This paper examines the cost efficiency of Indian commercial banks using Data Envelopment Analysis (DEA) and specifically incorporating interest and non-interest income measures in the estimation. In consistent with the earlier findings, the results show that there is substantial inefficiency among the commercial banks in India over the period of the study (2005-06 to 2010-11). This result suggests that the observed cost inefficiency in the Indian banking industry is primarily due to the regulatory environment in which public sector banks are operating rather than the managerial problems in using the financial resources. The results further signify that the level of competitive practices and technology in the Indian banking industry during the post-reforms period served as a catalyst in improving the level of cost efficiency.

Economic progress is an active and continuous process, and banks are the foremost players in the economic progress of a country. The economic development highly depends on the amount of mobilization of resources and investment, and on the operational efficiency of the various segments of the economy. With the advent of economic reforms launched in 1991, followed by the technological innovations in the fields of computation and communication, competition among the Indian banks has become intense, which indeed metamorphosized the Indian banking sector (Jesudasan and Xavier, 2011).

Theoretical Background

Efficiency is measured by the transformation of given inputs into maximum attainable outputs at least cost. Efficiency as a measure of performance may be related to the objectives of the organizations such as maximization of production, maximization of revenue and minimization of cost. It can be evaluated based on scale, scope, and X-efficiency. Scale efficiency considers the relationship between the size of the firm and the cost. Scope efficiency is the relationship between the multiple product mix of the firm and the cost. Firms enjoy scope efficiency when they produce multiple products at the lowest cost than if they have been produced individually by specialized firms. X-efficiency has two concepts: Technical Efficiency (TE) and Allocative Efficiency (AE). Farrell (1957) categorized Cost Efficiency (CE) into two distinct and separable components: Technical Efficiency (TE)—the ability of a firm to produce the existing level of output with minimum inputs (input-oriented), or to produce maximum output from a given set of inputs (output-oriented); and Allocative Efficiency (AE)—the ability of a firm to use the inputs in optimal proportions, given their respective prices. AE relates to prices, while TE relates to quantities (Barros and Mascarennas, 2005; and Kumar and Gulati, 2010). Thus, cost inefficiency incorporates both allocative inefficiency from failing to react optimally to relative prices of inputs and technical inefficiency from employing too much of the inputs to produce a certain output bundle. It is further noteworthy that technical inefficiency is caused and correctable by management, and allocative inefficiency is caused by regulation and may not be controlled by the management (Hassan, 2005).