Chapter-1 the efficiency. 1.1 Statement of the Problem

Topic: BusinessComparative Analysis
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Last updated: December 19, 2019

Chapter-1IntroductionEfficientand effective utilization of resources is the key objective of every bank. Thisobjectivehas always beenimportant in banking, but a number of recent events are helping to lay greateremphasis on bankingefficiency. Increasing competition for financial services, technologicalinnovation, andbanking consolidation, for example, are all focusing more attention oncontrolling costs inbanking, and providing services and products efficiently. Increasingcompetition from non- bankinginstitutions as well as banking institutions, expanding into new markets, isputting strong pressureon banks to improve their earnings and to control costs. Efficiency is clearlya critical factor forremaining competitive.

A number of recent statistical studies have shown thatthe most efficient bankshave substantial cost and competitive advantages over those with average orbelow average efficiency. Efficiency of banks is now a verysignificant issue. Nowadays the efficiency of banks has been studiedextensively in the banking literature, as the banks have very significant rolein the economic development of a country. For the country like Bangladesh theefficient banking system is more important. The banking industry of Bangladeshcomprises of four types of scheduled banks; these are state owned,nationalized, specialized, private and foreign banks. In the present time totalof 57 banks are operating in Bangladesh, among these 6 are state owned, 2 arespecialized, 32 are conventional private commercial banks, 8 are IslamiSahariah banks and the rest 9 are the foreign commercial banks.

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 The concern of the study is tomeasure the efficiency of the two principal segments of the commercial banks inBangladesh. These are how efficiently the banks control their cost and theefficiency level of the earnings of private commercial banks in Bangladesh.Data Envelopment Analysis is used as the tool to measure the efficiency.

               1.1Statement of the ProblemThe main problemof the research is dealing with the efficiencies in different segments ofbanks. To find out the solution to the problem, the paper will focus on twoprincipal segments of banks. The paper will focus on the cost and earning efficiencyof private commercial banks in Bangladesh.    1.2 Scope of the studyFor measuring the efficiency of thebanking sector of Bangladesh the study is conducting to the 22 sample banksrepresenting the conventional private commercial banks. For the efficiency measurementsome statistical tests have been used according to the nature and objectives ofthe study. Relative financial ratios are analyzed to measure the efficiency.

 1.3 Objectives of the StudyThe main objective of this study isto measure and to analyze the Cost and Earning efficiency of private commercialbanks of Bangladesh and to give some recommendations to improve theirefficiency. To do this, the specific objectives are 1.     To examine how efficient the cost andthe earnings of private commercial banks are, by examining the sample banks.2.     To conclude the efficiency result forthe population on the basis of sample Banks.

3.     To find the correlation between inputoutput variables. 1.4Rational of the StudyFrom the very early stage ofbusiness evolvement in the history efficiency is a very significant term. Inall stage of national economy and business efficiency is very significant.  As the banking sector has the major andcrucial role in the economy of the country and in the advancement of thenational economy banking sector has great influence, efficiency analysis ofthis sector is one of the principal task.

So the report has a greatsignificance.  1.5 Limitations of the study The study of this kind is generallyencountered with some limitations.         i.

           Unavailability of data is a majorproblem.       ii.           From among the 40 banks only 21 banksare taken as the sample for the study.     iii.           Data accuracy cannot be ensured asmainly secondary data collected from Annual Reports of the sample banks,various financial stability reports, Economic trends are used in this study.     iv.            Itwas difficult to organize the report in a simple manner within limited time.Time is an important limitation for the preparation of the report.

However, repeated and sincereefforts have been given to ensure the accuracy of the data used in this study.Chapter-2Literature ReviewOnlya few relevant works have been reviewed in order to understand efficiencydifferences among private, public and foreign banksin Bangladesh. Yasmeen (2006), conducted a study to find out the technicalefficiency and productivity growth of various banks in Bangladesh. She examinedfour ratios: two for input and two for output by taking the datafrom 2003-2007 of 35 banks. The findings also providedsome indication on the likelihood of dynamic convergence of these banks’performance as well as the challenges that these banks faced amidrising competition.  Anotherwork had been carried out byKhanam & Nghiem (2004), on the efficiency of commercial banks in Bangladeshand the data consist of only one year on 48 banks. Theyconsidered seven ratios of which five were inputs and two wereoutputs.

They also found that the technical efficiency score of banks in thesample is 84 percent(income based model)1 and 80 percent(user-cost model)2, which is consistent with results from a parametricapproach called parametric linear programming. However, the evidence onrelationship between foreign ownership on bank efficiency is notsignificant for the income-based model.  Uddinand Suzuki (2011) had undertaken a study to investigate the performance ofcommercial banks in Bangladesh after theimplementation of a significant financial reform. They considered datafrom2001-2008 of 38 banks including state owned, private owned, Islamic and foreignbanks and they had considered three inputs and two outputs tomeasure the efficiency. Their findings indicated that incomeefficiency and cost efficiency of sample banks have increased by 37.84 percentand 15.28 percent in 2008 and 2001 respectively.

On the other hand,private ownership has favorable impact on income efficiency,return on assets, and non-performing loans, whereas negative impact on costefficiency.  Akhtaret al. (2011), employed data envelopment analysis to estimate the relativeefficiency of 12 commercial banks of Pakistan.

The results of their study offered some very constructive managerialinsightsinto evaluation and advancing of banking operations. The estimated result showsthat 6 banks are relatively efficient when their efficiency ismeasured in terms of ‘constant returns to scale’2 and 8 banks are relativelyefficient when their efficiency is measured in terms of ‘variable return toscale’. However,they suggested that by improving the handling of operating expenses, advances,capital and by boosting banking investment operations, the lessefficient banks can successfully endorse resource utilizationefficiency.

Several models based on Data Envelopment Analysis(DEA)-have been developed in order to Operationalize the framework, andtheir use has been illustrated using data for the branches of a commercialBank. In particular, the service-profit chain has been cast as a cascade ofefficiency benchmarkingmodels. Empirical results indicate that superior insights can be obtained by analyzingsimultaneouslyoperations, service quality and profitability than the information obtainedfrom benchmarkingstudies of these three dimensions separately (Soteriou 1997).  Fiordelisiet al. (2010), assess the inter-temporal relationships among bank efficiency,capital and risk for the Europeancommercial banking industry. They build on previous work using Grangercausalitymethods3 (Berger and De Young 1997) in a panel data framework.

The results showthat subduedbank efficiency (cost or revenue) Granger causes risk supporting the “badmanagement” and the “efficiency version of the moral hazard”hypotheses. They found only limited evidence of relationshipsbetween capital and risk in line with the moral hazard hypothesis. The findingsshowed lowerefficiency scores (either cost or revenue) suggest greater future risks andefficiency improvementstend to shore up banks’ capital positions. Their findings also emphasize theimportance ofattaining long-term efficiency gains to support financial stability objectives. Followingthe profitability test as suggested by Spong et al. (1995), the maindifferences between the “most efficient” and”least efficient” bank seem to be mainly related to staff expenses.

Inthecontext of important technological improvements in banks’ productive processes,the study suggestedan urgent need for greater labor market flexibility and the consequentsubstitution of labor for capital. Moreover,inefficient banks always appear to have lower levels of equity/assets andhigher levelsof nonperforming loans. Their finding also suggested that efficient banks areassigning more attention and resources to loan origination,monitoring and other credit judgment activities.

Finally, the analysisalso shows that there is no clear relationship between the size of assets andbank efficiency. Yiweiet al. (2011), found that the average profit efficiency of Eastern Europe isclose to the Central Eastern Europe region,but average cost efficiency leaves considerable room for improvement.Theyalso found that foreign owned banks are somewhat less cost efficient thandomestic private banks. It is also evident that progress in theimplementation of major economic reforms such as enterpriserestructuring and privatization are positively associated with bankingefficiency. Moreover, banking efficiency affects the development of the capitalmarket. This highlights that the relationship betweenbanks and the capital market is both competitive and complementary.Whenbanks are very inefficient, an increase in banking efficiency actually resultsin more borrowers migrating to the capital market.

Beyond a certainpoint, an increase in the efficiency of banks attracts moreborrowers to banks. Thus, the quality cut-off that determines which borrowersgo to the market and which go to the banks is non-monotonic withrespect to bank efficiency. It may not be possible to develop agood capital market in an economy if it does not have good banks. Thus, indeveloping a financial system, the initial focus should be onimproving the efficiency of banks.  (Thakor,1998) Berger et al.

(2006), found astrong favorable efficiency effects from reforms that reduce the stateownership of banks in China and increase the role of foreign ownership. The BigFour National Banks4 are by far the least profit efficient,apparently due in large part to poor revenue performance and highnonperforming loans. The majority foreign-owned banks are also relativelyefficient. Theresults of the study conducted by Mihir et al. (2009) showed that foreign bankswere slightlymore efficient than the local public and private banks, and that there was notmuch of a differencein the efficiency of public and private banks.

Net worth was found to beunder-productive for efficient private and foreign banks, while itwas properly utilized by public banks. Thus, profitabilityof private and foreign banks is expected to be lower than that of public banks,especially in terms of return on net worth. Operating expenseswere found to be very under-productive for efficient privateand foreign banks.

 El-gamaland Inanoglu (2004) estimated the comparativecost efficiency of Turkish banks for the period 1990-2000 using the dataenvelopment analysis (DEA) method. They found that Islamic banks were moreefficient due to their asset-based financing.Samad(2004) compared the performance of Islamic banks and conventional commercialbanks of Bahrain with respect to (a) profitability, (b) liquidity,and (c) capital management. A comparison of eleven financial ratiosfor the period 1991-2001 found no difference in profitability and liquidityperformance between Islamic and conventional banks for that period.

Sufianand Majid (2006) investigated the comparative efficiency of foreign anddomestic banks of Malaysia during 2001-2005. They found thatbanks’ scale inefficiency dominated pure technical efficiency duringtheperiod. They also found that the foreign banks had higher technical efficiencythan the domestic banks.   An observation of Chowdhury (2002)was that the banking industry of Bangladesh is a combination of nationalized,private and foreign banks. Many efforts have been made to explain theperformance and efficiency of these banks. For understanding the performance ofthe bank requires knowledge about the profitability and relationship betweenvariables like, market size, bank’s risk and bank’s market size with theprofitability. In a study on Malaysian commercialbanks Mohd.

Zaini Abdul Karim (2003) found that ICT has significantly increasesthe cost efficiency after the legged period of one year. Some other studies onbanking market structure of Malaysia, such as Rostia Suhaimi(2006), AbdulGhafar Ismail (2002), found that Malaysia’s banking industry has an imperfectstructure. Van Horne & Wachowicz (2005)stated that for evaluating a firm’s financial condition and performance afinancial analyst need to perform “checkups” on various aspects of a firm’sfinancial health. A tool frequently used these checkup is financial ratio. Pandey (2006) stated that theeasiest way to evaluate the performance and efficiency of a firm is to compareits present ratio with the past ratio. It gives an indicator of the directionof change and reflects whether the firm’s financial performance has improved,deteriorated or remained constant over time.

 Small and medium sized banks fromthe early 1970’s until the early 1980’s deregulation occurred were examined byWall (1985). He found that profitable banks have lower interest rate and theirnon-interest expenses are lower than the less profitable banks. In addition themore profitable banks have had lower cost of funds, greater use of transactiondeposits, more marketable securities and higher capital.  Gup and Walter (1989) got theconsistently profitable small banks operates basic banking with low cast fundsand high quality investment. The study took under consideration the banks from1982 to 1987 during the deregulations. During this period there wereconsiderable differences between regions due to declining energy, real estateand commodity prices. During this period high quality loan was made by highperformance banks. And these banks held proportionately more capital, investedmore in more securities and relied on lower cost funding sources compared withthe average small bank.

 Chowdhury and Islam (2007) pointedthe sensitivity to the interest changes. They narrated that the deposit andloan advances of nationalized commercial banks (NCBs) are less sensitive to theinterest changes than those of specialized banks (SBs). So, SBs should not makeabrupt change in lending or deposit by following by NCBs. If NCBs changes theirlending rate their deposit or loan and advances will be affected less thanthose of SBs.

  Moreover, deposits of NCBshave higher volume and higher volatility than those of SBs. However SBs offerhigher deposit rates and charges higher lending rate than NCBs, which is whythe interest rate spread of SBs was higher than that of NCBs. Khan (2008) narrated that bank isevaluated based on profit and loss as the same way for other business. If theshareholders of the bank more profit than the bank is identified moresuccessful. Banks can attain success if relevant risks are effectivelycontrolled.  Mujeri & Younus (2009) statedthat the higher the higher and non interest income as a ratio of total assetsof banks, the lower the interest rate spread.

Similarly market share of adeposit of a bank, statutory reserve requirement and NSD certificate interestaffects the IRD. The analysis In terms of banks Group Shows that IRSsignificantly influenced by operating cost and clasifed loan of stated ownedcommercial bank and specialized banks while inflation, operating cost marketshare of deposit, statutory reserve requirement and taxes are important for theprivate commercial banks. On the other hand non interest income, inflation,market share and taxes matter for the foreign commercial banks. Another observation from theChowdhury and Ahmed (2009) is that all selected private commercial banks are ableto achieve a stable growth of branches, employee, deposit, loans and advances,net income, earning per share during the period of 2002-2006. They pointed thatthe prospect of private commercial banks in Bangladesh is very bright There has been some analysis of bank efficiency inIndia. For the most part, these analyses have used financialindicators for measuring bank efficiency as in the articles by Rammohan and Roy(2004) and Sarkaret al. (1998). Rammohan and Roy found that public sector banks are moreefficient than private sector banks in India.

In anotherstudy, Kumbhakar and Sarkar (2003) used a cost efficiency approach formeasuringbank efficiency and also concluded that private sector banks had higher levelsof efficiency in contrast to public sector banks in that country. Another group of Indian scholarsused the DEA approach in measuring bank efficiency, including Saha andRavishankar(2000), Bhattacharyya et al. (1997) and Sanjeev (2006). Bhattacharyya et al.(1997) determinedthat public sector banks were the best performing banks in India during thelate 1980s and early 1990s. Shanmugam and Das (2004)used a stochastic frontier analysis (SFA) process for measuring technicalefficiencies of Indian commercial banks and found that a group of state bankswere more efficient than a comparable group offoreign banks during a period from 1992-1999.Andries and Cocris (2010) analyzed the comparativeefficiency of banks in several southern European countriesduring the period of 2000-2006 using both DEA and SFA analytic processes.

Theyfound that banksin Romania, the Czech Republic, and Hungary all operated at relatively lowlevels of technical efficiency. Samad hasdone several evaluations of the Bangladesh banking system. Samad’s(2009) review of technical efficiencyusing data for 2000 found the average efficiency of those banks was 69.

6. Samad(2007) also examined the comparative performance of foreignbanks verses domestic banks in Bangladesh using variousfinancial ratios of bank performance and found no difference in profitperformance between domestic banks and foreign banksin the period 2000-2001. In yet another analysis, Samad (2010) estimatedthetechnical efficiency of Grameen bank micro-financing activities in Bangladeshas developed by Nobel Laureate, Dr. Muhammad Yunus.Samad(2009) has also previously examined the TE of Bangladesh banking industry, butthe current analysis isdifferent from the previous studies in several ways. First, there was nocomparison in the previous study. Second, unlike the 2009 study,this study estimates loan and deposit for technical efficiencies instead ofprofitsof the previous study. Samad (2013) investigated the efficiency of Islamicbanks using the time varying Stochastic Frontier functionon the Islamic banks of 16 countries.

Mean efficiencies between thepreglobal financial crisis and the post global crisis were estimated at 39 and 38percent respectively and the difference was notstatistically significant.                                 Chapter 3: MethodologyThe research methodology of theselected topic follows in these ways: 3.1Sample of the Study; There are 57 scheduled banks inBangladesh, within this 6 state owned commercial banks, 40 private commercialbanks that is a mix of 32 conventional private commercial banks and 8 IslamiShariah based commercial banks and the rest 9 are Foreign commercial banks.

Mystudy is on 40 private commercial banks. When choosing sample Islami Shariahbased banks are excluded from the sample because of the significant differencein operation. 21 banks are taken from among the rest 32 private commercialbanks as the sample. All the sample banks are listed in the DSE. 3.

2 Data Collection and VariablesThe study is basically based onsecondary data. For this purpose, data are collected from the annual reports ofBangladesh Bank and the sample banks for the period of last SIXyears from 2011 to 2016. Some other related websites are used to collect data.Moreover the journals, articles, reports and surveys have been referred.  Tomake the study elaborate, in depth andinformative, related financial ratios have been used as input and outputvariables.

Apart from the interest expense, operating expenses are the majorexpenditure of a bank and here fourfinancial ratios have been used to measure the efficiency in cost control, thusthree are inputand one isoutput. As a financial institution bank’s earning is the key function of it andfor this eightfinancial ratios have been used to measure the earnings efficiency. Hence seven ratiosare used as the input and the rest one is usedas the output. The financial ratios are presented below and their explanationsareto be given in the annexes.   Ratios for Cost Efficiency Input X1.

Operating Expense / Total Funds X2. Operating Expense / Interest Income X3. Operating Expenses / Interest Expense   Output Y1. Operating Expense/ Profit Before Provisions   Ratios for Earnings Efficiency Input X1.  Interest Income / Total Loan X2.

Operating Profit / (Total Interest + Investment Income) X3. Profit before Provision / (Total Interest + Investment income) X4. Return from Investment/ Total Investment X5. Interest Expense / Interest Income X6. Other Income / Total Interest Income X7. Operating Expense / Interest Income   Output Y1.

Net Income after Tax / Total Earnings

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