Academic journal article Journal of Money, Credit & Banking

Technical Progress, Inefficiency, and Productivity Change in U.S. Banking, 1984-1993

Academic journal article Journal of Money, Credit & Banking

Technical Progress, Inefficiency, and Productivity Change in U.S. Banking, 1984-1993

Article excerpt

The U.S. banking industry has had a tumultuous decade. Although large numbers of bank failures during 1985-91 have since given way to record profits, researchers continue to debate whether the industry faces long-term decline (for example, Wheelock 1993; Boyd and Gertler 1994; Berger, Kashyap, and Scalise 1995). From a post-World War II high of 15,126 banks in 1984, failures and acquisitions reduced the number of U.S. commercial banks to 9,490 by the end of 1996. Much of this decline can be attributed to the disappearance of very small banks, that is, those with assets of less than $100 million. Historically, small banks have been more profitable than large banks. As recently as 1982, average profit rates (return on average assets) were inversely related to bank size.(1) By 1995, however, this pattern had completely reversed, with a positive association between size and profit rates for banks of under $15 billion of assets.

In their comprehensive review of the ongoing transformation of the U.S. banking industry, Berger, Kashyap, and Scalise (1995) describe the technological and regulatory changes driving consolidation of the U.S. banking industry. Among these are rapid advances in computer and communications technology, which have led to the development of new bank services (from ATM machines to internet banking) and financial instruments (for example, various sorts of derivative securities), as well as increased competition from nonbank financial firms and markets. Perhaps even more important have been changes in regulation, including the deregulation of deposit interest rates, revisions to capital requirements, and elimination of many state and, beginning in 1997, federal restrictions on branch banking.

The many technological and regulatory changes affecting banking in recent years have substantially altered the environment in which banks operate. Such changes may have significantly altered the technology of bank production, with possible consequences for the long-run viability of the industry. Numerous studies, based largely on data from the 1980s and early 1990s, have found that commercial banks tend to suffer from substantial managerial inefficiency. That is, the average bank operates considerably less efficiently than the existing technology allows, as estimated by the operations of the most efficient banks [see Berger and Humphrey (1997) for a survey of this literature]. By itself, efficiency can be a misleading measure of the well-being of either a bank or an industry, however, particularly for one undergoing a major environmental transformation. Rapid technical progress, for example, which makes feasible the production of given levels of outputs with fewer inputs (or, equivalently, the production of more outputs with given levels of inputs) than in the past, could result in lower average bank efficiency, even if banks became increasingly productive over time.(2)

Whereas most studies of efficiency in banking have failed to consider the effects of technical change, studies of technical change in banking have typically failed to isolate shifts in the efficient frontier from changes in average inefficiency. Two important exceptions are Bauer, Berger and Humphrey (1993) and Berger and Mester (1997). Bauer et al. separate changes in average inefficiency from changes in scale economies for banks operating on the efficient frontier to come up with a measure of total factor productivity. For a panel of banks with assets of more than $100 million during 1977-88, Bauer et al. find little change in average inefficiency, but a noticeable decline in productivity over the period, which they attribute to deregulation and increases in competition, both among banks and from nonbank sources. Berger and Mester (1997) find that cost productivity continued to decline into the 1990s because of both an upward shift of the cost frontier and increased average inefficiency. Profit productivity rose, however, caused mainly by an outward shift in the efficient profit frontier. …

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