LITERATURE REVIEW

Earlier studies on the performance of banks focus on the presentation of financial ratios and the analysis of scale and scope economies. Molyneux, Altunbas and Gardener (1996) note that there are other aspects of efficiency such as technical and allocative efficiency. These two components of efficiency were first identified by Farrell (1957). The concept of X-efficiency encompasses both allocative and technical efficiency.¹ X-efficiency was introduced by Leibenstein (1966) and basically reflects the differences in managerial ability to control costs or maximise profits (Molyneux, Altunbas and Gardener, 1996).

The dominance of X-inefficiency over scale and scope inefficiency in banking has been recognised for quite some time, but researchers have only recently turned their focus to studying X-inefficiency. This new area or direction of research has brought about several approaches and methods of analysis. Molyneux, Altunbas and Gardener (1996) indicate that there is no agreement on how to measure and model X-inefficiency. The key issue is how to measure or determine the efficiency frontier. Farrell (1957) proposed that the efficiency frontier could be estimated from the sample data applying either a non-parametric or a parametric approach. The most widely used non-parametric estimation technique is the data envelopment analysis (DEA), while the stochastic frontier approach (SFA) and the distribution-free approach (DFA) are the most frequently used parametric techniques.

Berger and Mester (1997) in their article Inside the black box: What explains differences in the efficiencies of financial institutions? give a very informative synopsis of the elements of efficiency measurement (efficiency concept, measurement technique and functional form) and analyse the sources of differences in efficiencies across banks. They find that in general the choice of the measurement technique and functional form does not make a substantial difference in determining the average efficiency for the banking sector or the ranking of individual banks.

Although the body of literature on bank efficiency is substantial, it is heavily geared towards studies of U.S. banks, followed by European banks as a distant second. There are some studies on bank efficiency in less developed countries but their number is relatively small. Berger and

1 Terms X-efficiency and simply efficiency are not used consistently in the literature. They both refer to frontier efficiency.

Humphrey (1997) in their survey list only eight efficiency studies for developing countries, of which none deals with the transition countries of Central and Eastern Europe. Hence, extant research on bank efficiency in Central and Eastern European countries is relatively limited, especially when compared to studies of mature markets or other developing markets.

Another area of bank efficiency research that has not been intensively explored yet is bank efficiency across countries. In their survey, Berger and Humphrey (1997) list merely five inter-country comparisons at the time of their study. They note that cross-inter-country studies are difficult to perform and interpret because (i) the regulatory and economic environments are different across countries, and (ii) there are differences in the quality of banking services across countries that are difficult to account for. The first cross-country study was the 1993 comparative analysis of bank efficiency in Finland, Norway and Sweden by Berg, Forsund, Hjalmarsson and Suominen (1993). They found Swedish banks to be the most efficient in the pooled sample.

Most cross-country studies analyse developed countries, and only few focus on banking efficiency in Central and Eastern European economies. The 2002 working paper Determinants of Commercial Bank Performance in Transition: An Application of Data Envelopment Analysis by Grigorian and Manole (2002) estimates bank efficiency using the DEA (Data Envelopment Analysis) technique and also includes a dummy variable for foreign ownership. They divide the countries included in the study into three groups: Central Europe, South-Eastern Europe and the Commonwealth of Independent States. Overall, banks from Central Europe are found to be more efficient. Another study on transition economies is the working paper Efficiency of banks: Recent evidence from the transition economies of Europe 1993-2000 by Yildirim and Philippatos (2002). They use the SFA (Stochastic Frontier Analysis) as well as the DFA approach to estimate bank efficiency for 12 Central and Eastern European countries. On average, they find cost efficiency to be higher than profit efficiency in Central and Eastern European countries.

In recent years the role of foreign ownership in the banking industry has received increasing attention. Hasan and Hunter (1996) study cost and profit efficiency of Japanese and domestic banks in the US. For the 1984-1989 period they find that Japanese banks operating in the US were less cost and profit efficient that their US-owned counterparts. Chang, Hasan and Hunter (1998) perform a comparative study of efficiency of foreign and US-owned commercial banks operating in the United States. Their results indicate that in the US foreign banks are less cost efficient than domestic ones. In their extensive study Berger, DeYoung, Genay and Udell (2000) undertake an efficiency analysis of foreign and domestic banks in 13 countries. The average cost and profit efficiency of domestic banks is higher compared to that of foreign banks. The latter are found to be less efficient. This is one of the few studies analysing the role of foreign ownership in a cross-country comparison.

Again, the body of literature on the effects of bank ownership on efficiency for Central and Eastern European countries is quite limited. Nikiel and Opiela (2002) analyse the performance of domestic and foreign banks in Poland. Domestic private and state owned banks have on average higher profit and lower cost efficiency than foreign banks. This may seem unusual at first glance, but the authors explain it by the fact that many domestic banks operate in niche markets in which they may enjoy some market power. Hasan and Marton (2000) study bank efficiency in Hungary and the performance of foreign banks based on the extent of foreign involvement.

Banks with a higher percentage of foreign ownership turn out to be more efficient than those with a lower percentage.

A study by Weill (2003) represents an attempt of a direct comparison of the banking efficiency in Western and Eastern European countries. Weill’s research provides evidence on the existence of an efficiency gap between Western and Eastern banks, which is mainly caused by differences in managerial performance, while environmental and risk preference effects did not turn out to be important. As indicated by the author, further research in this area is needed, not only on the existence of the efficiency gap but also on the evolution of efficiency and its explanations.

A recent paper by Bonin et al. (2005) focuses on evaluating bank efficiency and identifying relevant efficiency correlates in transition countries, with focus on the efficiency-ownership relationship. The authors applied stochastic frontier estimation procedures to banks in eleven transition countries. The results provided by Bonin et al. (2005) indicate that private ownership is, by itself, insufficient to ensure bank efficiency in transition countries because no statistically significant evidence of an adverse effect of government ownership relative to private domestic ownership was found. Foreign-owned banks turn out to be more cost efficient than other banks and they also provide better services, particularly if they have a strategic foreign owner.

The recent study on bank efficiency by Fries and Taci (2005) was performed on a sample 289 banks from 15 East European countries for the period 1994-2001. The authors focused on cost efficiency of banks and investigated an extensive set of correlating factors that could be associated with costs of banking operations. They confirmed that greater macroeconomic stability and competition resulting from foreign bank entry, as well as development of the supportive institutions, promoted cost efficiency. However, they emphasized that for most Eastern European countries the major challenge after their accession to the European Union and the common market for financial services would be the increased competitive pressure. As they used only data up to 2001, this effect could not have been examined empirically.

3 METHODOLOGY

The concept of efficiency measurement assumes that the production function of the fully efficient firm or firms is known. Since this is not the case in practice, one has to estimate the production function. A number of different techniques are used to estimate efficiency. Farrell (1957) proposed that the production function can be estimated from sample data applying either a non-parametric (mathematical programming) or a parametric (econometric) approach.² The two most commonly used non-parametric efficiency estimation techniques are the data envelopment analysis (DEA) and the free disposable hull (FDH), the latter being a special case of DEA. DEA is a linear programming technique where the DEA frontier is constructed as piecewise linear combinations connecting a set of best-practice observations (Berger and Humphrey, 1997). Non-parametric techniques have some drawbacks. They focus on technological optimisation rather than economic optimisation. Since they ignore prices, they only provide

2 See Bauer et al. (1998) for a discussion of parametric and non-parametric estimation techniques.

information on technical efficiency and ignore allocative efficiency. Non-parametric techniques generally do not allow for random error in the data, i.e. they do not consider measurement error and luck as factors affecting efficiency estimates (Berger and Mester, 1997). Thus, any deviation from the frontier is assumed to reflect inefficiency. If there were any measurement errors, they would be reflected in a change of measured efficiency. Moreover, as pointed out by Berger and Humphrey (1997) any of these errors in one of the banks on the efficient frontier may change the measured efficiency of all banks. On the other hand, DEA does not require an explicit specification of the functional form of the underlying production function and thus imposes less structure on the frontier.

The three main parametric techniques are the stochastic frontier approach (SFA), the distribution-free approach (DFA) and the thick frontier approach (TFA). These methods focus on the difference or distance from the best-practice bank (efficient frontier), i.e. this distance reflects the inefficiency effect u_i. For example, if costs are higher than those of the best-practice bank, then the bank is cost inefficient. The key characteristic of parametric techniques is that they a priori impose a rule (assumption) for how random errors can be separated from inefficiency.

Thus, they make an arbitrary distinction between randomness and inefficiency, which is the main drawback and criticism of parametric techniques (Schure and Wagenvoort, 1999). Estimation techniques differ in the way they handle the composite error term v_i + u_i, i.e. in the way they disentangle the inefficiency term u_i from the random error term v_i. In our analysis we apply the SFA technique, which is based on the assumption that the random error v_i is symmetrically distributed (normal distribution) and that the inefficiency term u_i follows an asymmetric (one-sided) distribution (truncated normal distribution).