Consistency Conditions for Regulatory Analysis of Financial Institutions: A Comparison of Frontier Efficiency Methods

Abstract

NOTE: Below is a description of the paper and not the actual abstract.

We define six consistency conditions that frontier efficiency approaches to measuring the performance of financial institutions should meet to be useful for regulatory purposes. The first three conditions--that the efficiencies generated by these approaches be consistent with each other in terms of their efficiency levels, rankings, and identification of best and worst firms--help determine the degree to which the different approaches are consistent with each other. The latter three conditions--that the efficiencies are consistent over time, consistent with competitive conditions in the market, and consistent with standard non-frontier measures of performance--help determine the degree to which the efficiencies generated by the different approaches are consistent with reality and are believable, which is necessary for the efficiency estimates to be useful. We evaluate all four of the main approaches to estimating frontier efficiency or X-efficiency by employing multiple techniques within each of the four approaches, for a total of nine efficiency techniques evaluated. To be sure that the applications are comparable, all nine techniques estimated use the same efficiency concept (cost efficiency), the same sample of banks, same time interval, same specifications of inputs and outputs, and (for the parametric methods) the same functional form.

Our data set consists of a panel of 683 large U.S. banks that were in operation over the entire period from 1977-88 and operated in states that allowed branch banking. This was a period of many changes in regulations and market conditions, making it an almost ideal period to determine how the different frontier approaches identify and measure bank efficiency over a variety of extreme conditions.

Our findings yield some mixed evidence regarding the consistency of the four approaches. For the first three consistency conditions, these data suggest that the parametric methods are generally consistent with one another, and the non-parametric methods are generally consistent with one another, but the parametric and non-parametric methods are not generally mutually consistent.

Possible ?tie-breakers"--or conditions which help to choose whether the non-parametric versus parametric methods might be ?better?--are whether the efficiencies drawn from the different approaches are consistent with reality and are believable. All of the methods are found to be consistent over time (condition iv), but the parametric methods appear to be more consistent with what are generally believed to be the competitive conditions in banking markets (condition v), and also more consistent with non-frontier measures of bank performance such as return on assets or various cost ratios that are often used by regulators, managers, and consultants (condition vi). Furthermore, the parametric measures are generally highly positively correlated with the standard non-frontier performance measures, whereas DEA measures are much less strongly related to these other indicators of firm performance.

When performing regulatory analysis (or any other analysis that depends on frontier efficiency measurement), the use of multiple techniques and specifications should be helpful. If the six consistency conditions are met for two or more approaches, then one can be more confident in the conclusions drawn.

JEL Classification: G21, G28, E58, E61