Problem Loans and Cost Efficiency in Commercial Banks (WP 95-5)

Abstract

This paper addresses the seldom-examined intersection between the problem loan and the bank efficiency literatures. We employ Granger-causality techniques to test four hypotheses regarding the relationships among loan quality, cost efficiency, and bank capital — "bad luck," "bad management," "skimping," and "moral hazard."

In general, the data suggest that problem loans Granger-cause reductions in cost efficiency (supporting the bad luck hypothesis), and that cost efficiency Granger-causes reductions in problem loans (supporting the bad management hypothesis). On average, the data support neither the skimping or moral hazard hypotheses, although we find evidence of the former in a subsample of cost efficient banks, and evidence of the latter in a subsample of thinly capitalized banks.

Our results imply that policy makers and bank researchers should consider cost efficiency in addition to the more traditional indicators of bank failure (capital levels, credit risk, etc.). Our results are ambiguous concerning whether or not loan quality should be included as a control variable in cost efficiency models.

Authors

Allen N. Berger and Robert DeYoung