A Cost System Approach to the Stochastic Directional Technology Distance Function with Undesirable Outputs: The Case of U.S. Banks in 2001-2010

Journal of Applied Econometrics, Forthcoming

25 Pages Posted: 8 Sep 2015

See all articles by Emir Malikov

Emir Malikov

University of Nevada, Las Vegas

Subal C. Kumbhakar

State University of New York (SUNY) at Binghamton - Department of Economics

Efthymios G. Tsionas

Athens University of Economics and Business - Department of Economics

Date Written: September 5, 2015

Abstract

This paper offers a methodology to address the endogeneity of inputs in the directional technology distance function (DTDF) based formulation of banking technology which explicitly accommodates the presence of undesirable nonperforming loans -- an inherent characteristic of the bank's production due to its exposure to credit risk. Specifically, we model nonperforming loans as an undesirable output in the bank's production process. Since the stochastic DTDF describing banking technology is likely to suffer from the endogeneity of inputs, we propose addressing this problem by considering a system consisting of the DTDF and the first-order conditions from the bank's cost minimization problem. The first-order conditions also allow us to identify the "cost-optimal" directional vector for the banking DTDF, thus eliminating the uncertainty associated with an ad hoc choice of the direction. We apply our cost system approach to the data on large U.S. commercial banks for the 2001-2010 period, which we estimate via Bayesian MCMC methods subject to theoretical regularity conditions. We document dramatic distortions in banks' efficiency, productivity growth and scale elasticity estimates when the endogeneity of inputs is assumed away and/or the DTDF is fitted in an arbitrary direction.

Keywords: Bad Outputs, Commercial Banks, Directional Distance Function, Endogeneity, MCMC, Nonperforming Loans, Productivity, Technical Change

JEL Classification: C11, C33, D24, G21

Suggested Citation

Malikov, Emir and Kumbhakar, Subal C. and Tsionas, Efthymios (Efthymios) G., A Cost System Approach to the Stochastic Directional Technology Distance Function with Undesirable Outputs: The Case of U.S. Banks in 2001-2010 (September 5, 2015). Journal of Applied Econometrics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2657152

Emir Malikov (Contact Author)

University of Nevada, Las Vegas ( email )

4505 S. Maryland Parkway
Las Vegas, NV 89154
United States

Subal C. Kumbhakar

State University of New York (SUNY) at Binghamton - Department of Economics ( email )

Binghamton, NY 13902-6000
United States

Efthymios (Efthymios) G. Tsionas

Athens University of Economics and Business - Department of Economics ( email )

76 Patission Street
GR-10434 Athens
Greece
+301 8203 (Phone)
+301 8203 301 (Fax)

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