Costs and Efficiency in Japanese Banking

Given the problems experienced by the Japanese financial system (and banks in particular) in recent years, and the recent pressures for consolidation, surprisingly little academic research has been undertaken into the costs and efficiency of Japanese banks. This contrasts markedly with the wealth of research into the performance of US financial institutions detailed previously.

Tachibanaki et al. (1991) estimated a two-output translog cost function using a sample of 61 banks between 1985 and 1987 and found evidence of economies of scale for all sizes of banks in all three years of the study. It should be noted, however, that the outputs were proxied by revenues produced from earning assets. Hence, it is possible that these revenue-based measures of output may have been influenced by market power in respect of the setting of output prices.

Fukuyama (1993) used the non-parametric technique, DEA, to analyse the overall technical efficiency (OE) of Japanese commercial banks and to decompose this into its two constituent components, pure technical efficiency (PTE), and scale efficiency (SE). The cross-section sample consisted of 143 banks for the financial year 1990/91. The mean level of OE for the whole sample was found to be 0.8645 which, compared to a maximum level of unity, implies that banks could, on average, have produced the same levels of outputs with about 14 per cent fewer resources or inputs. Unlike other studies, Fukuyama found evidence of only mild economies of scale, with the mean level of SE being 0.9844. Hence, most of the observed inefficiency was associated with pure technical (mean PTE score, 0.8509), rather than scale, inefficiency. Interestingly, however, only 7 per cent of the sample exhibited constant returns to scale. Furthermore, of those banks exhibiting scale inefficiencies, 81 per cent exhibited increasing returns and only 12 per cent exhibited decreasing returns to scale.

McKillop et al. (1996) used the composite cost function developed by Pulley and Braunstein (1992) to analyse costs and efficiency in giant Japanese banks. The data relate to annual data from five very large Japanese city banks over the 1978-91 period and McKillop et al. use the intermediation approach in a three-output, three-input model. The specification of a composite cost function permits the estimation of four model variants, including the translog and generalized translog. However, for all the models estimated, McKillop et al. find evidence of statistically significant economies of scale for all banks at the sample mean. Furthermore, the estimated values of the economies of scale parameter were found to range between 1.08 and 1.28 (indicating economies of scale), very similar to the values found by Tachibanaki et al. (1991). It is interesting to note, however, that McKillop et al. found that this pattern of economies of scale holds for all years of the sample 'except for the late 1980s onwards where the results suggest that constant returns pertain for all models' (p. 1665). This accords with Fukuyama (1993) who finds that, based on 1990/91 data, 'the majority of the city banks exhibit constant returns to scale, implying that the city banks seemingly operate close to the minimum efficient scale' (p. 1107).

McKillop et al. (1996) refer to 'the persistent, and somewhat surprising, finding of increasing returns to scale for all sizes of Japanese banks' (p. 1652). Indeed, as detailed above, until recently the vast majority of empirical studies in other countries have found that economies of scale are exhausted at relatively low output levels. Hence, in this context, the Japanese results are indeed surprising. It is also clear, however, that both McKillop et al. (1996) and Fukuyama (1993) find some evidence that large city banks operating in the late 1980s/early 1990s exhibited constant returns to scale. Clearly, given the current consolidation wave sweeping

Japan, the precise nature of economies of scale in Japanese banking is extremely important, both from an academic and a policy perspective.

Some recent papers, however, have attempted to shed fresh light on the scale economy puzzle in Japanese banking. Altunbas et al. (2000) utilize the hybrid Fourier/translog cost function/frontier outlined previously to investigate both scale economies and X-efficiencies in Japanese banking. They specify three outputs (total loans, total securities and off-balance sheet items) and three inputs (labour, capital and total funds). In addition to the usual cost function specification, however, Altunbas et al. also test for the impact of risk and quality factors on costs, scale economies and X-efficiency. The ratio of loan-loss provisions to total loans is included in the cost frontier to capture loan quality, while risk is modelled via the inclusion of financial capital and the ratio of liquid assets to total assets. The incorporation of risk and quality factors is clearly potentially very important given the recent banking crisis in Japan. It should be noted, however, that Japanese banks were renowned for concealing the true scale of their bad-debt problems for a number of years during the 1990s.

The sample consists of about 136 Japanese banks and covers the years from 1993 to 1996. Furthermore, Altunbas et al. allow for the possibility of technical change over the period via the inclusion of a simple time trend.

Altunbas et al. find that economies of scale in Japanese banking tend to be overstated when risk and quality factors are not incorporated, particularly for the larger banks. Specifically, they find that 'diseconomies of scale become much more widespread and optimal bank size falls from around Yen 5-10 Trillion to Yen 1-2 Trillion when risk and quality factors are taken into account' (p. 1614). X-inefficiencies are found to range between 5 and 7 per cent, in contrast the levels of about 20 per cent typically found in studies of US banks. Interestingly, the X-efficiency estimates are found to be much less sensitive to the exclusion of risk and quality factors than the economies of scale estimates.

Drake and Hall (forthcoming), using DEA on a 1997 cross-section sample, also find that the largest city banks exhibit clear evidence of decreasing returns to scale with a mean SE level of 91.27. They do, however, find evidence of considerable potential economies of scale for most banks as the mean level of SE for the overall sample is only 92.78, with the vast majority of banks exhibiting increasing returns to scale.

In contrast to Altunbas et al. (2000), Drake and Hall find an indicative MES (minimum efficient scale) in the total lending range of ¥6 trillion to ¥10 trillion, and which is relatively invariant to controlling for lending quality (via the inclusion of loan-loss provisions). Furthermore, Drake and Hall find that the measures of pure technical efficiency are more sensitive to the latter than are the scale economy measures.

Interestingly, Drake and Hall (forthcoming) find important efficiency differences across the various subsectors of Japanese banks. Specifically, the trust banks and LTCBs (long term credit banks) are found to be by far the most efficient banking sectors in Japan. Both sectors exhibited mean SE and PTE scores of 100, in contrast to the sample mean levels of 92.78 and 78.11, respectively. Furthermore, this result pertains whether or not lending quality is controlled for. This is an interesting result in itself, but also in the context of the subsequent failures of a number of the LTCBs. The fact that most of these were associated with unrecorded bad debts appears to confirm that many banks continued to hide the true scale of their bad-debt problems for long periods during the 1990s. Hence, any efficiency results for Japanese banks using official 1990s data may not be totally reliable, even if they control for risk and lending quality (using reported loan-loss provisions). The results may also reflect the fact alluded to previously, however, that the major problem facing many Japanese banks was low profitability (and high bad debts) rather than high cost ratios. Hence, it is quite possible that the LTCBs and trust banks were highly cost efficient but neverthelesss suffered from asset quality and profitability problems.

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