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In the recent years, the analyses of banking efficiency have become an important inquiry
for policy makers, financial investors and bank managers alike. The design of macro policy for
the financial sector and the effective implementation of monetary policy hinge upon how
efficiently the banks perform their basic functions in the economy as financial intermediaries.
Higher banking efficiency means better intermediation services of banks, which imply a
better match between depositors and investors with all its positive effects on economic
indicators (Drechsel, 2007). Financial investors might use data on banking efficiency to identify the
robust banks of the industry so as to include them in their portfolios. Bank managers might be able
to use efficiency scores as a benchmark measure to identify areas that require improvements.
In fact, the efficiency scores are significant informative signals of management quality
(Barr et al., 1994; and Wheelock and Wilson, 1995). Owing to the aforementioned
relevance of banking efficiency, a large number of research efforts have been made to know how
efficiently the banks use their inputs to produce a cluster of financial products with minimum of waste
in the production process (see Berger and Humphrey, 1997).
Analyzing the operational efficiency of the Indian banks, particularly the domestic ones,
is an interesting research topic, especially after the initiation of the first phase of
banking reforms in 1992. The first phase of banking reforms was largely driven by the
recommendations of Narasimham Committee I
(1991) and heralded the beginning of implementing
prudential norms consisting of capital adequacy ratio, asset classification and income recognition
and provisioning, and the deregulation of the operating environment (Agarwal, 2000). In
particular, the reform measures were targeted to provide more operational flexibility and functional
autonomy to banks with the key objective of enhancing the resource use efficiency and profitability
levels in the banking system. The policy actions taken on the basis of the recommendations
of Narasimham Committee II (1997) and Verma Committee
(1999) further boosted the reforms process and initiated a drive towards restructuring of weak Public Sector Banks
(PSBs).
The notable policy measures, which have been taken with the objective of providing
greater operational and managerial freedom to PSBs, include the rights to establish overseas
branches or subsidiaries; to exit non-profitable ventures; set human resource policies; and to
acquire domestic and foreign banks. These measures were intended to level the playing field for
the state-controlled banks to compete with the private banks by increasing their efficiency
and helping them to expand into new business lines and geographies (Chan, 2005).
Traditionally, the efficiency of the banks has been evaluated using financial
accounting ratios such as Return on Assets (ROA), Profit Margin (PM), operating expenses to total expenses,
and net-profit per employee. However, the financial ratios give only a restricted,
incomplete picture of the process and fail to account for the interactions between different factors,
and thus lead to contradictory results. Manandhar and Tang (2002) noted that different ratios
may indicate the performance of a bank ambiguously in different directions. This may happen
when a bank that is poorly managed on certain dimensions may appear to be performing well as
long as it compensates in other dimensions. Further, in financial ratio analysis, each single
ratio must be compared with some benchmark ratios one at a time while one assumes that
other factors are fixed and the benchmarks chosen are suitable for comparison (Yeh, 1996).
Also, commonly used performance ratios fail to consider multiple outputs (services and/or
transactions) provided with multiple inputs. |
