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COST EFFICIENCY IN GREEK BANKING

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Niveau: Supérieur, Doctorat, Bac+8
COST EFFICIENCY IN GREEK BANKING Nicos C. Kamberoglou Bank of Greece, Statistics Department Elias Liapis Bank of Greece, Economic Research Department George T. Simigiannis Bank of Greece, Statistics Department Panagiota Tzamourani Bank of Greece, Statistics Department ABSTRACT This study uses the distribution free approach to investigate cost efficiency in a panel of Greek banks over 1993-1999, a period characterized by major changes in the banking sector brought about by gradual financial deregulation. These reforms were supposed to provide an opportunity to Greek banks to improve their efficiency and to enhance their competitiveness in view of ongoing financial integration in Europe and the introduction of the euro. The results obtained indicate that important cost X-inefficiencies are in place. Some evidence is provided that bank characteristics such as bank size, type of ownership and risk behaviour do play a role in explaining differences in measured inefficiencies. Scale economies are also examined and the findings indicate that the Greek banking industry experiences economies of scale, though they have declined throughout the observed period. This suggests that competitive viability may be an important factor for further consolidation in the Greek banking industry. Keywords: X-efficiency, scale economies, panel data JEL classification: C33, G21, G28 The authors wish to thank Heather Gibson and Martin Knott for helpful comments. The views expressed are those of the authors and do not necessarily reflect those of the Bank of Greece.

  • international financial

  • economic research

  • banks themselves

  • greek banks

  • gradually emerged

  • greek banking

  • determined bank

  • capital market

  • market along

  • financial system


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COST EFFICIENCY IN GREEK BANKING
Nicos C. Kamberoglou
Bank of Greece, Statistics Department
Elias Liapis
Bank of Greece, Economic Research Department
George T. Simigiannis
Bank of Greece, Statistics Department
Panagiota Tzamourani
Bank of Greece, Statistics Department

ABSTRACT
This study uses the distribution free approach to investigate cost efficiency in a panel of
Greek banks over 1993-1999, a period characterized by major changes in the banking sector
brought about by gradual financial deregulation. These reforms were supposed to provide an
opportunity to Greek banks to improve their efficiency and to enhance their competitiveness
in view of ongoing financial integration in Europe and the introduction of the euro. The
results obtained indicate that important cost X-inefficiencies are in place
.
Some evidence is
provided that bank characteristics such as bank size, type of ownership and risk behaviour do
play a role in explaining differences in measured inefficiencies. Scale economies are also
examined and the findings indicate that the Greek banking industry experiences economies of
scale, though they have declined throughout the observed period. This suggests that
competitive viability may be an important factor for further consolidation in the Greek
banking industry.
Keywords
: X-efficiency, scale economies, panel data
JEL classification
: C33, G21, G28
The authors wish to thank Heather Gibson and Martin Knott for helpful comments.
The views expressed are those of the authors and do not necessarily reflect those of
the Bank of Greece.
Correspondence:
Panagiota Tzamourani
Statistics Department,
Bank of Greece,
21, E. Venizelos Avenue,
102 50 Athens, Greece
Tel. +30210 3202441, Fax +30210 3233025
e-mail: ttzamourani@bankofgreece.gr

1. Introduction
During the last two decades, financial sectors have undergone profound
changes worldwide. Deregulation of financial systems and liberalisation of external
transactions, as well as the application of advanced information and communications
technologies have all intensified competition among institutions in local and
international financial markets and paved the way for the introduction of new
financial instruments and practices. Indeed, the way that banking is conducted was
gradually altered and the technology of bank production was significantly modified.
As a result, banking systems internationally have entered an era of restructuring and
reorientation of their activities. Similar developments were also observed in the Greek
banking system, as Greek banks had to adjust to the new conditions that resulted from
the gradual liberalisation of the domestic financial market and the completion of the
European internal market and, thus, to the increasingly competitive environment in
recent years. This trend is expected to continue as the number of non-bank
competitors increases and competition from foreign, and in particular from European
banks, picks up, mainly in response to the introduction of the common currency and
the initiatives taken by the European Commission in the context of the Financial
Services Action Plan to remove remaining obstacles to the European financial
integration, but also in response to the general globalization of markets.
In this regard, a frequently asked question is about the effect(s) of these
changes on Greek banks and, more precisely, how Greek banks will be affected by the
intensified competitive pressures. In other words, concerns raised about the long-run
competitive viability of various Greek banks in the new environment that has
gradually emerged. The answer to this question depends at least in part on how
efficiently they are run. Accordingly, the objective of this paper is to investigate the
efficiency of Greek banks and how it has developed in recent years. More specifically,
our aim is to shed light on the following: (1) whether all banks are cost efficient, that
is whether all banks operate on or close to the best practice cost frontier; (2) whether
larger banks enjoy a cost advantage over smaller competitors, that is, whether the
system is characterized by important economies of scale; and (3) whether factor
productivity has changed over time, that is, whether banks have benefited from
technical progress.

2

Previous research in Greek banking provides some contradictory evidence on
scale economies. A study by Karafolas and Mantakas (1996), who used a sample of
11 Greek banks over the period 1980-89, did not find any significant total cost scale
economies, although operating cost economies of scale were estimated to be
statistically significant. Eichengreen and Gibson (2001) investigating the profitability
of 25 Greek banks over the period 1993-98 found evidence of a bell-shaped
relationship between profitability and bank size, implying that profitability initially
increases and then declines as bank size increases. More specifically, their results
indicate that when profitability is measured by the rate of return on assets, ROA, scale
economies are exhausted at around the average size of banks in their sample, which is
indeed very low by European standards. On the other hand, when profitability is
measured by the rate of return on equity, ROE, their estimates suggest that banks of
all sizes may reap scale economies. More recently, Athanasoglou and Brissimis
(2003), comparing operational costs across banks of different size, concluded that for
the period 1994-97 economies of scale are present in the case of small and medium
size banks, but diseconomies of scale exist for large banks, whereas for the period
2000-02 economies of scale were found for all banks. On the other hand,, it has been
widely recognized that for a group of banks of similar size that show greater
dispersion of average costs (or profits) than banks of different sizes, X-efficiency is a
much more important source of cost reduction (or profit increase) than achieving an
optimum size of production to minimize average costs (see Maudos
et al
2002). To
our knowledge, there have been only two previous studies on the cost efficiency of the
Greek banks. The paper by Noulas (1997) was limited to the pre-1993 period and thus
it is of little relevance to the current study. Christopoulos, Lolos and Tsionas (2002)
however examined the cost efficiency of Greek banks in the 1993-1998 period, using
a heteroskedastic stochastic frontier approach. Given the liberalization of the banking
activities and the significant bank mergers that took place in the 90s, our paper
explores further cost efficiency, this time extending the sample period to 1999 and
using a different model. In addition, we try to explain the estimated inefficiencies in
terms of various bank characteristics.
The paper is structured as follows. Section 2 describes briefly the liberalisation
of Greek financial system and how this has affected banking structure and operations.
Section 3 provides an overview of the methodology used to investigate cost

3

efficiency. Section 4 presents the theoretical model and discusses data problems.
Section 5 discusses the main empirical findings and Section 6 concludes.
2. Deregulation and restructuring of the financial system
Until the mid-1980s, the banking system in Greece was used as a means of
implementing economic policy and promoting, mainly, industrial development, by
applying a highly complicated system of selective credit controls and regulations
along with a wide range of administratively-determined bank interest rates. In
practice, however, that system proved to be ineffective and led gradually to allocative
inefficiencies and to serious distortions in the functioning of the financial system. The
creation of a modern, market-oriented system necessitated the liberalisation of interest
rates, the deregulation of the domestic market and the lifting of restrictions on
external transactions.
By the early 1990s, bank interest rates had been gradually liberalised and all
quantitative credit restrictions and investment requirements concerning the financing
of specific economic sectors, notably the public sector, had been phased-out.
Moreover, the central bank had authorised the introduction of new financial products,
such as leasing, factoring, forfaiting and venture capital, while specialised credit
institutions had been given permission to expand their activities to sectors formerly
open only to commercial banks and vice versa. At the same time, restrictions on
capital movements and current transactions were also gradually lifted. Thus banks
were increasingly able to grant loans on their own terms and differentiate their lending
rates based on liquidity and risk considerations only, as well as to choose the types of
activity on which they wished to focus, to expand their operations in preferred
segments of the market and use new techniques for hedging against interest rate and
foreign exchange risks.
Important measures were also taken to promote the operation of the capital
market and new institutions were introduced such as brokerage firms. Furthermore,
the operating framework of undertakings for collective investment in transferable
securities (UCITS) was improved and the supervisory role of the Capital Market
Committee was enhanced. As a result, the capital market gradually became an
important source of capital for the funding of enterprises as an alternative to bank

4

financing. It also became an important source of funds for the banks themselves,
especially in the late-1990s.
The environment that emerged gave impetus to the establishment and
operation of new banks, either domestic institutions or branches of foreign banks.
Indeed, from the late-1980s to the late-1990s, ten commercial banks were
incorporated in Greece
1
. In addition, since 1993 when the Bank of Greece set the
operational and supervisory framework concerning cooperative banks, fifteen
cooperative banks have been established and operate, although their market share
remains very low (less than one per cent of total assets of the banking system).
Regarding foreign banks, the picture is mixed. On the one hand, seven foreign banks
established branches in Greece from the late-1980s to the late-1990s. On the other
hand, some foreign banks, in the context of their broader strategies, have withdrawn
from the Greek market over the past few years.
Following financial deregulation and the enactment of new legislation
implementing EU directives, banks operating in Greece had to adjust to new
conditions and cope with the ensuing intensified competition, both domestically and
cross-border. Besides, the completion of the European internal market along with the
major advances in information technology and telecommunications, which have led to
the globalisation of the financial services market, necessitated the reorientation of
banks activities and resulted in a restructuring of the banking system. Another factor
putting pressure on banks was the increasing role of institutional investors, which
made it more difficult for the former to attract deposits and, consequently, induced
banks to search for alternative sources of funds and for ways of reducing their
operating costs.
Moreover, Greek banks pursued restructuring policies in order to become
more efficient and obtain a size that would enable them to increase or, at least,
maintain their domestic market shares, facilitate their access to international financial
markets and exploit any possible economies of scale. To this end, since the mid-1990s
several Greek banks have been involved in mergers and acquisitions. Most of them
concerned the domestic market, including not only banks but also non-bank financial
enterprises. Some large credit institutions opted to merge with their subsidiaries with a
view to restructuring their activities and cutting their operating expenses. Others have


1 Six more banks were incorporated in the early 2000s.

5

forged strategic alliances with major European institutions in order to benefit from the
latters kno-whow, large branch network and presence in international financial
centres. Some Greek banks have also expanded their operations in countries to the
wider area of south-eastern Europe, notably in the Balkans, either via subsidiaries or
through the establishment of branches.
At the same time, Greek credit institutions have taken important steps towards
improving their efficiency by installing modern information technology systems,
cutting their operating costs and improving their organisational structure, while they
have extended their scope of business by offering new products and services. They
have merged their subsidiaries engaging in the same line of business and integrated
several of their activities in an effort to reduce costs and improve control and service
quality. Additionally, several banks have tried to expand or further develop their
activities in such sectors as bank assurance, where they can profit from synergies and
cross-selling by both bank networks and insurance companies.
Another very important aspect on which Greek banks have focused their
attention is on the branch network and alternative distribution channels. Branches
offer the advantage of (physical) proximity to customers, especially in retail banking.
On the other hand, the maintenance of an extensive branch network entails high
operating costs, with negative implications for bank efficiency. Technological
advances have allowed banks to develop remote banking channels: ATMs, telephone
banking, online PC banking and Internet banking, the first two being the most
commonly used in the Greek market at present. During the 1990s, the number of bank
branches operating in Greece almost doubled, from 1,529 in 1990 to 3,004 in 2000,
2mainly reflecting the relatively low level of branching in the past. In the same period,
the number of ATMs exhibited a remarkable increase, from 326 in 1990 to 3,472 in
2000. In addition, new technologies changed the way in which bank branches are
organised, by favouring the operation of smaller branches with fewer but more highly
qualified staff, focused on a better promotion of bank products and meeting of
customers needs .
Mergers and acquisitions have resulted in higher concentration in the banking
industry: the market share of the top-5 banks as a percentage of total assets rose from


2
It is worth noting that in terms of inhabitants per branch the Greek credit system is still underbranched
as compared to other EU countries. This is not, however, the case when GDP per branch is taken into
account.

6

57% in 1995 to 65% in 2000. This, however, has not led to less competition, as
evidenced by the reduction in interest rate spreads, especially in the segments of
consumer and housing loans, in the past few years, which can only partly be attributed
to convergence to the rates prevailing in the eurozone. Accordingly, this indicates
that, if anything, oligopolistic rents have been reduced in Greek banking.
The privatisation of several banks controlled by the Greek State was another
important development in the second half of the past decade, which also contributed
to the enhancement of competition in the market. In the period 1995-2000, the market
share of the State-controlled banks fell by almost 20 percentage points, from 72.3% in
1995 to 52.9% in 2000.
3. Efficiency measurement
To evaluate the effects of the banking sector reforms, the frontier of the most
efficient practices should first be estimated (as a function of the relevant variables),
and then one can measure how far from this frontier the efficiency levels of different
institutions or groups of institutions are.
3
Efficiency can be measured in terms of
profits, costs or revenues. Studies in bank efficiency are usually based on costs.
Profits and revenues are more vulnerable than costs to extraordinary factors that can
affect disproportionately different institutions or categories of institutions. In addition,
financial sector reforms in Greece had a relatively moderate impact on bank
profitability, given that the pressures to achieve cost efficiency were to some
important extent offset by the lower margins resulting from fiercer competition, as
indicated in the next section. That is, the welfare gains from financial reforms to a
large extent accrued to users of bank services. For these reasons, the particular
approach used here is based on cost efficiency.
A firm is said to be cost efficient if it produces a given volume of output at the
least possible cost. Thus, cost efficiency is directly related to the firms cost
minimisation objective. Deviations from this minimum thus determine cost
inefficiencies. Hence, realised cost can be defined as a function of the output vector,
the price of inputs, the level of cost inefficiency and a set of random factors. In
logarithimic terms, realised cost, y, can be expressed as follows:

3
Berger and Humphrey (1997) survey a large number of studies of bank efficiency based on this
approach.

7

y = f(x, w) + u + v

(1)
where x is the output vector, w the input prices vector, u the level of cost inefficiency
and v a random error term.
The problem of measuring cost inefficiency is to isolate it from the effect of
random factors on production costs. At least four cost frontier methods have been
used to measure inefficiencies in studies of the banking sector: the stochastic frontier
approach, the distribution free approach, the thick frontier approach, and the data
envelopment analysis.
4
As the efficient cost frontier is not
a priori
known, the
objective of these approaches is to estimate it by using the data. However, each
approach is based on different assumptions and thus may lead to quite different
results.
The stochastic frontier approach assumes that deviations of realised cost from
the cost frontier are due either to cost inefficiency or to random fluctuations or both.
The inefficiencies are usually assumed to follow a truncated normal distribution,
whereas the random fluctuations are assumed to be normally distributed.
Although the stochastic frontier model gives inconsistent estimators when
cross-sectional data are used for the estimation of the cost frontier, many of its
assumptions can be relaxed when panel data are used. According to Schmidt and
Sickles (1984), a data panel enables standard models of fixed and random effects to be
estimated without needing to make any assumption about the distribution of the
inefficiency term, provided that efficiency is constant over time. This method is thus
known as the 'distribution free' approach and it was first used by Berger (1993) in the
banking industry context. In the case of a fixed effects model, a bank specific
constant is taken to be the bank's measure of inefficiency, while in the case of a
random effects model the average predicted residual for each bank in the panel is the
estimate of that bank's average inefficiency.


4 Most earlier studies of bank efficiency, and in particular those dealing with the efficiency implications
of bank mergers, are based on inter-temporal comparisons of simple financial ratios, such as operating
costs divided by total assets, or the return on equity or assets, see for example Rhoades (1986) and
Srinivasan (1992). However, there are several problems with these studies. As noted by Berger
et al

(1993, p. 233) first and foremost, financial ratios may be misleading indicators of efficiency because
they do not control for product mix or input prices, as is the case with frontier methods. By comparing
cost-to- asset ratios inter-temporally, it is implicitly assumed that all assets are equally costly to
produce (and all locations have equal costs of doing business). In addition, the use of a simple ratio
cannot distinguish between X-efficiency gains and scale and scope efficiency gains. For a more recent
survey of studies on financial institutions efficiency, see Berger and Humphrey (1997).

8

The thick frontier approach (Berger and Humphrey, 1991; Humphrey, 1993)
attempts to reduce the impact of outliers in estimating the cost frontier and identifies a
'thick frontier' consisting of those firms which are on the frontier plus those close to it.
The thick frontier method selects a larger subset of firms with only low costs -
typically the quartile of firms with the lowest average cost - and estimates the 'thick'
cost frontier from a standard regression using only these observations. Similarly the
high cost frontier is determined from the quartile of firms with the highest average
costs. Inefficiency is measured as the range between these two frontiers.
Finally, the data envelopment analysis has also been used extensively in
banking studies. As against the three previous methods, this is a non-parametric
approach that maximises a function of weighted inputs and outputs subject to given
restrictions. It has the advantage that the efficient frontier is estimated solely on the
basis of the data, without requiring the specification of a particular form for the cost
function or the imposition of any distributional assumptions about the error term
and/or the inefficiency term, which may not be met in practice. Being deterministic,
this model does not allow for error. All deviations from the frontier are considered as
inefficiencies. This often results in their overestimation (Lozano-Vivas, 1998), as the
method is very sensitive to extreme observations (outliers), to measurement errors and
to the number of constraints specified.
There is no consensus in the literature as to which method should, in general,
be preferred. The choice usually depends on the available data. However, parametric
models are considered to be relatively more robust and for this reason such a model
will be used in this study. In particular, the fixed effects model proposed by Schmidt
and Sickles (1984) is used as it requires fewer assumptions and it is thus more
appropriate for a relatively small panel. This model was recently applied by Maudos
et al
(2002) to measure the efficiency of European banks.
The general form of the model to be estimated is the following:
y
it
1
a
#
X
'
it
b
#
v
it
#
u
i
(2)
where i=1,,N indexes the banks and t=1,,T indexes the time periods. In the case
of a translog cost function y
it
will be the log of cost, X'
it
a vector of the relevant
independent variables (in logs) and v
it
the random errors. The v
it
are uncorrelated with
the regressors X
it
. The u
i
represent technical inefficiency and thus u
i
= 0 for all i. In
addition, u
i
are assumed to be iid with mean µ and variance s
u2
and independent of the

9

v
it
. A particular distribution may or may not be assumed for the u
i
. If we let E(u
i
) = µ
> 0 and define a* = a +µ and u
i
* = u
i
- µ, so that the u
i
* are iid with mean 0, the
model can be rewritten in the following way:
y
it
1
a
*
#
X
'
it
b
#
v
it
#
u
i
*
(3)
Both the error terms v
it
and u
i*
now have zero means, and all results of the
panel data literature apply directly, with the exception of those that require normality.
** Letting a
i
= a +u
i
= a +u
i
the model becomes
y
it
1
a
i
#
X
'
it
b
#
v
it
(4)
Treating u
i
as fixed, a separate intercept for every bank can be estimated, as
above. A frontier can be estimated using the fact that u
i
= 0 for all i. If the N estimated
intercepts are a
1
,a
i
, a
N,
the frontier can be simply defined as a = min (a
i
) and the
estimated inefficiency of each bank as û
i
= a
i
- a. The estimates
a
and
û
i

are
asymptotically consistent (see Schmidt and Sickles (1984)). Since in the linear form
of the cost function the variables are the logs of the initial variables, taking the
exponents of the (-û
i
)s gives each banks (estimated) efficiency,
i,
E as a ratio of the
minimum cost to produce the output vector, Y
min
, to each banks realised cost,
i
Y
(i.e. E
i
= (Y
min
/Y
i
) = exp(-û
i
)).
4. Model specification and data
4.1 The model
In estimating a cost function it is important to distinguish between a firms
inputs and outputs. In the case of banks, this is not an easy job, given their important
role in intermediating between lenders and borrowers (i.e. between financial savings
and investments) and in providing financial services to their customers. Thus, in
estimating a banks cost function, two approaches have been proposed: the
production approach, and the intermediation approach .
According to the production approach, banks use capital and labour as
inputs to produce individual accounts of various sizes and incur operating costs in the
process. (Benston (1972), Benston
et al
(1983), Mester (1987), Hunter
et al
(1990)).

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