Studies in Economics and Finance

On the cross-methodological validation of bank efficiency assessments

Shrimal Perera Michael Skully
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Shrimal Perera Michael Skully, (2012),"On the cross-methodological validation of bank efficiency
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SEF
29,1 On the cross-methodological
validation of bank
efficiency assessments
26
Shrimal Perera and Michael Skully
Department of Accounting and Finance, Monash University,
Caulfield East, Australia

Abstract
Purpose Since there is no agreement on the consistency of their estimates, the purpose of this paper
is to investigate whether parametric stochastic frontier analysis (SFA) and nonparametric data
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envelopment analysis (DEA) generate consistent bank efficiency assessments.

Design/methodology/approach The authors utilize four alternative efficiency computation
models: two DEA technical efficiency models based on constant and variable returns to scale, and two
SFA cost efficiency models employing Translog and Fourier functional specifications. An unbalanced
panel of 59 Indian banks over 1990-2007 is employed as a model, developing country, banking market.
Findings The Translog and Fourier specifications in SFA and the constant and variable returns to
scale assumptions in DEA are found to rank and identify best-practice and worst-practice
approximately in the same order. The association between DEA efficiency estimates and non-frontier
standard performance measures, however, is mixed and inconclusive. Unlike DEA scores, SFA
efficiency assessments were found to be consistent with cost and profit ratios and hence are
believable.
Practical implications For regulators and bankers alike, the authors findings highlight the
importance of investigating the consistency of efficiency scores across various research methods.
They should ensure that frontier-based efficiency assessments are not simply artificial constructs of
models assumptions/specifications.
Originality/value This paper extends the existing literature by checking jointly the statistical
consistency of both DEA technical efficiency scores and SFA cost efficiency scores. The prior studies
focus either on technical efficiency or cost efficiency, but not both. Moreover, as far as the authors are
aware, this is the first cross-methodological validation study to focus on bank efficiency in the context
of a developing country banking market.
Keywords India, Developing countries, Banks, Non parametric measures, Parametric measures,
Stochastic frontier analysis, Data envelopment analysis, Cross-methodological validation, Assessment,
Bank efficiency
Paper type Technical paper

Studies in Economics and Finance
Vol. 29 No. 1, 2012
pp. 26-42
q Emerald Group Publishing Limited
1086-7376
DOI 10.1108/10867371211203837
1. Introduction
Academic research on banking efficiency has predominantly focused on two main
streams of alternative frontier efficiency methodologies: parametric and nonparametric.
The main difference is in their assumptions in terms of:
.
the functional form of the best practice frontier;
.
allowance/non-allowance of random error which may temporarily give some
units high or low outputs, inputs, costs, or profits; and
The authors would like to thank an anonymous referee for his/her insightful comments.
 .
if random error is allowed, the distributional assumptions imposed on it to Bank efficiency
separate the inefficiencies and random disturbance (Berger and Humphrey, 1997). assessments
The parametric approach employs econometric techniques to estimate efficiency scores.
They allow for random error and, therefore, are less prone to classify measurement errors
or momentary differences in costs as inefficiency (Bauer et al., 1998). They also impose
structure on the frontier by using a functional form for technology. The parametric 27
approach, however, may suffer from bias due to the distributional assumptions it
imposes to separate random error from inefficiency as neither of them is directly
observed (Bauer et al., 1998, p. 93)
In contrast, the nonparametric approach employs mathematical programming
techniques to obtain relative efficiency scores. It does not make restrictive assumptions
about the functional form of the technology and so impose relatively little structure on
the best practice frontier. Its key limitation, however, is the general assumption that
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there is no random error. In other words, it is assumed that there is no measurement

errors, no inaccuracies associated with accounting rules (and hence accounting data) and
chance will not temporarily give one bank a better performance measure in the short
term (Berger and Humphrey, 1997). If any such errors are present in the dataset, then
they may be reflected as an ingredient of the measured inefficiency. Even more
questionable is the possibility that errors in one unit on the efficient frontier may affect
the efficiency scores of all units when compared with this unit or any linear
combinations involving this unit.
Although both parametric and nonparametric approaches have been employed in
bank efficiency research, there is no agreement on the consistency of their estimates.
This consistency should imply that different methods rank banks approximately
in the same order, identify mostly the same Indian banks as best-practice and as
worst-practice and generate efficiency assessments which are consistent with
standard non-frontier performance measures (Bauer et al., 1998).
The cross-examination of computed efficiency results, therefore, is encouraged for
two main reasons. First, such analysis admits the possible chance for misspecifications
in assessment method and so serves as a robustness check. Second, it improves
the usefulness (policy relevance) of the efficiency assessments by providing evidence on
the consistency of efficiency scores and firm rankings derived from the different
methods and functional specifications. Furthermore, such analysis is in the spirit of
Leamer and Leonard (1983) who encourage the comparison of results from diverse and
extreme models to understand their fragility.
To date, however, only a few empirical studies have investigated the consistency of
bank efficiency scores generated by the various frontier methods. For example, Mortimers
(2002) extensive intra-industry literature survey identified only five in 51 previous studies
(using bank data) compare efficiency scores. Brown and Skully (2003) also highlight the
lack of such studies in their comprehensive literature survey. Furthermore, the results of
the studies that have been conducted are mixed and often inconclusive. Apart from
Bauer et al. (1998) work on the US banks, no other study conducts a comprehensive
methodological cross-examination of efficiency assessment results.
This information gap motivates the following research question: do various efficiency
measurement approaches generate consistent efficiency assessments for banks? To that
end, this paper cross-examines efficiency assessments, using the same dataset,
 SEF at three levels. First, they are tested using parametric stochastic frontier analysis (SFA)
29,1 cost efficiency scores to assess if Translog and Fourier functional specifications generate
consistent efficiency scores and firm rankings. Second, the same sample is tested again
using nonparametric data envelopment analysis (DEA) technical efficiency scores to
assess if different scale assumptions (constant returns to scale (CRS) and variable returns
to scale (VRS)) generate consistent and comparable results. Finally, parametric SFA
28 efficiency scores and nonparametric DEA efficiency scores are used to test whether
parametric SFA and nonparametric DEA approaches broadly provide consistent and
comparable results[1].
Our sample comprises an unbalanced panel of 59 Indian banks over 1990-2007, with
a total of 912 bank-year observations. The choice of India as our developing country is
driven by two reasons:
(1) It provide a rich basis for analysis as a developing banking market, where
measures are being taken to stimulate and facilitate greater competition and
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efficiency (Perera et al., 2010); and

(2) Despite a recent surge on Indian bank efficiency papers, none so far tests their
robustness by cross-examining the computed efficiency scores.

Our paper extends the existing literature by checking jointly the statistical consistency
of both DEA technical efficiency scores and SFA cost efficiency scores. The prior
studies focus either on technical efficiency or cost efficiency, but not both. Moreover, as
far as we are aware, this is the first methodological cross-examination study to focus
on bank efficiency in the context of a developing country banking market.

2. Literature review and hypotheses

Despite the extensive bank efficiency literature[2], few prior studies cross-examine their
efficiency assessments using different methodologies and underlying assumptions.
Those that do, have reported varying levels of agreement and consistency among the
different methods. In a pioneering study, Ferrier and Lovell (1990) compare DEA and SFA
efficiency results for US financial institutions and report statistically insignificant
Spearmans rank correlations. The authors do not find evidence to suggest consistency
and comparability among different parametric and nonparametric efficiency assessments.
In contrast, Restis (1997) Italian bank study reports strong Pearsons correlation and
Spearmans rank correlation results. In between, there is a moderate level of agreement
(Bauer et al., 1998).
A further area of interest is the consistency of parametric efficiency scores obtained
from employing different functional forms (for example, Translog form vis-a-vis more
flexible Fourier functional form). In their study of US commercial banks, Berger and
Mester (1997, p. 924) observe strong Pearsons rank-order correlations (0.979 or higher) for
Translog and Fourier efficiency scores and the average efficiencies of Translog
specification are about just 1 percent lower than those of the Fourier specifications. These
findings highlight that different functional forms employed in parametric efficiency
computation techniques do not distort the resulting assessments. Contradictory evidence
is provided by Ashton and Hardwick (2000), Mitchell and Onvural (1996) and McAllister
and McManus (1993). Mitchell and Onvural (1996) and McAllister and McManus (1993)
conclude that the Fourier specification fits the data more closely and hence superior to
Translog functional form. Likewise, Ashton and Hardwick (2000) find no strong
 correlations among cost efficiency scores derived from the Translog and Fourier Bank efficiency
functional specifications. Significant economies of scale are observed using the latter while assessments
constant economies are reported with Translog version.
With regard to the previous Indian banking studies[3], only Ataullah et al. (2004)
compute correlation between DEA technical efficiency scores and non-frontier
performance measures (return on assets). No study, however, cross-examines DEA
technical efficiency results obtained from different scale assumptions (CRS vis-a-vis 29
VRS) and SFA cost efficiency results obtained from Translog and Fourier functional
forms using the same sample of banks.
This information gap motivates the following research question: do various
efficiency measurement approaches generate consistent efficiency assessments for
Indian banks? To that end, this study tests whether different SFA (Translog vis-a-vis
Fourier) and DEA (CRS vis-a-vis VRS) specifications generate consistent efficiency
scores and firm rankings for Indian banks. Moreover, following Thanassoulis et al.
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(1996), we also investigate whether frontier efficiency estimates (derived from DEA and
SFA specifications) are consistent with non-frontier, financial ratio-based efficiency
measures. Our formal hypotheses are as follows:
H1. Efficiency scores generated by different specifications rank the Indian banks
approximately in the same order.
H2. Different efficiency measurement specifications identify mostly the same
Indian banks as best-practice and as worst-practice.
H3. Efficiency scores generated by different specifications for Indian banks are
consistent with standard non-frontier performance measures.
The first two hypotheses assess the degree to which different approaches are mutually
consistent with each other while the last one helps determine whether the efficiencies
generated by different approaches are consistent with reality or are believable
(Bauer et al., 1998, p. 87).

3. Sample and estimation models

3.1 Sample
The sample consists of 59 Indian domestic commercial banks over the period 1990-2007,
with a total of 912 bank-year observations. It provides reasonable coverage of the Indian
banking market with 70 percent of total assets. A domestic bank is one with more than
50 percent owned by local institutions and investors in any given year. This is
determined from bank corporate profiles and financial statements as well as central
bank publications. Foreign-owned banks are excluded as most publish only their
worldwide consolidated financial statements. The sample period is also constrained by
data availability from the main data source for this study: Fitch Ratings & Bureau van
Dijk (2009)s BankScope database.
Annual cross-section and time series pooled data (unconsolidated) are used to remove
biases caused by aggregating heterogeneous individual banks. It also minimizes the
chances that a particular time series/cross-section being atypical while providing
increased precision of regression estimates due to larger sample size. Most importantly,
pooled data helps control for unobserved heterogeneity/omitted variable problems.
 SEF In a strictly time series or cross-section approach, these are absorbed into the usual error
29,1 term and can cause problems in estimation (Perera et al., 2007).

3.2 Estimation models

This section starts with an outline of the four different efficiency computation
techniques utilised: two parametric cost efficiency models (SFA-Translog
30 and SFA-Fourier) and two nonparametric technical efficiency models (DEA-CRS and
DEA-VRS). Then, it presents the statistical procedures for testing our three hypotheses
using the efficiency scores obtained from our four different specifications.
3.2.1 Parametric cost efficiency models. The widely-used parametric stochastic
frontier approach (SFA) employs a composite-error where inefficiencies are assumed to
follow an asymmetric distribution (typically the half-normal) and random errors follow
a symmetric distribution (typically the standard normal) (Berger and Humphrey, 1997).
So, the composite error term (1) can be given as 1 m y , where m $ 0 represents
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half-normally distributed inefficiency while y represents normally distributed random

error. The rationale is that inefficiencies should follow a truncated distribution since
they cannot be negative. However, random error can both increase or decrease costs
and therefore should follow a symmetric distribution.
Given its popularity in the literature, we employ SFA to estimate cost efficiencies of
Indian banks and so test H1-H3. To that end, the following SFA total effects
(composite-error) cost function, which accommodates uncontrollable time-varying
effects is employed:

TC it a X it b Dt g 1it ; and 1it nit uit ; 1

where, subscripts i denote banks, and t time horizon and:

TC total cost;
a constant;
X vectors of outputs and input prices;
D a vector of time dummies;
b, g vectors of unknown parameters to be estimated;
1 composite error term;
n two-sided normally distributed term with zero mean and variance s 2
capturing random error; and
u positive half-normal term capturing inefficiency effects.
The efficiency term of the composite error term, u, can be estimated for each individual
bank by using the Jondrow et al. (1980) formula. Here, u can be computed as the
conditional mean of the efficiency term, given the conditional error term. Thus:

 

ui sl f 1i l=s 1i l
E ; 2
1i 1 l 2 1 2 F1i l=s s
 where, F(.) is the standard normal distribution and f(.) is the density function; E(u/1i) is Bank efficiency
an unbiased estimator of ui, and l su/sv measures the extent to which deviations
from the efficient frontier are due to inefficiency relative to random error.
assessments
The estimation of the system of equations (1) and (2) involves an assumption about
the structure of bank technology. In empirical studies, productive technology or
transformation process is represented by flexible functional forms. A functional form is
defined as flexible if it can approximate numerically or differentially any arbitrary 31
twice-continuously differentiable function (Ashton and Hardwick, 1996, p. 14).
As advocated by Carvallo and Kasman (2005) and Fries and Taci (2005) by far the most
popular and widely used flexible specification is the transcendental logarithmic
(Translog) function developed by Christensen et al. (1973). A more flexible yet less
frequently used one is the Fourier functional form widely attributed to Gallant (1982).
Translog cost efficiency specification. When a Translog specification is used, the
dependant variable (for example, TCijt in equation (1)) is approximated by a quadratic
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in the logarithms of input prices and outputs. The formal Translog model used
to estimate equations (1) and (2) is as follows:
X
n X
t
ln TC it a0 am ln P m;it bs ln Qs;it r1 T
m s
" #
1 Xn X
m t X
X s
2
am;n ln P m;it ln P n;it bs;t ln Qs;it ln Qt;it lT
2 m n s t
n X
X t X
t X
n
fm;s ln P m;it ln Qs;it cs T ln Qs;it um T ln P m;it 1;
m s s m
3
where, subscripts i denote banks, and t time horizon and:
ln TC natural log of total costs;
ln Pm natural log of input prices;
ln Qs natural log of output values;
T time trend variable; and
1 composite error term as defined by Battese and Coelli (1995); and a, b, t, r,
f, c, and u are parameters to be estimated.
In line with previous studies, the following restrictions are used to impose linear
homogeneity on the input prices and total cost variable as required by the duality
theorem (Fries and Taci, 2005). Specifically, these restrictions are:
X
n X
n X
n X
n
am 1; am;n 0; fm;s 0; and um 0: 4
m m m m

Linear homogeneity is achieved by normalizing TC and Pm (in equation (3)) by the price
of physical capital (ratio of other operating expenses to fixed assets) before the log
transformations are undertaken (Bos and Kool, 2006). Such normalizing also helps
to account for heteroskedasticity (Berger and Mester, 1997). Furthermore, the symmetry
 SEF of second-order parameters is achieved by setting:
29,1 am;n an;m and bs;t bt;s : 5
Moreover, factor share equations embodying Hotellings Lemma and Shephards
Lemma are excluded since they assume away possible allocative inefficiencies in the
sample (Berger and Mester, 1997)[4].
32 Fourier cost efficiency specification. The Fourier functional form imposes a
second-order polynomial in the dependant variables together with a combination of
trigonometric (sine and cosine) terms. This specification has the Translog form nested
within it as a special form and tends to closely approximate any well-behaved function
(Chung et al., 2001). Moreover, due to its trigonometric series, the Fourier functional
form has the ability to represent any function exactly and, therefore, can potentially
approximate any function beyond its local domain (Gallant, 1982). Moreover, Fourier
form is argued to be superior when firms in the sample show wide size disparities
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(Mitchell and Onvural, 1996).

Theoretically, however, an infinite number of trigonometric terms should be
employed in the Fourier functional specification to achieve the aforementioned
advantages, which is only feasible with an infinite number of observations. In applied
research, when samples constitute a finite number of observations, a subset of the
trigonometric terms should be selected to represent the cost function. However, the
empirical question of how to choose the trigonometric, i.e. sine and cosine terms, to be
included in the cost function is still an unresolved issue. Therefore, existing literature is
used as a guide (Altunbas et al., 2000).
Specifically, the Fourier form stochastic cost function used for efficiency
cross-examination in the present study is as follows:
X
n X
t
ln TC it a0 am ln P m;it bs ln Qs;it r1 T
m s
" #
1 Xn X
m t X
X s
2
am;n ln P m;it ln P n;it bs;t ln Qs;it ln Qt;it lT
2 m n s t
n X
X t X
t X
n
fm;s ln P m;it ln Qs;it cs T ln Qs;it um T ln P m;it
m s s m
X
4 2 X
X 2  
as cos zs bs sin zs
asm coszs zm bsm sinzs zm
s1 s1 m1
2 X
X 2 X
2
asm coszs zm zk bsm sinzs zm zk
1;
s1 m$1 k$j
ki
6
where, subscripts i denote banks, and t time horizon, and:
ln TC natural log of total costs;
 a0 constant; Bank efficiency
ln Pm natural log of input prices; assessments
ln Qs natural log of output values;
T time trend variable;
z adjusted values of the natural log of output ln Qs which span the interval, 33
[0.1*2p, 0.9*2p ]; and
1 composite error term as defined by Battese and Coelli (1995); and a, b, r, l,
f, c, u, a and b are parameters to be estimated.
Berger and Mester (1997) formula shown below is used to calculate the adjusted z values:
0:2p 2 m a m ln Qi ; 7
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where; m ; 0:9*2p 2 0:1*2p=b 2 a and a and b represents the range of ln Qs.

The other variables used in equation (3) remain unchanged as previously defined. The
bank-specific inefficiency scores are separated from the composite error (1) of equation (6)
using the conditional mean model (equation (2)) derived by Jondrow et al. (1980).
Another central issue in estimating the cost functions stated in equations (3) and (6)
is the identification of the banks outputs and inputs. Following the intermediation
approach, and consistent with prior research (Cavallo and Rossi, 2002), we use three
inputs and two outputs. The two outputs are net total loans and other earning assets of
banks. The three inputs are:
(1) price of funds (interest expenses per dollar of deposits and money market
funding);
(2) price of physical capital (administration and operating expenses per dollar of
fixed assets); and
(3) price of labour (personnel expenses per dollar of total assets)[5].

The specific variable definitions are provided in Table I.

3.2.2 Nonparametric technical efficiency specifications. The DEA model given in
equation (8) is utilized to test whether different scale assumptions (constant versus
variable) in nonparametric models generate consistent technical efficiency estimates for
Indian banks. Specifically, the input-oriented DEA specification employed is as follows:
minu;l u;
subject to:
2yi Y l $ 0;
uxi 2 X l $ 0;
8
N 10 l 1;
l $ 0:
Equation (8) is based on the assumption that K inputs and M outputs are available for each
of N firms. For firm i, these vectors are represented by xi and yi, respectively. The (K*N) input
matrix, X, and the (M*N) output matrix, Y, represent the data for all N firms. Parameter u
 SEF
Variable Definition
29,1
Panel A: dependant variable
TC Total cost Interest expense (BS6520) personnel expenses (BS6650) other
administration expenses (BS6660) other operating expenses (BS6670)
Panel B: input prices and outputs
34 P1 Price of funds Interest expenses (BS6520) divided by total deposits (BS6080)
money market funding (BS6160)
P2 Price of labour Personnel expenses (BS6650) divided by total assets (BS5670)
P3 Price of capital Other administration expenses (BS6660) other operating expenses
(BS6670) divided by total fixed assets (BS5660)
Q1 Net total loans Total customer loans (BS5190) problem loans (BS5195)
Q2 Other earning Other earning assets (BS5560)
assets
Table I.
Variable definitions Note: For each financial statement variable, Bankscope item code is provided within brackets for
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(equations (3) and (6)) referencing purposes

is a scaler and l is a (N*1) vector of constants. The value of u obtained is the efficiency score
for the ith firm. It satisfies the condition, u # 1, with a value of 1 indicating a point
on the efficient frontier and hence a technically efficient firm according to Farrel (1957)
definition. With regard to the scale assumptions, equation (8) represents the DEA variable
scale to returns specification (DEA-VRS) while DEA constant returns to scale specification
(DEA-CRS) is given by equation (8) minus the convexity constraint (N 1l 1).
In equation (8), the input orientation is selected as opposed to an output one following
previous studies (Lozano-Vivas et al., 2001). Under an input orientation, technical
efficiency is measured as a proportional reduction in input usage, with output levels
held constant (Coelli et al., 1998, p. 158). After all, the approach selected will have no
significant impact on the efficiency scores. For example, under DEA-CRS models, both
input and output orientations generate identical efficiency estimates. When VRS
assumption is used, both orientations identify the same set of banks as lying on the
efficient frontier (Coelli et al., 1998).
In order to maintain the consistency with the SFA-Translog (equation (3)) and
SFA-Fourier (equation (6)) specifications explained earlier, the same two outputs
(net loans and other earning assets) are used in the two DEA models (DEA-CRS and
DEA-VRS). However, instead of input prices, nonparametric DEA method requires
input quantities to compute technical efficiency scores. Thus, two inputs are used:
(1) deposits; and
(2) operating expenses (personnel expenses other administration
expenses other operating expenses).

The use of deposits as an input (as opposed to interest expenses) is in line with Tripe
(2005) who argues that interest expenses might reflect any risk premiums included in
interest rates[6].
For ease of reference, a summary of the four different efficiency measurement
specifications used in the cross-examination exercise and their estimation procedures
are presented in Table II. The maximum likelihood estimates of the SFA-Translog
(equation (3)) and SFA-Fourier (equation (6)) specifications are obtained using
 Coelli (1996) Frontier econometric software. Alternatively, Zhus (2003) DEA Excel Bank efficiency
Solver algorithm is utilized to compute DEA technical efficiency scores. assessments
3.3 Procedures for cross-examination of efficiency
The efficiency scores from these four different measurement models (summarized in
Table II) are used in the cross-examination exercise. The aim is to test whether the
different efficiency measurement specifications: 35
(1) rank the Indian banks approximately in the same order (H1);
(2) identify mostly the same Indian banks as best-practice and as
worst-practice (H2); and
(3) are consistent with standard non-frontier performance measures (H3).

H1 is tested using Spearmans rank-order correlation coefficients for the efficiency scores
generated by four different assessment specifications. The nonparametric Spearmans
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rank-order correlation is preferred to Pearsons (product-moment) correlation due

to latters assumption of normality. Such an assumption is not appropriate for the
statistical inference required here (Leong et al., 2003). Standard t-statistics are then
employed to evaluate if the Spearmans rank-order correlation coefficients are
statistically significantly different from zero.
H2 evaluates whether efficiency scores generated by the different efficiency
measurement methods identify mostly the same best-practice and worst-practice
institutions. Following Bauer et al. (1998), the best-practice banks are defined as the
banks within the top 25 percent when arranged in the descending order of efficiency
scores calculated using each method for each year. The worst-practice banks are those
in the lowest 25 percent. To test H2, the following procedure is employed. First, the
proportion of banks that were identified by one technique as having efficiency scores in
the most efficient 25 % (best-practice) of banks that were also identified in the most
efficient 25 % by the other technique is calculated (Bauer et al., 1998, p. 105). Second, the
standard x 2-test is used to assess if the association is statistically significantly different
from 0.25. The value of 0.25 is used as a benchmark since the random chance alone would
give an expected value of 25 percent.
Finally, as captured in H3, the efficiency scores generated by the various
measurement approaches should be significantly and positively related to standard
non-frontier measures. Such positive associations should provide assurances that the
frontier-based efficiency scores are not simply artificial constructs of various
assumptions and specifications used in model estimation. This is important since

Model Description

SFA-Translog As given in equation (3); maximum likelihood estimates are obtained using Coelli
(1996)s frontier econometric procedure
SFA-Fourier As given in equation (6); maximum likelihood estimates are obtained using Coelli
(1996)s frontier econometric procedure Table II.
DEA-CRS Equation (8) minus the convexity constraint, N 10 l 1; estimated using Zhu (2003)s Alternative efficiency
DEA Excel Solver algorithm measurement
DEA-VRS As given in equation (8); estimated using Zhu (2003)s DEA Excel Solver algorithm specifications
 SEF efficiency assessment results are widely used in respective decision-making processes
29,1 by regulators, managers and industry consultants, etc.
To that end, Spearmans rank-order correlations between the frontier efficiencies
and standard non-frontier measures are calculated. The corresponding t-statistics are
then used to test H3. Following Bauer et al. (1998), three financial statement based
non-frontier ratios are used in this regard: return on assets (ROA), the negative of the
36 total cost per dollar of total assets (2 TC/TA) and the negative of total cost per dollar of
revenue (2 TC/TR).
4. Results and discussion
The section starts with a summary of the efficiency scores obtained from the four
different specifications. Then, it presents and discusses the empirical results for the
three hypotheses.

4.1 Summary of efficiency scores by method

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The summary of efficiency scores obtained from four models employed is presented in
Table III, Panel A[7]. The mean efficiency scores for the Indian banks vary from 0.7946
for DEA-CRS model to 0.9148 for the SFA-Fourier model. These values closely follow
the median efficiency scores for the four models. The minimum efficiency scores range
from 0.4712 for the DEA-CRS model to 0.6996 for the SFA-Fourier model. The two
parametric models (SFA-Translog and SFA-Fourier) display less score variations then
the two nonparametric models (DEA-CRS and DEA-VRS). Our observations are
compatible with the argument that nonparametric efficiency scores should be lower on
average (showing a greater dispersion) since random error is not eliminated in the
estimation process[8]. These descriptive statistics are broadly in line with those of
Bauer et al. (1998) and Ferrier and Lovell (1990).
Table III, Panel A also shows that the average efficiencies (mean and median) for
nonparametric methods are lower than those for parametric SFA-Translog and
SFA-Fourier methods. This preliminary observation reveals that nonparametric
methods generate relatively low efficiencies for most Indian banks. Similarly, the
parametric methods seem to be mutually consistent with each other yielding relatively
higher efficiency scores for most banks.

DEA-CRS DEA-VRS SFA-Translog SFA-Fourier

Panel A: summary of efficiency scores by method

Mean 0.7946 * 0.8463 * 0.8912 * 0.9148 *
Median 0.8011 0.8473 0.9001 0.9185
SD 0.0924 0.0666 0.0373 0.0101
Minimum 0.4712 0.5551 0.6485 0.6996
Maximum 1 1 1 1
Panel B: mean and variance equality test results
DEA-CRS 47.1871 * * 93.0008 * * 119.4685 * *
DEA-VRS 3.0003 * * 12.3612 * * 22.2163 * *
Table III. SFA-Translog 12.4672 * * 5.2148 * * 51.2876 * *
Summary of efficiency SFA-Fourier 97.2543 * * 48.1118 * * 4.4971 * *
scores by method and
mean and variance Notes: Statistically significance at: *5, * *1 percent levels; in Panel B, mean equality test results are
equality tests given in bold letters and variance equality test results are given in italicized letters
 The standard mean equality tests (in bold letters) and standard variance equality tests Bank efficiency
(in italicized letters) are given in Table III, Panel B. The F-statistics are large and assessments
statistically significant at 95 percent level or higher. This clearly rejects the proposition
that the efficiency distributions obtained by the four methods have equal means and
standard deviations, respectively. The benchmarking of these results is infeasible due
to absence of previous evidence.
37
4.2 Rank-order correlations of efficiency distributions (H1)
The six Spearmans rank-order correlations (given in Table IV, Panel A) are all positive and
statistically significant ranging from 0.3252 (between DEA-VRS and SFA-Fourier) to
0.7672 (between DEA-CRS and DEA-VRS). This means that the efficiency ranking of
Indian banks using the four specifications are mutually consistent to the extent shown by
the Spearmans rank-order correlation value at 95 percent level or higher. This supports H1.
The observed rank-order correlations, however, are lower than those reported
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in similar studies. Bauer et al. (1998, p. 104) and Berger and Mester (1997, p. 924), for
example, report Spearmans rank-order correlations of 0.98 (or higher) and 0.70,
respectively, among efficiency scores obtained from SFA Translog and Fourier
specifications. This anomaly may be driven by the nature of the sample. For example,
the two studies mentioned above used balanced panel datasets as opposed to our
unbalanced data.

4.3 Correspondence of best-practice and worst-practice banks across methods (H2)

The correspondence of best-practice (in bold letters) and worst-practice (in italicized
letters) banks across four measurement methods are presented in Table IV, Panel B.
For example, 77 percent and 66 percent of the banks identified by DEA-VRS
specification as best-practice and worst-practice, respectively, were also identified as
best-practice and worst-practice by the DEA-CRS specification. As with Leong et al.
(2003), the overall results indicate consistency between and within parametric and
nonparametric approaches in identifying the best-practice and worst-practice banks.

DEA-CRS DEA-VRS SFA-Translog SFA-Fourier

Panel A: Spearmans rank-order correlations among the efficiency scores (H1)

DEA-CRS 0.7672 * * 0.5873 * * 0.4679 * *
DEA-VRS 0.4186 * * 0.3252 *
SFA-Translog 0.6727 * *
SFA-Fourier
Panel B: correspondence of best-practice and worst-practice banks (H2)
DEA-CRS 0.7712 * * 0.5928 * * 0.5184 * *
DEA-VRS 0.6571 * * 0.3789 * 0.2912 *
SFA-Translog 0.4962 * * 0.4017 * 0.6472 * *
SFA-Fourier 0.4656 * 0.4300 * 0.5700 * *
Panel C: correlations with standard non-frontier performance measures (H3)
ROA 0.0541 0.1117 0.5825 * 0.7291 * *
-TC/TA 0.1185 0.3814 * 0.5412 * * 0.6385 * *
-TC/TR 0.0609 0.1971 0.5852 * * 0.5873 * *
Table IV.
Notes: Statistically significance at: *5, * *1 percent levels; in Panel B, correspondence of best-practice Statistical tests results
is given in bold letters and correspondence of worst-practice is given in italicized letters for H1, H2 and H3
 SEF Since all the correspondence values are statistically different from 0.25 at 95 percent level
29,1 or higher, this provides support for H2.

4.4 Efficiency correlations with standard non-frontier performance measures (H3)

As shown in Table IV (Panel C), the efficiency scores generated by parametric methods
(SFA-Translog and SFA-Fourier) are consistent with non-frontier performance
38 measures. For example, all six reported parametric correlations are positive and
statistically significant at 99 percent level. In contrast, only one out of six nonparametric
correlations is statistically significantly different from zero. This observation becomes
more obvious when average correlation values are considered. For example, the simple
average of the six DEA-based rank-order correlations is 0.15 (not shown in Table IV,
Panel C) while the corresponding value for parametric-based methods is 0.61.
Overall, these results provide mixed support for H3. On the one hand, strong support is
provided by consistently positive and statistically significant correlation coefficients
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between parametric efficiency scores and non-frontier performance measures. It signifies

that the computed efficiency scores are consistent with actual bank performance, and
not just artifacts of the assumptions of the efficiency approaches (Bauer et al., 1998,
p. 88). On the other hand, the relatively small and statistically insignificant (five out of six)
correlation coefficients between nonparametric efficiency scores and non-frontier
performance measures provide little support. A possible reason for this observation is
that unlike financial ratios, DEA scores take no account of interest costs. This finding is
broadly in agreement with Thanassoulis et al. (1996, p. 229) who report that the
nonparametric DEA efficiency assessments and financial ratios disagree substantially
on the relative performance of individual units[9].

5. Conclusion
This paper contributes to the bank efficiency literature by jointly investigating the
statistical consistency of both DEA technical efficiency scores and SFA cost efficiency
scores. In particular, it extends the literature by simultaneously comparing:
.
DEA technical efficiency scores computed using different scale to returns
assumptions (DEA-CRS vis-a-vis DEA-VRS); and
.
SFA cost efficiency scores obtained employing different functional specifications
(SFA-Translog and SFA-Fourier).

Moreover, as far as we are aware, this is the first methodological cross-examination

study on a developing country banking market.
Overall, despite ranking and identifying best-practice and worst-practice banks
approximately in the same order, DEA efficiency scores are not associated with
directly observable cost (total cost per dollar of total assets and total cost per dollar of
revenue) and profit (return on assets) ratios. These findings closely follow Bauer et al.
(1998, p. 109) finding that parametric-based approaches were generally consistent
with the standard performance measures, but the DEA-based efficiencies were much
less so. Such findings, according to Bauer et al. (1998), question the believability of
DEA efficiency scores in comparison to SFA estimates.
These results broadly suggest that:
.
The separation of bank-specific inefficiencies from the composite error term of
parametric SFA methods did not cause excessive distortions.
 .
DEA methods used have unintentionally considered a substantial part of Bank efficiency
random error as differences in efficiency. assessments
The latter argument may be further supported by the possible noise in data from
developing country banking markets such as the one used in this study.
For the regulators and bankers alike, our findings highlight the importance of
investigating the consistency of efficiency scores across various research methods. They 39
need to ensure that frontier-based efficiency assessments are not simply artificial
constructs of various assumptions and specifications used in the model estimation.
Such cross-examinations are vital since the decisions based on incorrect or inferior data
may otherwise increase costs, systemic risk as well as reduce quality and quantity of
bank services.
Our studys contributions and findings need to be interpreted in light of its
limitations. Throughout the DEA and SFA efficiency computation exercise, it was
implicitly assumed that the production functions across different entities in the sample
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are homogenous. Although this is a less severe issue in the present study (given the one
banking market) than in a cross-market analysis, it can still affect the computed
efficiency estimates if the sample banks exhibit short-term differences in objectives and
strategy due to competitive pressures. Moreover, it is possible that the results may be
specific to Indian banks and may not extend beyond the sample[10]. Our results,
however, are broadly consistent and comparable to findings by Bauer et al. (1998) and
Leong et al. (2003) who focus on developed country banking markets.
With regard to possible extensions to our work, it would be interesting to investigate
whether efficiency scores computed using different methods and specifications exhibit
similar stability over time. Such analyses involve calculating correlations between
n-year-apart efficiencies for each bank for each period covered by the sample.
Regrettably, our unbalanced sample does not allow such scrutiny.

Notes
1. In the empirical literature, SFA and DEA are the most widely used parametric and
nonparametric approaches, respectively, (Brown and Skully, 2003). Bauer et al. (1998)
observe that that nonparametric models (such as DEA) typically account for technical
efficiency while parametric approaches (such as SFA) measure cost efficiency.
2. Excellent overviews are presented in Berger and Humphrey (1997) and Brown and Skully
(2003).
3. See Das and Ghosh (2006) for an excellent review of the Indian bank efficiency literature.
4. An excellent review of the technical details about factor share equations consistent with
Hotellings Lemma and Shephards Lemma can be found in Coelli et al. (1998).
5. Even though ratio of other operating expense to physical capital is commonly used in the
literature as the price of physical capital, it suffers from some limitations. For example,
the amount of reported physical capital depends on accounting choices and whether they are
owned or leased. In addition, banks use relatively small investments in physical capital
compared to other inputs to their production process. We thank an anonymous referee for
this insightful comment.
6. As pointed out by an anonymous referee, the inclusion of risk premiums (by use of interest
expense, in place of deposits) might be desirable to bank efficiency in an overall sense. This
measure, however, is distorted by broader monetary policy decisions and their changes
 SEF (in the form of announced base interest rate changes by the Reserve Bank of India) over the
sample period. Hence, the bank-specific deposit base was chosen as an input in the bank
29,1 production process. This approach is consistent with the intermediation approach to bank
production.
7. The issue of estimating a common frontier becomes less of an issue in this paper since we
estimate efficiency scores for each bank and for each year in the sample period. Moreover,
40 the effect of technological change (identified to be important by Tulkens and Eeckhaut
(1995)) is captured (partially, at least) in the way banks have combined their inputs to
generate observed output levels and mixes over the sample period. A similar efficiency
computation approach has been utilised by Perera et al. (2007) in their cross-country study of
120 South Asian banks. We thank an anonymous referee for this insightful comment.
8. The authors would like to thank an anonymous referee for this comment.
9. The authors would like to thank an anonymous referee for this comment.
10. The authors would like to thank an anonymous referee for raising this concern.
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About the authors

Dr Shrimal Perera has a PhD from Monash, MPhil (Glasgow), BSc (Hons) USJ, SA Fin, and GCHE
(Monash). He lectures in the area of Banking and Finance and has published in International
Review of Finance, Applied Financial Economics, South Asia: Journal of South Asian Studies and
International Journal of Emerging Markets. Shrimal Perera is the corresponding author and can
be contacted at: Shrimal.Perera@buseco.monash.edu.au
Professor Michael Skully has a BS BA (Arizona), MBA (Utah), GradDipEc (Stockholm),
SnFin, FCPA. He holds the Chair in Banking at the Department of Accounting and Finance,
Monash University. His research and teaching is mainly in the area of financial institutions in
Australia and the Asia Pacific region, as well as in corporate finance. Professor Skully has
published widely in these areas within academic and professional journals.

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