Japan and the World Economy 27 (2013) 83–94

Contents lists available at SciVerse ScienceDirect

Japan and the World Economy

journal homepage: www.elsevier.com/locate/jwe

Bank performance and its determinants in Korea

Jeong Yeon Lee a,*, Doyeon Kim b
a
Graduate School of International Studies, Yonsei University, Seoul, Republic of Korea
b
School of Economics and Finance, Yeungnam University, Gyeongbuk, Republic of Korea

A R T I C L E I N F O A B S T R A C T

Article history: In this study we develop a measure of bank performance based on the Malmquist index approach. This
Received 28 August 2012 measure supplements existing financial ratios such as ROA and ROE by addressing some of limitations of
Received in revised form 7 April 2013 these ratios. In our empirical investigation building upon the Malmquist index measure as well as the
Accepted 18 May 2013
profitability ratios, we never find convincing evidence of economies of scale present in the Korean
Available online 12 June 2013
banking sector. It also appears that a certain type of ownership such as foreign international banks has
the potential to significantly improve bank performance while the management control of government
JEL classification:
or foreign buyout funds has mainly unfavorable effects on bank performance.
G21
ß 2013 Elsevier B.V. All rights reserved.
L2

Keywords:
Bank
Profitability
Economies of scale
Ownership structure
Malmquist index

1. Introduction under the given regulatory and macroeconomic environment. The

The state ownership of private banks following public bailouts
in response to the financial crisis gives the government a means to
reshape the post-crisis banking sector. For example, the sale of
government holdings to recover part of funds used for public
rescue inevitably influences the size and ownership structure of
surviving banks, hence effectively redefining the industry land-
scape, whether the government intends to or not. To the extent
that bank performance depends on those bank characteristics,
different schemes to offload government holdings are expected to
have different effects on the overall bank performance. Subse-
quently, the link between bank characteristics and performance
should be of great interest to government authorities who try to
ensure the future health of the country’s banking sector in addition
to the quick and full recovery of public funds when mapping out
the exit strategies for their bank holdings.
In this regard, the Korean experience following the financial
crisis of 1997 serves as an ideal laboratory for identifying bank
characteristics that would lead to better managerial performance
* Corresponding author at: Graduate School of International Studies, Yonsei
University, 50 Yonsei-ro, Seodaemun-gu, Seoul 120-749, Republic of Korea.
Tel.: +82 2 2123 4645; fax: +82 2 2123 8653.
E-mail address: leejy@yonsei.ac.kr (J.Y. Lee).
financial meltdown in the country was followed by a series of
public rescue through which the Korean government took an
ownership stake in the majority of domestic banks. Then, public
rescue was unwound over time as the government tried to recover
public funds by selling their stakes to various types of investors in
different times. As a result, one can find a rich and varying mix of
bank types in terms of size and ownership structure in Korea over
time.
Based on the Korean experience, we try to identify bank-specific
factors that tend to assume particular importance in determining
bank performance by means of panel data methods. The study of a
single country, despite its limitation of a narrow scope, enables us
to separate out the possible effects of the regulatory framework on
bank performance and focus on internal bank-specific factors by
examining the time period under stable banking regulations. Of
bank-specific factors tested, bank size and ownership structure are
indeed found to be worth noting. Inconsistent with the popular
notion regarding bank size, we never find convincing evidence of
economies of scale clearly present in the Korean banking sector. It
also appears that a certain type of ownership such as foreign
international banks has potential to significantly improve bank
performance while management control of government or foreign
buyout funds has mainly unfavorable effects on bank performance.
In measuring bank performance, profitability ratios such as
return on asset (ROA) and return on equity (ROE) are traditionally

0922-1425/$ – see front matter ß 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.japwor.2013.05.001
84 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94

Table 1
Summary statistics (2003–2010).

Nationwide commercial banks Regional banks Specialized banks

Number of banks 7 6 4
Total assets (billions of won)a
Mean 146,718 19,188 119,931
Median 138,965 19,155 139,344
Standard deviation 78,766 12,163 72,891

Book value of equity (billions of won)a

Mean 10,671 1302 6980
Median 8410 1297 5670
Standard deviation 5618 862 7732

Net interest margin

Mean 0.023 0.028 0.018
Median 0.022 0.028 0.020
Standard deviation 0.003 0.003 0.003

ROA
Mean 0.009 0.009 0.007
Median 0.009 0.009 0.008
Standard deviation 0.004 0.002 0.004

ROEb
Mean 0.133 0.170 0.116
Median 0.144 0.173 0.085
Standard deviation 0.062 0.040 0.060

Note: Means and medians are calculated for all banks over all years. Standard deviations are calculated on a bank-by-bank basis and then averaged.
a
Means, medians and standard deviations are for 2010.
b
NACF is not included because the value of its equity is unusually low in certain years during 2003–2010. For example, its equity value is negative in 2008.

used because of their obvious advantages. ROE provides a direct
assessment of the financial return of a shareholder’s investment,
and ROA serves as a reliable gauge of shareholder value with the
leverage effect taken into account. Furthermore, these profitability
ratios are relatively easy to calculate using public information.
Nonetheless, ROA and ROE only offer a snapshot of profitability
based on a single measure of operating profit in which all expenses
and revenues are thrown altogether. In our analysis, we supple-
ment ROA and ROE by developing a Malmquist index-based
indicator that shows the dynamics of profitability while allowing
different types of expenses and revenues of banks to be taken into
account individually.
The next section provides an overview of the banking sector in
Korea. The definition of our measure based on the Malmquist index
and its estimates are presented in Section 3. The section also
examines the link between the shadow value of capital and various
performance measures. Main empirical findings regarding the
determinants of bank performance are reported in Section 4.
Section 5 concludes.
2. The overview of the Korean banking sector
As of 2010, there are 13 commercial banks operating in Korea.
They include 7 major banks with nationwide presence and 6
regional banks. Regional banks mainly lend to small and medium
sized companies and households in their respective regions. Four
specialized banks also compete with commercial banks for
deposits. They include: National Agricultural Cooperative Federa-
tion (NACF), National Federation of Fisheries Cooperatives (NFFC),
Industrial Bank of Korea (IBK), and Korea Development Bank
(KDB).1 These four banks were initially established to support
specific sectors or purposes, but they are now increasingly
expanding their businesses into commercial banking. KDB is
wholly state-owned, and the government owns a majority stake of
IBK. In addition, 37 foreign banks were operating branches in Korea
as of December 2010.
1
Another specialized bank, Korea Eximbank, is not taking deposits.
Among commercial banks, nationwide banks are much larger
than regional banks. The mean of total assets for nationwide banks
in 2010 is 147 trillion Korean won (KRW), about 128 billion US
dollars using the exchange rate of 1150 KRW per US dollar,
whereas the mean for regional banks in the same year is only 19
trillion KRW, about 17 billion US dollars (Table 1). The assets of 4
specialized banks are comparable to those of nationwide
commercial banks with their mean of 120 trillion KRW (about
104 billion US dollars) and median of 139 trillion KRW (about 121
billion US dollars) in 2010. Table 1 also shows that the average
equity held by nationwide commercial banks is at least eight times
larger than that of regional banks with the average equity of
specialized banks located somewhere in between.
Before the Asian crisis of 1997, ownership structure in the
Korean banking sector was fairly monolithic. All domestic banks
were either state-owned or tightly controlled by the government
as no private entity was allowed to hold a controlling stake in
commercial banks. In the wake of the crisis, however, bank
ownership began to show increasing diversity. Such foreign buyout
funds as Newbridge Capital, Carlyle Group and Lone Star Funds
became controlling shareholders of domestic commercial banks.
Two of these banks have become wholly owned subsidiaries of
international banks since Citibank and Standard Chartered Bank
respectively acquired stakes of Carlyle and Newbridge along with
each bank’s remaining shares. On several occasions, the govern-
ment also took a controlling stake in private commercial banks in
exchange for rescue funding. But, such holdings have been mostly
offloaded by now with currently little direct government control
over management of even widely held banks. One notable
exception is Woori Financial Group. The Korean government still
remains to be a majority shareholder of the financial holding
company that controls three subsidiary banks – Woori Bank,
Kyongnam Bank, and Kwangju Bank.
Table 1 summarizes the net interest margin for the three groups
of banks during the years 2003–2010. The net interest margin
defined as net interest income divided by total assets tends to be
the highest for regional banks with the group average of 2.8%,
followed by nationwide commercial banks (2.3%) and specialized
 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94
banks (1.8%). The figures for regional banks and nationwide
commercial banks are comparable to the average net interest
margin of 2.6–2.7% that Demirgüç-Kunt and Huizinga (1999) find
for banks from high income, industrial economies over the period
1988–1995.2
In terms of average ROA over 2003–2010, there is no clear
difference between nationwide commercial banks and regional
banks in profitability. However, yearly figures show that nation-
wide commercial banks are consistently less profitable than
regional banks following the global financial crisis in 2008 even
though their average ROA clearly surpasses that of regional banks
at least in 3 out of the 5 pre-crisis years in our sample period. This
suggests that nationwide commercial banks with greater global
exposure were affected more severely by the financial crisis. In
addition, specialized banks are found to be lagging behind the two
groups of commercial banks in average ROA throughout the
sample period, but this consistent gap is far from being statistically
significant.
It should be also noted that there is a wide range of differences
in ROA performance within each group of banks. For example, 2
nationwide commercial banks, Korea Exchange Bank (KEB) and
Shinhan Bank, are found to be consistently profitable by belonging
to the highest 25th percentile of ROAs in 5 and 3 years,
respectively, over 2003–2010 with their period average ROA
exceeding 1%. At the same time, another nationwide commercial
bank, SC First Bank, never makes it to the top 25th percentile over
the period and in fact joins the lowest 25th percentile in 5 years.
Among regional banks, 3 banks – Busan, Kyongnam, and Daegu –
exhibit higher average ROAs than any other banks over 2003–2010
and each join the top 25th percentile in 4 years during the period.
In contrast, markedly poor performance over the sample period
comes from Jeju Bank; this regional bank never makes it to the top
25th percentile group and joins the lowest 25th percentile in 5
years.
In terms of ROE, Table 1 shows that regional banks are clearly
more profitable than nationwide commercial banks during the
years 2003–2010. This gap in ROE between the two groups, which
tends to persist over the entire sample period unlike in ROA, is
found to be statistically significant. We also find widely different
levels of profitability within each group of banks when profitability
is measured by ROE. Over the sample period, for example, Shinhan,
Busan, Daegu, and Kyongnam display highest average ROEs –
ranging from 18 to 21% – and join the highest 25th percentile of
ROEs more frequently than any other banks while never being part
of the lowest 25th percentile. On the other hand, SC First and Jeju
continue to be identified as one of the least profitable when
profitability is measured in terms of ROE as well. These one
nationwide and one regional banks both share average ROEs below
10% and belong to the bottom 25th percentile group at least in 4
years during 2003–2010.
3. Profit-generating efficiency
Various financial indicators are employed to describe the
managerial performance of banks. The most common include
profitability ratios such as return on asset (ROA) and return on
equity (ROE). ROE offers a direct estimation of the financial return
of a shareholder’s investment, and ROA serves as a measure of
shareholder value with the leverage effect taken into account.
Sinkey (1983, p. 201) argued that ‘‘the best measures of a [banking]
firm’s overall performance are the profitability ratios ROE and
ROA.’’ It is sensible to focus on profitability in the analysis of bank
performance because ‘‘[p]rofitability is a bank’s first line of defense
against unexpected losses, as it strengthens its capital position and
2 4
See Demirgüç-Kunt and Huizinga (1999), Table 1.
85
improves its future profitability through the investment of
retained earnings.’’3
Despite their obvious advantages and extensive use, the
existing profitability ratios are not without limitations. For
example, banks conduct multi-dimensional tasks, while incurring
different types of expenses and generating different types of
revenues. Since ROA and ROE are based on a single measure of
operating profit in which all expenses and revenues are simply
added up, they have to be one-dimensional. Subsequently, there is
a danger that these profitability ratios send a misleading signal
regarding managerial capacity to generate profit when unsustain-
able changes in one type of expenses or revenues simply swamp all
other factors. In addition, while ROA and ROE provide a sensible
snapshot of profitability, they may be less effective in illustrating
the dynamics of managerial performance. For example, the ability
of banks to improve their capacity to generate profit over time is a
better guide to their future profitability than the mere levels of
profit in the past.
In this paper we develop a Malmquist index-based measure to
examine bank performance. Various expenses from the income
statement are used as inputs and revenues as outputs in
calculating the Malmquist index. Our measure is expected to
complement the existing financial ratios ROA and ROE by
addressing some of their limitations. For example, the Malmquist
index method allows multiple inputs and multiple outputs so that
different types of expenses and revenues of banks can be taken into
account individually, instead of simply being lumped up together,
in measuring profit-generating efficiency of banks. In addition, our
measure captures the dynamic aspect of managerial capacity to
generate profit since the Malmquist index assesses the change in
efficiency over time.
3.1. Malmquist index: definition
In the Malmquist index method, a sample of decision-making
units (DMUs) – banks in this study – are chosen to construct the
best-practice frontier using input–output combinations of the
sample DMUs, and measure the distance between any particular
observation and the frontier. In line with Shephard (1970) and
Caves et al. (1982), we define the output distance function at t, Dt0 ,
as follows:
Dt0 ðX t Y t Þ ¼ fu : ðX t ; Y t =uÞ 2 T t g (1)
t
where T denotes the production technology which is defined as
T t ¼ fX t ; Y t g : X t can produce Yt at time t}. Xt is a vector of inputs at
t, and Yt is a vector of outputs at t. Note that Dt0  1 signifies (Xt,
Yt) 2 Tt with (Xt,Yt) lying on the best-practice frontier when Dt0 ¼ 1.
Using the output distance function described in Eq. (1), we
define the output-based Malmquist index for an individual DMU or
bank between period t and period t + 1 as4
" #1=2
Dt0 ðX tþ1 ; Y tþ1 Þ Dtþ1
0 ðX tþ1 ; Y tþ1 Þ
M0 ðX tþ1 ; Y tþ1 ; X t ; Y t Þ ¼ (2)
Dt0 ðX t ; Y t Þ Dtþ1
0 ðX t ; Y t Þ
A value of M0 greater than 1 indicates an improvement of input–
output efficiency from period t to period t + 1, and a value less than
1 represents a deterioration of input–output efficiency.
The Malmquist index method allows for technical inefficiency
by building on the concept of the best-practice frontier. With the
possibility of technical inefficiency, productive efficiency of an
individual DMU may not be solely driven by progress in available
production technologies but also by each DMU’s capacity to keep
up with the existing best practices. To show this point more
3
European Central Bank (2010, p. 8).
This follows Caves et al. (1982).
86 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94

Table 2
Bank revenues and expenses (2003–2010).

Nationwide commercial banks Regional banksa Specialized banks

Interest income
Mean 6784 1005 5202
Median 4949 1050 4992
Standard deviation 1496 208 1105

Fee income
Mean 713 84 377
Median 504 77 411
Standard deviation 197 14 65

Interest expense
Mean 3758 500 3263
Median 2957 490 3525
Standard deviation 1094 138 895

Fee expense
Mean 252 26 104
Median 229 23 68
Standard deviation 91 10 44

Operating expense
Mean 1661 251 958
Median 1249 225 730
Standard deviation 291 28 141

Loan loss provision

Mean 802 96 590
Median 513 73 417
Standard deviation 493 46 349

Note: Means and medians are calculated for all banks over all years. Standard deviations are calculated on a bank-by-bank basis and then averaged. All figures are adjusted in
2010 prices (in KRW billions).
a
Jeju Bank is not included due to data availability.

formally, we rewrite Eq. (2), following Färe et al. (1994), as
Dtþ1
0 ðX tþ1 ; Y tþ1 Þ
M 0 ðX tþ1 ; Y tþ1 ; X t ; Y t Þ ¼
Dt0 ðX t ; Y t Þ
" #1=2
Dt0 ðX tþ1 ; Y tþ1 Þ Dt0 ðX t ; Y t Þ
 (3)
Dtþ1 tþ1
0 ðX tþ1 ; Y tþ1 Þ D0 ðX t ; Y t Þ
Eq. (3) shows that the Malmquist index can be broken down
into two basic components – ‘‘technical change’’ and ‘‘efficiency
change’’. Each ratio inside the bracket on the right hand side of
Eq. (3) measures a shift in the best-practice frontier estimated at
the input level in each of period t and period t + 1, and the
geometric mean of these two shifts represents ‘‘technical
change’’ from period t to period t + 1. The first ratio on the right
hand side of Eq. (3) represents ‘‘efficiency change’’ measuring the
change in technical efficiency from period t to period t + 1.
Subsequently, ‘‘efficiency change’’ determines whether produc-
tion is moving closer to or away from the prevailing frontier, and
captures the efficiency catch-up effect between the two periods t
and t + 1. The value of ‘‘efficiency change’’ greater than 1 implies
that a DMU has narrowed its efficiency gap with the prevailing
best practice.
The Malmquist index is widely used to measure productivity
growth of a sample of firms in various industries. Several
studies apply the index to examine changes in input–output
efficiency of financial institutions in particular. For example, Berg
et al. (1992) use the Malmquist index approach to investigate
productivity growth in the Norwegian banking sector that
underwent extensive deregulation during the 1980s. They find
a sharp reversal in productivity growth of Norwegian banks
before and after deregulation; productivity on a declining path
starts growing rapidly after deregulation with this turnaround
particularly pronounced for the largest banks. Berg et al. (1993)
extend the Malmquist index-based analysis of banking produc-
tivity by considering multiple countries – Finland, Norway, and
Sweden – to compare productivity growth of banks across
countries.
Leightner and Lovell (1998) apply the Malmquist index to gauge
changes in total factor productivity of Thai banks. According to
their findings, the average bank in Thailand manages to achieve
positive productivity growth during the period of sweeping
financial deregulation, and productivity growth is particularly
strong in foreign-owned banks. Isik and Hassan (2003) also find
substantial productivity gains of commercial banks following
financial deregulation in their Malmquist index-based analysis of
the Turkish banking sector. By decomposing productivity growth
into technical change and efficiency change, they identify
efficiency increases to be the dominant source of productivity
growth in the Turkish banking system. Similarly, Worthington
(1999) finds that any productivity gains of Australian credit unions
are largely due to an increase in efficiency rather than technical
change.
In contrast, a robust increase in total factor productivity of
Australian banks in the second half of the 1990s is found to be
driven mostly by technical change that shifts out the best-
practice frontier (Neal, 2004). It appears that a regress in
efficiency change is in fact eating away part of positive technical
change during the period. Drake (2001) also finds a similar
pattern of positive productivity growth driven by positive shifts
of the best-practice frontier coupled with negative efficiency
catch-up for UK banks over the years 1984–1995. Similarly,
Fukuyama (1995) shows that technical change is largely behind
positive productivity growth of Japanese banks during 1989–
1991 while technical efficiency of those banks is on average
deteriorating at the time.
3.2. Malmquist index: estimation results
There is longstanding disagreement over what constitutes
inputs and outputs in defining the production technology of banks.
In the existing literature, three different approaches are generally
 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94
Table 3
Profit-generating efficiency (2003–2010).
Nationwide commercial banks
Malmquist index
Mean 1.012
Median 1.021
Standard deviation 0.244
Technical change
Mean 1.011
Median 1.017
Standard deviation 0.229
Efficiency change
Mean 1.000
Median 1.000
Standard deviation 0.052
Note: Means and medians are calculated for all banks over all years. Standard deviations are calculated on a bank-by-bank basis and then averaged.
a
Jeju Bank is not included due to data availability.
identified: the intermediation approach, the user cost approach,
and the production approach.5 The three approaches employ
usually different but overlapping sets of inputs and outputs in the
analysis of productive efficiency in banking. However, our
approach is different from each of the three existing approaches
in the sense that we are not particularly interested in identifying
products of banks and measuring productive efficiency according-
ly. We are mainly motivated to produce a measure of profit-
generating efficiency (PGE) – efficiency of banks in transforming
various expenses into various revenues – in parallel with existing
profitability ratios.
We specify a set of four inputs to reflect our motivation. They
consist of interest expense, fee expense, operating expense, and
loan loss provision.6 Operating expense captures labor and fixed
capital cost by including personnel, premise and equipment
expense, whereas loan loss provision represents the cost of risk-
taking in lending. We specify two outputs: interest income and fee
income.7 Subsequently, our Malmquist index measure focuses on
the operating capacity in commercial banking. Table 2 shows some
relevant statistics for input and output variables used in estimating
the Malmquist index.
For estimation of the best-practice frontier, we employ the data
envelopment analysis (DEA) approach. In the DEA approach, the
best-practice frontier is estimated by non-parametric linear
programming methods that require no superimposed functional
form on the frontier. We assume constant returns to scale (CRS) as
underlying technology and calculate Malmquist indexes. Variable
returns to scale (VRS) may be an alternative specification of
technology, but the Malmquist index is equivalent to the
traditional notion of total factor productivity (TFP) under a CRS
specification (Färe et al., 1997; Ray and Desli, 1997). For calculation
of indexes, we use DEAP version 2.1 (Coelli, 1996).
Table 3 summarizes averages of the Malmquist index,
technical change, and efficiency change for the three groups of
banks during 2003–2010.8 Of 17 banks in our sample, Jeju Bank is
not included in estimating the Malmquist index due to data
availability. The Malmquist index suggests that most nationwide
commercial banks improve their PGE during our sample period
while regional banks and specialized banks generally suffer
declining PGE over the period. This apparent gap in PGE change
between nationwide commercial banks and the other two groups
5
See Berger and Humphrey (1992).
6
The source of data is Financial Statistics Information System of Financial
Supervisory Service, Republic of Korea.
7
The source of data is Financial Statistics Information System of Financial
Supervisory Service, Republic of Korea.
8
All averages are geometric means.
87
Regional banksa Specialized banks
0.971 0.959
0.991 0.995
0.110 0.202
0.971 0.963
0.989 0.996
0.107 0.200
1.000 0.996
1.000 1.000
0.010 0.013
of banks is in fact found to be statistically significant. In addition,
mean standard deviations of the Malmquist index indicate that
PGE changes of nationwide commercial banks exhibit a much
higher volatility over the sample period compared to regional
banks.
As Eq. (3) shows, the Malmquist index of PGE changes can be
decomposed into ‘‘technical change’’ and ‘‘efficiency change.’’
Technical change represents a shift in the best practice frontier,
and subsequently captures a change in a bank’s potential capacity
to generate profit. Efficiency change determines if a bank’s
operation is moving closer to or away from its prevailing potential.
This breakdown reported in Table 3 suggests that actual PGE
changes in a reasonably long period of time such as our sample
period of 8 years mainly reflect changes in the potential capacity
over the period. The median efficiency change over 2003–2010
stands at 1 for all 3 groups of banks.
Malmquist indexes are found to be positively correlated with
ROAs or ROEs over the period 2003–2010, but this correlation is
generally very weak with correlation coefficients and rank
correlation coefficients (Spearman’s rho) ranging from 8% to less
than 1%. Furthermore, the correlation is far from being statistically
significant. The weak correlation between Malmquist indexes and
financial ratios are in sharp contrast with a very high correlation
between financial ratios themselves. Between ROA and ROE,
correlation coefficients and rank correlation coefficients both are
found to be higher than 80% and statistically significant over our
sample period.
Subsequently, our testing of correlation strongly suggests that
PGE measured by the Malmquist index should add another
meaningful angle to the analysis of banking performance that
could supplement the picture provided by the existing financial
ratios. In fact, the dynamic picture of PGE changes is often
pointing to the different direction than the snapshot taken by
ROA or ROE. For example, 3 regional banks with relatively strong
financial ratios – Kyongnam, Busan, and Daegu – fail to achieve,
on average, any progress in PGE, and hardly join the highest 25th
percentile of PGE improvement over 2003–2010. In contrast,
Hana Bank, which is not particularly profitable in terms of ROA
and ROE, is found to be one of noticeably fast PGE-improving
banks during the period.
3.3. Performance measures and the shadow value of capital
The shadow value of capital is supposed to incorporate all
meaningful developments in bank performance. In contrast, a
development that is perceived to be only a passing change is less
likely to translate into the shadow value of capital held by the bank.
A performance measure that serves as a more reliable gauge of
88 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94
shareholder value is obviously the one that better reflects the
shadow value of capital. In this section we examine the reliability
of our Malmquist index measure as well as ROA and ROE to this
effect.
In the literature, the shadow value of capital is typically
represented by Tobin’s q. Even though it is marginal q – the ratio of
the market value of an additional unit of capital to its replacement
cost – that corresponds to the shadow value of capital, this ratio is
not directly observable. Consequently, the ratio of the market value
of existing capital to its replacement cost, which is more readily
observable and dubbed as average q to be differentiated from
marginal q, is normally used in empirical work instead. Hayashi
(1982) finds that average q is equal to marginal q if the firm is a
price-taker with constant returns to scale in production and
installation. In our testing, we use a proxy for average q to measure
the shadow value of capital held by each bank.
We define a proxy for Tobin’s q as
ASSET þ ðMB  1ÞBVE
Q¼
ASSET
where MB is the market price per share of a bank divided by the
book value per share, ASSET is total assets, and BVE is the book
value of equity.
In estimating the proxy for Tobin’s q, three banks – National
Agricultural Cooperative Federation (NACF), National Federation of
Fisheries Cooperatives (NFFC), and Korea Development Bank (KDB)
– are excluded since their shares have never been publicly listed. Of
the remaining 14 banks in our sample, Citibank and SC First Bank,
which went private respectively in 2004 and 2005, are considered
only for the years when they remained listed in the Korea
Exchange. During our study period of 2003–2010, some banks in
the sample were part of holding companies whose shares, not
those of individual banks, were listed in the Korea Exchange. For
those banks, MB of their holding companies is used in estimating
Tobin’s q. For example, MB of Shinhan Financial Group, the holding
company of Shinhan Bank, is used over the entire period of 2003–
2010. On the other hand, MB of holding companies applies to only
part of the study period for Hana Bank and Kookmin Bank whose
holding companies were established respectively in 2005 and
2008. Since Woori Bank, Kyongnam Bank, and Kwangju Bank are all
subsidiaries of Woori Financial Group, these three banks are
assumed to share MB of their holding company for the entire study
period.
Table 4 summarizes the results of fixed effects regressions that
examine the link between the shadow value of capital and various
performance measures. In regressions we include each bank’s total
assets to control for the possible effect of bank size in market
Table 4
Fixed effects regressions for Tobin’s q.
Malmquist index 0.2350*
(0.076)
Technical change
Efficiency change
ROA
ROE
ASSET 0.0013
(0.181)
Observation 91
Within R-sq 0.0905
F 3.78**
(0.0272)
Note: *, **, *** stand for, respectively, 10%, 5%, and 1% level of significance. The p-values are reported below the coefficient estimates.
ASSET: total assets adjusted in 2005 prices (in KRW trillions).
valuation. According to Table 4, bank size measured by total assets
is found to be negatively related to the proxy for Tobin’s q,
suggesting a possible discount for larger banks in market valuation.
But, this negative relationship is not always statistically significant.
Our regression results show that an improvement in all of
performance measures tested tends to be positively reflected in the
shadow value of capital. This positive association appears to be
more pronounced for the Malmquist index measure than for the
existing profitability ratios ROA and ROE. Only the Malmquist
index measure is found to be statistically significant at the 10%
level. Since Jeju Bank is not included in estimating the Malmquist
index as noted above, we also conducted our regressions for ROA
and ROE using the sample that excludes Jeju to make the test more
comparable across performance measures. The results that are not
reported here exhibit more or less the same pattern.
Of the two components of the Malmquist index, technical
change is found to be statistically significant while efficiency
change is far from being statistically significant. This suggests that
(4) the shadow value of capital depends importantly on changes in a
bank’s potential capacity to generate profit but little on whether
the bank moves closer to or away from its potential from one year
to another. A bank may be better or less able to achieve its
prevailing potential compared to the previous year, but this catch-
up effect over one-year period is found to be largely irrelevant to
the shadow value of capital.
4. Determinants of bank performance
4.1. Model specification
The first bank characteristic we consider in our analysis of
determinants of bank performance in Korea is ownership
structure. In fact, the existing literature finds that ownership
structure can be an important internal determinant of bank
performance. For example, Short (1979) presents cross-country
evidence that government ownership clearly reduces bank
profitability. Barth et al. (2004) also report a negative correlation
between government ownership and banking efficiency based on
their cross-country database covering 107 countries. However,
some empirical findings on the banking sector question if there
exists an indeed meaningful gap in performance of government-
owned banks (see, among others, Bourke, 1989; Bonin et al., 2004;
Bhaumik and Dimova, 2004). Molyneux and Thornton (1992) even
offer cross-country evidence of a strong positive relationship
between government ownership and bank profitability.
Another type of controlling shareholders that attracts much
attention in the literature of bank performance is foreign investors.
0.2422*
(0.075)
0.3030
(0.760)
5.6788
(0.319)
0.4879
(0.204)
0.0013 0.0018* 0.0017* 0.0015
(0.165) (0.058) (0.069) (0.108)
91 91 99 99
0.0908 0.0531 0.0632 0.0702
3.79** 2.13 2.80* 3.13**
(0.0269) (0.1260) (0.0666) (0.0488)
 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94 89

Table 5
Fixed effects regressions for performance measures.

Malmquist index ROA ROE

ASSET 0.0068* 0.0068* 0.0077* 0.0002** 0.0002** 0.0001** 0.0013 0.0011 0.0010
(0.082) (0.098) (0.060) (0.017) (0.019) (0.035) (0.206) (0.260) (0.349)
2
(ASSET) 1.47E05 1.50E05 1.76E05 6.97E07*** 6.94E07*** 6.53E07*** 7.23E06 ** 6.82E06 * 6.30E06 *
(0.270) (0.285) (0.206) (0.002) (0.002) (0.004) (0.036) (0.052) (0.075)
RISK 0.0827 0.0478 0.0652 0.0037 0.0036 0.0041 0.0461 0.0466 0.0528
(0.597) (0.763) (0.681) (0.148) (0.147) (0.105) (0.250) (0.237) (0.188)
GOVERNMENT 0.399* 0.4083* 0.0046 0.0053 0.0566 0.0644
(0.085) (0.080) (0.215) (0.152) (0.336) (0.272)
FOREIGN 0.1311 0.1172 0.0072** 0.0078** 0.0829* 0.0903*
(0.499) (0.544) (0.018) (0.012) (0.087) (0.067)
GDPGR 0.0286** 0.0236** 0.0283** 0.0006*** 0.0006*** 0.0005** 0.0089*** 0.0093*** 0.0076**
(0.021) (0.030) (0.031) (0.001) (0.000) (0.011) (0.005) (0.001) (0.021)
GOVERNMENT  GDPGR 0.0193 0.0185 0.0002 0.0003 0.0032 0.0046
(0.380) (0.410) (0.536) (0.320) (0.563) (0.412)
FOREIGN  GDPGR 0.0051 0.0009 0.0011* 0.0012* 0.0090 0.0105
(0.901) (0.983) (0.088) (0.065) (0.374) (0.310)
M&A 0.0685 0.0579 0.0569 0.0033 0.0038* 0.0036* 0.0324 0.0396 0.0372
(0.590) (0.656) (0.658) (0.113) (0.065) (0.078) (0.320) (0.221) (0.252)

Observation 128 128 128 136 136 136 128 128 128
Within R-sq 0.1970 0.1625 0.2030 0.3004 0.3249 0.3395 0.2489 0.2638 0.2742
F 3.68*** 2.91*** 2.91*** 6.87*** 7.70*** 6.28*** 4.97*** 5.38*** 4.32***
(0.0014) (0.0080) (0.0041) (0.0000) (0.0000) (0.0000) (0.0001) (0.0000) (0.0001)
Hausman Statistic 14.48** 10.70* 16.38** 17.41*** 15.74** 17.53** 12.29* 12.53* 18.08**
(0.0247) (0.0981) (0.0372) (0.0079) (0.0152) (0.0251) (0.0558) (0.0511) (0.0206)

Note: *, **, *** stand for, respectively, 10%, 5%, and 1% level of significance. The p-values are reported below the coefficient estimates.
ASSET: total assets adjusted in 2005 prices (in KRW trillions).
RISK: the ratio of loans to deposits.
GOVERNMENT: a dummy for government ownership.
FOREIGN: a dummy for the management control of a foreign buyout fund.
GDPGR: the growth rate of real GDP.
M&A: a dummy for the event of M&A transactions.

However, the existing evidence regarding foreign ownership tends
to be mixed. For example, Sturm and Williams (2004) find that
foreign banks are generally more efficient than domestic banks in
their investigation of the Australian banking sector. In contrast,
Hasan and Hunter (1996), Mahajan et al. (1996), and Chang et al.
(1998) conclude that foreign banks are less cost efficient than
domestic US banks. Demirgüç-Kunt and Huizinga (1999) and
Claessens et al. (2001) suggest that the effect of foreign ownership
differs depending on a host country’s level of economic develop-
ment. In terms of profitability, for example, foreign banks are found
to outperform domestic banks in developing countries but lag
behind local banks in industrialized countries.
The foreign ownership of banks has been a subject of much
controversy in Korea since the acquisition of Korea First Bank by
Newbridge Capital in 1999.9 It was in fact the first foreign
acquisition of a domestic Korean bank. Since then, more cases of
foreign ownership of a domestic bank have followed: the
acquisition of Hanmi Bank by Carlyle Group in 2000 and KEB by
Lone Star Funds in 2003.10 At the time of their acquisitions, these
foreign investors were argued to be instrumental in introducing
international banking practices and innovations into the Korean
banking sector. However, critics have downplayed this potential
benefit by pointing out that those investors are basically buyout
funds with limited experience in commercial banking. Choi and
Hasan (2005) offer evidence of generally favorable effects of
foreign ownership in the Korean banking sector by finding a
statistically strong positive association between the percentage of
9
Under the agreement that Newbridge and the Korean government signed in
September 1999, Newbridge acquired a 51 percent economic interest in Korea First
Bank and became in charge of operating the bank.
10
In November 2000, the consortium led by Carlyle assumed the management
control of Hanmi Bank by becoming the largest shareholder with a 36.6 percent
stake. Lone Star became the controlling shareholder of KEB holding 51 percent of
the bank’s total outstanding shares following the special shareholder meeting in
September 2003.
foreign ownership and bank performance. In defining foreign
ownership, however, the authors encompass all foreign investors
including minority shareholders and ADR that exert no control
over bank management. By contrast, our study only considers the
foreign shareholders with a controlling stake.
To the extent that bank activities exhibit economies of scale,
bigger banks may be more effective at improving managerial
performance. Berger and Mester (1997) and Hughes and Mester
(1998) find significant economies of scale present in the US
banking sector. However, it is equally possible that a large scale
undermines bank performance by causing coordination problems
within the organization. For example, Drake and Hall (2003) find
apparent diseconomies of scale for Japan’s largest banks. Therefore,
the existing evidence suggests the possibility of a non-linear
relationship between bank size and performance.11 To allow for
possible non-linearity, we introduce a quadratic specification for
bank size by including total assets as well as their square in our
empirical testing.
The last bank-specific determinant we consider in our empirical
analysis is credit risk. We use the ratio of loans to deposits to
measure credit risk. Flamini et al. (2009) argue that ‘‘this [ratio]
provides a forward-looking measure of bank exposure to default
and asset quality deterioration.’’12 Consistent with their study, we
model credit risk as a predetermined variable in our specification
based on the assumption that outstanding loans are not tradable. If
standard asset pricing arguments apply, bank performance
measured by profitability is expected to be positively associated
with the extent of credit risk.
Turning to external factors, we control for the effects of
macroeconomic fluctuations in our specification. There are many
11
Eichengreen and Gibson (2001) in fact find the non-linear effect of size on bank
profitability – profitability initially rising with size and then falling – in their
analysis of the Greek banking sector.
12
Flamini et al. (2009, p. 7).
90 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94
ways that the business cycle can affect bank performance. In an
economic downturn, for example, bank lending is more likely to slow
down, the quality of loans is more likely to deteriorate, and the default
risk is more likely to rise. Bikker and Hu (2002) and Flamini et al.
(2009) provide empirical evidence in support of pro-cyclicality of
bank profits. The cyclical output effects are expected to assume
particular importance during our sample period of 2003–2010 since
it includes the episode of a sharp output downswing following the
global financial crisis. We use GDP growth to proxy for cyclical output
effects. In our specification GDP growth rates are also interacted with
ownership dummies to determine whether the sensitivity of bank
performance to the business cycle varies depending on ownership
structure of banks. Finally, a dummy is introduced to control for
possible effects of mergers and acquisitions (M&A’s) on contempo-
raneous bank performance. The three cases of M&A took place during
our sample period: Hanmi Bank was acquired by Citibank in 2004;
Korea First Bank by Standard Chartered Bank in 2005; and Chohung
Bank by Shinhan Bank in 2006.
Subsequently, the model to be estimated takes the following
form:
Per formanceit ¼ f0 þ f1 ASSET it þ f2 ASSETit2 þ f3 RISK it
þ f4 GOVERNMENT it þ f5 FOREIGN it
þ f6 GDPGRt þ f7 GOVERNMENT it  GDPGRt
þ f8 FOREIGN it  GDPGRt þ f9 M&Ait þ eit (5)
where Performanceit is bank performance for bank i at time t;
ASSETit denotes constant price total assets adjusted in 2005 prices;
RISKit refers to credit risk measured by the ratio of loans to
deposits; GOVERNMENTit is the government ownership variable
which equals 1 if government or a government agency is the
largest controlling shareholder among shareholders with an equity
stake of more than 10% in bank i at time t, and equals 0 otherwise;
FOREIGNit is the foreign ownership variable which equals 1 if the
management control of bank i belongs to a foreign buyout fund at
time t, and equals 0 otherwise; GDPGRt denotes the growth rate of
real GDP in Korea at time t; M & Ait is the M&A dummy which
equals 1 if bank i engages in an M&A transaction at time t, and
equals 0 otherwise; and eit ¼ vi þ uit is the disturbance where vi
represents the unobserved bank-specific effect, and uit is the
idiosyncratic error.13
4.2. Empirical results
Table 5 reports the results of fixed effects regressions we ran on
Eq. (5). We use our Malmquist index of PGE changes as well as the
two profitability ratios – ROA and ROE – as a measure of bank
performance. For all three measures of bank performance, the
Hausman test rejects the null hypothesis that the difference in
coefficients between fixed effects and random effects is not
systematic. Consequently, the test results provide evidence in
support of the fixed effects model in our empirical testing.
The regression results show that ownership structure is an
important determinant of bank performance in Korea. When other
control variables are held constant, for example, government-
owned banks are found to be clearly lagging behind privately
13
In our model bank performance is regressed on contemporaneous bank-specific
variables. But, if the model instead takes the form of a predictive regression with
lagged stochastic regressor(s), then the estimated coefficient(s) of lagged
regressor(s) can be biased with our sample size. Although our sample of 17 banks
includes all commercial banks as well as specialized banks competing for deposits
in Korea, the sample size is still low. If lagged regressor(s) are highly persistent and
their innovations are highly correlated with the regression error, then the problem
of small sample biases can arise. See, for example, Stambaugh (1999) for predictive
regressions in time series analysis, and Bali and Demirtas (2007) for regressions in
panel data analysis.
owned banks in promoting PGE. These results are in line with
Gilbert and Wilson (1998) who find considerable efficiency gains
from privatization of government-controlled banks in Korea
during the 1980s and early 1990s. In our regressions the
government ownership of banks tends to be negatively related
to ROA and ROE as well, but this negative relationship is not
statistically significant at the 10% level. These findings, coupled
with testing results in Table 4 suggest that government ownership
is likely to undermine the shadow value of capital held by banks
even when it is not noticeably hurting bank profitability measured
by ROA or ROE.
Regarding the foreign ownership of banks, we find little evidence
that the management control of foreign buyout funds improves the
performance of domestic banks. Table 5 shows that any effect their
control has on bank performance is consistently negative. In
particular, this negative effect is found to be statistically significant
when managerial performance is measured by ROA and ROE. There
is a widespread sentiment in Korea that foreign buyout funds have
profited largely on the intrinsic franchise value of acquired banks
rather than their genuine efforts to turn the banks around. According
to the skeptics, buyout funds make merely cosmetic changes to bank
balance sheets until they choose to exit from their investment under
the most favorable macroeconomic and capital market conditions.
At least in light of bank profitability, such a view is not found to be
entirely without foundation.
However, it should be noted that Newbridge and Carlyle sold
their respective controlling stakes in Korea First Bank and Hanmi
Bank during our sample period. In January 2005, Standard
Chartered Bank acquired the whole stake in Korea First Bank,
and has renamed the bank as SC First Bank. Hanmi Bank also has
been wholly owned by Citibank since November 2004. These two
foreign-owned banks now under the control of international banks
are found to be clearly more profitable than domestic banks when
other bank-specific factors are held constant.14 Accordingly, it
appears that different types of foreign controlling shareholders
have different effects on bank performance.
It is possible that certain types of ownership structure produce
better bank performance simply because they employ a different
corporate governance system. If this is the case, then we may be
able to identify specific governance mechanisms that would help
to improve bank performance regardless of ownership structure. In
their analysis of publicly listed nonfinancial firms in Korea, Choi
et al. (2007) find that board independence, measured by the
proportion of outside directors, has strongly positive effects on
firm performance. Subsequently, we included the ratio of outside
directors in our regressions to test whether board independence
has similarly significant effects on bank performance as well.
However, the proportion of outside directors was far from being
statistically significant, and its inclusion hardly affected the results
for other variables.
In relation to bank size, our regression results provide no
convincing evidence of economies of scale to be clearly present in
the Korean banking sector. The positive coefficient on asset size,
significant at the 10% level, in the ROA regressions gives some
support to the economies of scale hypothesis, but the negative and
14
We rewrite Eq. (5) as (1)’ Performance = b0 + b1FOREIGN + b2OTHER + e0 where
Performance is bank performance; FOREIGN denotes the foreign ownership variable
which equals 1 if management control belongs to a foreign buyout fund, and equals
0 otherwise; and OTHER refers to other control variables. Suppose that INTBANK
denotes the foreign ownership variable which equals 1 if ownership belongs to a
foreign international bank, and equals 0 otherwise. Then, the following holds true
for foreign-owned banks during our sample period: (2)’ FOREIGN = 1  INTBANK.
Using Eq. (2)’, Eq. (1)’ can be rewritten as (3)’
Performance = (b0 + b1)  b1INTBANK + b2OTHER + e0 . Thus, during our sample
period the coefficients on FOREIGN and INTBANK have the opposite sign but share
the same absolute value.
 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94 91

Table 6
Fixed effects regressions for technical change and efficiency change.

Technical change Efficiency change

ASSET 0.0059 0.0059 0.0067* 0.0009 0.0010 0.0010

(0.118) (0.137) (0.089) (0.283) (0.281) (0.256)
2
(ASSET) 1.31E05 1.33E05 1.57E05 1.79E06 1.91E06 2.11E06
(0.310) (0.325) (0.243) (0.548) (0.534) (0.497)
RISK 0.1568 0.1263 0.1410 0.0737** 0.0785** 0.0756**
(0.300) (0.408) (0.358) (0.037) (0.026) (0.035)
GOVERNMENT 0.3668* 0.3753* 0.0323 0.0333
(0.100) (0.095) (0.529) (0.522)
FOREIGN 0.1147 0.1033 0.0147 0.0121
(0.539) (0.580) (0.729) (0.779)
GDPGR 0.0265** 0.0223** 0.0263** 0.0024 0.0016 0.0024
(0.026) (0.033) (0.037) (0.379) (0.490) (0.412)
GOVERNMENT  GDPGR 0.0165 0.0159 0.0027 0.0027
(0.435) (0.463) (0.577) (0.596)
FOREIGN  GDPGR 0.0036 0.0016 0.0005 0.0003
(0.928) (0.969) (0.953) (0.972)
M&A 0.1378 0.1278 0.1272 0.0603** 0.0611** 0.0616**
(0.262) (0.308) (0.306) (0.035) (0.034) (0.034)

Observation 128 128 128 128 128 128

Within R-sq 0.1969 0.1666 0.2021 0.1168 0.1097 0.1183
F 3.68*** 3.00*** 2.90*** 1.98* 1.85* 1.54
(0.0014) (0.0066) (0.0043) (0.0642) (0.0856) (0.1451)
Hausman Statistic 14.54** 11.11* 15.97** 7.19 8.11 8.49
(0.0241) (0.0851) (0.0428) (0.3039) (0.2305) (0.3868)

Note: *, **, *** stand for, respectively, 10%, 5%, and 1% level of significance. The p-values are reported below the coefficient estimates.
ASSET: total assets adjusted in 2005 prices (in KRW trillions).
RISK: the ratio of loans to deposits.
GOVERNMENT: a dummy for government ownership.
FOREIGN: a dummy for the management control of a foreign buyout fund.
GDPGR: the growth rate of real GDP.
M&A: a dummy for the event of M&A transactions.

significant coefficient on the square of size variable in both ROA
and ROE equations indicates that the relation between size and
bank profitability may well be non-linear. This suggests that any
economies of scale enjoyed by smaller banks may quickly
disappear as soon as they reach a certain size. The negative and
significant coefficient on total assets, with their square highly
insignificant, in the Malmquist index regressions adds further
evidence against the economies of scale hypothesis. All in all, if
there exists a meaningful link between the size and performance of
relatively large banks in Korea, it appears to be diseconomies
rather than economies of scale.
In fact the possibility of diseconomies of scale for relatively
large banks seems to extend well beyond the boundary of Korea.
We find the empirical evidence of a similar trend, presented in
Appendix A at the end, when commercial banks from China and
Japan are considered in addition to banks from Korea. Walter
(2009) ascribes the potential for diseconomies of scale in large
financial services firms to ‘‘disproportionate increases in adminis-
trative overheads, management of complexity, agency problems
and other cost factors.’’15 Although high fixed costs typically
associated with financial services offer some room for scale
economies among small banks, these initial scale economies
appear to be increasingly swamped by the additional cost factors
just described as bank size increases.
In line with the standard asset pricing arguments, we find some
evidence that banks are able to increase profitability by assuming
greater credit risk. There is a positive and marginally significant
association between ROA and the ratio of loans to deposits.
However, the assumption of greater credit risk does not necessarily
raise banking efficiency in generating profit. The coefficient on the
ratio of loans to deposits in the Malmquist index regressions is far
from being statistically significant. Considering that household
loans are generally believed to carry higher credit risk than
15
Walter (2009, p. 597).
corporate loans, we also tried the ratio of household loans to
corporate loans as another proxy for credit risk in our estimation.
The estimation results that are not reported here offer more or less
the same picture for the link between bank performance and credit
risk as well as other bank-specific variables. In addition, we
considered liquidity risk by including the ratio of liquid domestic
assets to liquid domestic debts in our estimation.16 But, this proxy
for liquidity risk was never found to be statistically significant.
Turning to cyclical output effects, we see that bank performance
is highly sensitive to the business cycle. The GDP growth variable
consistently has a positive and statistically significant coefficient in
all regressions. In particular, there is some indication that the
profitability of banks managed by foreign buyout funds tends to
show even higher sensitivity to the business cycle compared to
domestic banks. The interaction of GDP growth with the foreign
ownership variable enters the ROA equation positively with its
coefficient found to be statistically significant. By contrast, the
interaction of GDP growth with the government ownership
variable is found to be statistically insignificant in all regressions,
indicating that there is no clear difference in cyclical output effects
between government-owned and privately held banks.
We find bank profitability measured by ROA and ROE may
suffer in the year when M&A takes place. In particular, the negative
coefficient on the M&A dummy is statistically significant in the
ROA regressions. However, this negative windfall effect of M&A on
bank performance is not clearly detected when bank performance
is measured by our Malmquist index measure of PGE changes. The
M&A dummy enters the Malmquist index equation even positively,
although its coefficient is far from being statistically significant.
16
Liquid assets (or debts) include assets (or debts) with the maturity of one month
or less. For the exact definition of the liquidity ratio variable and the source of data,
see Financial Statistics Information System of Financial Supervisory Service,
Republic of Korea.
92 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94
As Eq. (3) illustrates, actual PGE changes of individual banks are
driven by two forces: (i) changes in the potential capacity to
generate profit represented by technical change; and (ii) catching
up with the prevailing potential represented by efficiency change.
We conducted fixed effects regressions for technical change and
efficiency change using Eq. (5). The regression results summarized
in Table 6 show that the business cycle is a significant determinant
of technical change. The positive coefficient of the GDP growth
variable suggests that a bank’s potential capacity to generate profit
is more likely to improve in an economic upswing. On the other
hand, credit risk enters the efficiency change equation positively,
and its coefficient is statistically significant. Therefore, a higher
degree of risk-taking is expected to help individual banks with
achieving their potential. As regards the ownership of banks,
government ownership has a negative effect on technical change,
although the variable is only marginally significant. In contrast, the
management control of foreign buyout funds has no significant
impact on the two constituents of PGE changes.
Finally, we note that specialized banks were initially set up to
support specific policy purposes. It is subsequently possible that
incentive structures faced by four specialized banks included in
this study may be different from those for commercial banks even
though they all compete for deposits and other bank activities. To
check whether our empirical findings are driven by a small number
of specialized banks with possibly non-commercial incentives of
their own, we excluded those banks from our sample and
considered only commercial banks – both nationwide and regional
– in conducting regressions for bank performance. However, these
additional regressions were found to offer more or less the same
picture as our previous regressions for the larger sample including
specialized banks.
5. Concluding remarks
In this study we develop a measure of bank performance based
on the Malmquist index approach. This approach allows for
multiple inputs and multiple outputs, and thus enables us to
measure a bank’s efficiency in transforming various expenses into
different types of revenues. We label this efficiency as profit-
generating efficiency. Since the Malmquist index assesses growth
in input–output efficiency, our measure based on this approach is
expected to capture the dynamics of profit-generating efficiency,
and as a result supplement the snapshot profitability measures of
ROA and ROE. Empirical tests find that our Malmquist index
measure shows relatively strong association with the shadow
value of capital held by banks.
Building upon our Malmquist index measure as well as
profitability ratios, this study provides empirical evidence that
has bearings on some of recent banking sector issues in Korea. In
policy debate, it is often argued that bank consolidation through
mergers and acquisitions will help the Korean banking sector grow
to be more efficient and profitable, given that even major banks in
Korea are relatively small compared to global banks. This line of
argument implicitly assumes the presence of economies of scale in
bank activities. However, this widely held assumption may be too
simplistic and hence could be misleading. In our empirical
investigation of Korean banks over 2003–2010, we never find
convincing evidence of economies of scale for relatively large
banks. Empirical evidence in fact suggests that the creation of the
so-called mega bank is more likely to face diseconomies rather
than economies of scale.
Our results also have interesting implications for policy issues
regarding bank ownership. For example, the topic of heated debate
currently in Korea includes the issue of how quickly government-
controlled commercial banks should be fully privatized. We find
negative and statistically significant effects of government
ownership on bank performance assessed by the Malmquist
index-based measure. Given a close link between this measure and
the shadow value of capital, our empirical findings suggest the
potentially substantial opportunity cost associated with delays in
privatization even when government control is not noticeably
hurting bank profitability in terms of ROA or ROE.
Another hot-button issue of bank ownership regards foreign
investors. The foreign ownership of banks has been a subject of
much controversy in Korea since the acquisition of Korea First Bank
by Newbridge Capital in 1999. Are foreign investors instrumental
in introducing global best practices to the Korean banking sector?
Or is their role simply overrated? The evidence we find tends to be
mixed. Insofar as foreign ownership has meaningful effects on
bank performance in Korea, foreign strategic investors with
extensive banking experience tend to improve bank performance
while the effects of foreign buyout funds with purely financial
motives appear to be largely negative.
If one attempts to draw general policy conclusions from single-
country evidence offered in this study, the usual caveats should
apply. Nonetheless, our findings may well have the potential to
serve as a useful guide for policymakers outside Korea especially
when they try to ensure sound bank performance in shaping the
post-crisis industry landscape. For example, we find the relation-
ship between bank size and performance is not simple and linear,
suggesting that banks may become ‘‘too big to stay profitable’’ even
before they are ‘‘too big to fail.’’ Similarly, our empirical evidence
shows that the effect of foreign ownership is not so simple and
homogeneous but instead can vary depending on certain factors.
Earlier studies identify the economic development of a host
country as one of such factors by examining the profitability of
foreign-owned banks in developing and industrialized countries.
We find the types of foreign controlling shareholders – interna-
tional banks with strategic motives vs. buyout funds with purely
financial motives – could also matter in determining bank
profitability.
Acknowledgements
We are extremely grateful to an anonymous referee and Hoe
Kyung Lee for providing key suggestions and insights. We also
gratefully acknowledge comments by Yong Sun Kim, Sung Hwan
Shin and other participants in two seminars held at the Bank of
Korea in Seoul and at the Asian Office of the Bank for
International Settlements in Hong Kong. The research on which
this paper is based was supported by a grant from the Bank of
Korea.
Appendix A
To include China and Japan in addition to Korea in the regression
analysis of bank performance, we consider the following specifica-
tion:
Per formanceit ¼ f0 þ f1 ASSET it þ f2 ASSETit2 þ f3 RISK it
þ f4 GDPGRt þ eit (A-1)
where Performanceit is bank performance for bank i at time t;
ASSETit denotes constant price total assets adjusted in 2005 prices;
RISKit refers to credit risk measured by the ratio of loans to
deposits; GDPGRt denotes the growth rate of real GDP in each
country at time t; and eit ¼ vi þ uit is the disturbance where vi
represents the unobserved bank-specific effect, and uit is the
idiosyncratic error.
We run fixed effects regressions on Eq. (A-1) using the two
profitability ratios – ROA and ROE – as a measure of bank
 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94 93

Table A1
Fixed effects regressions for China and Japan.

China Japan

ROA ROE ROA ROE

ASSET 1.42E-07*** 1.46E06** 8.74E08 1.53E05

(0.000) (0.012) (0.707) (0.557)
(ASSET)2 4.68E13*** 4.97E12** 1.60E13 5.13E11
(0.000) (0.041) (0.883) (0.675)
RISK 5.27E05** 0.0004 1.76E05 0.0046
(0.019) (0.526) (0.626) (0.255)
GDPGR 3.06E05 0.0008 6.03E05 0.0006
(0.754) (0.790) (0.131) (0.894)

Observation 559 558 562 559

Within R-sq 0.1462 0.0167 0.0077 0.0035
F 18.40*** 1.82 0.92 0.42
(0.0000) (0.1231) (0.4537) (0.7954)

Note: *, **, *** stand for, respectively, 10%, 5%, and 1% level of significance. The p-values are reported below the coefficient estimates.
ASSET: total assets adjusted in 2005 prices (in $ millions).
RISK: the ratio of loans to deposits.
GDPGR: the growth rate of real GDP.

Table A2
Regressions for China, Japan and Korea combined.

Panel data Averages over 2003–2010

ROA ROE ROA ROE

ASSET 1.21E07*** 1.04E06 1.41E08 3.58E07

(0.000) (0.283) (0.430) (0.863)
2
(ASSET) 3.99E13*** 3.72E12 1.20E13 4.02E12
(0.000) (0.331) (0.259) (0.745)
RISK 6.78E06 0.0008 1.40E05 0.0066***
(0.610) (0.376) (0.393) (0.001)
GDPGR 5.73E05 0.0011 2.08E06 0.0217
(0.145) (0.700) (0.994) (0.523)

Observation 1250 1246 224 224

Within R-sq 0.0754 0.0023 0.0124 0.0577
F 20.79*** 0.59 0.68 3.32**
(0.0000) (0.6724) (0.6073) (0.0115)

Note: *, **, *** stand for, respectively, 10%, 5%, and 1% level of significance. The p-values are reported below the coefficient estimates.
ASSET: total assets adjusted in 2005 prices (in $ millions).
RISK: the ratio of loans to deposits.
GDPGR: the growth rate of real GDP.

performance. For bank-specific variables, we use income statement
and balance sheet data of commercial banks from the Bankscope
database provided by Fitch Ratings. To maintain comparability with
previous regressions in examining size effects, we only consider the
banks whose sizes fall within the bank size range of Korean banks,
thereby excluding banks with their average assets over 2003–2010
less than 1.5 billion U.S. dollars (in 2005 prices) or greater than 250
billion U.S. dollars (in 2005 prices). The final sample includes 125
banks from China, 84 banks from Japan and 15 banks from Korea, for
which data is available from the Bankscope database.
Table A1 reports the results of fixed effects regressions for China
and Japan over the period 2003–2010. The results for China suggest a
clearly nonlinear relationship between bank size and profitability
measured by ROA or ROE. Subsequently, Chinese banks are likely to
encounter diseconomies of scale once they grow asset size beyond a
certain level. However, the link between bank size and profitability
for Japanese banks is not found to be statistically significant. When
fixed effects regressions are run for all commercial banks from China,
Japan and Korea pooled together, we find clear evidence of a nonlinear
relationship between bank size and ROA, but fail to find a statistically
significant link between asset size and ROE (Table A2). If we use the
variables averaged over 2003–2010 instead of yearly data in running
regressions for all three countries combined together,17 a statistically
significant relationship is not detected between bank size and
profitability. On the whole, the inclusion of China and Japan little
changes our previous findings on size effects based on the sample
comprising only Korean banks. To the extent that there is a
meaningful link between the size and performance of relatively
large banks, the link seems to suggest diseconomies rather than
economies of scale.
References
Bali, T.G., Demirtas, K.O., 2007. Small sample bias in panel data. Finance Letters 5,
17–21.
Barth, J.R., Caprio Jr., G., Levine, R., 2004. Journal of Financial Intermediation 13,
205–248.
Berg, S.A., Forsund, F.R., Jansen, E.S., 1992. Malmquist indices of productivity growth
during the deregulation of Norwegian banking, 1980–1989. Scandinavian
Journal of Economics 94 (Suppl.) 211–228.
Berg, S.A., Forsund, F.R., Hjalmarsson, L., Suominen, M., 1993. Banking efficiency in
the Nordic countries. Journal of Banking and Finance 17, 371–388.
Berger, A.N., Humphrey, D.B., 1992. ‘‘Measurement and efficiency issues in com-
mercial banking,’’ in Output measurement in service sectors. NBER Studies in
Income and Wealth 56, 245–279.
17
Country dummies are also included to control for country differences other
than the growth rates of real GDP.
94 J.Y. Lee, D. Kim / Japan and the World Economy 27 (2013) 83–94
Berger, A.N., Mester, L.J., 1997. Inside the black box: what explains differences in the
efficiencies of financial institutions. Journal of Banking and Finance 21, 895–947.
Bhaumik, S.K., Dimova, R., 2004. How important is ownership in a market with level
playing field? The Indian banking sector revisited. Journal of Comparative
Economics 32, 165–180.
Bikker, J.A., Hu, H., 2002. Cyclical patterns in profits, provisioning and lending of
banks and procyclicality of the New Basel Capital Requirements. BNL Quarterly
Review 221, 143–175.
Bonin, J.P., Hasan, I., Wachtel, P., 2004. ‘‘Bank performance, efficiency and owner-
ship in transition countries,’’ BOFIT Discussion Papers No. 7. Bank of Finland.
Bourke, P., 1989. Concentration and other determinants of bank profitability in
Europe, North America and Australia. Journal of Banking Finance 13, 65–79.
Caves, D.W., Christensen, L.R., Diewert, W.E., 1982. The economic theory of index
numbers and the measurement of input, output and productivity. Econometrica
50, 1393–1414.
Chang, C., Hasan, I., Hunter, W., 1998. Efficiency of multinational banks: an
empirical investigation. Applied Financial Economics 8, 689–696.
Choi, J.J., Park, S.W., Yoo, S.S., 2007. The value of outside directors: evidence from
corporate governance reform in Korea. Journal of Financial and Quantitative
Analysis 42, 941–962.
Choi, S., Hasan, I., 2005. Ownership, governance, and bank performance: Korean
experience. Financial Markets, Institutions & Instruments 14 (4) 215–242.
Coelli, T., 1996. ‘‘A guide to DEAP Version 2.1: A data envelopment analysis
(computer) program,’’ CEPA (Centre for Efficiency and Productivity Analysis)
Working Paper 96/08. Department of Econometrics, University of New England,
Australia.
Claessens, S., Demirgüç-Kunt, A., Huizinga, H., 2001. How does foreign entry affect
domestic banking markets? Journal of Banking and Finance 25, 891–911.
Demirgüç-Kunt, A., Huizinga, H., 1999. Determinants of commercial bank interest
margins and profitability: Some international evidence. The World Bank Eco-
nomic Review 13, 379–408.
Drake, L., 2001. Efficiency and productivity change in U.K. banking. Applied Finan-
cial Economics 11, 557–571.
Drake, L., Hall, M.J.B., 2003. Efficiency in Japanese banking: an empirical analysis.
Journal of Banking and Finance 27, 891–917.
Eichengreen, B., Gibson, H.D., 2001. Greek banking at the dawn of the new
millennium. CEPR Discussion Paper 2791, London.
European Central Bank, 2010. Beyond ROE – How to measure bank performance.In:
Appendix to the Report on EU Banking Structures. .
Färe, R., Grosskopf, S., Norris, M., 1997. Productivity growth, technical change, and
efficiency change in industrialized countries: reply. American Economic Review
87, 1040–1043.
Färe, R., Grosskopf, S., Norris, M., Zhang, Z., 1994. Productivity growth, technical
change, and efficiency change in industrialized countries. American Economic
Review 84, 66–83.
Flamini, V., McDonald, C., Schumacher, L., 2009. ‘‘The determinants of commercial
bank profitability in sub-Saharan Africa,’’ IMF Working Paper, WP/09/15. In-
ternational Monetary Fund.
Fukuyama, H., 1995. Measuring efficiency and productivity growth in Japanese
banking: a nonparametric frontier approach. Applied Financial Economics 5,
95–107.
Gilbert, R.A., Wilson, P.W., 1998. Effects of deregulation on the productivity of
Korean banks. Journal of Economics and Business 50, 133–155.
Hasan, I., Hunter, W., 1996. Efficiency of Japanese multinational banks in the United
States. Research in Finance 14, 157–173.
Hayashi, F., 1982. Tobin’s marginal q and average q: a neoclassical interpretation.
Econometrica 50, 213–224.
Hughes, J.P., Mester, L.J., 1998. Bank capitalization and cost: evidence of scale
economies in risk management and signaling. Review of Economics and Statis-
tics 80, 314–325.
Isik, I., Hassan, M.K., 2003. Financial deregulation and total factor productivity
change: an empirical study of Turkish commercial banks. Journal of Banking
and Finance 27, 1455–1485.
Leightner, J.E., Lovell, C.A.K., 1998. The impact of financial liberalization on the
performance of Thai banks. Journal of Economics and Business 50, 115–131.
Mahajan, A., Rangan, N., Zardkoohi, A., 1996. Cost structures in multinational and
domestic banking. Journal of Banking and Finance 20, 283–306.
Molyneux, P., Thornton, J., 1992. Determinants of European bank profitability: a
note. Journal of Banking and Finance 16, 1173–1178.
Neal, P., 2004. X-efficiency and productivity change in Australian banking. Austra-
lian Economic Papers 43 (2) 174–191.
Ray, S.C., Desli, E., 1997. Productivity growth, technical change, and efficiency
change in industrialized countries: comment. American Economic Review
87, 1033–1039.
Shephard, R., 1970. Theory of Cost and Production Functions. Princeton University
Press, Princeton.
Short, B.K., 1979. The relation between commercial bank profit rates and banking
concentration in Canada, Western Europe, and Japan. Journal of Banking and
Finance 3, 209–219.
Sinkey Jr., J.F., 1983. Commercial Bank Financial Management. McMillan, New York.
Stambaugh, R.F., 1999. Predictive regressions. Journal of Financial Economics 54,
375–421.
Sturm, J.-E., Williams, B., 2004. Foreign bank entry, deregulation and bank efficien-
cy: lessons from the Australian experience. Journal of Banking and Finance 28,
1775–1799.
Walter, I., 2009. Economic drivers of structural change in the global financial
services industry. Long Range Planning 42, 588–613.
Worthington, A.C., 1999. Malmquist indices of productivity change in Australian
financial services. Journal of International Financial Markets, Institutions and
Money 9, 303–320.