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IJPPM
59,5
432
Ioannis E. Tsolas
National Technical University of Athens, Athens, Greece
Abstract
Downloaded by Independent University At 00:47 29 November 2014 (PT)
Purpose The purpose of this paper is to provide a framework for evaluating the overall
performance of bank branches in terms of profitability efficiency and effectiveness.
Design/methodology/approach Applying a two-stage DEA model to a sample of bank branches
of a large commercial bank in Greece this study disaggregates overall performance into profitability
efficiency and effectiveness.
Findings The results indicate that superior insights can be obtained by employing the proposed
two-stage DEA model compared to the outcomes from the analysis based on selected key performance
indicators (KPIs). Some relations between profitability efficiency and effectiveness are also
investigated.
Originality/value The study highlights the importance of encouraging increased profitability and
efficiency throughout the branch network of the commercial bank under study.
Keywords Banking, Banks, Process efficiency, Organizational effectiveness, Data analysis, Greece
Paper type Research paper
1. Introduction
To maintain viability and to improve competitiveness, commercial banks in Greece are
currently restructuring the operation of branch networks. Branches are a major
delivery vehicle of business volume in banking and the performance of the branch
network is bound to have a significant impact on the bank performance as a whole.
The Greek financial system is dominated by banking institutions. In the end of
2006, domestic commercial banks controlled approximately 86.5 per cent of the total
asset pool, followed by foreign owned banks operating in Greece (10.1 per cent),
cooperative banks (0.8 per cent) and special credit organizations (2.6 per cent) (Bank of
Greece, 2007). The banking sector has significant growth potential since Greek banks
have a lower branch density relative to population compared to the Eurozone average
(3.2 versus 5.4 branches per 10,000 inhabitants). As they conduct a relatively smaller
business volume from their branch networks, profitability and size can be improved by
a concerted effort to expand their network and increase their services penetration in the
economy.
The problems that Greek banks face are related to the declining income to cost ratio,
the low turnover of the retail network, the high percentage of non-performing loans, the
lengthy legal bankruptcy procedures that lower the value of collateral in case of
default, and the high cost of capital. They also face competition from foreign banks
that have a significant edge in terms of banking know-how and technology
(Hardouvelis et al., 2006).
The banks are forced to re-evaluate their branch networks in order to identify the
business drivers and improve the performance of their branches. The availability of
performance analysis tools of bank networks can contribute positively in this effort.
Among them a linear programming-based benchmarking technique, called data
envelopment analysis (DEA), has been gaining increasing popularity as a viable
technique for the analysis of branch performance. The employment of such a technique
can assist in restructuring branch networks by gaining insight into the operation of the
branches so that managerial actions can be taken to improve their performance (Berger
and Humphrey, 1997; Oral and Yolalan, 1990; Sherman and Gold, 1985; see also
Manandhar and Tang, 2002).
DEA has successfully been used to provide bank branch benchmarks, when
multiple outputs and multiple inputs are considered. However, even though some DEA
models appeared in the literature address issues of profitability and effectiveness (Ho
and Zhu, 2004), most DEA models developed to assess bank branch performance do
not assess both profitability and effectiveness as different dimensions of performance.
This paper aims to provide a framework for evaluating the overall performance of
bank branches in terms of both profitability efficiency and effectiveness. The case
study presented here concerns a sample of branches of a large commercial Greek bank
(henceforth simply The Bank). We focus on the branch network, since The Bank
that provided the data set used in this study was interested in gaining insights into the
performance of its network of branches as a first step in comparing the results of a
DEA assessment with the results of an in-house performance measurement model
(referred to as PMM henceforth).
The current study deviates from previous studies in several respects. First, we focus
separately on both profitability efficiency and effectiveness, as components of a new
overall performance metric concept. This is the overall performance
(profitability-effectiveness measure) extracted from the DEA-profitability efficiency
and DEA-effectiveness measures. Our findings provide direct guidance for the optimal
deployment of cost input categories and the scale of outcomes produced in terms of
income categories and net income. In particular, we aim at answering the following
three questions:
(1) What is the most efficient level of cost categories in generating income?
(2) What is the most efficient level of income (interest and non-interest) in
generating profits?
(3) Is there a correlation between bank branch profitability efficiency and
effectiveness?
Second, the research is designed to measure the branch-level profitability efficiency
and effectiveness of The Bank compared to the in-house PMM by answering one more
question:
(4) Is there a correlation between DEA measures and PMM outcomes?
In Section 2 we include a brief review of the relevant literature. Section 3 provides the
conceptual framework and briefly outlines the DEA methodology and the proposed
models. The data sources along with identification of inputs and outputs for the case
study are reported in Section 4. Section 5 discusses the findings from the empirical
analysis. Section 6 concludes the paper.
Modeling bank
branch
profitability
433
IJPPM
59,5
434
Inputs
Radial: CCR-O
Radial: BCC-I
Radial: BCC-I
Radial: BCC-I
Radial: BCC-I
PA
PA
TE
IA
PA
Non-radial: BCC
IA
Radial: CCR-I
Radial: CCR-I
PA
PA
Radial: CCR-I
PA
PA
171
44
44
44
47
47
68
68
17
20
Notes: PA: Production approach; IA: Intermediation approach; TE: Transaction efficiency (Giokas, 2008a), CCR-I: CCR (Charnes et al., 1978) input-oriented model,
CCR-O: CCR output-oriented model, BCC-I: BCC input-oriented model
Giokas (2008b)
Giokas (2008a)
Athanassopoulos and
Giokas (2000)
Transactions
Outputs
Publication
Efficiency measure
(DEA model: type and
Approach orientation)
Modeling bank
branch
profitability
435
Table I.
Studies of DEA applied to
branch banking in Greece
with their specific
features
IJPPM
59,5
436
measure the performance of Taiwans commercial banks. Related studies are those by
Zhu (2000) to analyze the financial efficiency of firms, Sexton and Lewis (2003) to
measure the efficiency of the American Major Baseball League, Chen and Zhu (2004) to
measure information technologys indirect impact on firm performance, Kao and
Hwang (2008) to decompose the efficiency of non-life insurance companies in Taiwan
into the product of the efficiencies of the two sub-processes, and Chen et al. (2009) to
examine relations and equivalence between the approaches of Chen and Zhu (2004) and
Kao and Hwang (2008).
Figure 1.
Profitability efficiency
(stage 1) and effectiveness
(stage 2)
minimum of total income to generate net income. The above analysis shows that
overall performance is disaggregated into profitability efficiency and effectiveness.
This approach accounts for the possible trade-off between profitability efficiency and
effectiveness in bank branch operation.
The operationalization of overall performance model, i.e. the specification of inputs
and outputs for each individual model, and their integration to reflect the causal
relationship among the performance dimensions is shown in Figure 1.
The causal relationships are operationalized by specifying the outputs of one
model (stage 1) as inputs to another (stage 2). The output of profitability efficiency
model, which is specified as the aggregate measure of total income to total cost ratio, is
an input to the effectiveness model. The outputs of profitability efficiency model
positively influence effectiveness and hence they are inputs to effectiveness model.
Our sample as described in section 4 includes branches of various sizes, hence, the
variable returns to scale (VRS) model, accounting for possible scale effects, is a natural
choice (see also Paradi and Schaffnit, 2004). Since the branches typically have little or no
direct control over the demand for services required by their customers, input-orientation
was chosen for the first (profitability efficiency) model presented in this study. For the
effectiveness approach we retain the same model orientation in order to investigate
whether the branches use the efficient level of income (interest and non-interest) in
generating profits.
For the identification of best-practice branches for each dimension the input
minimization BCC (Banker et al., 1984) model (2) is used.
Given a set of n decision making units (DMUs), i.e. bank branches, j 1, . . . , n, utilizing
k
quantities of inputs X [ (m
to produce quantities of outputs Y [ ( , we can denote xij and
th
th
yrj the amount of the i input and r output respectively used by the jth DMU.
The following VRS input oriented value-based model (Thanassoulis, 2001) can be
used to assess efficiencies.
Max h
k
X
mr yrj0 v
r1
s.t.
m
X
vi xij0 1
i1
k
X
mr yrj 2
r1
m
X
vi xij v # 0
i1
j 1; 2; :::; j0 ; :::; n
mr $ 1
r 1; 2; :::; k
vi $ 1
i 1; 2; :::m
v free on sign
Modeling bank
branch
profitability
437
IJPPM
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438
where:
1 . 0 a convenient small positive number (non-Archimedean), see also Charnes
et al. (1994).
mr
vi
We can use the model (2) to identify the nature of returns to scale holding locally at
DMU jo in case that jo is Pareto-efficient:
.
If v , 0 in all optimal solutions to model (2) then locally at DMU jo decreasing
returns to scale hold.
.
If v 0 in some optimal solutions to model (2) then locally constant returns to
scale hold where DMU jo lies or is projected on the efficient frontier.
.
If v . 0 in all optimal solutions to model (2) then locally at DMU jo increasing
returns to scale hold.
The radial efficiency h derived from model (2) shows the rate of reduction to the input
levels of branch under evaluation. The dual of model (2) provides the slack values of
inputs (see Thanassoulis, 2001).
We use the inputs and outputs in stage 1 and stage 2 to characterize the profitability
efficiency and effectiveness, respectively (Figure 1). The overall efficiency is calculated
as the product of profitability efficiency and effectiveness, see also Ho and Zhu (2004).
4. Data sources and identification of inputs and outputs
Data on branches of The Bank for the year 2006 were collected as part of the diploma
thesis of I. Lamprinidis (2008). The Bank is one of the major commercial banks
operating in Greece and it has already developed an in-house performance model that
is based on its management information system (MIS) for assessing the
multidimensional performance of its branch network.
These data are likely to be considerably cleaner than standard banking data sets.
Our information is retrieved from the MIS of The Bank (i.e. a single bank) and refers to
a sample of its bank branches operating all over Greece. Moreover, the same data feed
the PMM, a model already in use in The Bank and the models used here.
DEA models are most meaningful when they are applied to observation sets of bank
branches providing similar services and using similar resources. The Bank uses its
PMM to classify the various branches according to their net interest income taking into
account the type and operations performed at each branch. To maintain homogeneity,
only the 50 best-in-class branches in selling loans according to PMM classification
were selected to form the observation set for this study.
As mentioned earlier we aim not only to analyze the profitability of bank branches
but also to assess their effectiveness. Therefore, two sets of inputs and outputs were
needed; one set for profitability analysis, and one for effectiveness assessment.
A slight deviation is introduced here in the specification of the output set of the
profitability efficiency model. Instead of using gross interest income with gross
non-interest income in the output side of DEA to assess the efficiency of resource use in
delivering income, as done through profitability efficiency model by Oral and Yolalan
x4 depreciation.
On the output side of profitability analysis a set of four outputs was considered;
namely:
y1 origination income generated from selling Banks assets (used as a proxy for
interest income).
y2 the outcome of a predetermined function mapping the performance of the
bank branch in giving loans to the clients.
y3 commissions.
y4 other non-interest income.
The assessment of the profitability efficiency of the bank branches is based on their
ability to generate short and long-term profits. By short-term profitability we indicate
the income from commissions that branches generate and by long-term profitability we
indicate the income from the lending activity of the branch (see also Giokas, 2008a).
Note that the inputs above correspond to major cost items of bank operations. The
output set of profitability assessment, on the other hand, included only two items
which accounted for a sufficiently large part of total income of a bank branch; interests
earned on loans (net interest income), and non-interest (gross) income (commissions
and other non-interest income). Another output, the outcome of a predetermined
function mapping the performance of the bank branch in giving loans to the clients is
considered in line with the PMM, a model already in use in The Bank.
With the above sets of inputs and outputs for profitability assessment, it is clear
that the ratio appearing in the objective functions of DEA models is nothing but the
ratio of weighted sum of incomes to weighted sum of expenses, hence an index of
profitability.
The input set for effectiveness assessment consisted of four elements:
x1 origination income generated from selling Banks assets (used as a proxy for
interest income).
x2 the outcome of a predetermined function mapping the performance of the
bank branch in giving loans to the clients.
x3 commissions.
x4 other non-interest income.
Modeling bank
branch
profitability
439
IJPPM
59,5
The output set of effectiveness assessment, on the other hand, included only one item
which accounted for the net income of a bank branch:
y1 net income.
440
With the above sets of inputs and outputs for effectiveness assessment, it is clear that
the ratio appearing in the objective functions of DEA models is nothing but the ratio of
weighted net income to weighted sum of income categories, hence an index of
effectiveness.
Descriptive statistics of inputs-outputs used in the assessment are presented in
Table II.
5. Results
5.1 Profitability efficiency
The profitability efficiency of the bank branches is assessed in the light of contrasting
their operating cost with the monetary outcomes (i.e. incomes) that are generated by
the branches. Such assessment is achieved by creating an input-output framework
explained in the previous section. Results concerning the distribution of the
profitability efficiency of the bank branches are presented in Figure 2. The median
efficiency is of the order of 92 per cent. Noteworthy are also the extreme values and in
particular the minimum efficiency value below the 60 per cent (Table III). The results
indicate that there is scope for efficiency improvement in profitability efficiency by
minimizing costs of about 12.4 per cent.
Out of the 50 branches 19 (38 per cent) were found relatively efficient. The model
suggests that most of the technically efficient branches (74 per cent) are operating
under constant returns to scale (CRS), three branches (15 per cent) under local
decreasing returns to scale (DRS) and the rest of the branches (11 per cent) under local
increasing returns to scale (IRS). For branches not operating on the frontier, their
returns to scale determined after elimination of pure technical inefficiency through the
projection towards the VRS frontier. Most of the branches (48 per cent) of the inefficient
branches seem to operate under IRS, eight branches (26 per cent) under DRS and the
remaining (26 per cent) under CRS. The results indicate that a possible increase in the
scale size of operations for 34 per cent of the branches will lead to increased levels of
monetary outcomes with a rate higher than that used to increase the input level
(expenses). In other words there is potential in the branch network to accommodate and
manage higher levels of business volume (Table IV).
5.2 Effectiveness
The overall results concerning the effectiveness are presented in Figure 2. As can
be seen from the results distribution the median efficiency is of the order of 98 per
cent. Out of the 50 branches 19 (38 per cent) were found to be relatively efficient
(Table III).
The results indicate that most (58 per cent) of the efficient branches operate under
CRS, four branches (21 per cent) operate under local IRS and the rest of the efficient
branches (21 per cent) operate under local DRS. In the same way as before, the model
suggests also that most of the branches (68 per cent) of the inefficient branches are
operating under IRS, eight branches (26 per cent) under DRS and the rest of the
branches (6 per cent) under CRS. The results indicate that a possible increase in the
0.137
0.131
0.083
0.051
0.162
0.021
0.511
0.991
0.639
0.861
0.643
1.048
0.254
3.653
0.112
0.069
0.096
0.076
0.125
0.041
0.390
0.054
0.026
0.054
0.038
0.061
0.011
0.138
1.817
1.162
1.403
1.265
1.724
0.993
7.270
Other operational
Origination
expenses
Depreciation
income
Mean
SD
Median
Q1
Q3
Min
Max
Rental
expenses
Personnel
expenses
0.030
0.021
0.024
0.018
0.032
0.009
0.124
Commissions
Net
income
1.629
1.320
1.210
1.027
1.631
0.510
7.406
Modeling bank
branch
profitability
441
Table II.
Descriptive statistics of
inputs-outputs used in
the assessment
(mil euros)
IJPPM
59,5
442
Figure 2.
Distribution of efficiency
measures of bank
branches
scale size of operations for 50 per cent of the branches will lead to increased levels of
net profits with a rate higher than that used to increase the input level (income
categories) (Table IV). The results indicate that there is scope for efficiency
improvement in effectiveness by minimizing the income categories values of about 9.3
per cent.
5.3. Profitability efficiency versus effectiveness
To further illustrate the important difference between profitability efficiency and
effectiveness, a cross-tabulation is presented in Figure 3 and moreover, DEA scores
obtained from the profitability and effectiveness assessments are plotted in Figure 4.
Branches fall into four quadrants: stars, sleepers, dogs, and question marks similar to
the classifications done in the efficiency-profitability matrix proposed by Dyson et al.
(1990) and Boussofiane et al. (1991); see also Luo (2003), Portela and Thanassoulis
(2007), and Giokas (2008a). Splitting half by the median was used to create high-low
groups profitability efficiency and effectiveness (based on Model (2) results), see also
Luo (2003). As a result, a total of four groups (2x2 high versus low groups) is created,
each representing one of the four quadrants. It should be noted that these thresholds
are arbitrary since the managerial implications of drawing such a matrix do not really
depend on the chosen thresholds, but on the number of units close to the ideal
performance (1,1). It should be noted that different thresholds might be justified by
different magnitudes of efficiency scores.
Bank branches that achieve both higher level of profitability efficiency and
effectiveness can be classified as stars. Star branches (n 21, or 42 per cent of the
total sample) represent benchmarks to be matched by inefficient branches.
Problem branches are the branches that are in the bottom-left quadrant, with
inferior performance both in profitability efficiency and effectiveness. The results
78.66
83.63
72.57
11.23
10.24
18.23
Median (%)
92.02
97.58
83.00
Standard
deviation (%)
Mean (%)
72.39
77.94
56.89
76.26
82.15
59.94
Q1 (%)
87.30
94.78
95.16
100.00
100.00
99.83
Q3 (%)
58.62
65.62
39.95
58.62
65.62
39.95
Min (%)
98.68
99.32
99.32
100.00
100.00
100.00
Max (%)
19
19
13
Number of
efficient branches
38
38
26
Percentage of
efficient branches
Modeling bank
branch
profitability
443
Table III.
Mean (standard
deviation), median,
quartiles (Q1, Q3), Min,
Max values of efficiency
measures, number and
percentage of efficient
branches
Table IV.
Returns to scale (RTS)
classification
4
11
4
19
Panel B: effectiveness
IRS
CRS
DRS
Total
21
58
21
100
11
74
15
100
21
2
8
31
15
8
8
31
68
6
26
100
48
26
26
100
Projected
Number of
Percentage of
branches
branches
Notes: IRS: increasing returns to scale, CRS: constant returns to scale, DRS: decreasing returns to scale
2
14
3
19
Efficient
Percentage of
branches
25
13
12
50
17
22
11
50
Number of
branches
444
RTS
Number of
branches
50
26
24
100
34
44
22
100
Total
Percentage of
branches
IJPPM
59,5
indicate that there are 21 problem branches, consisting 42 per cent of the sampled
branches and special attention should be paid to these branches as well as action is
needed to diagnose their problems and to improve their performance.
Sleepers experience higher level of effectiveness, but lower profitability efficiency.
There are four branches (8 per cent of the total sample) falling into the sleepers
quadrant.
Finally, dogs are those branches that earn higher profitability efficiency, but
lower effectiveness. Thus, these branches (n 21, or 42 per cent of the total sample)
should place more emphasis on generating profits.
The Pearsons correlation coefficient between profitability efficiency and
effectiveness is 0.725 ( p value 0.000), a high correlation coefficient that it is
statistically significant at the 0.01 level (two-tailed). Moreover, Kendalls and
Spearmans correlation coefficients are 0.575 ( p value 0.000), and 0.715 ( p
value 0.000), respectively. This means that, higher profitability efficiency tends to
be related with higher effectiveness as can be seen in Figure 4.
Modeling bank
branch
profitability
445
Figure 3.
Effectiveness
profitability efficiency
cross-tabulation
Figure 4.
Profitability efficiency
versus effectiveness
IJPPM
59,5
446
Two different input-output models are proposed for assessing the performance in
terms of profitability efficiency and effectiveness, respectively. The profitability
efficiency is assessed based on four inputs (cost categories) and four outputs (income
categories). The effectiveness efficiency is modeled by using the net income as output
and the income categories as inputs.
In both cases, the empirical results, providing answers to questions (1) and (2),
indicate that there is scope for substantial efficiency improvements; there is scope for
efficiency improvement in profitability and in effectiveness by minimizing costs of
about 12.4 per cent and income categories values of about 9.3 per cent, respectively. In
particular, we found that the real problem of bank branch inefficiency is due to
profitability inefficiency rather than ineffectiveness. Thus, the branches that acquire
higher effectiveness, but lower profitability performance should place more emphasis
on income generating activities by minimizing costs.
The efficiency improvement at the worst-performing branches can generate a
substantial increase in profit for The Bank. From the analysis of the efficiency
profitability-effectiveness matrix it becomes evident that branches can still increase
their profit through efficiency improvements. In addition, we had the opportunity to
discriminate among bank branches that have excelled in all performance dimensions
and therefore could be proposed as benchmark branches across the network.
Results, providing answers to questions (3) and (4), point out for positive links
between DEA individual measures as well as between DEA-overall efficiency measure
and one of the PMM outcomes, respectively; higher significant correlations are
observed between DEA-profitability efficiency and effectiveness, and between total
income to total cost ratio, a selected KPI, and DEA-overall efficiency measure. Another
striking result of the analysis is that the overall efficiency level is governed primarily
by profitability efficiency level, and therefore higher overall efficiency tends to be
related with higher profitability efficiency.
Future research regarding the performance of Bank branches should no doubt
consider as impressive the incorporation of environmental factors into the proposed
DEA models. These factors were excluded from our DEA models due to non-provision
from The Bank of branch-specific data like location, investment portfolio risk etc.
Note
1. Rental expenses are used as a proxy to quantify premises usage (Paradi and Schaffnit, 2004).
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About the author
Ioannis E. Tsolas is lecturer in economic analysis at National Technical University of Athens,
School of Applied Mathematics and Physics, Greece. He earned his PhD from the National
Technical University of Athens. His teaching and research interests are in economic analysis
(microeconomics, macroeconomics) and business economics. Ioannis E. Tsolas can be contacted
at: itsolas@central.ntua.gr
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