The paper examines the determinants of cost efficiency of commercial banks in India by employing the Stochastic Frontier Approach (SFA) and the Tobit regression technique for the period 1992-2006. Empirical results reveal that cost efficiency of banks in India decreased during the study period. Among the three groups of banks, foreign banks seem to be relatively efficient, followed by private domestic banks and public sector banks. The Tobit regression results reveal that the earning capacity of banks is the main determinant factor of efficiency, followed by diversified and strategic non-interest income activities.

The need for an efficient financial sector for the overall development of an economy has long been recognized. Joseph Schumpeter, in his book Theory of Economic Development (1912), argued that scarcity of finance is a severe problem for economic development (Neumann, 2001). Cross country experience suggests that development of economy necessarily requires the existence of a healthy, efficient and competitive financial sector. This is because, in an economy with an underdeveloped financial market, the opportunity cost of capital is more. As a consequence, financing of projects in such an economy is more expensive (Smith, 1998). Therefore, an efficient and enduring financial sector is an important factor for overall economic development.

The Indian banking sector is the largest in South Asia with its varied financial institutions and instruments. It is distinguished by the coexistence of different ownership groups, such as public, private, domestic and foreign. Prior to 1969, all the banks, except the State Bank of India (SBI) and its seven associates, were privately owned. However, as India increasingly became a planned economy, there was a perception among policy makers that it would be difficult to undertake credit planning unless the industry and the banks are linked. Keeping in view its financial linkage with the rest of the economy, the Government of India nationalized 14 largest privately owned domestic banks in 1969 and six more in 1980, in order to meet the socioeconomic objectives of economic development.

Bank Management Journal, Stochastic Frontier Approach, SFA, Financial Sector, Theory of Economic Development, State Bank of India, SBI, Socioeconomic Objectives, Reserve Bank of India, RBI, Banking Sectors, Cash Reserve Ratio, CRR, Statutory Liquidity Ratio, SLR, Non-Performing Assets, NPAs, Financial Sector Reforms, Capital Adequacy Ratio, Automatic Teller Machines, Indian Banking Sector.