Bank Efficiency and the Effectiveness of Monetary Policy

By Jonas, Michael R.; King, Sharmila K. | Contemporary Economic Policy, October 2008 | Go to article overview
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Bank Efficiency and the Effectiveness of Monetary Policy

Jonas, Michael R., King, Sharmila K., Contemporary Economic Policy


This paper examines how bank efficiency affects the bank lending channel of monetary policy transmission. We define efficiency as providing more financial services output per unit of input, that is, a larger marginal product at every input level, and calculate efficiency using stochastic frontier analysis. Measuring efficiency as cost-efficiency, we find evidence suggesting that more efficient banks experience a larger loan response to policy than less efficient banks of the same size. This discrepancy is due to a larger elasticity of loan supply. The more efficient bank has a steeper production function and therefore a flatter marginal cost curve and a more elastic loan supply curve. This increased flexibility in the production process allows more efficient banks to have a larger and more rapid response to a policy induced change in the cost of acquiring loanable funds.

The U.S. banking industry is vastly different than it was 20 yr ago. Up until the 1980s, the number of commercial banks ranged between 13,000 and 15,000. During the mid-1980s, the number of commercial banks declined to below 10,000 (Mishkin, 1996). Banks have been consolidating for efficiency gains. There are a number of reasons for bank consolidation, which are the following: changes in regulation, (1) scale economies, technological and financial innovations, (2) and increasing pricing power. Large banks have become financial supermarkets, while smaller community banks still offer a narrow range of service-intensive products.

Financial innovations resulting in new financial instruments such as commercial paper and money market mutual funds diminished the profitability of traditional banking (Mishkin and Strahan, 1999; Samolyk, 2004). In response to declining profitability, the banking industry has had to control costs and expand its traditional financial intermediation role by pursuing off-balance sheet activities or stand by letters of credit (Samolyk, 2004; Siems and Clark, 1997). One measure for the increase in off-balance sheet activities is the ratio of noninterest income to total income. The ratio of noninterest income to total income for U.S. commercial banks from 1960 to 1980 averaged 19%. From 1980 to 1996, this ratio increased to 35% (Siems and Clark, 1997).

The surge in the number of bank mergers and rapid advances in technology have increased productive efficiency and the ability of banks to serve geographically distant customers (Berger and De Young, 2002; Peterson and Rajan, 2002). Typically, increases in competition between banks and technology increase productivity and efficiency in banking. (3) The effect of efficiency on the transmission of monetary policy is still an open question. This paper examines how efficiency levels in the U.S. banking sector influences the effectiveness of the lending channel of monetary policy.


This paper uses cost-efficiency as a measure of operating efficiency. Cost-efficiency measures the amount of output obtained from an additional dollar spent on input. (4) Scale or size efficiency is associated with increasing production and declining production costs, while scope efficiency refers to efficiency gains from product mix. There are many small banks and few large banks in the United States. Since banks in the United States vary dramatically in size and product mix, an estimate or comparison of scale efficiency across banks would be inappropriate for our analysis. A cost-efficiency model accounts for bank expenses and product mix and is a better measure of comparing efficiency across banks (Kwan, 1997; Spong, Sullivan, and De Young, 1996).

Banks must increase efficiency in order to remain competitive. Technological innovation and bank consolidation help improve efficiency. Bank consolidation helps improve efficiency through scale economies. Advances in technological innovation lower transactions costs and informational asymmetries associated with lending (Mishkin and Strahan, 1999), thereby improving efficiency.

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