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The influence
of bank efficiency on bank performance

The efficiency of a specific bank
can have various impacts on its performance, which can be viewed on the ratios
and data from the banks’ balance sheet. 
In recent academic literature, the efficiency of a bank can be measured
in a different way. Berger (1993) introduced a way to derive efficiency ratio
from the profit function, since the profit function allows to measure
inefficiencies on the output side, as well as the input side.  Another technical approach is commonly used
in measuring efficiency, the DEA Method, which was first introduced by Charnes,
Cooper and Rhodes (1978) who employed a mathematical planning model ( the CCR
model) to measure the technical efficiency frontier based on the concept of the
Pareto Optimum. In this study, an alternative approach of measuring the
efficiency is going to use, which is the efficiency ratio derived from the data
from the income statement and balance sheet. The efficiency ratio is calculated
by dividing the bank’s non-interest expenses by its net income. Banks are
striving for lower efficiency ratio, since a lower efficiency ratio indicates
that the bank’s income is exceeding its expense

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In order to figure out the influence
of bank efficiency on bank performance, this study is focusing on the relation
between a bank’s efficient ratio and its performance ratio, since the tendency
of the ratio can reflect the impact of a bank’s efficiency on its performance.
To specify the study, the banking industry in Great Britain is closed as the
major research object, and all the data analysis is based on data given by the
Bloomberg.

According to the data on Bloomberg,
seven banks are listed in Britain, including two new-comers, Metro Bank PLC and
CYBG PLC, both of which are listed on the market less than four years. Since
the period of the research ranges from S1 2005 to S1 2017, the analysis of
those two banks will only cover the data from the date they went public now.

In this study, efficiency ratio
calculated from the data in balance sheet stands for the efficient level of a
specific bank, with the lower ratio the higher efficient, while three return
ratios ( Return on Common Equity, Return on Assets and Return on Capital) stand
for the performance of a selected bank, with the higher ratio the better
performance.

When it comes to the positive aspect
of the efficiency-performance relationship, a bank with lower efficiency ratio
usually have a higher performance ratio. 
That is to say. Higher efficiency can lead to a better performance of a
bank. Since the efficiency ratio is calculated by the following formula, lower
efficiency ratio stands at a relatively lower operating expense and a
relatively higher income, which will naturally lead to a better banking performance.

The following graphs show the
efficiency ratio variation and the performance ratio (Return on Common Equity,
Return on Assets and Return on Capital) variation. Profit efficiency is
computed using three different measures, ROA, ROE and ROC. ROA is earnings
after taxes as a percent of total assets. For ROE, the numerator is identical
with for ROA, but the denominator is shareholders equity. The use of both ROA
and ROE is important since small banks, many of which are privately held,
differ from larger publicly traded banks in their use of leverage. Small banks
generally use less leverage, which lowers ROE relative to ROA. And Return on
Capital is a profitability ratio. It evaluates the return that an investment
generates for capital contributors, i.e. bondholders and stockholders. Return
on capital indicates how effective a company is at turning capital into
profits. The dominator of ROC is identical with ROA and ROE, while the
numerator is Net Income minus Dividends. So ROC can be regarded as earnings
after dividends as a percent of total assets.

In the above graphs, it is obvious
to note that banks with lower efficiency ratio (higher efficiency) tend to have
higher performance ratio, which is rather significant in the before- crisis
period (periods happened before the 2008 financial crisis). For example, in S2
2006, the rank of return on common equity is the reverse order of the rank of
the efficiency ratio, which strongly proves the conclusion mentioned before.
Similar relationship can be discovered in the graphs of return on assets and
the return on capital, both of which stand for the performance in a slightly
different way.

When it comes to the negative aspect
of the relationship, it can be seen that a bank with lower efficiency tend to
have worse performance than the industry average. As Epure (2015) mentioned,
risk variables can be used as an efficiency measure, efficiency ratios contain
the information that the potential risk that a bank is facing. A bank with relevant
lower efficiency is exposed at a higher risk, since risk variables can be seen
as an alternative to measure a bank’s efficiency. While higher risk is a signal
that leads to a possibility of a bank’s failure.  In academic literature, measure efficiency by
using risk parameter is a widely -accepted approach. . Altunbas et al. (2000)
express loan portfolio quality through the ratio of non-performing loans (NPL)
to total loans, which may be considered an endogenous measure of risk.
According to Berger and DeYoung (1997) and Van Hoose (2010) this variable
captures the quality of monitoring over loan portfolios. So it is easy to
construct a communal connected relationship among riskiness, efficiency and
performance. The efficiency ratio is in negative correlation with performance
and in a positive relationship with risk.

Back to the result of the study,
this relationship can be discussed in the above graphs. Before the 2008
financial crisis, the potential risk of the banking industry is relevant lower,
while the risk is relevant higher when the crisis is happened. It can be seen
from the graph of the efficiency ratio, before the crisis, the efficiency ratio
is applicable lower when it compared to the ratio in the crisis period (S2
2008-S1 2010).  When it comes to
performance, it can be seen from the graphs of performance that the return
ratio is relatively higher than the return ratio in and after the crisis
period. This tendency matches the relationship among them mentioned before.
That just says, when banks are facing higher risk, their efficiency will be
affected negatively and their performance will be negatively affected since
their efficiency is no longer higher than before.

A bank can be categorised by the
portion of its major shareholders, since the Ownership of banks varies. Berger
(2009) divides banks into the following category solely based on their
ownership when he made his research on bank ownership and efficiency in China.

With respect to the unique
characteristic of Britain’s banking industry, the above classification is no
longer part suitable for British Banks, since most banks share the similar
ownership structure and the only difference is the portion. In order to conduct
a more detailed study, we then focus on the two major owners with the greatest
portion of shares of each bank. The result shows in the following table, with
data quoted in 10/12/2017.

From the table, it is easy to find
that “investment Advisor” play a dominate role in each bank except
for the Royal Bank of Scotland Group PLC, whose majority owner is the
government. In Bloomberg, the term “investment Advisor” stands for a
group of mutual funds and global investment group, which come from different
countries. In this study, the group that “investment Advisor” can be
treated as foreign investors when it compared with domestic investors such as
Sovereign Wealth Fund and government. Armed with this criterion, it is obvious
that six out of seven banks are majorly foreign owned, while only the Royal
Bank of Scotland Group PLC is majorly owned by the government. However, the
efficiency varies a lot in these six foreign owned banks, even though
investment Advisors is the dominate owners.

Firstly, different major ownership
has different impact on efficiency.  When
compared the efficiency ratio of Royal Bank of Scotland Group PLC (RBS) with
that of other six banks, the efficiency ratio of RBS is significantly higher
than other banks except for CYBG PLC and Metro Bank PLC, which can be expressed
as the fact that compared to the major government-owned bank, the major
foreign-owned bank have a relevant higher efficiency. Similar conclusion was
conducted by Bonin (2005) when he made his research on efficiency and ownership
in transition countries, who said that “foreign participation enhances the
efficiency of domestic banking”. Based on his research and my own
understanding, the reason why majority foreign-owned banks have higher
efficiency can be explained that the foreign owner is an incentive for a bank’s
efficiency, which allows the bank to access world-widely. This wide connection
can improve the efficiency.

Secondly, in the group of major
foreign-owned banks, efficiency still varies due to the portion of shares that
foreign investors hold. By reviewing the portion held by foreign investors
among six banks, it can be seen that the potion ranks in the following order:
Lloyds Banking Group PLC (81.34%), HSBC Holdings PLC (77.67%), Barclays PLC
(75.66%), Metro Bank PLC (68.84%), Standard Charted PLC (64.71%) and CYBG PLC
(61.69%).  Then we can derive the rank of
efficiency from the graph of the efficiency ratio, which ranks (from low to
high) HSBC Holdings PLC, Lloyds Banking Group PLC, Barclays PLC, Standard
Charted PLC, Metro Bank PLC and CYBG PLC. It is evident that those two ranks
roughly match in the same order. From this similarity, it can be derived that
for the major foreign-owned banks, the portion of foreign shares and the
efficiency levels are in a positive correlation, meaning that the more shares
owned by foreign investors, the more efficient the bank will be. This tendency
can be attributed to using the same explanation when we compared the efficiency
between majorly foreign-owned banks and majorly government-owned banks. Foreign
ownership gives the bank prior to access world-widely, making it operated more
efficient.

In a conclusion, the influence of
bank efficiency on bank performance can be divided into two parts. From the
progressive aspect, higher efficiency stands for generating profits with lower
cost, which directly links to better bank performance. From the negative
aspect, efficiency can be treated as a measurement for risk. The performance of
a bank may suffer when it is facing for high risks, which lead to lower
efficiency.

In the further study, the ownership
structure is an important element in the efficiency of a bank. Compared with
the major domestic-owned banks, majority foreign-owned banks are more
efficient. And among major foreign-owned banks, banks with larger foreign-owned
shares are more efficient. Both facts can be attributed to the same reason.
Foreign ownership gives the bank more exposure world-widely, making them
operate more efficient.

 

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