What Drives Bank Efficiency The Interaction of Bank Income Diversification and Ownership

International Review of Economics and Finance 55 (2018) 203–219
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International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref
What drives bank efficiency? The interaction of bank income

diversification and ownership
Anh-Tuan Doan a, Kun-Li Lin b, Shuh-Chyi Doong c, *
a
Faculty of Finance and Banking, Ton Duc Thang University, 19 Nguyen Huu Tho Street, Tan Phong Ward, District 7, Ho Chi Minh City, Viet Nam
b
Department of Finance, Feng Chia University, 100 Wenhwa Road, Seatwen, Taichung 407, Taiwan
c
Department of Finance, National Chung Hsing University, 145 Xinda Road, South Dist., Taichung 402, Taiwan
A R T I C L E I N F O A B S T R A C T
JEL classification: This paper examines the relation between income diversification and bank efficiency across 83
G21 countries over the period 2003–2012. We also evaluate how ownership structure affects the
G28 impact of bank diversification on cost efficiency. Using a stochastic frontier approach to estimate
G34 bank cost efficiency, we find evidence that increased diversification tends to improve bank effi-
ciency but the benefits of diversification are offset by the increased exposure to volatile non-
Keywords: interest activities. With respect to the impact of ownership, we find that state-owned banks
Income diversification with fewer volatile income sources are likely to be less efficient in terms of income diversification.
Ownership structure Our results also reveal that more diversified foreign-owned banks tend to be less efficient in
Efficiency developed countries, while the increased foreign ownership of banks appears to improve the
Banking
diversification benefits in developing countries after the financial crisis. Our findings highlight the
implications of bank income diversification and ownership for efficiency and are relevant to bank
regulators who are considering additional regulations on bank management.
1. Introduction
What drives bank efficiency? Understanding the determinants of bank efficiency is important because bank efficiency establishes
bank health and is an important driver of economic growth (Allen & Gale, 2000; Levine, 2005). A growing literature has taken up this
task, documenting positive and negative empirical links between bank efficiency and various bank and market characteristics. With
financial deregulation and market integration, the scope of bank activities has been completely reshaped, from traditional inter-
mediation products to an array of new businesses (Clark & Siems, 2002). These trends have led to substantial consolidation in the
banking industry and, consequently, to significant changes in ownership structure. However, this literature contains few empirical
studies examining the links among bank efficiency, income diversification, and ownership structure. We contribute to this nascent
literature by examining the effects of the two interrelated dimensions of bank income diversification and ownership structure on
efficiency.
However, while that literature has provided considerable understanding of the effects of bank frontier efficiency, its primary focus is
mostly based on traditional balance sheet figures (e.g., Lensink, Meesters, & Naaborg, 2008). Rogers (1998) argues that models that
ignored non-traditional outputs penalized banks heavily involved in such activities, because resources that used to produce these non-
traditional services were included in the input vector without accommodating the relevant variables in the output vector. Therefore,
* Corresponding author.
E-mail addresses: doananhtuan@tdt.edu.vn (A.-T. Doan), kllin@fcu.edu.tw (K.-L. Lin), scdoong@dragon.nchu.edu.tw (S.-C. Doong).
http://dx.doi.org/10.1016/j.iref.2017.07.019
Available online 19 July 2017

1059-0560/© 2017 Elsevier Inc. All rights reserved.
A.-T. Doan et al. International Review of Economics and Finance 55 (2018) 203–219
there is no general consensus in the literature regarding the definition of the relevant output vector. Furthermore, relatively few studies
provide a comparison of models developed both with and without proxies for non-traditional activities, thereby offering a bleak picture
of their relative significance in bank efficiency estimates. Most of the studies report that ignoring measures of non-traditional activities
in the estimation of bank efficiency can be misleading, although at least two studies find little or no impact of off-balance sheet activities
(Jagtiani, Saunders, & Udell, 1995; Pasiouras, 2008), while the results of Clark and Siems (2002) are mixed, dependent on the ex-
amination of cost or profit efficiency.
Additionally, bank strategies differ because of differences in customer preferences, information quality, and production methods,
which could be driven by differences in bank ownership structure. Few studies on the benefits of state ownership support efficiency
arguments for state ownership (e.g., police and prison ownership; see Hart, Shleifer, & Vishny, 1997). In contrast, most studies have
found that state-owned firms do not better serve the public interest (e.g., Grossman & Krueger, 1993) and that, in fact, state-owned firms
are typically extremely inefficient (e.g., Dewenter & Malatesta, 2001). On the other hand, there is a tendency for foreign-owned in-
stitutions and foreign banks to be more oriented toward transaction lending and to provide financial services to large corporate clients
rather than lend to smaller firms, which are more likely catered to by domestic banks. Empirical studies show that foreign banks tend to
have a wholesale orientation and may favorably lend to large corporate affiliates of their customers in their home nation (DeYoung &
Nolle, 1996; Grosse & Goldberg, 1991). In addition, foreign banks are more exposed to developed country banking markets, which tend
to be more competitive and use more sophisticated information and communication technologies (Claessens, Demirgüç-Kunt, & Hui-
zinga, 2001). These advantages could favor foreign banks in managing operating and financial leverage when diversifying toward non-
interest activities. Despite the extensive literature on bank efficiency (Berger, 2007; Berger & Humphrey, 1997), there is yet no com-
prehensive study on whether bank income diversification and ownership enhance or impede efficiency.
The purpose of this paper is to contribute to the assessment of the types of bank income diversification and ownership that work best
to achieve well-functioning banking systems. To our knowledge, no research has addressed whether bank efficiency may be different for
privately owned banks and publicly held banks under specific ownership profiles. Thus, our aim is to assess bank efficiency levels by
combining the two interrelated dimensions of bank diversification and ownership structure. In particular, our cross-country analysis is
able to compare the impact of bank income diversification and ownership across different levels of economic development (e.g.,
advanced and developing) and across different geographic regions. Furthermore, we are able to incorporate other country-based
characteristics such as the relative presence of foreign and government-owned banks in the market, the degree of information shar-
ing, and the degree of bank regulation. Policymakers can surely make more informed decisions about the income diversification of banks
if they know the likely effect of these decisions on bank performance.
This study contributes to the literature in several ways. First, the literature is mostly based on the relation between bank income
diversification and performance (DeYoung & Roland, 2001; Stiroh, 2004; Stiroh & Rumble, 2006). In contrast, we estimate bank ef-
ficiency using stochastic frontier analysis (SFA), which is superior compared to traditional measures of performance because the effi-
cient frontier approach could simultaneously account for a variety of output/input specifications (Berger & Humphrey, 1997). Second,
while a related study of Lozano-Vivas and Pasiouras (2010) examines the effect of non-traditional activities on bank efficiency, we use
both income diversification and non-interest income as two main independent variables to investigate the impact of a shift toward non-
interest activities on bank cost efficiency. This allows us to clarify the framework that decomposes the effect of strategic shifts into
a “direct exposure effect” of an increased share of non-interest income and an “indirect diversification effect” of a resultant variation in
income concentration. In addition, this paper shifts the focus to banks and to whether their ownership structure influences their effi-
ciency levels.
Finally, our paper provides international evidence about the relevance of bank income diversification and ownership in the esti-
mation of bank efficiency levels. Since some related studies investigate mainly the United States (e.g., Liang, Chen, & Chen, 2016;
Rogers, 1998; Stiroh, 2000) and a few developed countries such as Spain (Tortosa-Ausina, 2003) and Greece (Pasiouras, 2008), our
knowledge with regard to a broader range of countries, particularly transition and less developed countries, remains limited.
We investigate the effects of ownership structure on the relation between income diversification and bank efficiency using data for
more than 7533 bank–year observations in 83 countries over the period 2003–2012. We obtain the following main findings. First, we
find that increases in income diversification are positively associated with bank efficiency, but these benefits of diversification are offset
by increasing exposure to volatile non-interest activities. Second, state-owned banks tend to have lower diversification benefits than
their private-owned counterparts, even though they have low costs of diversification. Third, we find that the higher the proportion of
foreign shareholders, the fewer the benefits of bank diversification in developed countries, but these gains are likely to be higher for
foreign-owned banks in developing countries after the financial crisis. Finally, banks with foreign ownership in developed countries are
able to better mitigate the costs of diversity compared to domestic private banks, while the opposite is true in developing countries.
The rest of the paper is organized as follows. Section 2 reviews the literature on bank efficiency, ownership structure, and income
diversification. Section 3 presents our measures of bank efficiency, ownership structure, and income diversification and analyzes how
ownership structure affects the income diversification–bank efficiency nexus. Section 4 describes the data sources and estimated effi-
ciency scores. Section 5 analyzes the empirical results and discusses their implications. Finally, Section 6 concludes the paper with
a concise discussion of policy implications.
2. Literature review and hypothesis development
2.1. Effects of income diversification on bank efficiency
Spreading activities across different products and economic environments could help banks reduce their expected costs of financial
204
distress/bankruptcy (Boot & Schmeits, 2000). As screeners or monitors of borrowers, banks with a more diversified intermediary can
minimize their cost of monitoring information and thus lower total costs, even in a risk-neutral economy. In models of delegated in-
vestment monitoring (e.g., Boyd & Prescott, 1986), diversification within financial institutions serves an important role in providing
sufficient loan proceeds to repay fixed debt claims to depositors, with well-diversified financial intermediaries reducing their chances of
costly financial distress. Similarly, Stiroh (2004) reveals that banks can reduce cyclical variations of profit by shifting their total income
toward non-interest income, depending less on general business conditions. To investigate whether income diversification affects bank
efficiency levels, Lozano-Vivas and Pasiouras (2010) find that, on average, cost efficiency increases when non-interest income is used as
an output in the global best practice frontier model. As suggested by Meslier, Tacneng, and Tarazi (2014), greater competition in
financial markets leads to banks’ increasing need to diversify. Banks with various diversification strategies can produce information that
enhances their loan making through such activities as securities underwriting, brokerage, and other trading services. Indeed, activities
that generate non-interest income are believed to be imperfectly associated with those that generate interest income, thereby producing
profitable growth and providing a better risk–return trade-off.
Although diversification plays an important role in a bank's desirable efficiency, its costs could be associated with higher income
volatility, implying higher risk. This argument is supported by empirical studies. Notably, DeYoung and Roland (2001) conclude that
a shift toward non-interest income is related to higher leverage and increased income volatility, which could increase the volatility of
bank earnings. One possible reason is that commercial banks tend to easily lose fee-based activities clients because of high switching
costs for borrowers associated with lending relationships. Moreover, banks tend to increase operating leverage for additional investment
in human resources and technology infrastructure while shifting toward fee-based activities, leading to high earnings volatility. In
a sample of US commercial banks, Morgan and Samolyk (2003) investigate the nexus between geographic diversification and bank
performance and report that diversification is not associated with increased returns or reduced total risk. Similarly, focusing on loan
portfolio diversity, Acharya, Hasan, and Saunders (2006) find that loan diversification is not associated with better performance but
increases risk in the Italian banking industry. Stiroh and Rumble (2006) show that the benefits from diversification are offset by an
increase in exposure to non-interest income business, which increases the volatility of equity market returns. More recently, using
a sample of small US credit unions, Goddard, McKillop, and Wilson (2008) find a negative association between diversification and both
unadjusted and risk-adjusted profitability. This is true particularly in terms of cost and profit efficiency according to Berger, Hasan, and
Zhou (2010), who show diversified banks are less profitable than focused Chinese banks.
2.2. Effects of ownership structure on bank efficiency
In addition to bank income diversification, another important dimension of ownership structure is state ownership and foreign
ownership versus private ownership structure. Megginson and Netter (2001) present a survey of studies that have provided evidence on
the relative performance of state-owned and privately owned firms. Reasons for different ownership forms leading to different efficiency
levels have been extensively explored in the literature and the dominant model of the effect of ownership utilizes the principal–agent
framework and public choice theory to highlight the importance of management being constrained by capital market discipline. Few
studies on the benefits of state ownership support efficiency arguments for state ownership (e.g., police and prison ownership; Hart
et al., 1997). In contrast, most studies find that state ownership is inherently inefficient. First, the agent–principal problem is more
prominent under state ownership. When there is separation between ownership and management controls, managers (agents) may
pursue their own interests rather than act in the best interest of owners (principals) (Berle & Means, 1932), which could result in
negative effects on performance. Second, the free-rider problem also becomes more common. State ownership theoretically means that
all citizens are co-owners who, in practice, have no power or incentive to influence and monitor the management of state banks, leaving
governments as the only effective representative (Huibers, 2005). Governments, however, have multiple (often conflicting) goals. Third,
soft budget constraints faced by state banks could induce moral hazard problems leading to poor performance. State banks act as
government agents and finance state-owned enterprises based on political preference rather than commercial considerations.1 When
banks are in difficulty, they expect help from the government. Therefore, managers of state banks have little incentive to minimize costs
or maximize profits. Finally, other reasons also explain the poor performance of state banks, including the general view of “too big to
fail,” the “quiet life” hypothesis, poor monitoring, and lack of market discipline (Megginson, 2005).
On the other hand, in developing nations, on average, foreign banks are most commonly more efficient than or approximately as
efficient as private domestic banks. Both groups are typically found to be significantly more efficient, on average, than state-owned
banks, but there are variations to all of these findings. For example, research using data from the transition nations of Eastern
Europe finds foreign banks to be the most efficient, on average, followed by private domestic banks, and then state-owned banks (Bonin,
Hasan, & Wachtel, 2005). However, another study of transition nations finds the mixed result that foreign banks are more cost efficient
but less profit efficient than either private domestic or state-owned banks (Yildirim & Philippatos, 2007). Also, foreign banks appear to
not have any advantage in terms of profit efficiency in the Middle East and North Africa region (Haque & Brown, 2017). A study of 28
developing nations from various regions finds foreign banks to have the highest profit efficiency, followed by private domestic banks,
and then state-owned banks (Berger, Hasan, & Klapper, 2004). Focusing on commercial banks in Asian developing countries, Lin, Doan,
1
For example, Sapienza (2004) finds that the party affiliation of state-owned banks' chairpersons in Italy has a positive impact on the interest rate discount given by
state-owned banks in provinces where the associated party is stronger. The empirical results in Dinc (2005) indicate that government-owned banks increase their
lending in election years relative to private banks in major emerging markets in the 1990s, and these actions are influenced by political motivations other than dif-
ferences between privately-owned banks and government-owned banks in efficiency and objective.
205
and Doong (2016) find that foreign presence improves bank efficiency, primarily in countries with high financial freedom. In terms of
cost efficiency, private domestic banks rank higher than foreign banks, but both are still much more efficient than state-owned banks.
Two studies using Argentine data (prior to the crisis in 2002) find foreign and private domestic banks to be of roughly equal efficiency
and that both are more efficient on average, than state-owned banks (Berger, Clarke, Cull, Klapper, & Udell, 2005; Delfino, 2003). A
study of Pakistani data finds foreign banks are more profit efficient than private domestic and state-owned banks, but all of these groups
are of similar average cost efficiency (Bonaccorsi di Patti & Hardy, 2005). Finally, a study of Indian banks finds that foreign banks are
more efficient, on average, than private domestic banks (Bhattacharyya, Lovell, & Sahay, 1997).
3. Methodology
3.1. Measuring bank efficiency
In line with Berger and Mester (1997), we measure cost efficiency by how close a bank's actual cost is to what a best practice bank's
cost would be for producing identical output under the same conditions. Cost (in)efficiency measures the reduction in costs that could
have been achieved if a bank were both allocatively and technically efficient. Since costs functions are not directly observable, in-
efficiencies are measured in comparison with an efficient cost frontier. Most studies on cost efficiency use data envelopment analysis
(DEA) or SFA. While DEA is built under the assumptions that there is no random error, SFA approach modifies the traditional assumption
of a deterministic production frontier which got its advantage (Sun & Chang, 2011).2 We use SFA because it controls for measurement
error and other random effects and has therefore been widely applied to banking and other industries (Aigner, Lovell, & Schmidt, 1977;
Berger & Mester, 1997; Kumbhakar & Lovell, 2000). In line with the translog specification of Bonin et al. (2005), we estimate the
stochastic frontier using a cost function to obtain efficiency scores across countries, based on the assumption that efficiency differences
between banking industries are determined by country-specific characteristics.3 In its general form, the cost model can be written as
follows:
TCit ¼ f1 ðYit ; Wit Þ þ uit þ vit ; (1)
where TCit is total costs of bank i at time t and f1 ðYit ; Wit Þ is the cost frontier. In this model, bank efficiency is measured in relation to
a global best practice frontier. The advantage of this approach is that a frontier formed from the complete data set across nations allows
for a better comparison across nations (Berger & Humphrey, 1997).
In the cost frontier model, Yit represents the logarithm of the output of bank i at time t, Wit is a vector of the logarithms of the input
prices of bank i at time t, uit captures cost inefficiency and is independent and identically distributed with a truncated normal distri-
bution,4 vit captures measurement error, and random effects are distributed as a standard normal variable. Both uit and vit are time and
bank specific and are represented as

uit N þ μit ; σ 2it and vit N 0; σ 2v ; (2)
X
μit ¼ δ0 þ δn;it zn;it ; (3)
n
Equation (3) models inefficiency and its explanatory variables, where z represents the vector of n variables that drive the inefficiency
of bank i at time t. The deltas represent the coefficients. Equations (1) and (3) are solved in one step by using maximum likelihood
estimation. The detailed description of SFA is discussed in the Appendix. The cost (in)efficiency scores of each bank, estimated from the
stochastic frontier technique as INEkt ¼ exp(ui), should take on a value between one and infinity. However, to make our results com-
parable across banks, we follow the same procedure employed by Pasiouras, Tanna, and Zopounidis (2009) and calculate the index of
cost efficiency as CEkt ¼ 1/INEkt. Therefore, efficiency is always positive and it is equal to one for a best practice banks and zero for an
inefficient bank. To examine the impact of the diversification and ownership variables on (in)efficiency while controlling for other bank-
and country-specific characteristics, μit in Eq. (3) is specified in terms of Bank Efficiency in Eqs. (6) and (8).
3.2. Measuring bank ownership
The procedure used to calculate a bank's proportion of state ownership is similar to that of La Porta, Lopez-de-Silanes, and Shleifer
(2002); that is, the first measure identifies the large blockholder ownership of banks. A large blockholder is any shareholder owning
more than 20% of the shares in a bank, using the 20% threshold of La Porta, Lopez-de-Silanes, and Shleifer (1999). Then, we calculate
2
SFA – sometimes also referred to as the econometric frontier approach – employs a composed error model in which inefficiencies are assumed to follow an
asymmetric distribution, usually the half-normal, while random errors follow a symmetric distribution, usually the standard normal (Aigner et al., 1977; Berger &
Humphrey, 1997).
3
We follow recent cross-country studies (e.g., Dietsch & Lozano-Vivas, 2000; Lozano-Vivas, Pastor, & Pastor, 2002) that account for differences arising from country-
specific aspects of technology, macroeconomic conditions, and regulatory conditions by including the indicators of these environmental factors in a more compre-
hensive definition of a common frontier.
4
Thus, the total costs a bank faces are never lower than the costs of the frontier. For a graphical representation of the frontier and its dynamics see Berger et al.
(1993), who show how inefficiency is determined by both technical and allocative inefficiency.
206
the proportion of government ownership for the bank (GO) by first multiplying the share of each shareholder in that bank by the share of
that shareholder the government owns and then summing the resulting products over the shareholders of the bank:
X
J
GOic ¼ sji sgj ; where sji sgj > 0:2; (4)
j¼1
where c ¼ 1, …, 83 indexes the 83 countries in the sample; i ¼ 1, …, 10 indexes the 10 largest banks in the country; j ¼ 1, …,J indexes
banks' shareholders; sji is the share of bank i owned by shareholder j; and sgj is the share of shareholder j that is owned by a government
shareholder. The variable GOic stands for the total share of bank i in country c that is owned by large government shareholders at the end
of each year.
Following Dinc (2005), a bank is classified as state owned if the level of government ownership is at least 20%. The 20% threshold is
used here and by Dinc (2005) following the corporate control literature, which suggests that 20% ownership is often sufficient to control
a company. We use a similar procedure to construct the domestic private (DOic) and foreign (FOic) blockholder ownership variables.
3.3. Measuring income diversification
In line with the studies of Stiroh and Rumble (2006) and Sawada (2013), this paper primarily utilizes non-interest income share as an
income structure to measure the functional diversification of banks. The measure of non-interest income share is defined as the ratio of
non-interest income to total operating income and is expected to capture any non-traditional bank business. Income diversification,
INCDIV, is measured by constructing the Herfindahl–Hirschman Index (HHI) for each bank, with total operating income decomposed
into two categories: net interest income, NET, and non-interest income, NON. The non-interest income includes fee and service income,
trading income, fiduciary income, and other banks' non-interest income shares. Following this procedure, the bank's income diversi-
fication is calculated as

INCDIV ¼ 1 NETSHARE2 þ NONSHARE2 ; (5)
where NETSHARE ¼ NET/(NET þ NON) and NONSHARE ¼ NON/(NET þ NON) are defined as the shares of net interest income and of non-
interest income from total operating income, respectively, and INCDIV measures the degree of diversification in a bank's net operating
revenue. A higher value indicates a more diversified mix: A value of zero means that all revenue comes from a single source (complete
concentration), while 0.5 indicates an even split between net interest income and non-interest income (complete diversification).
3.4. Basic model
The basic model is as follows:
Bank Efficiencyi;c;t ¼ β0 þ β1 INCDIVi;c;t þ β2 NONSHAREi;c;t

þβ3 Ownership Structurei;c;t
þα0 Bank Regulation Controlc;t
þγ Information Sharingc;t (6)
þλ0 Bank Controlsi;c;t
þρ0 Macro Controlsc;t
þCountry Dummies þ Year Dummies þ ei;j;t ;
where Bank Efficiencyi,j,t is the cost efficiency scores of bank i in country c in time t. The variable Bank Efficiency is always positive and
equal to one for a best practice or zero-inefficiency bank; INCDIV is the value of income diversification following the basic HHI-type
approach; NONSHARE is the share of non-interest income; Ownership Structure serves as a proxy for bank ownership types, including
government ownership (D20GO) and foreign ownership (D20FO); D20GO is a dummy variable that equals one if the bank is state owned
(we define ownership using the 20% threshold)5; and D20FO is a dummy variable that equals one if a bank is foreign owned (the dummy
denoting a private domestically bank is excluded).
The vector of bank regulation control variables, Bank Regulation Control, which includes the following variables from the database
of Barth, Caprio, and Levine (2013): overall capital stringency (OCS) and official supervisory power (OSP). While OCS reflects the
extent of regulatory requirements regarding the amount of capital banks must hold and deducts the certain market value losses from
the determinants of capital adequacy, OSP represents the extent to which bank supervisory authorities possess the power to take
specific actions against violations of bank regulations to prevent and correct problems. We also use Information Sharing to control for
the effects of each country's information channel on bank efficiency. The variable Information Sharing is defined as a dummy equal to
one if a country has either a public credit registry6 or a private credit bureau7 and zero otherwise. The vector of bank control
5
We also refer to Micco et al. (2007) and define ownership using the 50% threshold in our robustness test.
6
A public credit registry is defined as a database managed by public authorities (usually the central bank or the superintendent of banks) that collects information on
the standing of borrowers (individuals and/or businesses) in the financial system and makes it available to financial institutions.
7
A private credit bureau is owned by a private firm or nonprofit organization that maintains a database on the standing of borrowers in the financial system and its
primary role is to facilitate the exchange of credit information among banks and financial institutions.
207
variables, Bank Control, includes bank size defined as the logarithm of the bank's total assets (Size) and bank equity captured by the
ratio of total equity to total assets (Equity). Furthermore, Macro Controls is a vector of macroeconomic controls including economic
growth (GDP) and inflation (CPI). Finally, Countries Dummies is a set of country dummy variables and Year Dummies is a set of time
dummy variables.
A statistical issue arises, since the values of Bank Efficiency in the regression range from zero to one, such that this dependent variable
has a truncated distribution. Ordinary least squares (OLS) regression parameter estimates for truncated variables should then be biased
upward because the OLS approach assumes a normal and homoskedastic distribution (Maddala, 1983). To resolve this data censoring
problem, we carry out our regressions using the Tobit maximum likelihood procedure. A Tobit model can handle the characteristics of
the distribution of efficiency scores and thus provide unbiased coefficient estimates.
It is worth noting that b β 1 measures the impact of diversification and b β 2 the direct effect of a shift from interest activities to non-
interest activities. If income diversity leads to higher efficiency, one would expect b β 1 to be positive. We are interested in the relation
between bank income diversification and efficiency, but it is important to include NONSHARE directly as an independent variable
because we would like to control for the correlation between income diversification and the non-interest income share.8 We follow the
methodology developed by Stiroh and Rumble (2006) to assess the effects of diversification toward non-interest activities. The impact of
a change in non-interest income on efficiency is measured using the first derivative of our dependent variables with respect to non-
interest income:
∂Bank Efficiency b ∂INCDIV

¼ β1 þb
β2: (7)
∂NONSHARE ∂NONSHARE
The first term on the right-hand side of Eq. (7) measures the effect of a change in the non-interest income share through its effect on
diversification. As Stiroh and Rumble (2006) do, we refer to this as the indirect effect of a change in non-interest income. Since this effect
depends on both the sign of b β 1 and the magnitude of the non-interest income share, the indirect effect is calculated accordingly for
different levels of non-interest income. Meanwhile, b β 2 captures the direct effect of a shift from interest effect. Using a portfolio-style
interpretation, bβ 1 measures the covariance effect while b β 2 measures the variance effect. The net effect, which is the sum of the
direct and indirect effects, determines how efficiency varies with an increase in the share of non-interest income.
The dependence, however, between b β 1 and b
β 2 raises econometric issues, since NONSHARE and INCDIV are collinear. Although both
estimates may be unbiased, their variance and covariance are overestimated (Chiorazzo, Milani, & Salvini, 2008). Wald tests need to be
conducted to check the joint statistical significance of b β 1 and bβ 2 in the various estimations. Moreover, we estimate the equation by using
only NONSHARE to check for robustness.
3.5. The interaction of bank income diversification and ownership
Based on the main implications of income diversification and ownership structure and allowing for other factors to influence a bank's
overall efficiency, the basic empirical specification is formulated as follows:
Bank Efficiencyi;c;t ¼ β0 þ β1 INCDIVi;c;t þ β2 NONSHAREi;c;t

þβ3 INCDIVi;c;t Ownership Structurei;c;t
þβ4 NONSHAREi;c;t Ownership Structurei;c;t
þβ5 Ownership Structurei;c;t
þα0 Bank Regulation Controlc;t (8)
þγ Information Sharingc;t
þλ0 Bank Controlsi;c;t
þρ0 Macro Controlsc;t
þCountry Dummies þ Year Dummies þ ei;j;t ;
where Bank Efficiencyi,j,t is the cost efficiency scores of bank i in country c at time t. All other variables are defined in Eq. (6) and we
continue to impose the sample restrictions and country and year fixed effects used in the model specifications. Notably, the coefficient of
the interaction term INCDIVi;c;t Ownership Structurei;c;t ðβ3 Þ will explain whether income diversification and ownership enhance or
impede bank efficiency. In other words, β3 indicates the differential in income diversification benefits between government-, domestic
private, and foreign-owned banks. If one ownership group (i.e., state- or foreign-owned banks) has more benefits of diversification than
its privately controlled counterparts, we would expect β3 to be significant and positive. Similarly, β4 measures the effects of government
and foreign ownership expressed as the difference from the increased exposure to the volatile non-interest activities of domestic private
banks. If government-controlled (or foreign-owned) banks perform better in mitigating the drawback effect of a shift toward non-
interest activities than domestic private banks, the coefficient of the interaction term β4 would also be expected to be significant and
positive.
8
For example, a bank with a 0.25 non-interest income share and a bank with a 0.75 non-interest income share would appear to have the same value of income
diversification, but this situation implies a very different range of strategies among banks.
208
Table 1
Descriptive statistics of the variables used in the estimations of Bank Efficiency.
Mean SD Median Minimum Maximum
Interest expenses (in billions US $) 1.647 5.683 0.142 0.000 138.483

Non-interest expenses (in billions US $) 1.218 3.900 0.134 0.000 52.298
Total costs (in billions US $) 2.865 8.840 0.302 0.000 147.100
Outputs (in billions US $)
Y1 ¼ Total loans 37.121 110.255 2.888 0.000 1399.722
Y2 ¼ Other earning assets 36.111 147.664 1.403 0.000 2240.273
Y3 ¼ Total deposits 62.636 200.277 4.364 0.001 2537.282
Y4 ¼ Liquid assets 19.811 85.922 0.955 0.000 1416.301
Input prices
w1 ¼ Price of capital 4.665 22.920 1.846 0.073 787.000
w2 ¼ Price of funds 0.042 0.080 0.032 0.000 3.870
Notes: The price of capital is the ratio of non-interest expenses to total fixed assets. The price of funds is the ratio of interest expenses to total deposits. Total costs are the
summation of interest expenses and non-interest expenses. Data source: Bankscope, 2003–2012.
4. Data
4.1. Data sources
This study examines year-end financial statement data from 2003 through 2012 for 83 countries obtained from Bankscope database.
Unconsolidated data were selected but, when these were not available, we chose consolidated data instead. For each bank in the
database, state and foreign ownership information was hand-collected from a variety of sources. We first gathered information from the
Shareholder Information section of the Bankscope database. When Bankscope's shareholder database did not have enough information
for us to determine the percentage of state, foreign, or domestic private ownership, we used bank ownership information from additional
sources, as used by La Porta et al. (2002). These sources include the Europa World Yearbook, the Banker's Almanac, the Thomson Bank
Directory, the Asian Company Handbook, the Euromoney Bank Register, the Bankers Handbook for Asia, Moody's International Company Data,
World Scope Global Disclosure, and the MFC Investment Handbook.
Information on bank regulation and supervision variables was obtained from the World Bank database developed by Barth, Caprio,
and Levine (2001) and updated by Barth, Caprio, and Levine (2006, 2008, 2013). Furthermore, specifically, data for the indicator of
information sharing were obtained from Djankov, McLiesh, and Shleifer (2007). Finally, data for country-specific variables were col-
lected from the World Bank database and the International Monetary Fund. In addition, we use the International Monetary Fund (2012)
report to classify countries according to analytical development level criteria, with the sample divided into two major groups: developed
countries and developing countries.9 These analytical criteria are based on the compositions of (1) the source of export earnings and
other income from abroad considered analytical criteria and (2) financial criteria focusing on external financing sources and experience
with external debt services.10
4.2. Efficiency scores
Table 1 provides summary statistics of the variables used in bank efficiency estimations. On average, commercial banks have a higher
amount of total deposits than total loans. The average total cost of the sample banks is $2.865 billion. The mean values of the price of
capital and the price of funds are about 4.665 and 0.042, respectively. These values are higher than the price of capital of 2.82 reported
by Sun and Chang (2011) and lower than the price of funds of 0.21 reported by Berger, Hasan, and Zhou (2009). Notably, the standard
deviations of our output variables are very high, which reflects large differences in bank size in the cross-country sample.
Table 2 summarizes the data by presenting the country average of several variables for each country. Panels A and B show the means
of the Bank Efficiency score in each country range from 34.9% to 89.6% from 2003 to 2012, while the overall mean is 70.6%. These
figures indicate that, on average, all banks could have produced their outputs by using 34.9%–89.6% of the inputs that they actually
consumed during 2003–2012. The results in Panel C reveal no difference in average bank efficiency between before and after the
financial crisis. In contrast, Panel D indicates that cost efficiency in developed markets (73.5%) is higher than in developing markets
(69.2%) and the difference is statistically significant at the 1% level.
Table 2 also provides descriptive statistics for government and foreign block ownership by country. From 2003 to 2012, the means of
the government, domestic private, and block foreign ownership of banks for the 83 countries in the sample are 9.31%, 25.6%, and
33.5%, respectively. The results in Panel C also show that government ownership of the top 10 banks has been declining since the
aftermath of the financial crisis, although the difference in GO between before and after the financial crisis is insignificant. The opposite
is true for domestic private and foreign ownership. After the financial crisis, average foreign ownership increased about 4.19% relative
to the prior period, while the difference in private ownership increased by 1.08% (not statistically significant). It would be not surprising
9
As used here, the terms developed countries and developing countries refer to advanced economies and emerging and developing economies, respectively, in the
International Monetary Fund (2012) report.
10
Countries are categorized into one of the related groups when their main source of export earnings exceeds 50% of total export values, on average, between 2005
and 2009. Countries are placed in the net debtor category when their current account balance accumulations from 1972 to 2009 are negative. Net debtors are grouped
in the external financing category when 65% or more of their total debt, on average, between 2005 and 2009, is funded by official creditors.
209
Table 2
Bank efficiency, ownership, share of non-interest income, and income diversification around the world. The variable CE is cost efficiency estimated by the SFA, INCDIV is
the value of income diversification following the basic Herfindahl-type approach, and NONSHARE is the share of non-interest income. Panels A and B show the per-
centage of assets owned by government (GO), private domestic (DO) and foreign-held block shareholders (FO), classified by the 20% threshold of La Porta et al. (1999).
Panels C and D show the results of the tests of mean values across economies that experienced the financial crisis and across levels of economic development (developed
vs. developing). The economic development classification follows World Economic Outlook reported by the International Monetary Fund (2012).
Countries CE GO DO FO NON- INCDIV Countries CE GO DO FO NON- INCDIV

SHARE SHARE
Panel A—Developed countries Panel B—Developing countries (continued)

Australia 0.833 0.000 0.247 0.000 0.415 0.399 Dominican 0.730 0.167 0.436 0.167 0.404 0.398
Austria 0.837 0.213 0.336 0.275 0.334 0.423 Ecuador 0.472 0.075 0.414 0.179 0.412 0.416
Belgium 0.847 0.093 0.447 0.359 0.263 0.346 El Salvador 0.694 0.000 0.256 0.698 0.218 0.275
Canada 0.747 0.000 0.072 0.103 0.465 0.459 Ethiopia 0.774 0.286 0.286 0.000 0.540 0.481
Cyprus 0.784 0.100 0.216 0.288 0.301 0.391 Georgia 0.658 0.000 0.193 0.419 0.315 0.410
Czech 0.675 0.000 0.090 0.852 0.306 0.395 Honduras 0.615 0.000 0.302 0.512 0.250 0.362
Denmark 0.723 0.000 0.310 0.105 0.329 0.420 Hungary 0.758 0.000 0.062 0.783 0.417 0.437
Finland 0.721 0.000 0.449 0.226 0.531 0.396 India 0.858 0.435 0.037 0.056 0.350 0.431
France 0.847 0.000 0.511 0.067 0.493 0.430 Indonesia 0.778 0.326 0.070 0.296 0.238 0.349
Germany 0.839 0.071 0.254 0.213 0.363 0.400 Jordan 0.770 0.021 0.059 0.091 0.333 0.426
Greece 0.673 0.017 0.104 0.405 0.336 0.390 Kenya 0.519 0.094 0.117 0.179 0.376 0.445
Ireland 0.779 0.026 0.000 0.647 0.408 0.336 Latvia 0.646 0.109 0.252 0.441 0.469 0.424
Italy 0.734 0.000 0.109 0.054 0.331 0.426 Lebanon 0.843 0.000 0.423 0.190 0.280 0.390
Japan 0.509 0.000 0.337 0.020 0.256 0.330 Malaysia 0.876 0.013 0.394 0.400 0.328 0.415
Korea 0.835 0.126 0.388 0.238 0.308 0.362 Mauritius 0.819 0.041 0.105 0.486 0.326 0.404
Luxembourg 0.873 0.105 0.000 0.861 0.405 0.402 Moldova 0.706 0.022 0.042 0.211 0.462 0.460
Netherlands 0.792 0.000 0.537 0.330 0.376 0.400 Nepal 0.812 0.000 0.085 0.136 0.253 0.372
Norway 0.784 0.000 0.225 0.240 0.344 0.334 Nigeria 0.513 0.000 0.057 0.087 0.459 0.461
Portugal 0.815 0.102 0.380 0.338 0.379 0.412 Pakistan 0.753 0.200 0.092 0.306 0.262 0.370
Singapore 0.707 0.000 0.379 0.217 0.495 0.411 Panama 0.774 0.096 0.292 0.547 0.249 0.350
Slovakia 0.576 0.000 0.015 0.871 0.291 0.395 Paraguay 0.881 0.000 0.133 0.675 0.596 0.389
Slovenia 0.734 0.096 0.125 0.405 0.362 0.435 Peru 0.529 0.102 0.219 0.574 0.269 0.364
Spain 0.771 0.000 0.119 0.232 0.386 0.407 Philippines 0.620 0.031 0.292 0.089 0.540 0.436
Sweden 0.642 0.011 0.445 0.188 0.438 0.363 Poland 0.668 0.119 0.095 0.552 0.434 0.479
Switzerland 0.623 0.000 0.599 0.303 0.615 0.382 Qatar 0.814 0.071 0.076 0.086 0.293 0.388
Taiwan 0.721 0.240 0.612 0.000 0.332 0.402 Romania 0.739 0.114 0.006 0.671 0.348 0.425
United Kingdom 0.758 0.000 0.905 0.095 0.433 0.459 Russian 0.693 0.231 0.258 0.268 0.411 0.360
United States 0.456 0.000 0.624 0.087 0.431 0.455 Saudi Arabia 0.589 0.127 0.097 0.152 0.339 0.425
Developed countries 0.735 0.044 0.315 0.287 0.382 0.400 South Africa 0.802 0.000 0.645 0.265 0.473 0.427
average
Developed countries 0.806 0.000 0.000 0.000 0.353 0.434 Sri Lanka 0.815 0.261 0.146 0.000 0.293 0.392
median
Panel B—Developing countries Tanzania 0.516 0.093 0.120 0.513 0.379 0.451
Argentina 0.543 0.227 0.237 0.298 0.667 0.386 Thailand 0.656 0.110 0.207 0.271 0.255 0.361
Armenia 0.631 0.000 0.051 0.571 0.350 0.417 Tunisia 0.760 0.076 0.058 0.223 0.342 0.441
Azerbaijan 0.696 0.101 0.340 0.108 0.430 0.353 Turkey 0.794 0.000 0.335 0.254 0.343 0.406
Bahrain 0.764 0.064 0.093 0.379 0.336 0.405 Ukraine 0.718 0.100 0.196 0.388 0.400 0.432
Bangladesh 0.859 0.124 0.407 0.028 0.468 0.458 United Arab Emirates 0.829 0.282 0.145 0.000 0.347 0.418
Belarus 0.684 0.128 0.050 0.640 0.584 0.450 Uruguay 0.413 0.172 0.000 0.705 0.478 0.420
Bolivia 0.383 0.049 0.323 0.379 0.373 0.387 Uzbekistan 0.621 0.336 0.070 0.111 0.577 0.458
Bosnia and Herzegovina 0.523 0.000 0.000 0.763 0.390 0.417 Venezuela 0.644 0.040 0.309 0.250 0.271 0.376
Brazil 0.842 0.167 0.406 0.245 0.277 0.357 Vietnam 0.896 0.325 0.000 0.052 0.249 0.324
Bulgaria 0.707 0.000 0.209 0.612 0.326 0.412 Zambia 0.349 0.102 0.195 0.575 0.475 0.447
China 0.792 0.291 0.114 0.038 0.136 0.222 Developing countries 0.692 0.111 0.189 0.330 0.368 0.405
average
Colombia 0.599 0.000 0.240 0.490 0.458 0.452 Developing countries 0.744 0.000 0.000 0.124 0.343 0.437
median
Costa Rica 0.705 0.278 0.433 0.111 0.296 0.400 Full sample mean 0.706 0.089 0.230 0.316 0.373 0.403
Croatia 0.739 0.099 0.000 0.672 0.338 0.434 Full sample median 0.767 0.000 0.000 0.000 0.346 0.436
Panel C—Means by countries experiencing a financial crisis between 2003-2007 and 2008–2012 (t-statistics in italics are for differences in means)
CE GO DO FO NON- INCDIV
SHARE
Before crisis 0.708 0.093 0.227 0.296 0.389 0.408
After crisis 0.705 0.084 0.234 0.334 0.357 0.398
Difference 0.003 0.009 0.007 0.038 0.032 0.010
t-Stats (Before vs. After) 0.72 1.57 0.75 4.94*** 7.91*** 4.39***
Panel D—Means by country characteristics (t-statistics in italics are for differences in means)
Developed economies 0.735 0.044 0.315 0.287 0.382 0.400
Developing economies 0.692 0.111 0.189 0.330 0.368 0.405
Difference 0.043 0.067 0.126 0.043 0.014 0.005
*** *** *** *** ***
t-Stats 9.17 11.22 14.26 4.22 3.12 1.95*
Notes: ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.
210
Table 3
Descriptive statistics of main variables. The variable Bank Efficiency is cost efficiency estimated by the stochastic frontier approach. The variable D20GO (D20FO) is
dummy variable that takes a value of one if the percentage of a bank owned by government (foreign) block shareholders is above the threshold of 20% and zero otherwise.
Similarly, D50GO (D50FO) is a dummy variable that takes a value of one if the percentage of a bank owned by government (foreign) block shareholders is above the
threshold of 50% and zero otherwise. The variable INCDIV is the value of income diversification following the basic Herfindahl-type approach and NONSHARE is the
share of non-interest income. The bank regulatory variables include OCS and OSP, which represent overall capital stringency and a bank's official supervisory power,
respectively. The variable Size controls for economies of scale, which is calculated by the log of bank total assets; Equity denotes the ratio of total equity to total assets;
Information Sharing is defined as a dummy equal to one if a country has either a public credit registry or a private credit bureau and zero otherwise; GDP is defined as the
log of the gross domestic product (GDP) per capita based on purchasing power parity; and CPI is the deflated consumer price index for each country for the base year 2005.
Variable Mean SD Median Minimum Maximum
Bank Efficiency 0.706 0.193 0.767 0.007 0.973

INCDIV 0.403 0.102 0.436 0.001 0.500
NONSHARE 0.373 0.180 0.346 0.000 0.999
GO 0.089 0.248 0.000 0.000 1.000
DO 0.230 0.366 0.000 0.000 1.000
FO 0.316 0.419 0.000 0.000 1.000
D20GO 0.135 0.341 0.000 0.000 1.000
D20FO 0.417 0.493 0.000 0.000 1.000
D50GO 0.091 0.288 0.000 0.000 1.000
D50FO 0.333 0.471 0.000 0.000 1.000
OCS 3.950 1.607 4.000 0.000 7.000
OSP 10.890 2.375 11.000 3.000 14.000
Information Sharing 0.713 0.452 1.000 0.000 1.000
Size 3.758 1.057 3.713 0.640 6.476
Equity 0.102 0.071 0.087 0.001 0.864
GDP 4.063 0.475 4.103 2.687 4.961
CPI 1.187 0.329 1.098 0.634 4.379
that these changes are consistently influenced by the evolution of the privatization and liberalization process. We also group countries
by their economic development in Panel D and find that the means of both government and foreign ownership are higher for developing
countries, while average private ownership in developing countries is significantly lower than in developed countries.
We report the mean values of income diversification and banks’ non-interest income share variables disaggregated by the financial
crisis, as well as by economic development. Panel C of Table 2 compares the mean values of non-interest income share and bank
diversification before and after the financial crisis. It appears that, before the crisis, on average, these values were both higher than after
the financial crisis. The differences are statistically significant at the 1% level, indicating a downtrend in bank activities toward non-
interest income. Our univariate results in Panel D show that bank diversification in developing countries tends to be greater than in
developed countries, although whether the benefits of diversification are improved or reduced by the changes in ownership structure
mentioned above is still questionable.
Table 3 shows summary statistics for bank efficiency, ownership structure, income diversification, bank regulations, and bank- and
country-level control variables. The mean value of income diversification in the whole sample is 0.40, while the overall mean of non-
interest income share is 0.37. On average, the dummy variables of both government ownership (13.47%) and foreign ownership
(41.74%) with a threshold of 20% are higher than those with a threshold of 50% (9.13% and 33.29%, respectively). The mean and
standard deviation of overall capital stringency are 3.95 and 1.61, respectively, whereas these values for the official supervisory power
index are 10.89 and 2.38, respectively. In addition, the mean values of the logarithm of bank total assets and the log of the GDP per
capita are 3.76 and 4.06, respectively, corresponding to standard deviations of 1.06 and 0.48. These results suggest fairly low cross-
country variation. Finally, we find that the average value of the deflated CPI is 119, higher than the value of 100 for the base year 2005.
The pairwise correlation values between independent variables in the pre-crisis period are reported in Table 4. The matrix explaining
the correlation between D20GO and INCDIV is negative and statistically significant, while the correlation between D20FO and INCDIV
shows a positive relation (but not statistically significant). These correlations indicate that banks with high government ownership have
a lower level of income diversification than their non-government counterparts, whereas banks with high foreign ownership are not
likely to have greater diversification. A significantly positive association is shown for the correlation between INCDIV and bank reg-
ulatory variables, indicating that economies with more bank supervisory and regulatory system requirements are more likely to increase
their banking diversification. Similarly, INCDIV is positively correlated with Size, which suggests that banks with more assets tend to
have a higher level of diversification. The opposite is true for the relation between bank diversification and Equity. In addition, the
positive correlation between NONSHARE and Equity shows that the higher the ratio of total equity to total assets, the greater the share of
bank non-interest income. The matrix correlation also indicates that an increase in GDP will increase banks’ non-traditional activities,
while an increase in domestic inflation (CPI) will improve income diversification.
5. Regression results
5.1. Bank income diversification, ownership, and efficiency
Table 5 reports our baseline results. The first and last three columns reports estimations for the model over the pre- and post-crisis
periods, respectively. Models (1) to (3) of Table 5 report estimations of the parameters from Eq. (6) prior to the financial crisis by using
211
Table 4
Correlation coefficient matrix. This table provides the correlation coefficient matrix of the main independent variables. The sample includes 783 banks from 83 countries
and the statistics are based on annual data for the pre-financial crisis period 2003–2007. The variable D20GO (D20FO) is a dummy variable that takes on a value of one if
the percentage of the bank owned by government (foreign) block shareholders is above the threshold of 20%. The variable INCDIV is the value of income diversification
following the basic Herfindahl-type approach and NONSHARE is the share of non-interest income. The bank regulatory variables include OCS and OSP, which represent
overall capital stringency and the bank's official supervisory power, respectively. The variable Size controls for economies of scale, calculated by the log of the bank's total
assets; Equity denotes the ratio of total equity to total assets; Information Sharing is defined as a dummy equal to one if a country has either a public credit registry or
a private credit bureau and zero otherwise; GDP is defined as the log of the GDP per capita based on purchasing power parity; and CPI is the deflated Consumer Price Index
for each country for the base year 2005.
INCDIV NONSHARE D20GO D20FO OCS OSP Information Sharing Size Equity GDP CPI
INCDIV 1.000
NONSHARE 0.290*** 1.000
D20GO 0.033** 0.047*** 1.000
D20FO 0.022 0.050*** 0.209*** 1.000
OCS 0.091*** 0.075*** 0.048*** 0.111*** 1.000
OSP 0.048*** 0.011 0.058*** 0.065*** 0.156*** 1.000
Information Sharing 0.089*** 0.001 0.155*** 0.019 0.123*** 0.114*** 1.000
Size 0.041** 0.018 0.056*** 0.177*** 0.073*** 0.051*** 0.395*** 1.000
Equity 0.028* 0.083*** 0.012 0.066*** 0.056*** 0.045*** 0.164*** 0.477*** 1.000
GDP 0.000 0.031* 0.117*** 0.001 0.012* 0.078*** 0.443*** 0.590*** 0.186*** 1.000
CPI 0.031* 0.003 0.009 0.019 0.027 0.013 0.040** 0.066*** 0.004 0.022 1.000
Notes: ***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively.
Table 5
Bank diversification and ownership. This table reports the differential impact of income diversification on bank efficiency, estimated by Tobit regressions. The statistics
are based on an unbalanced panel during 2003–2007 (before the financial crisis) and 2008–2012 (after the financial crisis). The variable D20GO (D20FO) is dummy
variable that takes a value of one if the percentage of a bank owned by government (foreign) block shareholders is above the threshold of 20% and zero otherwise (with
private domestic ownership as the excluded dummy). The variable INCDIV is the value of income diversification following the basic Herfindahl-type approach and
NONSHARE is the share of non-interest income. The bank regulatory variables include OCS and OSP, which represent overall capital stringency and a bank's official
supervisory power, respectively. The variable Size controls for economies of scale, which is calculated by the log of bank total assets; Equity denotes the ratio of total equity
to total assets; Information Sharing is defined as a dummy equal to one if a country has either a public credit registry or a private credit bureau and zero otherwise; GDP is
defined as the log of the gross domestic product (GDP) per capita based on purchasing power parity; and CPI is the deflated consumer price index for each country for the
base year 2005. Models (1) through (3) report the basic regression results that include the main independent variables and bank-specific control variables prior to the
financial crisis, while models (4) through (6) provide the regression results after the financial crisis.
Independent variables Dependent variable: Cost efficiency
Before the financial crisis After the financial crisis
Full Developed Developing Full Developed Developing
(1) (2) (3) (4) (5) (6)
Intercept 0.595* 0.445 0.656*** 0.555 1.067 0.153

(1.888) (0.715) (2.706) (-1.043) (1.128) (1.505)
INCDIV 0.115*** 0.112** 0.126*** 0.158*** 0.231*** 0.114**
(3.755) (2.136) (3.103) (3.909) (4.818) (2.290)
NONSHARE 0.176*** 0.176*** 0.187*** 0.207*** 0.275*** 0.131***
(-9.150) (-5.355) (-7.324) (-7.026) (-7.596) (-3.604)
D20GO 0.035** 0.002 0.045** 0.010 0.021 0.009
(-2.157) (0.047) (-2.324) (0.455) (0.718) (0.364)
D20FO 0.005 0.029 0.008 0.039** 0.020 0.066***
(0.497) (1.522) (0.657) (2.518) (0.942) (2.830)
OCS 0.016 0.028** 0.013 0.001 0.003 0.000
(-0.856) (2.021) (-0.634) (-0.369) (1.222) (0.053)
OSP 0.005 0.005 0.007 0.001 0.001 0.003
(0.324) (-0.338) (0.640) (0.753) (0.381) (-1.348)
Size 0.060*** 0.063*** 0.032*** 0.079*** 0.086*** 0.051**
(7.373) (5.330) (2.729) (5.754) (4.615) (2.426)
Equity 0.386*** 0.866*** 0.190*** 0.047* 0.413*** 0.142
(-7.544) (-6.194) (-3.017) (-1.854) (-3.035) (1.275)
Information Sharing 0.011 0.017 0.019** 0.037** 0.007 0.018
(1.358) (-0.659) (2.101) (1.978) (0.367) (0.711)
GDP 0.027 0.094 0.013 0.174 0.280 0.094**
(0.574) (-0.543) (0.177) (1.286) (-1.445) (2.214)
CPI 0.019 0.289 0.020 0.033** 0.412** 0.012
(-1.377) (1.459) (0.465) (2.120) (2.307) (0.761)
Country fixed effects YES YES YES YES YES YES

Year fixed effects YES YES YES YES YES YES
Log pseudo-likelihood 2494.54 984.30 1442.91 1383.69 836.05 955.52
Observations 2996 1138 1858 3232 1174 2058
Notes: ***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively. The figures in parentheses indicate t-values.
212
Table 6
Estimation impact of a change in non-interest income share on bank efficiency. Estimates of are based on regression results reported in Table 5, evaluated at different
values of the average non-interest share based on percentile ranks. The 10th, 25th, 50th, 75th, and 90th percentiles correspond to average non-interest shares of 0.18,
0.27, 0.37, 0.48, and 0.65, respectively, for Panel A, and non-interest income shares of 0.17, 0.24, 0.32, 0.44, and 0.59 for Panel B. Direct effect is estimated impact of
a 1% increase in the non-interest income share. Indirect effect is estimated impact of a change in revenue diversification from a 1% increase in the non-interest income
share. Net effect sums of the indirect and direct effects.
Percentiles of non-interest income share
10th 25th 50th 75th 90th
Panel A—Impact of change in non-interest income share before the financial crisis
Indirect effect 0.0018*** 0.0016*** 0.0013*** 0.0010*** 0.0007***
(3.755) (3.754) (3.754) (3.753) (3.751)
Direct effect 0.0018*** 0.0018*** 0.0018*** 0.0018*** 0.0018***
(-9.150) (-9.150) (-9.150) (-9.150) (-9.150)
Net effect 0.0000 0.0002 0.0005* 0.0008** 0.0011***
(0.089) (-0.552) (-1.728) (-2.540) (-3.711)
Panel B—Impact of change in non-interest income share after the financial crisis
Indirect effect 0.0026*** 0.0023*** 0.0019*** 0.0016*** 0.0012***
(3.909) (3.909) (3.908) (3.908) (3.907)
Direct effect 0.0021*** 0.0021*** 0.0021*** 0.0021*** 0.0021***
(-7.026) (-7.026) (-7.026) (-7.026) (-7.026)
Net effect 0.0005* 0.0002 0.0002 0.0005* 0.0009***
(1.757) (0.722) (-0.852) (-1.825) (-3.998)
cost efficiency scores as a dependent variable. The coefficient of income diversification, INCDIV, is positive and significant in all cases
during the pre-crisis period, showing that increased income diversification enhances bank efficiency. In contrast, the negative co-
efficients for the share of non-interest income (NONSHARE) across these regressions imply that a larger portion in non-interest income is
associated with reduced efficiency. Based on the portfolio framework, the coefficient of INCDIV is interpreted as the benefit of diver-
sification from a covariance effect, while that of NONSHARE denotes the negative effect from increased exposure to more non-interest
income activities (volatile investments). These results are consistent with the double-edged nature of the trend toward non-interest
income reported by Stiroh and Rumble (2006), who suggest that an increase in income diversity will lead to higher potential gains
for banks but these benefits are offset by the increased exposure to volatile non-interest income. This evidence is also similar to the view
that banks use up their diversification benefits through increasing their financial leverage or holding less equity capital, hence making
riskier loans (DeYoung & Roland, 2001).
Table 5 also reports our baseline results with the differences of bank efficiency across ownership groups. The first model shows that
banks with a high level of government ownership tend to have lower cost efficiency than comparable domestic private banks. The effect
is quantitatively substantial and indicates that the average state-owned bank has an efficiency level that is 0.035 points lower than that
of the average private-owned bank. However, we find no statistically significant difference between the bank efficiency of foreign-
owned banks and that of similar domestic private banks. When we look at the effects of ownership structure on bank efficiency
across countries, we find only differences in the developing countries, not in the developed countries, during the pre-crisis period. The
result of model (3) shows that state-owned banks in developing economies tend to have lower efficiency than their privately owned
counterparts. In developed economies, we find no significant difference in bank efficiency between government, domestic private, and
foreign-owned banks. These results are consistent with previous findings that banks with high government ownership tend to be less
efficient and less profitable than banks with high private ownership in developing countries (e.g., Berger et al., 2009; Bonin et al., 2005),
but not so in developed countries (Micco, Panizza, & Yanez, 2007).
Models (4) to (6) of Table 5 show the results after the financial crisis. The coefficients of INCDIV and NONSHARE continue to provide
significantly positive and negative impacts, respectively, on bank efficiency for all these model specifications. This evidence suggests
that the benefits of diversification and the negative aspects of non-interest exposure are more pronounced even during the financial
crisis period. Although income diversification is positively associated with bank efficiency across countries, it relates to a lower mag-
nitude of diversification gains in developing countries. Based on our analysis in models (5) and (6), banks in developed economies that
experienced a 1% increase in diversification could improve their efficiency about 0.231%, higher than in developing countries
(0.114%). In contrast, the offsetting effect of non-interest income share on bank efficiency in developed countries (0.275) is greater
than in developing ones (0.131). Notably, after the financial crisis, the diversification benefits between developed and developing
countries display magnitudes opposite those reported in the pre-crisis sample. This could be due to government intervention in the
allocation of credit in the banking industry, as well as possible obstacles in operating financial services concerning bank ownership
structure, especially in the aftermath of the financial crisis.
We also find different results when we compare the efficiency of foreign-owned banks and their domestic private counterparts after
the financial crisis. There is no difference in cost efficiency between state-owned and domestic private banks, while foreign-owned banks
tend to have greater efficiency than comparable private banks in developing countries (model (6) of Table 5). More interestingly, the
previously insignificant coefficient of D20FO before the financial crisis becomes positively significant in developing countries, while the
negative coefficient of D20GO becomes statistically insignificant after the crisis period. This result indicates that the foreign-owned
banks in developing countries tend to be more effective in cost management than comparable private banks during the crisis after-
math (consistent with the findings of Micco et al., 2007).
213
Table 7
The interaction of bank income diversification and ownership. This table reports the interaction of bank ownership and diversification on differential impact of ownership
structure on the relation between income diversification and bank efficiency, estimated by Tobit regressions. The statistics are based on an unbalanced panel during
2003–2007 (before the financial crisis) and 2008–2012 (after the financial crisis). The variable D20GO (D20FO) is dummy variable that takes a value of one if the
percentage of a bank owned by government (foreign) block shareholders is above the threshold of 20% and zero otherwise (with private domestic ownership as the
excluded dummy). The variable INCDIV is the value of income diversification following the basic Herfindahl-type approach and NONSHARE is the share of non-interest
income. The bank regulatory variables include OCS and OSP, which represent overall capital stringency and a bank's official supervisory power, respectively. The variable
Size controls for economies of scale, which is calculated by the log of bank total assets; Equity denotes the ratio of total equity to total assets; Information Sharing is defined
as a dummy equal to one if a country has either a public credit registry or a private credit bureau and zero otherwise; GDP is defined as the log of the gross domestic
product (GDP) per capita based on purchasing power parity; and CPI is the deflated consumer price index for each country for the base year 2005. Models (1) through (3)
report the basic regression results that include the main independent variables and bank-specific control variables prior to the financial crisis, while models (4) through
(6) provide the regression results after the financial crisis.
Independent variables Dependent variable: Cost efficiency
Before the financial crisis After the financial crisis
Full Developed Developing Full Developed Developing
(1) (2) (3) (4) (5) (6)
Intercept 0.574* 0.416 0.629** 0.510 1.186 0.135

(1.821) (0.663) (2.584) (-0.960) (1.259) (1.307)
INCDIV 0.181*** 0.185*** 0.160*** 0.178*** 0.349*** 0.149***
(4.462) (3.263) (2.858) (3.150) (5.383) (3.180)
NONSHARE 0.224*** 0.267*** 0.222*** 0.240*** 0.377*** 0.139***
(-8.660) (-6.855) (-6.175) (-5.749) (-7.771) (-3.587)
INCDIV*D20GO 0.155*** 0.286** 0.147** 0.230*** 0.325** 0.149**
(-2.657) (-2.508) (-2.095) (-3.054) (-2.419) (-1.989)
NONSHARE*D20GO 0.164*** 0.274*** 0.151** 0.129* 0.170* 0.014
(3.002) (2.612) (2.254) (1.697) (1.662) (0.203)
INCDIV*D20FO 0.123** 0.261*** 0.023 0.011 0.202** 0.110**
(-2.018) (-3.058) (-0.294) (0.131) (-2.131) (2.158)
NONSHARE*D20FO 0.073* 0.283*** 0.030 0.031 0.207*** 0.114**
(1.933) (3.526) (0.614) (0.545) (3.047) (-2.359)
D20GO 0.035* 0.026 0.043* 0.003 0.084 0.013
(-1.725) (0.694) (-1.782) (0.087) (1.596) (-0.599)
D20FO 0.028 0.030 0.006 0.019 0.039 0.021
(1.087) (1.345) (0.176) (0.593) (1.062) (-1.142)
OCS 0.015 0.025* 0.012 0.001 0.003 0.000
(-0.826) (1.846) (-0.615) (-0.280) (1.236) (0.162)
OSP 0.005 0.006 0.006 0.001 0.001 0.007
(0.323) (-0.394) (0.597) (0.714) (0.598) (0.313)
Size 0.060*** 0.063*** 0.033*** 0.081*** 0.079*** 0.102***
(7.397) (5.531) (2.810) (5.868) (4.236) (5.999)
Equity 0.383*** 0.910*** 0.181*** 0.044* 0.430*** 0.045
(-7.504) (-6.594) (-2.868) (-1.717) (-3.171) (0.581)
Information Sharing 0.011 0.016 0.019** 0.038** 0.005 0.000
(1.406) (-0.627) (2.112) (2.027) (0.261) (0.006)
GDP 0.029 0.083 0.020 0.164 0.307 0.079***
(0.612) (-0.474) (0.267) (1.213) (-1.595) (2.915)
CPI 0.017 0.276 0.015 0.032** 0.437** 0.016
(-1.240) (1.380) (0.366) (2.059) (2.460) (1.545)

Observations 2996 1138 1858 3232 1174 2058
Notably, the coefficient of the foreign ownership dummy in developing countries is very large and indicates that the differential
between the cost efficiency of foreign- and private-owned banks more than triples when compared with that of developed countries
during the post-crisis period (the two values are 0.066 and 0.020, respectively). On the other hand, the result of D20GO also suggests
that it is not necessarily true that banks with more government ownership are less efficient than banks with more domestic private
ownership, in line with Altunbas, Evans, and Molyneux (2001), who find no evidence that private-owned banks are more efficient or
perform better than mutual and state-owned banks in Germany. The authors also argue that public banks having lower funding costs
based on less interest rate-sensitive retail depositors are a fundamental reason for their superior performance over that of domestic
private banks.
Table 6 reports estimates of the indirect, direct, and net effects from the bank efficiency regression, regressed at various (10th, 25th,
50th, 75th, and 90th) percentile ranks of non-interest income share.11 The first row of Panel A presents the indirect effect before the
11
The 10th, 25th, 50th, 75th, and 90th percentiles correspond to the non-interest income shares of 0.18, 0.27, 0.37, 0.48, and 0.65, respectively, in Panel A (before
the financial crisis), and 0.17, 0.24, 0.32, 0.44, and 0.59 in Panel B (after the financial crisis).
214
financial crisis, which varies monotonically from over 0.002 for a bank with a non-interest income share at the 10th percentile to about
0.001 for a bank at the 90th percentile.12 The results indicate that banks with relatively smaller non-interest income shares (10th and
25th percentiles) have greater potential diversification gains from a shift toward non-traditional activities, whereas banks with rela-
tively larger non-interest income shares (75th and 90th percentiles) have fewer potential diversification benefits. The second row shows
the direct effect, which indicates that a 1% increase in non-interest income share is associated with a 0.18% decline in bank efficiency.
The net effect in the final row of Panel A shows that the costs associated with increased income diversification offset the positive gains
from a more diversified income stream. Interestingly, the potential diversification benefits are significantly smaller when banks tend to
be more diversified (75th and 90th percentiles), indicating that increased shifts toward non-interest income are related to lower bank
efficiency.13 The evidence from the net effect again confirms the double-edged nature of the shift toward non-traditional activities:
Increased income diversification does benefit banks, but these gains are likely to be offset by the extra costs associated with the more
volatile activities. This result supports the strategic focus hypothesis, consistent with the findings of DeYoung and Roland (2001) and
Stiroh and Rumble (2006) for earlier periods.
5.2. The interaction of bank income diversification and ownership
We are now interested in whether the influence of income diversification varies with different characteristics of countries that
experienced the most considerable changes in the ownership structure of commercial banks. In particular, we examine the role of
ownership structure in determining the benefits of income diversification. Table 7 presents the estimates of regressions with bank
diversification and the share of non-interest income variables interacted with a dummy for government ownership and a dummy for
foreign ownership. The coefficients of the interaction INCDIV*D20GO are significant and negative for both full and subsample cases,
indicating that the efficiency of increased diversification is significantly lower for banks with more government ownership. Specifically,
models (1) through (3) of Table 7 show that, compared with domestic private banks, a 1 percentage point increase in income diversity is
associated with about a 0.155 percentage point lower efficiency level for state-owned banks. The result is also similar to that obtained in
developed countries (0.286) and developing countries (0.147), consistent with the findings of Berger et al. (2010) for the regression
of cost efficiency. However, the negative effects of government ownership on bank diversification are mitigated by low costs of diversity.
All the coefficients of NONSHARE*D20GO are positive and significant in the pre-crisis period, implying that government-owned banks
are better than their domestic private counterparts at decreasing the drawback effect of an increased share of non-interest income on
bank efficiency.
When we focus on foreign ownership before the financial crisis, we find that the coefficient of the interaction term INCDIV*D20FO is
negative in the developed countries but is not statistically significant in the developing countries. Model (2) of Table 7 show that,
compared with domestic private banks, foreign-owned banks in developed countries tend to have lower efficiency of income diversi-
fication. In contrast, the coefficient of NONSHARE*D20FO is positive and significant, implying that foreign-owned banks can better
mitigate the negative impact of an increased share of non-interest activities on bank efficiency than private-owned banks. This finding is
in line with the findings of Berger et al. (2010): In developing countries, foreign banks generally suffer from insufficient knowledge of
the local market and are disadvantaged in terms of collecting soft information, which may be vital in lending not only to small businesses
but also to larger firms. Thus, it pays for foreign banks to specialize in non-interest income-generating activities rather than traditional
intermediation activities.
In Table 7, after the financial crisis, most ownership interactions are statistically significant, implying that the benefits of diversi-
fication and potential risks of non-interest income vary with bank ownership structure. We find that government ownership continues to
have a negative impact on the relation between income diversification and bank efficiency. The results show that the cost efficiency of
state-owned banks is lower than that of domestic private banks when experiencing an increase in income diversification. For instance, in
models (5) and (6) of Table 7, the differential in diversification effectiveness between average state-owned and domestic private banks
in developed countries is approximately 0.325 basis points, while in developing countries the estimated figures yield a difference of
approximately 0.149 basis points relative to the benchmark of private banks.
It is interesting to note that the previous coefficient of the interaction INCDIV*D20FO is negatively insignificant (0.202) and
becomes positive and statistically significant (0.110) for the subsample of developing countries after the financial crisis. This result
suggests that, compared with domestic private banks, foreign-owned banks in developing countries tend to be more efficient in their
diversified activities during the post-crisis period. The opposite is true for foreign-owned banks in developed countries. One possible
reason is that foreign-owned banks are more exposed to financial markets in developed countries. They tend to be more competitive due
to their greater use of communication technology and better risk management when operating in developing countries. These ad-
vantages in financial services could favor foreign banks in expanding total income for diversification target and thus enhance their
profitability (Claessens et al., 2001). Unlike a foreign presence in developed markets, the presence of foreign ownership in developing
countries generally represents the monitoring of professionalism at the top management level. Moreover, foreign-owned banks in
developing countries are also often associated with solid information networks and wide partnerships and even have an advantage in
their affiliation with conglomerates; therefore, diversified activities can improve their efficiency more than for their comparable non-
foreign counterparts (Berger et al., 2010).
12
Similar to Stiroh and Rumble (2006), the effects are estimated for a 1% increase in the share of non-interest income.
13
We also report the indirect, direct, and net effects of non-interest income share after the financial crisis in Panel B, the results for which are similar to those in Panel
A, for the fourth column of Table 5.
215
Table 8
Roubustness test for bank ownership: Before the financial crisis. This table reports the differential impact of income diversification on cost efficiency, estimated by Tobit
regressions. The statistics are based on an unbalanced panel during 2003–2007. The variable D50GO (D50FO) is dummy variable that takes a value of one if the per-
centage of a bank owned by government (foreign) block shareholders is above the threshold of 50% and zero otherwise (with private domestic ownership as the excluded
dummy). The variable INCDIV is the value of income diversification following the basic Herfindahl-type approach and NONSHARE is the share of non-interest income.
The bank regulatory variables include OCS and OSP, which represent overall capital stringency and a bank's official supervisory power, respectively. The variable Size
controls for economies of scale, which is calculated by the log of bank total assets; Equity denotes the ratio of total equity to total assets; Information Sharing is defined as
a dummy equal to one if a country has either a public credit registry or a private credit bureau and zero otherwise; GDP is defined as the log of the gross domestic product
(GDP) per capita based on purchasing power parity; and CPI is the deflated consumer price index for each country for the base year 2005. Models (1) and (2) report the
basic regression results that include main independent variables and bank-specific control variables prior to the financial crisis of 2008. Models (3) and (4) show the
estimated results for developed countries, while models (5) and (6) provide the regression results for developing countries.
Independent variables Dependent variable: Cost efficiency before the financial crisis (2003–2007)
Full Developed countries Developing countries
(1) (2) (3) (4) (5) (6)
Intercept 0.597* 0.588* 0.465 0.413 0.657*** 0.625**

(1.895) (1.866) (0.782) (0.660) (2.710) (2.572)
INCDIV 0.114*** 0.161*** 0.111** 0.185*** 0.126*** 0.150***
(3.744) (4.587) (2.126) (3.269) (3.089) (2.811)
NONSHARE 0.177*** 0.227*** 0.177*** 0.258*** 0.187*** 0.208***
(-9.169) (-8.815) (-5.371) (-6.643) (-7.340) (-6.041)
INCDIV*D50GO 0.150** 0.279** 0.139**
(-2.567) (-2.442) (-1.977)
NONSHARE*D50GO 0.163*** 0.268** 0.137**
(2.983) (2.551) (2.057)
INCDIV*D50FO 0.078* 0.244*** 0.002
(-1.954) (-2.853) (-0.030)
NONSHARE*D50FO 0.077** 0.255*** 0.000
(2.056) (3.147) (0.005)
D50GO 0.034** 0.037* 0.000 0.031 0.049** 0.046*
(-2.080) (-1.817) (0.007) (0.820) (-2.513) (-1.895)
D50FO 0.007 0.007 0.029 0.034 0.000 0.001
(0.732) (0.606) (1.623) (1.393) (0.029) (0.028)
OCS 0.016 0.016 0.032** 0.026* 0.013 0.012
(-0.856) (-0.840) (2.030) (1.901) (-0.639) (-0.623)
OSP 0.005 0.005 0.009 0.006 0.006 0.005
(0.323) (0.287) (-0.788) (-0.375) (0.559) (0.518)
Size 0.060*** 0.060*** 0.064*** 0.062*** 0.032*** 0.033***
(7.387) (7.404) (5.391) (5.382) (2.725) (2.791)
Equity 0.386*** 0.384*** 0.873*** 0.897*** 0.190*** 0.183***
(-7.546) (-7.503) (-6.251) (-6.484) (-3.027) (-2.889)
Information Sharing 0.011 0.011 0.016 0.017 0.019** 0.019**
(1.359) (1.371) (-0.628) (-0.689) (2.079) (2.088)
GDP 0.026 0.030 0.067 0.089 0.016 0.024
(0.563) (0.634) (-0.428) (-0.512) (0.215) (0.319)
CPI 0.019 0.017 0.247 0.303 0.020 0.016
(-1.372) (-1.238) (1.355) (1.507) (0.475) (0.370)

Observations 2996 2996 1138 1138 1858 1858
On the other hand, models (5) and (6) of Table 7 also report that the interaction terms regarding the volatile non-interest activities of
foreign-owned banks (NONSHARE*D20FO) found in developed and developing countries. Not surprisingly, the coefficient of the
interaction NONSHARE*D20FO remains positively significant in the post-crisis sample of developed countries, indicating the role of
foreign ownership in mitigating the negative effect of diversified activities that are inherently more volatile. On the contrary, this
interaction term has a negative coefficient (statistically significant at the 5% level) for the subsample of developing countries, explaining
that foreign-owned banks with a high degree of non-traditional activities tend to be less effective than their private counterparts. This
evidence is also consistent with that of Pennathur, Subrahmanyam, and Vishwasrao (2012), who show that foreign banks pursuing a fee-
based income tend to increase risk, as measured by earnings volatility.
5.3. Robustness tests
To gauge the reliability of the results, we apply an alternative threshold to identify ownership: We alternatively define ownership as
a large blockholder when any shareholder owns more than 50% of total shares outstanding, following Iannotta, Nocera, and Sironi
(2007). This approach decreases the number of banks classified as held by large blockholders but leaves our main results unchanged, as
shown in Tables 8 and 9.
216
Table 9
Roubustness test for bank ownership: After the financial crisis. This table reports the differential impact of income diversification on cost efficiency, estimated by Tobit
regressions. The statistics are based on an unbalanced panel during 2008–2012. The variable D50GO (D50FO) is dummy variable that takes a value of one if the per-
centage of a bank owned by government (foreign) block shareholders is above the threshold of 50% and zero otherwise (with private domestic ownership as the excluded
dummy). The variable INCDIV is the value of income diversification following the basic Herfindahl-type approach and NONSHARE is the share of non-interest income.
The bank regulatory variables include OCS and OSP, which represent overall capital stringency and a bank's official supervisory power, respectively. The variable Size
controls for economies of scale, which is calculated by the log of bank total assets; Equity denotes the ratio of total equity to total assets; Information Sharing is defined as
a dummy equal to one if a country has either a public credit registry or a private credit bureau and zero otherwise; GDP is defined as the log of the gross domestic product
(GDP) per capita based on purchasing power parity; and CPI is the deflated consumer price index for each country for the base year 2005. Models (1) and (2) report the
basic regression results that include main independent variables and bank-specific control variables after the financial crisis of 2008. Models (3) and (4) show the
estimated results for developed countries, while models (5) and (6) provide the regression results for developing countries.
Independent variables Dependent variable: Cost efficiency after the financial crisis (2008–2012)
Full Developed countries Developing countries
(1) (2) (3) (4) (5) (6)
Intercept 0.587 0.508 0.993 1.225 0.151 0.107

(-1.115) (-0.970) (1.050) (1.297) (1.489) (1.032)
INCDIV 0.157*** 0.237*** 0.234*** 0.334*** 0.115** 0.160***
(3.913) (4.062) (4.872) (5.325) (2.315) (3.292)
NONSHARE 0.203*** 0.242*** 0.275*** 0.363*** 0.131*** 0.145***
(-6.922) (-5.998) (-7.604) (-7.682) (-3.613) (-3.732)
INCDIV*D50GO 0.516*** 0.323** 0.216**
(-4.529) (-2.303) (-2.385)
NONSHARE*D50GO 0.312*** 0.191* 0.002
(3.730) (1.827) (0.026)
INCDIV*D50FO 0.023 0.191** 0.108**
(-0.279) (-1.967) (2.051)
NONSHARE*D50FO 0.002 0.177*** 0.105**
(-0.035) (2.717) (-2.117)
D50GO 0.033 0.102** 0.033 0.036 0.020 0.050
(1.180) (2.050) (0.825) (1.101) (0.613) (1.162)
D50FO 0.119*** 0.131*** 0.016 0.029 0.068*** 0.002
(6.147) (3.670) (0.628) (0.707) (2.895) (-0.100)
OCS 0.001 0.001 0.003 0.003 0.000 0.000
(-0.444) (-0.287) (1.226) (1.234) (0.046) (0.051)
OSP 0.002 0.001 0.001 0.001 0.003 0.005
(0.870) (0.836) (0.357) (0.573) (-1.342) (0.316)
Size 0.090*** 0.090*** 0.086*** 0.080*** 0.050** 0.100***
(6.368) (6.379) (4.580) (4.255) (2.381) (5.834)
Equity 0.054** 0.054** 0.417*** 0.436*** 0.142 0.026
(-2.136) (-2.133) (-3.065) (-3.211) (1.279) (0.324)
Information Sharing 0.038** 0.040** 0.006 0.007 0.018 0.003
(2.055) (2.178) (0.349) (0.391) (0.717) (0.185)
GDP 0.166 0.142 0.267 0.313 0.095** 0.081***
(1.243) (1.063) (-1.379) (-1.619) (2.216) (2.971)
CPI 0.031** 0.030* 0.429** 0.426** 0.012 0.017
(2.019) (1.931) (2.408) (2.409) (0.761) (1.542)

Observations 3232 3232 1174 1174 2058 2058
6. Conclusion
An important challenge for policymakers across the world is the design of effective policies that deal with bank efficiency. These
policies are better informed if we can empirically disentangle the relative importance of push factors that are internal to diversification
and ownership. This paper contributes to the debate on what drives bank efficiency by estimating a parametric stochastic frontier
approach over more than 10 years across 83 countries.
First, we find higher income diversification improves bank efficiency but the diversification gains are offset by the increased
exposure to volatile non-interest activities. Second, state ownership is associated with lower efficiency in developing countries before
the financial crisis, but foreign ownership has the upper hand in bank efficiency compared with domestic banks in developing countries
after the financial crisis. Third, different types of bank ownership have various effects on the relation between diversification and ef-
ficiency based on national characteristics, as well as types of bank business. We find strong and robust evidence that state ownership
diminishes the impact of diversification on efficiency in developed and developing countries. In particular, foreign ownership magnifies
the impact of diversification on efficiency in developing countries.
Our findings have several implications. We show that commercial banks should be aware of the potentially increased costs of
a strategy that expands more non-traditional intermediation activities. Our findings are consistent with recent studies on the
217
performance–diversification nexus (e.g., Berger et al., 2010; DeYoung & Roland, 2001; Stiroh & Rumble, 2006). Assessing the effects of
ownership structure and volatile earnings for financial institution efficiency has direct implications in the context of this debate. From
a policy perspective, our findings suggest that banks’ supervisors and regulators should consider the effect of ownership structure when
evaluating the impact of income diversification on bank efficiency. In countries where banks are likely to be controlled by state owners,
greater activity diversification is likely to yield less efficiency. But, in developing countries with foreign ownership after the financial
crisis, banks could enjoy efficiency of income diversification.
Appendix
Let us estimate efficiency levels by specifying the common translog functional form, which results in the following empirical cost
frontier:
X
4 X 1X 4 X 4
1X
lnðTC=w2 TAÞ ¼ α þ βi lnðYi =TAÞ þ ψ k lnðWk =w2 Þ þ βij lnðYi =TAÞln Yj TA þ
i¼1 k¼1
2 i¼1 j¼1 2 k¼1
X X
4 X
ψ km lnðWk =w2 ÞlnðWm =w2 Þ þ ϕik lnðYi =TAÞlnðWk =w2 Þ þ year dummiest þ ln uit þ ln vit
m¼1 i¼1 k¼1
where TC is the bank's total costs in a given year; TA is the bank's total assets in a given year; Yi are outputs; Wk are input prices (w1, price
of capital; w2, price of fund); and α, β, ψ, and ϕ are the parameters to be estimated. The translog cost function is estimated using ln uit þ
ln vit as a composite error term.
Following Bonin et al. (2005) and Berger et al. (2009), we choose the following four outputs: total loans (Y1), other earning assets
(Y2), total deposits (Y3), and liquid assets (Y4). In addition, widely consistent with previous studies on bank efficiency, we use the
following two input prices: the price of capital (w1), calculated as the ratio of non-interest expenses to total fixed assets, and the price of
funds (w2), defined by the ratio of interest expenses to total deposits. The total cost (TC) of banks is defined as the summation of interest
expenses and non-interest expenses. In addition, we impose linear homogeneity restrictions by normalizing by using the price of funds
(w2). Following Jiang, Yao, and Feng (2013), we also normalize total costs and output variables by total assets to control for scale biases
and heteroskedasticity.
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What Drives Bank Efficiency The Interaction of Bank Income Diversification and Ownership

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International Review of Economics and Finance 55 (2018) 203–219

Contents lists available at ScienceDirect

International Review of Economics and Finance

What drives bank efﬁciency? The interaction of bank income

Available online 19 July 2017

2. Literature review and hypothesis development

2.1. Effects of income diversiﬁcation on bank efﬁciency

2.2. Effects of ownership structure on bank efﬁciency

3.1. Measuring bank efﬁciency

TCit ¼ f1 ðYit ; Wit Þ þ uit þ vit ; (1)

3.2. Measuring bank ownership

3.3. Measuring income diversiﬁcation

3.4. Basic model

The basic model is as follows:

Bank Efficiencyi;c;t ¼ β0 þ β1 INCDIVi;c;t þ β2 NONSHAREi;c;t

∂Bank Efficiency b ∂INCDIV

3.5. The interaction of bank income diversiﬁcation and ownership

Bank Efficiencyi;c;t ¼ β0 þ β1 INCDIVi;c;t þ β2 NONSHAREi;c;t

Mean SD Median Minimum Maximum

Interest expenses (in billions US $) 1.647 5.683 0.142 0.000 138.483

4.1. Data sources

4.2. Efﬁciency scores

Countries CE GO DO FO NON- INCDIV Countries CE GO DO FO NON- INCDIV

Panel A—Developed countries Panel B—Developing countries (continued)

Variable Mean SD Median Minimum Maximum

Bank Efﬁciency 0.706 0.193 0.767 0.007 0.973

5.1. Bank income diversiﬁcation, ownership, and efﬁciency

Independent variables Dependent variable: Cost efﬁciency

Before the ﬁnancial crisis After the ﬁnancial crisis

Full Developed Developing Full Developed Developing

(1) (2) (3) (4) (5) (6)

Intercept 0.595* 0.445 0.656*** 0.555 1.067 0.153

Country ﬁxed effects YES YES YES YES YES YES

Percentiles of non-interest income share

10th 25th 50th 75th 90th

Independent variables Dependent variable: Cost efﬁciency

Before the ﬁnancial crisis After the ﬁnancial crisis

Full Developed Developing Full Developed Developing

(1) (2) (3) (4) (5) (6)

Intercept 0.574* 0.416 0.629** 0.510 1.186 0.135

Country ﬁxed effects YES YES YES YES YES YES

5.2. The interaction of bank income diversiﬁcation and ownership

Full Developed countries Developing countries

(1) (2) (3) (4) (5) (6)

Intercept 0.597* 0.588* 0.465 0.413 0.657*** 0.625**

Country ﬁxed effects YES YES YES YES YES YES

5.3. Robustness tests

Full Developed countries Developing countries

(1) (2) (3) (4) (5) (6)

Intercept 0.587 0.508 0.993 1.225 0.151 0.107

Country ﬁxed effects YES YES YES YES YES YES

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Intercept 0.597* 0.588* 0.465 0.413 0.657* 0.625