Frontier efficiency measurement in deposittaking financial mutuals: A review of techniques, applicat

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Frontier efficiency measurement in deposit-taking
financial mutuals A review of techniques,
applications, and future research directions

• Professor Andrew Worthington
• Griffith University

Paper presented at the AbacusMelbourne Centre
for Financial Studies Research Workshop on
Financial Mutuals, 28 April 2008, Sydney.
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Introduction

• Frontier efficiency measurement techniques have
  been increasingly used to financial institution
  efficiency.
• A small but steadily increasing number of studies
  are concerned with deposit-taking financial
  mutuals, especially credits unions (CU), building
  societies (BS) and savings and loans (SL).
• A variety of contexts but concentrated in
  Australia (CU and BS), the US (CU and SL) and
  the UK (CU and BS).
• Several now rather dated surveys of frontier
  efficiency techniques in financial institutions
  now exist, but these mostly relate to large banks
  in the US.

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Efficiency concepts

• Technical efficiency is the productive resources
  in the most technologically efficient manner.
• ? the maximum possible output from a given set of
  inputs or the minimum possible inputs for a given
  level of output.
• Allocative efficiency is the ability of an
  organisation to use these inputs in optimal
  proportions, given their respective prices and
  the available production technology.
• ? choosing between the different technically
  efficient combinations of inputs used to produce
  the maximum possible outputs.
• Allocative efficiency and technical efficiency
  determine the degree of productive efficiency (or
  total economic efficiency).
• Also cost efficiency, scale efficiency, revenue
  efficiency, and profit efficiency and the
  separation of productivity into the components
  attributable to efficiency and technological
  change.

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Frontier efficiency approaches

• All efficiency measures assume the production
  frontier of the fully efficient organisation is
  known.
• A this is usually not known, the production
  frontier must be estimated using sample data.
• Two approaches are possible
• a nonparametric piecewise-linear convex frontier
  constructed such that no observed point should
  lie outside it (the mathematical programming
  approach) or
• a parametric function fitted to the data, again
  such that no observed point should lie outside it
  (the econometric approach).
• These approaches use different techniques to
  envelop the observed data, and therefore make
  different accommodations for random noise and for
  flexibility in the structure of the production
  technology.

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Specific approaches

• Econometric (parametric) techniques
• Deterministic frontier analysis (DFA)
• Stochastic frontier analysis (SFA)
• Mathematical programming (non-parametric)
  techniques.
• Data envelopment analysis (DEA)
• Free-disposal hull (FDH)
• Malmquist productivity indices (MI)

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Econometric techniques

• DFA usually restricted to single outputs.
• In DFA no allowance for specification and data
  measurement errors
• SFA adds information on prices and costs in
  addition to quantities.
• Popular form for assessing cost efficiency.
• Can use complex or simple functions.
• SFA introduces a disturbance term representing
  noise, measurement error, and exogenous shocks.
• The efficiency of mutuals are measured against
  some theoretical standard normally find no
  fully efficient firms.
• Difficult to include inputs and outputs not
  specified in dollars or prices.

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Mathematical programming techniques

• Non-stochastic and non-parametric.
• Allows multiple inputs and outputs specified in
  various measures (, ).
• Can impose a large number of additional
  constraints.
• Especially useful in contexts where strict profit
  maximisation is the not the objective.
• This has been used to justify its use for mutuals
  (along with hospitals, education, police, etc.)
  but equally in favour for bank studies.
• DEA most favoured approach.

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Conceptualising mutual behaviour

• production approach views mutuals as producers of
  deposit accounts and loans defining output as
  the number and type of accounts and their
  associated transactions. Inputs are calculated as
  the number of employees and capital expenditures
  on fixed assets and other material.
• intermediation approach conceptualises mutuals as
  intermediators, converting and transferring
  financial assets, inputs are labour and capital
  costs, and the interest payable and the value of
  deposits and other borrowed funds, with the
  outputs denominated in loans and financial
  investments.
• asset approach conceptualises a institutions
  primary function as the creation of loans
  closely related to the intermediation approach
  except that outputs are strictly defined by loan
  assets.

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Deciding upon a specification

• Intermediation approach dominates existing work.
• Useful for comparing mutuals at the industry
  level with relatively modest data requirements.
• Production approach regarded as potentially most
  useful at branch level but would rely on in-house
  information.
• Problem is whether any of these should apply to
  mutuals.

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Explaining efficiency differences

• the benefits and costs of the mutual form
• regulation, organisational and legal structures
• the role of branches and membership
• merger activity

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Directions for future research

• Combine comparable institutions from different
  sub-sectors (say, small banks with building
  societies and credit unions) or institutions from
  different national contexts (like UK and
  Australian building societies) in a single study.
  
• Consult with industry and regulators on the
  nature of the behavioural objectives in
  deposit-taking financial mutuals and the extent
  to which they differ (if any) from other
  organizational forms.
• Apply other measures like revenue and profit
  efficiency not previously found in the mutual
  literature.
• Consider productive efficiency at the
  branch/sub-unit level