Al-Jarrah & Molyneux, 2003)
Capital Adequacy
Time (Bhattacharya (Girardone et al., 2004)
et al. 1997).
Efficiency Loan Quality (Berger &
Ownership Status Mester, 1997).
(Sturm & Williams, 2004).

Expenses (Bauer et
Geographical region al., 1998)
(Abdul Karim, 2001)

Bank Age
(Mester, 1996).

In Table 3, the details of each familiar regulatory-specific variables, which are categorical in
nature and can be found in the literature, are shown. They are; time trend, bank type, ownership
status and geographical region.

Table 3

Regulatory-specific variables

Explanation of the variables Previous studies

1. Time trend
• Time trend will show how bank
efficiency evolves through time relative
to the base year.
• It can also be used to indicate the
impact of changes in the regulatory
environment.
• A positive co-efficient of time implies
that banks became more efficient as
they slowly adapted to the competition
within the banking environment
Bhattacharya et al. (1997).
• Kwan and Eisenbeis (1996) found that the
average inefficiency appears to be
declining over time.
• Bhattacharya et al. (1997) reported a
declining trend of efficiency for commercial
banks in India during the 1986-1991
period.
• Casu and Molyneux (2000) found a slight
improvement in efficiency levels through
time for European banks with the exception
of the banks in Italy.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 10

 Explanation of the variables
2. Bank type
• An analysis of different bank type will
indicate whether there is any difference
in efficiency between the types of
banks.
3. Ownership status
• An analysis of different ownership
status will indicate whether there is any
efficiency difference in different kinds
of ownership status.
• Common ownership status is a
comparison between domestic or local
banks with foreign banks (Sturm &
Williams, 2004).
4. Geographical region
• An analysis by geographical region is
to test whether there is any difference
in efficiency in different geographical
region.
Sources: Authors’ own updates
Table 4, on the other hand, summarises the bank-specific variables. They are also used in many
studies on bank efficiency. The bank-specific variables normally consist of bank size, capital
adequacy or strength of the bank, bank’s expenses, bank’s loan quality and the age of the bank.
The bank-specific variables can also assist us to explain the differences in efficiency for a different
type of bank and ownership status.
UNITAR E-JOURNAL Vol. 2, No. 2, June 2006
Previous studies
• Al-Jarrah and Molyneux (2003) reported
that Islamic banks (0.98) appear to be
more cost efficient than commercial (0.94-
0.95) and investment banks (0.93). They
studied the cost and profit efficiency of 82
banks in Jordan, Egypt, Saudi Arabia and
Bahrain during the period of 1992-2000.
• Elyasani and Mehdian (1992) found that
both minority and non-minority owned
banks in the US had closed efficiency with
an average of 0.89 and 0.87 respectively.
Elyasani and Mehdian (1992) used DEA
techniques to measure the technical and
allocative efficiency.
• Zaim (1995) found that foreign banks are
the most efficient banks, followed by state
banks, which were more efficient than
private banks.
• Sturm and Williams (2004) reported that
foreign banks are more technically efficient
than domestic banks in Australia during the
period from 1988 to 2001.
• Favero and Papi (1995) found that
Southern Italy has lesser efficiency results
than Northern and Central Italy.
• Abdul Karim (2001) reported that Thailand
banks are the most efficient banks,
followed by Malaysian banks, Indonesian
banks and finally the Philippines banks.
11
 Table 4

Bank-specific variables

Explanation of the variables Previous studies

Bank size
• To examine whether size would be
the determinants of bank efficiency.
• The natural log of total assets is
used to examine the relationship
between efficiency and bank size.
• Previous studies also categorised
the bank by different sizes; e.g.
large, medium and small banks.
• Most of the studies used asset size, but no
consistent results emerge of its relationship
with efficiency (Berger & Mester, 1997).
• Abdul Karim (2001) reported that larger
banks tend to be more cost efficient
compared to their smaller rivals.
• Abdul Majid et al. (2003) found that size had
positive relationship with the efficiency of the
banks.

Capital Adequacy
• Capital adequacy can be proxy by • Kaparakis et al. (1990) and Elyasani et al.
the ratio of equity to total assets (1994) reported a positive correlation
(EQTA). between capital to asset ratio and efficiency.
• EQTA indicates capital strength or • Mester (1993), Mester (1996) and Girardone
bank safety and soundness. et al. (2004) found a negative correlation
• Positive correlation is expected as between capital adequacy ratio and
high capitalised banks tend to be inefficiency.
more efficient since efficient banks
tend to have more profits, which in
turn strengthen their capitalisation
status (Isik & Hassan, 2003).
Bank Expenses
• Berger and Mester (1997) and Bauer et al.
• The ratio of total costs to total assets
(1998) studies reported a negative
(TCTA) can be used to analyse the
correlation between bank efficiency and
relationship between bank expenses
proportions of cost to total assets.
and efficiency.
• A negative correlation between
TCTA and efficiency is expected,
since banks with higher expense
may overutilise inputs and therefore
be less efficient.
Loan Quality
• A general finding is that more efficient banks
• The ratio of loan loss reserve to total
have lower levels of non-performing loans
loans (LLRTL) can be used to
(Berger & Mester, 1997).
measure loan quality (Molyneux et
• Similarly, Kwan and Eisenbeis (1996)
al., 1996).
reported that the inefficient bank is
• The larger the ratio, the poorer the
associated with higher loan losses.
loan quality. As Intarachote (2001)
points out, LLRTL is expected to be
negatively related to efficiency, since
greater loan losses increase financial
risk and would reflect passive risk
management, which should lead to
lower efficiency.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 12

 Explanation of the variables Previous studies

Bank Age
• Bank Age is assessed by the number • Mester (1994, 1996) found that inefficient
of years the bank has been in banks tend to be younger in her study of 214
operation. third district banks.
• According to learning by doing • However, Isik and Hassan (2003) found
hypothesis, the older the bank, the insignificant negative relationship between
more experience they have, the bank age and efficiency.
therefore the bank could better
manage their operations and might
become more efficient, (Mester,
1994, 1996).
• A positive relationship with efficiency
might also suggest that more
efficient banks are more likely to
survive (Mester, 1994, 1996).
Sources: Authors’ own updates

CONCLUSION

One of the best ways to learn about the banking efficiency is to learn from the experiences of
others. Many efficiency studies have been conducted in recent years that you can read and learn
from before you embark on your empirical analysis.

This paper provides conceptual framework for the bank efficiency study and a survey of previous
banking efficiency literature. The findings show that no estimation techniques dominate the other
with DEA widely used to measure the technical efficiency while SFA was mostly used to measure
the cost efficiency. The paper also found that the intermediation approach is the common
approach used to decide the appropriate input and output variables.

While there has been extensive literature examining the efficiency of US and European
conventional banking over the recent years (Berger & Humphrey, 1997; Goddard et. al, 2001), the
empirical work on developing countries is still lacking. The study on Islamic Banking efficiency is
also in its infancy apart from a few studies (Hassan, 2003; Elzahi Saaid, 2002; Brown & Skully,
2003). Typically the studies on Islamic banks have focussed on theoretical issues, and empirical
work has relied mainly on the analysis of descriptive statistics rather than rigorous statistical
estimation (El-Gamal & Inanoglu, 2003). These are the gaps in the bank’s efficiency study.

A contribution of the present paper is that it provides the framework of the banking efficiency study
as a reference for the researcher on banking efficiency. The present paper basically provides you
the step that you need to follow in analysing the “frontier” efficiency. The interested researcher can
also refer to Coelli, Rao and Battese (1998) and Kumbhakar and Lovell (2003) for a much more
rigorous overview of the efficiency methods and conceptual issues. Besides that, the SFA and
DEA programmes can be downloaded free from this web site
(http://www.une.edu.au/econometrics/cepa.htm), which was developed by Tim Coelli, one of the
prominent scholars on efficiency study.

Acknowledgement
The authors would like to thank Associate Professor Dr. R. Ravindran, two anonymous referees, and the
editors of this journal for useful comments on previous drafts of this paper. The usual caveats apply.

UNITAR E-JOURNAL Vol. 2, No. 2, June 2006 13

 REFERENCES

Abd. Karim, M.Z. (2001). Comparative bank efficiency across select ASEAN countries. ASEAN
Economic Buletin, 8(3), 289-304.

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 APPENDIX

DEA MODELLING FRAMEWORK

This section provides the mathematical formulation for technical and cost efficiency using DEA
techniques. Following Coelli et. al (1998) and Coelli (2004), we assume N firms or banks, each has
K inputs and M outputs. For the i-th firm, xi and yi represent the column vectors of input and
output respectively. For N firms, X represents the K*N input matrix and Y is the M*N output
matrix. For example, the VRS input-oriented technical efficiency of each bank is estimated by
solving a linear programming problem. The mathematical formulation is as follows:

m i n θ ,λ θ
s u b je c t to − yi + Y λ ≥ 0,
(2)
θ xi − X λ ≥ 0,
N 1'λ = 1
λ ≥ 0

where λ is N*1 intensity vector of constants and θ is a scalar. N1 is an N*1 vector of ones. The
estimated value of θ is the efficiency score for each of the N firms. The estimate will satisfy the
restriction θ ≤ 1 with a value θ = 1 indicating a technically efficient firm. The problem has to be
solved N times, once for each firm, to derive a set of N technical efficiency scores. Note that the
convexity constraints ( N 1' λ = 1 ) ensures that an inefficient firm is benchmarked against firms of a
similar size and the projected point of that firm on the DEA frontier will be a convex combination of
observed firm.

The cost efficiency, according to Coelli et. al (1998) and Coelli (2004), is defined as the ratio of the
minimum possible cost to the observed cost for the i-th firm. DEA cost efficiency can be estimated
by solving a linear programming problem. In this example, the problem is to choose input
quantities to minimise costs holding constant input prices and output quantities.

The mathematical formulation is as follows:

m i n λ , X i* w i'xi *
s u b je c t to − yi + Y λ ≥ 0, (3)
x − X λ ≥ 0,
*
i

N 1'λ = 1
λ ≥ 0

where wi is a vector of input prices for the i-th firm and Xi* is the cost-minimising vector of input
quantities for the i-th firm, given the input price ( wi ) and the output quantities ( yi ). Cost efficiency
' * ' '
for firm i is calculated as the ratio of wi xi / wi xi , where wi is the transpose of firm i’s input price
vector. Thus, cost efficiency (CE) is the ratio of frontier costs of firm i’s output vector, given the set
of its input prices, to its actual cost, where 0 ≤ CE ≤ 1 , and CE=1 for fully efficient firms or banks.

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 SFA MODELLING FRAMEWORK

This example shows the parametric cost efficiency model which is derived from a cost function.
The cost function can be written in a natural logarithm form as the following:

ln ΤC = f (Y, W) + ln U c + ln Vc (4)

Where ln ΤC is the total cost, f denotes some functional form, Y is the vector of quantities of
output variables, W is the vector of price input variables, ln U c is the inefficiency factor that
may raise cost above the best-practice optimal cost and ln Vc is the random error incorporated to
capture the measurement error and luck, which may temporarily increase or decrease a bank’s
costs. Basically, the cost function above describes the relationship between the cost variable with
prices of input variables, quantities of output variables plus the inefficiency and random error.

For parametric techniques, the inefficiency and random error components of the composite error
term are disentangled by making explicit assumptions about their distributions. For the composite
error-term component in the equation 1.3, it can be written as,

E = U +V (5)

Following Aigner, Lovell and Schmidt (1977), the study normally assumes the distribution of the
error term or statistical noise, V , to be two-sided normal distribution while the inefficiency term,
U , is assumed to be one space (half normal distribution).
Note that the cost function can take various functional forms in bank efficiency study. The
functional forms (f) for the majority of cost-based studies are translog cost function. An example of
a standard translog cost function is shown as:

m n

ln TC = α 0 + ∑ α i ln Yi + ∑ β j ln W j
i =1 j =1

m m n n
+ [∑∑ δ il ln Yi ln Yl + ∑∑ γ jk ln W j ln Wk ]
1
2 i =1 l =1 j =1 k =1 (6)
m n
+ ∑∑ ρij ln Yi ln W j + Ei
i =1 j =1

where, lnTC is the natural logarithm of total costs, lnY is the natural logarithm of output
quantities; lnWj is the natural logarithm of input prices; Ei = V + U is as defined in equation 1.4;
γ
whereas α , β , δ , and ρ are coefficients to be estimated.

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