Academic journal article Academy of Banking Studies Journal

An Analysis of Alternative Profit Efficiency Scores and Financial Ratios: Does Bank Size Matter?

Academic journal article Academy of Banking Studies Journal

An Analysis of Alternative Profit Efficiency Scores and Financial Ratios: Does Bank Size Matter?

Article excerpt

INTRODUCTION

Although there is probably no one correct measure of performance, the area of performance measurement can be divided into two rather large streams of research: bank efficiency measures and accounting-based financial ratios. Thus, determining the correct performance measure of a bank operating in the United States today is a diverse and complicated issue. The two performance measures mentioned above may seem varied and appear to utilize different information, which is why most previous studies investigate these areas in isolation. This paper merges the topics of bank efficiency and accounting-based financial ratio performance and examines the relationship between these seemingly separate areas to determine when and if they should be used in combination.

This study involves a multi-stage process. Stage one is the calculation of alternative profit efficiency scores, using the stochastic frontier approach (SFA), for all banks operating in the United States during the years 1996 and 1999. This model is termed the national model per Mester (1997) due to the fact that all banks, for which sufficient data are available, are used to estimate the efficient alternative profit frontier. Stage two involves gathering and/or calculating financial ratios that are, according to previous research, highly correlated with each of the CAMELS rating components used by financial regulators. Stage three involves the use of multiple regression to determine 1) if a relationship exists between the chosen financial ratios, which serve as a proxy for the publicly unavailable CAMELS ratings, and the alternative profit efficiency scores and 2) the strength and direction of the aforementioned possible relationship.

It is hypothesized that accounting-based financial ratios utilized by various financial institution examination agencies in the formulation of CAMELS ratings provide significant information regarding the efficiency measure of a bank. It is further hypothesized that different types of relationships will exist among banks of varying asset size. If different relationships do exist, this will shed new light on the issue proposed by many researchers regarding the use of efficiency measures as complements to CAMELS ratings in the financial institution examination process. The results of this paper will be of interest to many parties due to the fact that determining a correct measure of bank performance must take into account the high degree of competitiveness, technological change, customer-base diversity, and other areas of the firm's operating environment found in the U.S. banking industry.

LITERATURE REVIEW

While the area of production frontiers was introduced by Farrell (1957), the stochastic frontier, also called the composed error, is relatively new having been introduced by Aigner, Lovell and Schmidt (1977) and Meeusen and van den Broeck (1977). Many of the first papers on this topic were applied to manufacturing data, as were other efficiency methods. Much study has taken place regarding the early problems associated with this method. (See also Battese and Corra (1977), Lee and Tyler (1978), Stevenson (1980), Pitt and Lee (1981), Kalirajan (1982), Bagi and Huang (1983), Schmidt and Sickles (1984), Waldman (1984), and Battese and Coelli (1988) for early examples of SF estimation.) Stochastic frontier analysis (SFA) is today, however, one of the most popular efficiency estimation techniques due in part to its robustness and relative ease of use.

Among the first to examine the relationship between financial performance, measured by accounting-based ratios, and production performance proxied by efficiency indices, are Elyasiani, Mehdian, and Rezvanian (1994). They find a significant association between financial ratios and bank efficiency and suggest that efficiency analysis should be considered as a supplement to financial ratio analysis by regulatory agencies and bank managers. …

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