Efficiency in European Banking: A Risk Perspective

Abstract

This research aims (1) to risk-modify the functional forms applied to estimate technical efficiency in European banking,
and (2) to evaluate the sensitivity of estimates to risk and to functional forms’ specification.
This research methodology applies the Fourier Flexible functional forms to derive estimates using accounting data from the Bankscope database. For efficiency analysis, profit and cost frontiers are estimated using the Stochastic Frontier Analysis (SFA) in a single-stage estimation approach where the inefficiency term is specified under the time-flexible
Battese & Coelli (1995) model.
The past studies tend to overlook a number of significant banking risks, or restrict the estimated functional form, or do both. This research demonstrates that it is paramount to comprehensively accounting for risk in the analysis of efficiency to obtain accurate estimates, and that estimates are very sensitive to the specification of the underlying functional form.
The main limitation to this research related to data availability: data covers 10-year period (2008 – 2018) with 541 only observations. Moreover, risk factors could have been measured using more advanced methodologies (e.g. Merton Approach for measuring the probability of default) which paves the way for further research.
The findings result show that unless risk is adequately accounted for, efficiency estimates tend to be misleading or even erroneous. Findings indicate that European banks can enhance their cost efficiency: (1) by being better capitalized, and (2) by better managing the exposure to trading risk. On the other hand, European banks can enhance their profit efficiency mainly by: (1) maintaining high quality loan portfolios, (2) focusing on interest-based income, (3) relying more on customer deposits as a main source of funding and (4) better managing trading risk exposure to enhance the risk-return payoff. Moreover, results suggest that there is more profit inefficiency than cost inefficiency in European banking overall.