Productive efficiency in banking

In this article we discuss the concept of efficiency in production, define its various aspects and the means to measure it, and review the relevant literature concerning inefficiency in the banking industry. Our major conclusion is that there appears to be significant inefficiency in banking. Inefficiency resulting from operating at an inappropriate scale of operation is probably in the range of 10-20 percent of costs. However, by emphasizing the role of scale, researchers have essentially overlooked a major portion of bank inefficiency. The evidence suggests that inefficiencies resulting from the suboptimal utilization of inputs is larger than that resulting from other factors. According to a majority of studies, banks operate relatively efficiently with respect to the optimal combination of inputs, yet many are very inefficient in converting these inputs into outputs. This inefficient utilization of inputs accounts for an additional 20-30 percent of costs. This is particularly interesting because it implies that, to a great extent, the future viability of an individual bank is under its own control. To the extent that bank inefficiency can be accurately measured, it appears that the largest inefficiencies are not the result of regulation or technology, but result directly from an underutilization of factor inputs by bank management. This inefficiency will most likely decline in the future as bankers respond to increased competitive pressures and strive to become more efficient. Failing this, the inefficient firms will become prime merger candidates to be acquired and restructured.