Economic reforms and bank efficiency in developing countries: the case of the Indian banking industry

Abstract

Using the Indian banking industry as a case study, this paper proposes and tests hypotheses regarding the possibility of a relationship between three elements of the Economic Reforms (ERs) – namely, fiscal reforms, financial reforms, and private investment liberalisation – and bank efficiency in developing countries. Bank efficiency is measured using data envelopment analysis (DEA); the relationship between the measured efficiency and various bank-specific characteristics and environmental factors associated with the ERs is examined using the OLS and the GMM estimations. Our results show an improvement in the efficiency of banks, especially that of foreign banks, after the ERs. We find a positive relationship between the level of competition and bank efficiency. However, a negative relationship between the presence of foreign banks and bank efficiency is found, which we attribute to a short-run increase in costs due to the introduction of new banking technology by foreign banks. Furthermore, we find that fiscal deficits negatively influence bank efficiency.

Notes

¹ The economic reforms primarily include: fiscal reforms, investment liberalisation, financial reforms, and trade and foreign exchange liberalisation (see Williamson, 2000).

² In this paper, the efficiency refers to the ability of a firm to utilise its inputs. In the empirical literature, this is usually known as technical efficiency. Our analysis could be extended to include allocative efficiency as well. However, in the case of developing countries, as the data on input prices are usually not available or are distorted due to restriction on wages and interest rates, we restrict the analysis to the technical efficiency of banks only.

³ For example, to finance its high fiscal deficits, the government of India required commercial banks to invest more than 30% of their loanable funds in approved government securities (see Arun and Turner, 2002). Although this declined slightly after the implementation of the ERs in 1991–1992, persistently high fiscal deficits have impeded the government's ability to lower this requirement impartially (see Ahluwalia, 1999).

⁴ For example, in the case of India, the cash reserve requirement was around 15% before the implementation of the ERs. This ratio was still above 10% by the end of 1998. A key reason behind this high reserve requirement, it is argued, was the government's need to finance its persistently high fiscal deficits (see Ahulwalia, 1999).

⁵ Another channel through which the liberalisation of private investment can have positive impacts is entry of foreign firms that bring new technical skills that can be spilled over to other sectors including the banking sector.

⁶ www.rbi.org.in

⁷ www.finmin.nic.in

⁸ For example, in 1997–1998, gross non-performing loans as a percentage of total advances of public sector banks, domestic private banks and foreign banks were around 16%, 6.7%, and 6.4%, respectively (RBI, 1999).

⁹ See Arellano and Bond (1991).

¹⁰ A recent study by the Reserve Bank of India, substantiates our conclusion by pointing out that the average IT expenditures as a percentage of total expenses during 1996-2000 in public sector banks, domestic private banks, and foreign banks were 4.5%, 7%, and 8.6%, respectively.