Efficiency of Banks in the Third Federal Reserve District

Abstract

In recent years banks have had to operate in an increasingly competitive environment. How banks will be affected by the increased competitive pressures depends in part on how efficiently they are run. This paper uses the stochastic econometric cost frontier approach to study efficiency at banks in the Third Federal Reserve District. The paper looks at scale efficiency - whether banks are operating with the efficient level of outputs; scope efficiency - whether banks are operating with the efficient mix of outputs; and x-efficiency - whether banks are using their inputs efficiently. The cost model differs from previous studies in that it explicitly accounts for the quality of banks' assets and the probability of failure, which influences banks' costs in a number of ways. The paper also differs from previous studies in its treatment of financial capital as an input into the production process. In addition to providing a cushion against losses, financial capital can be used to fund loans as a substitute for deposits or borrowed funds. The paper differs in a third way in reporting confidence intervals for the bank- specific measures of efficiency. There do not seem to be many cost efficiency gains made from Third District banks' changing their sizes, and these results are much like those obtained in studies using U.S. samples. The model shows that there is no evidence of either scope economies or diseconomies at the average efficient bank in the Third District, nor at banks in different size categories. While the scope measures suggest there is no cost justification for joint production, the approach leaves open the possibility of revenue benefits. Average x-inefficiency at banks in the Third District is on the order of 6 % to 9 %. In competitive markets not all of this gain would be retained by the bank - the savings would be passed on to customers - increasing overall welfare. When compared to U.S. samples, Third District banks seem to be outperforming U.S. bankers on average in this regard. A simple correlation and regression results indicate that inefficient banks in the District tend to be younger. There is no statistically significant differences in efficiency across the three states. There is no evidence that larger banks are more or less x-efficient than smaller banks. Inefficient banks have a higher percentage of loans in construction and land development, and loans to individuals. One of the more interesting relationships is the negative relationship between inefficiency and the capital-asset ratio. It may indicate that higher capital may prevent moral hazard. In conclusion, inefficient banks may have more to fear from efficient producers than from banks producing particular volume or product mix.