[Abstract]: During the last 27 years, the banking industry in Sri Lanka has undergone a series of changes through financial reforms, advancement of communication and information technologies, globalisation of financial services, and economic development. Those changes should have had a considerable effect on efficiency, productivity change, market structure and performance in the banking industry. The motivation of this study is to investigate empirically the impact of those changes on the banking industry. Thus, this study aims to address three main research issues related to the banking industry in Sri Lanka, namely:
1. Whether deregulation of the financial services sector has led to improvement in efficiency and productivity gains.
2. Whether banks’ inefficiency in the banking industry in Sri Lanka is determined by a set of microeconomic and macroeconomic variables.
3. Whether the changes in efficiency or changes in market structure have influenced the overall operational performance of banks in Sri Lanka.
This study adopts a non-parametric Data Envelopment Analysis (DEA) and Malmquist Productivity Index (MPI) to measure efficiency and productivity gains of banks in Sri Lanka using financial and other information representing all local banks over a sixteen year period from 1989 to 2004. Input and output variables are refined to represent the intermediation and assets transformation roles of banks. Window analysis of mean estimated efficiency scores in both aspects indicates a negative trend in estimated efficiency during the study period. However, the analysis of efficiency scores (intermediation) of different forms of banks shows a negative trend during the first half of the study period and a slight positive trend during the end of the second half. These results imply that deregulation may have failed to improve the efficiency of the Sri Lankan banking industry in the short-term. However, the expected benefits of deregulation can be achieved in the long-term. Interestingly, the two state-owned banks have responded poorly to the initial phase of Sri Lankan financial reforms. However, the improved autonomy given to boards of management under the commercialisation process has led not only to improved efficiency, but also to the reduction of the efficiency gap between the state-owned banks and privately-owned banks. The analysis of efficiency scores (asset transformation) of different forms of banks records a stable trend in estimated efficiency. On the other
hand, estimated MPIs show that Sri Lankan banks have focused on improving productivity in the asset transformation process rather than the intermediation
process.
Analysis of determinants of technical efficiency shows that technical efficiency in intermediation has positive relationships with variables such as profitability,
operational risk, purchased funds, liquidity and stock market capitalization; and negative relationships with variables such as product quality and line of business
(commercial bank). Further, results show that efficiency in the asset transformation process has positive relationships with capital strength, operational risk, and market capitalisation; and negative relationships with line of business ownership (privately owned banks) and old banks. The investigation of influence of market structure and efficiency on operational performance finds that banks’ relative market power and technical efficiency have a significant influence on their return on assets (ROA). No
evidence supports any relationship of net interest margin with variables such as market power, concentration and efficiency
