Ample scope for efficiency improvement

AN IMPORTANT aspect of the functioning of financial entities relates to the measurement of efficiency of the banking system.

Such measurement can be done either in respect of banks or individual branches of a bank. The information so obtained can be used to assess how efficiency is affected by deregulation, mergers and market structures as well as its effect on scale and scope economies of the entity. It can also be used to determine managerial efficiency relative to a certain threshold by identifying the best and worst practices (associated with high and low measured efficiency, respectively).

Efficiency can be of two kinds -- technical and economic. The former arises when a (banking) firm minimises its inputs, given outputs, while in the latter case, the banking firm would maximise its outputs, given inputs. Technical efficiency is, thus, input saving and the economic efficiency represents output augmenting efficiency.

Economic efficiency is a much broader concept in the sense that it involves choosing optimal levels and combinations of inputs and/or outputs, based on reactions to market prices. Economic efficiency involves technical efficiency, but not vice-versa. When efficiency is estimated, it would be usually in terms of `economic' efficiency, unless otherwise specified.

International experiences regarding average efficiency estimates of banks across countries reveal wide divergences in efficiency estimates. A study of banks in Norway, Sweden and Finland showed that banks in Sweden were the most efficient.

Two other cross-country studies covered 11 OECD countries and eight developed countries respectively. In the first study (Fecher and Pestieau, 1993), the average efficiency of financial services (banking and insurance) was determined for 11 OECD countries for the period 1971-86. The mean average efficiency was 0.82 with a range of 0.67 (for Denmark) to 0.98 (for Japan).

In another study using the non-parametric technique to a cross-section of 427 banks in eight developed countries (Pastor et.al., 1997), the mean efficiency value was 0.86 with a range of 0.55 (for UK) to 0.95 (for France). However, it is important to recognise that cross-country comparisons are often difficult to interpret because the regulatory and economic environment encountered by financial entities are different across nations and also because the level and quality of services associated with deposits and loans in different countries could differ.

In the Indian banking system, the commercial banks serve manifold purposes. While commercial considerations have been recognised as important, especially since 1992-93, the objective of maintaining the safety and soundness of the system is also given emphasis.

These considerations would imply different combinations of outputs and inputs giving rise to different efficiency estimations. The different portfolio combinations, the risks involved, and provisioning requirements would need to be reckoned in working out the net rates of return.

In view of the complexities inherent in such exercises, empirical studies have proceeded in two broad directions. The first set of exercises has been one of estimating technical efficiency of commercial banks, which reveal that there is ample scope for improving the technical efficiency of the banking system in India. The second set of studies has focussed on estimating cost functions and measuring economies of scale with the implicit assumption that banks operate on an efficiency frontier. However, studies in India are in a state of infancy and considerable work needs to be done before one could concretise the inferences.

Country experiences reveal that efficiency measures could be used to improve the predictive accuracy of forecasting banking problems and crises and provide basis for tailoring policy decisions to raise efficiency levels.

Similarly, studies on universal banking using efficiency techniques would help policy-makers to parameterise the degree of scale and scope economies needed for organisational restructuring. These issues are highly relevant to India at present since improvement in efficiency of banks would help further diversify and develop the financial sector.

(Edited extract from the Report of Trend and Progress in Banking in India, 1999-2000 published by the Reserve Bank of India.)