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Banking reforms and the evolution of cost efficiency in Indian public sector banks

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Abstract

This paper analyses the trends of cost efficiency and its components across Indian public sector banks (PSBs) during the post-deregulation period spanning from 1992/1993 to 2007/2008. The study also examines the issue of convergence in cost, technical and allocative efficiency levels of Indian PSBs. The empirical results indicate that deregulation has had a positive impact on the cost efficiency of Indian public sector banking industry over the period of study. Further, technical efficiency of Indian PSBs followed an uptrend, while allocative efficiency followed a path of deceleration. We note that in Indian public sector banking industry, the cost inefficiency is mainly driven by technical inefficiency rather than allocative inefficiency. The convergence analysis reveals that the inefficient PSBs are not only catching-up but also moving ahead of the efficient ones, i.e., the banks with the low level of cost efficiency at the beginning of the period are growing more rapidly than the highly cost efficient banks. In sum, the study confirms a strong presence of σ- and β-convergence in cost efficiency levels of Indian public sector banking industry.

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Notes

  1. See, for example, Ataullah et al. (2004), Shanmugam and Das (2004), Sensarma (2005, 2006, 2008), Rezvanian et al. (2008), and Das and Ghosh (2006, 2009).

  2. By 1991, the pre-emption under the cash reserve ratio and the statutory liquidity ratio, on an incremental basis, had reached 63.5% of net demand and time liabilities.

  3. The combined pre-emption under CRR and SLR, amounting to 63.5% of net demand and time liabilities in 1991 (of which CRR was 25%) has since been reduced and presently, the combined ratio stands below 35% (of which, the SLR is at its statutory minimum at 25%).

  4. Prior to 25th October, 2011, except saving deposit account, non-resident Indian (NRI) deposits, small loans up to Rupee 0.2 million and export credit, all the interest rates were fully deregulated. Recently, RBI also deregulated the savings bank deposit interest rate.

  5. In 1993, the RBI issued guidelines concerning the establishment of new private sector banks. Nine new private banks have entered the market since then. In addition, over twenty foreign banks have started their operations since 1994.

  6. India adopted the Basel Accord Capital Standards in April 1992. An 8% capital adequacy ratio was introduced in phases between 1993 and 1996, according to banks ownership and scope of their operations. Following the recommendations of Narasimham Committee II, the regulatory minimum capital adequacy ratio was later raised to 10% in the phased manner.

  7. The time for classification of assets as non-performing has been tightened over the years, with a view to move towards the international best practice norm of 90 days by end 2004.

  8. From 2000 to 2001, the PSBs are required to attach the balance sheet of their subsidiaries to their balance sheets.

  9. The GOI has injected about 0.1% of GDP annually into weak public sector banks (Hanson 2005; Rangarajan 2007). During the period 1992/1993–2001/2002, GOI contributed some Rupee 177 billion, about 1.9% of the 1995/96 GDP, to nationalized banks (Mohan and Prasad 2005).

  10. In banking efficiency literature, the term cost efficiency is being used interchangeably with economic efficiency, X-efficiency and overall efficiency.

  11. Even though the true technology could be different from constant returns-to-scale (CRS), but we adopt the CRS specification of technology on account of the following reasons. First, given the small sample size like ours (27 banks in each years), one may get a distribution with many observations having efficiency score equal to 1 using variable returns-to-scale (VRS) specification. This implies that one may not get better discrimination of sampled units under VRS specification of technology in case of small sample size. Second, regarding the use of VRS specification of technology, Noulas (1997) stated that the assumption of CRS allows the comparison between small and large banks. In a sample where a few large banks are present, the use of VRS framework raises the possibility that these large banks will appear as being efficient for the simple reason that there are no truly efficient banks. Avkiran (1999) also mentions that under VRS each unit is compared only against other units of similar size, instead of against all units. Pasiouras et al. (2007) point out that the assumption of VRS is more suitable for large samples. The prominent studies that made use of CRS assumptions for measuring cost and technical efficiencies in banking system include Aly et al. (1990), Ariss et al. (2007), Hassan and Sancez (2007), Pasiouras et al. (2007), Rezvanian et al. (2008) among others.

  12. The interested readers can consult, for instance, Berger and Humphrey (1992), Mlima and Hjalmarsson (2002), Tortosa-Ausian (2002) and Hafferman (2005), for details on these approaches.

  13. No public sector bank failed or exited the market during the study period. The exit of banks from the market has taken place only in the private and foreign banking segments of the Indian banking sector.

  14. The ‘grand frontier’ envelops the pooled input–output data of all banks in all years.

  15. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) empowers banks to recover their non-performing assets without the intervention of the court.

  16. The ‘profitability’ is measured in terms of return on assets (ROA).

  17. The variable ‘size’ is measured in terms of value of total assets.

  18. The ‘intermediation cost’ is measured as the ratio of operating expenses as a percentage of total assets.

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  1. Faculty of Economics, South Asian University, New Delhi, 110067, India

    Sunil Kumar

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  1. Sunil Kumar
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Kumar, S. Banking reforms and the evolution of cost efficiency in Indian public sector banks. Econ Change Restruct 46, 143–182 (2013). https://doi.org/10.1007/s10644-012-9121-8

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