Three essays on bank technology, cost structure, and performance

Three essays on bank technology, cost structure, and performance

THREE ESSASYS ON BANK TECHNOLOGY, COST STRUCTURE, AND PERFORMANCE BY DAN WANG M.A., Binghamton University, 2003 M.A., Xiamen University (China), 2001 B.A., ZhongNan University of Economics and Law (China), 1996 DISSERTATION Submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Economics in the Graduate School of Binghamton University State University of New York 2007 UMI Number: 3266486 3266486 2007 UMI Microform Copyright All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, MI 48106-1346 by ProQuest Information and Learning Company. © Copyright by Dan Wang 2007 All Rights Reserved iii Accepted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Economics in the Graduate School of Binghamton University State University of New York 2007 Feb 28, 2007 Chairman, Subal C. Kumbhakar, Department of Economics, Binghamton University Christopher L. Hanes, Department of Economics, Binghamton University Daniel J. Henderson, Department of Economics, Binghamton University Jian Zhou, School of Management, Binghamton University iv ABSTRACT This dissertation addresses the issues around the technology and cost structure in commercial banking industries in both industrialized economy (US) and transitional economy (China). In addition, internal and external factors that affect bank performance, in terms of technical change, technical efficiency and total factor productivity, are examined to provide policy and business implications to regulatory authorities and banking managers. The first paper investigates the existence of strategic group and heterogeneous technology in the US banking industry. Two stages of analyses are conducted. First, cluster analysis is carried out to segment the US commercial banks into seven distinct strategic groups in terms of their product mix and allocation of inputs. The membership shifts across strategic groups during the sample period (1991-2000) are traced to explore the response of banks to the changes of market conditions and regulatory environments. Second, based on the segmentation by cluster analysis, we further investigate the production technology and cost structures for each strategic group in the US commercial banking industry. A system of cost function and derived share equations are used to estimate the technology for each group. The distributions of returns to scale and technical change for each strategic group are also examined. The results provide the evidence of the presence of distinct strategic groups and heterogeneous technologies in the US banking industry. We find returns to scale and technical change vary substantially across strategic v groups. Based on our findings, we conclude that the traditional application of a single homogeneous technology to the entire industry is likely to misrepresent the US banking industry. The second paper examines how and why the de novo banks in the US banking industry distinguish from their peer established banks. Using a selected sample data of 2001-2005, we find that a typical de novo bank has higher capital equity ratio, higher concentration in real estate loans, higher cost of deposits and labor, and higher average quality of loans as well. In terms of profitability (ROA), our observation on the de novo banks in recent years is consist with previous studies on the de novo banks active in the 1980s: negative earnings in first two or three years followed by substantial improvement in their profitability, though still lagging behind a typical established bank at least in their first eight years of operation. In order to link profitability with production process, we introduce a cost metafrontier model that enables us to compare technologies across different groups of banks by using measures of technology gap and global technical (cost) efficiency. Empirically, we find that improving cost efficiency leads higher profitability for the de novo banks. In contrast, this effect is absent for the established banks. Scale economy exhibits its most advantageous effects on the smallest new banks by improving their technology, cost efficiency and thus profitability, while these advantages of scale diminish with the increase in size and finally they disappear when bank size reaches certain level. In the third paper, focus is shifted from industrialized economy (US) to transitional economy, China, where markets and institutional structures are different from those of vi developed countries. We employ an input distance function approach to analyze the impact of banking deregulations/reforms in China since early 1990s on the efficiency and the total factor productivity (TFP) change in Chinese banking industry. We find that the joint-equity banks are more efficient than the wholly state-owned banks (WSOBs). Furthermore, both the WSOBs and the joint-equity banks are found to be operating slightly below their optimal size, suggesting potential advantages of expansion of their businesses. Overall, TFP growth in Chinese banking industry was 4.4% per annum for the sample period 1993-2002. Joint-equity banks experienced much higher growth in TFP (5.5% per annum) compared to the WSOBs (1.4% per annum). vii To Quan and Julie viii ACKNOLEGEMENTS I am greatly indebted to Subal C. Kumbhakar, my dissertation advisor, for his thoughtful guidance, critical comments, and constant encouragement. Throughout my tenure as a Ph.d. student, Subal has been a teacher, a mentor, and a friend. Thanks to Subal, I have enjoyed learning econometrics and research skills from scientific writing to structural way of thinking. He gave me his hearty support during the time when I was on the job market. Additional thanks go to other members of my dissertation Committee. I am very grateful to Christopher L. Hanes and Daniel J. Henderson for their intuitive questions and invaluable comments on my dissertation. I thank Jian Zhou, who joined my dissertation committee as an outside examiner, for his tireless reading and commenting. I would also like to thank Neha Khanna, Clifford Kern and staffs in the Economics Department at Binghamton University for many helps and considerations along the way in the years back in Binghamton. My mother-in-law, JieZhi Hu came to the States and took care of my daughter during my hectic days of preparing my dissertation. Without her help, I couldn’t have gone so far with family obligations. I greatly appreciate all she has done. I am deeply indebted to my parents for their unconditional love and support during all these years when I am away from them. Julie, my daughter, is my angel and brings endless joys and laughs to my life. ix Without her, I couldn’t have been so energetic and kept pushing myself beyond what I thought I was capable of. Last but not least, I cannot express the level of gratitude and love that I have for my husband, Quan Zhou. He witnessed and shared every difficult and happy moments of my research. His encouragement, support and help are so appreciated that my feelings are beyond any words to describe. [...]... (See Berger and Humphrey (1997) for an international survey of banking studies of production, efficiency and performance) This dissertation consists of three independent but related studies on the US commercial banking industry, the de novo banks in the US and the banking industry in China, respectively All of the three chapters address the topics around technology, cost structures, and performance. .. metafrontier model and estimates a cost function for each of the five groups of the de novo banks Furthermore, for comparison purpose, a population of established banks with similar scale as the de novo banks is included in the study Cost structures and cost efficiencies across the groups of de novo banks and between subpopulations of the de novo banks and the established banks are examined and compared... results from these three studies strengthen the findings from prior studies and offer new insights to understanding production technologies and cost structures of banking industry in both developed economy and transitional economy This more in-depth understanding of technologies and cost structures further helps assess the performance of the banking industries in a more accurate way and provide more... the US banks Next, an empirical model of cost function is outlined, followed by discussion of variables and data Empirical results of both cluster and cost analysis are summarized in section 4 Meanwhile, the validity of bank size as a grouping criterion is also assessed in section 4 Section 5 concludes the paper 1.2 CLUSTER ANALYSIS AND STRATEGIC GROUPS Deregulation and technological innovations in... for example, Hayes et al (1983) on investment banking industry, Curry and Rose (1997) on thrift institutions, and Amel and Rhoades (1988, 1992) on commercial banking industry However, there is no consensus among these studies on the definition of “strategy” and hence on the criterion which is used to classify strategic groups As a result, various strategic variables and grouping methods have been used... technical efficiency change and change induced by bank characteristics and environmental forces Through the examination, the third chapter provides a comprehensive assessment of the performance of Chinese domestic banks, and the internal and external factors that affect their performance All in all, the dissertation enriches the body of literature of banking studies on production and performance with some... order to reduce estimation biases and accurately measure the production technology (or /and cost structure) of the US banking industry, it is necessary to treat different strategic groups separately Otherwise, misleading conclusions are very likely to be drawn, based on the analysis by pooling all banks together This is the major conclusion and contribution of the first paper Concurrent to the overall... underlying production process can be examined by estimating either production or cost functions Since late 1960s the production function and its dual cost function approaches have been well employed in the empirical studies using microeconomic data (for example, Diewert (1974), Christensen and Greene (1976), Brown, Caves and Christensen (1979), Caves and Christensen and Swanson (1981), among others) Both... distortional effects of outliers on the formation of clusters 1.3 COST ANALYSIS 1.3.1 Methodology 8 Several numbers were used in the experiments, including 20, 25, 30, 50 and so on After the elimination of clusters with low frequency and repetition of the process, it turned out that the similar numbers of clusters were always obtained 17 Conventional cost function estimation is based on the assumption of... represented by a production function, or indirectly by a cost function Since outputs in service industries are exogenous to the firms (demand determined) and cannot be stored, a cost function approach is more appropriate and is widely used in banking studies Furthermore, the cost function approach has an advantage over a production function approach in handling multiple outputs (Kumbhakar and Lovell (2000)) . response of banks to the changes of market conditions and regulatory environments. Second, based on the segmentation by cluster analysis, we further investigate the production technology and cost. inference on the policy implications in the current economic and banking industrial environments. Second, the study employs a cost metafrontier model, which is relatively new and has only been. COST STRUCTURE, RETURNS TO SCALE AND TECHNICAL CHANGE 31 1.4.5 COMPARISON OF RTS AND TC ACROSS STRATEGIC GROUPS WITHIN BANK SIZE GROUP 34 1.5 SUMMARY AND CONCLUSIONS 36 CHAPTER 2 54 THE PERFORMANCE