Eff and Risk Taking
Eff and Risk Taking
Eff and Risk Taking
DOI 10.1007/s10693-011-0111-1
Abstract Investment banks core functions expose them to a wide array of risks. This
paper analyses cost and profit efficiency for a sample of investment banks for the G7
countries (Canada, France, Germany, Italy, Japan, UK and US) and Switzerland prior to the
recent financial crisis. We follow Coelli et al. (J Prod Anal 11:251273, 1999)s
methodology to adjust the estimated cost and profit efficiency scores for environmental
influences including key banks risks, bank- and industry- specific factors and
macroeconomic conditions. Our evidence suggests that failing to account for environmental
factors can considerably bias the efficiency scores for investment banks. Specifically, bank
risk-taking factors (including liquidity and capital risk exposures) are found particularly
important to accurately assess profit efficiency: i.e. profit efficiency estimates are
consistently underestimated without accounting for bank risk-taking. Interestingly, our
evidence suggests that size matters for both cost and profit efficiency, however this does not
imply that more concentrated markets are more efficient.
Keywords Investment banking . Stochastic frontier analysis . Efficiency . Environmental
conditions . Banking risks
JEL classification D2 . G24 . G32 . L25
The authors wish to express thanks to Haluknal (the Editor) and an anonymous referee for their useful
comments and suggestions. We also thank Meryem D. Fethi, Iftekhar Hasan, Fotios Pasiouras, and
conference participants at the International Conference on Global trends in the Efficiency and Risk
Management of Financial Services and the Financial Crisis held 2009, in Leicester. All errors, of course, rest
with the authors.
N. Radi (*)
Centre for EMEA Banking, Finance and Economics, London Metropolitan Business School, London
Metropolitan University, 84 Moorgate, London EC2M 6SQ, UK
e-mail: n.radic@londonmet.ac.uk
F. Fiordelisi
University of Rome III, Via S. DAmico 77, 00145 Rome, Italy
e-mail: fiordelisi@uniroma3.it
C. Girardone
University of Essex, Wivenhoe Park, Colchester CO4 3SQ, UK
e-mail: cgirardone@essex.ac.uk
82
1 Introduction
In the Great Moderation era, the investment banking industry in all advanced economies
benefited from the processes of liberalisation, internationalisation and consolidation
activities. An increasing number of financial institutions have been involved in crossborder activities and in providing banking services globally. Investment banks main
business is to intermediate between issuers and investors through the functions of M&A
advisory services and underwriting of securities issues. They also provide trading and
investing in securities and asset management.
Yet, investment banks core function lays in the origination of large and complex
financial instruments that expose them to market risks and imply that their business
relies predominantly on the short-term. The recent financial turmoil affected a relatively
large number of investment banks. Under pressure for profits, these latter have
contributed to the emergence of an unprecedented system of compensations, a highly
leveraged industry and a pervasive risk culture. Post-crisis, surviving banks will have to
comply with new constraints thus the evaluation of their operating efficiency will likely
gain a new impetus, particularly on the cost side. In this context, the description of
modern investment banks production process should reflect the changes in their
business focus. As well, it should account for risk and other environmental and
regulatory factors.
The need for a correct evaluation of investment banks efficiency can be explained by
various reasons. First, investment banks typically have a large number of stakeholders since
they engage in public and private market transactions for corporations, governments and
investors. An inaccurate assessment of their operating efficiency could bias their
performance analysis and, consequently, cover up their financial difficulties thus resulting
in negative externalities for all investment banks stakeholders (including governments,
stake-issuers and, ultimately, investors). Second, the investment banking sector is probably
one of the most globalised industries: investment banks from various countries compete
with each other to acquire customers in all countries. As such, the assessment of investment
banks efficiency cannot accurately be made focussing on national banking market; rather it
should take a worldwide perspective. Moreover, investment banking is a complex business
mostly based on risk-taking and risk-transferring services. Therefore, a correct assessment
and recognition of these risks play a key role in the investment banking efficiency
estimation. Finally, investment banking is a revenue-motivated business. Managing the cost
base has always been dominated by human capital, and influenced by investments in IT,
global infrastructure and product platforms. However, this raises also the issue of the
relationship between cost and revenues, which means that banks can match their cost base
to the revenue generating potential over time. The most valuable of investment banks
tangible assets is staff, so that the largest expenses regard the workforce compensation and
benefits.1
The contribution of this paper to the existing literature is manifold. This study is one
of the few focussing on the investment banking industry, which is surprisingly
inadequately explored (e.g. Berger and Humphrey 1997; Berger 2007; Hughes and
Mester 2009 do not cite any study on investment banks). Moreover, we assess both cost
1
Other operating expenses are generally lower than compensation expenses, and concern communication
and technology, occupancy and depreciation, brokerage, clearing and exchanges fees, marketing and
advertisements, office supplies, etc. For further details see e.g. Liaw (2006).
83
2 Literature review
The efficiency studies applied to the banking sector focus predominantly on commercial
banking (see e.g. the extensive reviews by Berger and Humphrey 1997; Goddard et al.
2001; Berger 2007; Hughes and Mester 2009). Only a handful of studies (Allen and Rai
1996; Vander Vennet 2002) analyse universal banking (which includes investment
banking in their business) and compare it with traditional banking. Namely, Allen and Rai
(1996) use the distribution-free approach (DFA) and stochastic frontier approach (SFA)
for a systematic comparison of X-inefficiency measures across 15 developed countries
under different regulatory environments. Inputs selected to describe the production
process of banks are the price of labour, the price of fixed capital and the price of
borrowed funds, while outputs are defined as loans and investment assets. The authors
estimate a global cost function for international banks to test for both input and output
inefficiencies.
More recently, Vander Vennet (2002) uses the SFA in order to measure cost and profit
efficiency of European financial conglomerates and universal banks over 19951996. The
author employs an input specification similar to Allen and Rais, whereas outputs are
defined using two different approaches: one focussing on output volumes (i.e. total loans
84
and total securities) and the other on output revenues (i.e. total interest income and total
non-interest revenues). Results show that financial conglomerates are more revenue
efficient than specialized banks and that universal banks are more efficient both on the
cost and revenue side. The author suggests that further research should examine the
sources of the efficiency differences between various types of banks (Vander Vennet
2002, p. 280).
As far as we are aware, Beccalli (2004) is the only study directly examining the
efficiency of investment firms by comparing the cost efficiency of UK and Italian
investment firms over the period 19951998. Parametric stochastic frontier approach (SFA)
is used in order to model cost efficiency. According to the authors findings, controlling for
environmental variables is crucial in assessing the investment banking business since these
factors have a significant influence on cost efficiency as well as profitability. In terms of
cross-country operations, more efficient investment firms were found to be more
international, thus exporting a more efficient model, while less efficient firms tend to
attract foreign investment firms with higher efficiency.
The paucity of efficiency studies in investment banking can be explained by three
main factors: first, the lack of good quality data; second, the difficulties in
successfully modelling the peculiar nature of investment banks production process
(i.e. a problem of variables identification); and third, the need to accurately account
for different environmental conditions in various countries: investment banking is a
global business and efficiency needs to be measured running an international
comparisons of investment banks.
Recent developments in the literature dealing with commercial banks can help to
circumvent the latter two problems. Regarding the variables identification to
successfully modelling the production process, this is a serious problem since the
investment banking business is multifaceted. Gardener and Molyneux (1995)
categorise the investment banks business into five main areas: broking (i.e. the broking
of securities is commodity business in which firms appeal to customers mainly on price
and integrity); trading (i.e. the trading of securities drives on market volatility); core
investment banking (i.e. the underwriting of new issues and advisory work also referred
to as Mergers and Acquisitions); fund management (i.e. both retail and wholesale fund
management); interest spread (i.e. income derivatives from borrowed funds). As such,
the accurate measurement of the investment banking risk-taking and risk-transferring is a
key issue. Recent studies dealing with commercial banks included risk characteristics in
cost or profit functions estimation, such as the liquidity risk exposure (Altunbas et al.
2000; Demirguc-Kunt and Huizinga 2004; Brissimis et al. 2008; Fiordelisi and
Molyneux 2010); insolvency risk exposure (Lepetit et al. 2008); credit risk (Athanasoglou
et al. 2008; Brissimis et al. 2008; Fiordelisi and Molyneux 2010); capital risk exposure
(Dietsch and Lozano-Vivas 2000; Lozano-Vivas et al. 2002; Altunbas et al. 2000;
Athanasoglou et al. 2008; Brissimis et al. 2008; Lepetit et al. 2008); market risk
exposure (Fiordelisi and Molyneux 2010); and the off-balance risk exposure (Casu and
Girardone 2005).
Regarding the need to assess investment banking efficiency on a worldwide base, there
is an increasing number of studies dealing with commercial banks running international
comparisons of bank efficiency by including environmental factors to face environmental
differences across countries. By summarising 100 studies that compare bank efficiencies
across different nations, Berger (2007) observes that efficiency has been measured using
either: 1) the estimation of nation-specific frontiers; and 2) the estimation of common
85
frontiers including specific variables in the estimation to account for country differences.
While the first approach guarantees the sample homogeneity, it does not enable the authors
to directly compare banks from different countries. In contrast the second approach allows a
direct comparison of efficiency levels and rankings from different countries (Coelli et al.
2005; Bos and Schmiedel 2007) by implicitly assuming that banks in different countries
have access to the same technology and effectively compete with each other. However, this
approach requires dealing with the sample heterogeneity by controlling for systematic
differences across banks that are not due to inefficiency2: failure to account for
heterogeneity is a likely candidate to cause instability of efficiency results as recently
emphasised by Bos et al. (2009). Various studies focus on country-specific environmental
factors in order to avoid this technology problem (see Lozano-Vivas et al. 2002; Dietsch
and Lozano-Vivas 2000).
Focussing on recent studies, various factors are used to account for countries macroeconomic differences, as the population density (Dietsch and Lozano-Vivas 2000; LozanoVivas et al. 2002; Carbo-Valverde et al. 2007; Fiordelisi and Molyneux 2010); the
countries wealth (e.g. the GDP procapita, as in Salas and Saurina 2003; Carbo-Valverde et
al. 2007; Fitzpatrick and McQuinn 2008; Brissimis et al. 2008; Fiordelisi and Molyneux
2010); the density of demand and per capita income (Dietsch and Lozano-Vivas 2000;
Lozano-Vivas et al. 2002); the FDI inflows and outflows (Beccalli 2004); the short-term
interest rate, foreign and public ownership (Brissimis et al. 2008); inflation and cyclical
output (Athanasoglou et al. 2008). The importance of accounting for environmental
variables in cross-country comparisons of banking industries was also recognised by
Beccalli and Frantz (2009) that included real growth in GDP as control variable in their
empirical model.
Overall, the vast majority of the literature on bank efficiency focuses on commercial
banking and, to the best of our knowledge, only one study (Beccalli 2004) has specifically
investigated the investment firms cost efficiency comparing UK and Italy. The present
study advances the existing literature by examining specifically cost and profit efficiency of
the investment banking industry in eight large industrialised countries and by taking into
account of environmental factors in the estimation. The next section outlines the details of
the methodology and data used.
3 Methodology
3.1 Stochastic frontier and environmental factors
Our empirical analysis aims to identify the framework for comparing investment banks
efficiencies across nations. Cost and profit efficiency are measured using the Stochastic
Frontier Analysis (SFA) that can be written as follows:
1
ln TCi;t xi;t b Vi;t Ui;t
where t denotes the time dimension, ln TCi is the logarithm of the cost of production (pretax profits, PT, for the profit function) of the i-th bank, xi is a kx1 vector of input prices and
output quantities of the i-th bank, is a vector of unknown parameters, Vi are random
2
Deprins and Simar (1989), Kumbhakar and Lovell (2000) observe that it can be difficult to determine if an
exogenous variable is a characteristic of production technology or a determinant of productive efficiency.
86
variables which are assumed to be i.i.d N(0, v2) and independent of Ui, Ui are nonnegative random variables which are assumed to account for cost inefficiency and to be i.i.
d. as truncations at zero of the N(0, U2).
ln TCk;t ln TP b0
12
2
P
i1
2 P
2
P
i1 j1
2 P
2
P
i1 j1
2
P
i1
bi ln Yi
2
P
j1
aj lnPj l1 T
dij ln Yi ln Yj
rij ln Yi ln Pi
biE ln Yi ln E
2
P
j1
2
P
i1
2 P
2
P
i1 j1
g ij ln Pi ln Pj l11 T 2
biT T ln Yi
2
P
j1
ajE ln Pj ln E "kt
ajT T ln Pj 12 t EE ln E ln E t E ln E
for i 6 j
where lnTCkt (ln TP) is the natural logarithm of total cost (total profit) of bank k in period t,
Yi is the vector of output quantities, Pj are the input prices, E represents banks equity
capital and is included as a fixed input, specifying interaction terms with both output and
input prices in line with recent studies (see e.g. Altunbas et al. 2000; Beccalli 2004; and
Vander Vennet 2002). We include the time trend t to capture technological change.3
We use this functional form to estimate a base model for a common frontier of
investment banks operating in the G7 countries and Switzerland (see Section 3.1 for more
details). In this model, we do not account for possible heterogeneity in the sample. This
problem is tackled in a second model that we estimate to account for heterogeneity
including environmental conditions, or firm-specific factors, following the two methods
proposed by Coelli et al. (1999) and that the authors define as Case I and Case II model
(for a recent application, see e.g. Glass and McKillop 2006).
In Case I, environmental factors are assumed to have a direct influence on the production
structure. As such, we include some control variables in the deterministic portion of the
stochastic frontier function in Eq. 2, as follows:
ln TCk;t ln TP b0
2
X
i1
bi ln Yi
2
X
aj lnPj l1 T
j1
!
2 X
2
2 X
2
X
1 X
2
dij ln Yi ln Yj
g ij ln Pi ln Pj l11 T
2 i1 j1
i1 j1
2 X
2
X
i1 j1
rij ln Yi ln Pi
2
X
i1
biT T ln Yi
2
X
ajT T ln Pj
j1
1
t EE ln E ln E t E ln E
2
2
X
i1
biE ln Yi ln E
2
X
j1
ajE ln Pj ln E
M
X
q j ln zji "kt
j1
3
As usual, symmetry and linear homogeneity restrictions are imposed standardising total cost TC and input
prices Pi by the last input price.
87
M
X
d j ln zjit
j1
The deterministic portion of the frontier remains the same as in Eq. 3. In this case we are
assuming that all firms share the same technology, and environmental/firm-specific factors
have an influence only on the distance between each firm and the best-practice. The
resulting efficiency estimates incorporate the effect of environmental factors and can be
viewed as gross measures of efficiency.
We apply the methods presented above also to estimate the alternative profit
efficiency. The frontier definition is similar to the one described in Eqs. 2 and 3. There
are only two notable differences: we replace total cost (TC) with total profit (TP) as
dependent variable; and the inefficiency term (ui) is subtracted (and not added as in the
cost function), given that we need to solve a profit maximisation problem (rather than a
cost minimisation).5 We choose to consider both cost and profit efficiency because
investment banking is traditionally a revenue-motivated business and competitive
pressure (e.g. due to deregulation and globalisation) put further pressure for the efficiency
enhancement. Besides, as noted by Berger and Mester (1999, p. 3), profit maximization
is superior to cost minimization for most purposes because it is the more accepted
economic goal of firms owners, who take revenues as well as costs into account when
making decisions.
3.2 Data and variables
This study comprises banks balance sheet, income statement and annual reports data for
the G7 countries (Canada, France, Germany, Italy, Japan, UK and US) and Switzerland over
4
88
20012007.6 The data were compiled from the International Bank Credit Analysis
Bankscope Database. Table 1 illustrates the breakdown by country of the number and
asset size of the banks included in the sample. The total number of observations is 800; US
banks are the biggest on average by asset size, whereas Switzerland has the largest number
of institutions both as a total and by year.7
In the bank efficiency literature, the definition of inputs and outputs varies across
studies and mainly depends on the researchers assumptions on the production process
of banks. For multi-product commercial banks, much of the debate is on how to treat
deposits: the intermediation approach assumes that they are inputs to the banks
production process while the production approach views them as outputs. The more
common of these two approaches is probably the former, where inputs are identified as
labour, physical capital and deposits. On the other hand, there seems to be some
agreement on what constitutes output, i.e. the dollar volume of banks assets and, more
frequently, total loans and other earning assets (Hughes and Mester 2009; Goddard et al.
2001; Berger and Humphrey 1997).
Since investment banks main business is not lending, it would be inaccurate to borrow
the input/output definition used for commercial banks to describe the production process of
investment banks. As discussed in Section 2, the extant literature on investment bank
efficiency is rather limited. Beccalli (2004) employs the price of labour and price of
physical capital as inputs, while debtors plus bank deposits is the single output.
In this study, we assume that in carrying out their production process investment banks
use two standard input variables: labour and physical capital. Specifically, the price of
labour (P1) is calculated as personnel expenses over total assets; and the price of physical
capital (P2) is measured as other administrative expenses plus other operating expenses over
total fixed assets. On the output side, we choose a novel definition to capture investment
banks main business as follows: total earning assets (Y1),8 that is the sum of loans and
other earning assets9; and investment banking fees (Y2), calculated as the sum of
commission, fee and trading income. As in Altunbas et al. (2001), we include both stock
and flow variables as outputs. The main motivation stems from the particular nature of the
investment banking business as derived from their financial statements, and on the
assumptions we make on the investment banks production process.10
In order to estimate cost and profit efficiency scores, we use as dependent variables total
cost (TC), calculated as the sum of personnel expenses, other administrative expenses and
6
The investigation of the financial crisis effects on investment banks efficiency would require a different
research methodology and a tailored dataset (therefore we do not include 2008 data in the sample). In
addition, the number of banks available in Bankscope for 2008 would be drastically reduced making our
sample heterogeneous.
7
We are aware that Bankscope data on investment banks is not as detailed as for commercial banks. One of
the main limitations is that the input and output data cannot be disaggregated by investment banking function
or activity (e.g. merger and acquisition advisory).
8
As a robustness test, we also re-estimate all models with the total interest income added in the definition of
investment banks total earning assets. The new efficiency estimates are very similar to the original estimates
thereby suggesting that our main findings are robust across different output specifications. We thank the
referee for suggesting this test.
9
Following the Bankscope global specification, the item other earning assets comprises deposits with
banks, due from central banks, due from other banks, due from other credit institutions, total securities,
treasury bills, other bills, bonds, CDs, equity investments and other investments.
10
However, in this study we have carried out various robustness tests by using alternative models. First, the
number of input and output specifications for our model has been tested. We have estimated alternative
models with total funds and interest income as additional outputs (we thank an anonymous referee for
suggesting these robustness checks). The chosen specification seems to best fit the available data.
89
Table 1 Sample description: number of banks and average asset size by country
Country/Year
2001
2002
2003
2004
2005
2006
2007
Total by country
Canada
16
3,951,175
France
30
26,175,525
Germany
11
55
12,182,958
Italy
25
1,814,332
Japan
19
23
23
22
19
114
29,686,104
UK
10
20
27
32
25
132
36,565,124
USA
15
19
21
18
15
14
111
115,358,872
Switzerland
Total by year
50
87
44
90
44
105
45
122
45
131
45
143
44
122
317
800
21,406,169
other operating expenses; and total pre-tax profit (TP). The variable equity (E) controls for
the differences in equity capital across banks. Table 2 reports the descriptive statistics of the
variables used in the cost and profit functions.
In order to account for heterogeneity we follow Coelli et al. (1999)s approach that
proposes two different ways of including environmental conditions or firm-specific factors
in the cost/profit function: Case I, where environmental factors have a direct influence on
the production structure; and Case II, where environmental factors influence the
inefficiency distribution.
In order to decide on which firm-specific factors to account for to tackle the
heterogeneity problem in our sample, we follow the most recent empirical literature in
this area. Accordingly, we account for potential differences arising from countryspecific aspects of banking technology on one hand and from the environmental and
regulatory conditions on the other. In particular, the economic environment is likely to
differ significantly across countries. Three categories of environmental variables are
taken into account: (1) variables that describe the structure of the banking industry and
risks; (2) those that describe the main macroeconomic conditions, which determine the
banking product demand characteristics; and (3) those that account for bank
profitability.
The first group of environmental factors, named banking structure and risks,
consists of four specific risk variables (capital risk, liquidity risk, securities risk,
Table 2 Descriptive statistics of variables used in the cost and profit functions. All values are in thousand
dollars, except for relative prices
Variable
Description
Mean
Median
Std. Dev.
Min.
Max
TC
Total Cost
1,325,752
149,368
4,622,540
76
70,302,088
TP
Pre-Tax Profits
308,618
37,321
1,004,517
60
10,815,637
Y1
32,527,530
1,359,342
101,254,934
6,931
972,522,434
Y2
660,916
112,575
1,916,440
52
21,082,186
P1
Price of Labour
0.049
0.028
0.079
0.0001
1.093
P2
20.491
2.871
98.088
0.143
1862.00
Total Equity
1,673,869
249,585
4,624,642
371
49,180,809
90
insolvency risk) and six bank- and market-specific variables: asset diversification, bank
asset size, Herfindahl index of concentration, income diversification, Off-Balance Sheet
business and publicly listed banks. A detailed list with related literature can be found in
Table 3.
Many efficiency studies outlined the importance of accounting for bank risk preferences
(see for example Mester 1997; Altunbas et al. 2000; Lepetit et al. 2008). In our study we
use five measures of risk, based on annual accounting data and determined for each bank
throughout the period. Capital risk exposure represents a proxy for regulatory conditions,
and we measure it as equity over total assets. Usually, a lower capital ratio leads to lower
efficiency levels because less equity implies higher risk taken at greater leverage, which
normally results in greater borrowing costs.
Low level of liquidity is one of the major causes of bank failures. During periods
of increased uncertainty, financial institutions may decide to diversify their portfolios
and/or raise their liquid holdings in order to reduce their risk. Banks would therefore
improve their efficiency by improving screening and monitoring of liquidity risk,
and such policies involve the forecasting of future levels of risk. Following the
empirical literature, we use the ratio of liquid to total assets (LIQ) to proxy liquidity
risk.
The nature of the investment banking business and specifically their securities issuance
and underwriting, has led us to introduce one more risk variable. We call it securities risk
exposure, and define it as total securities over total assets.
We also compute insolvency risk measures which proxy the probability of failure of a
given bank based on its Z-score as in Lepetit et al. (2008) as follows:
Z score 100 average ROE=s ROE
Table 3 Environmental variables included in the estimation and related literature. CAR = equity over assets;
LIQ = liquid assets over assets; SR = total securities over total assets; IR = (1 + average ROE)/SDROE;
AD = 1- |(Net loansOther earning assets)/Total earning assets|; BAS = total assets; CONC = the sum
of the squares of market shares for all banks operating in the industry; ID = 1- |(Net interest income
Other operating income)/Total operating income|; OBS = off-balance sheet items over total assets; The
bank is publicly listed or otherwise, where 1 = listed; 0 = non-listed; ROA = Net profits over total
assets; ROE = Net profits/Shareholders equity (total assetstotal liabilities)
Symbol
Variable name
Risks, bank- and market-specific factors
* Capital risk exposure
CAR
CASE I
CASE II
LIQ
SR
IR
Asset Diversification
Bank asset size
AD
BAS
Herfindahl index of
concentration
Income Diversification
Off-Balance Sheet business
Publicly listed bank
CONC
ID
OBS
LB
Macroeconomic Conditions
Population density
PD
GDP
FDI Inflows
FDI Outflow
FDII
FDIO
Profitability
ROA
ROA
ROE
ROE
Studies
Dietsch and Lozano-Vivas, 2000; Lozano-Vivas et al., 2002; Altunbas et al., 2000;
Athanasoglou et al., 2008; Brissimis et al., 2008; Lepetit et al., 2008
Altunbas et al. 2000, Demirguc-Kunt and Huizinga 2004, Brissimis et al. 2008,
Fiordelisi and Molyneux, 2010
Authors estimate
Lepetit et al., 2008
Laevena and Levine, 2007
Altunbas et al., 2000; Lozano-Vivas et al., 2002; Carbo-Valverde et al., 2007;
Athanasoglou et al., 2008; Lepetit et al., 2008; Fiordelisi and Molyneux, 2010
Dietsch and Lozano-Vivas, 2000; Vander Vennet, 2002; Athanasoglou et al., 2008;
Fiordelisi and Molyneux, 2010
Laevena and Levine, 2007; Fiordelisi and Molyneux, 2010
Altunbas et al., 2000; Casu and Girardone, 2005
Beccalli, 2004; Fiordelisi and Molyneux, 2010
Dietsch and Lozano-Vivas, 2000; Lozano-Vivas et al., 2002; Carbo-Valverde et al.,
2007; Fiordelisi and Molyneux, 2010
Salas and Saurina, 2003; Carbo-Valverde et al., 2007; Fitzpatrick and McQuinn, 2008;
Brissimis et al., 2008; Fiordelisi and Molyneux, 2010
Beccalli, 2004
Beccalli, 2004
Athanasoglou et al., 2008; Lepetit et al., 2008; Berger et al., 1993; Allen and Rai, 1996;
Lozano-Vivas et al., 2002; Vander Vennet, 2002
Beccalli, 2004; Athanasoglou et al., 2008; Lepetit et al., 2008
91
Higher values of Z-scores imply lower probabilities of failure. Moreover, we add asset
diversity (AD) as a measure of diversification across different types of assets. AD is
calculated as:
AD 1 jNet loans Other earning assets=Total earning assetsj
Other earning assets include securities and investments, and total earning assets is
the sum of net loans and other earning assets. Asset diversity takes values between 0
and 1 with higher values indicating greater diversification (see, for more details, Laeven
and Levine 2007).
One of the most important questions underlying bank policy is which size optimizes bank
efficiency. Generally, the effect of a growing size on efficiency has been proved to be positive
to a certain extent. However, for banks that become extremely large, the effect of size could be
negative due to bureaucratic and other reasons. Even if there are no clear conclusions and
results change depending on the methodologies applied (as outlined in Weill 2007) accounting
for size differences is certainly significant. Another important environmental variable is
banking industry concentration that is measured by the Herfindahl-Hirshmann index. This is
defined as the sum of squared asset market shares of all banks in each country. Higher
concentration may be associated with either higher or lower costs.
To take into account of the diversification across different sources of income, we include
a measure of income diversity that is calculated as:
ID 1 jNet interest income Other operating income=Total operating incomej
Income diversity takes values between zero and one with higher values indicating
greater diversification. The asset and income diversity measures are complementary in that
asset diversity is based on stock variables and income diversity is based on flow variables.
We also account for the level of off-balance sheet (OBS) items over assets and assume
that they generate additional (and hidden) financial exposures for banks. Although OBS
business has originally developed to help banks prepare for contingencies, recent events
have shown that often this type of business produces additional risks for the parties
involved in these types of contract.
The publicly listed bank is not just a pure scale measure, but represents the opportunity for
diversification offered by the market to the clients of investment firms. Our sample includes
both listed and unlisted banks. Beccalli et al. (2006) showed the existence of a positive
relationship between efficiency and stock performance. Therefore our hypothesis is that
listed banks could be more efficient since they are more exposed to competitive pressures.
The second group of environmental variables is defined macroeconomic conditions
and includes a measure of population density, GDP per capita, inflows and outflows of
foreign direct investment (FDI). These indicators describe the main conditions under which
banks operate. The supply of banking services in areas with a low population density
generates higher banking costs, and does not encourage banks to increase their efficiency
levels. GDP per capita affects numerous factors related to the demand and supply of
banking services. Countries with a higher GDP per capita have a banking system that
operates in a mature environment resulting in more competitive interest rates and profit
margins. Finally, FDI is a measure of foreign ownership of productive assets. Cross-border
mergers and acquisitions in the developed world as well as direct and portfolio investment
in emerging markets have fuelled the profitability of these sectors, primarily US-based
banks, which have had the relationship and networks to capture these flows. We expect to
find, a positive (negative) relationship with cost (profit) efficiency.
92
4 Empirical results
In our empirical analysis we assess the efficiency of investment banks. In order to account
for sample heterogeneity, three models are estimated: 1) the base model, i.e. a common
frontier that includes only the structural variables described in Eq. 2; b) the Case I model,
where environmental conditions/firm- specific factors have a direct influence on the
production process (Eq. 3); and 3) Case II, where environmental factors influence the
inefficiency distribution, i.e. the Battese and Coellis (1995) model (Eq. 4). In the first case,
our estimates provide a net measure of efficiency, i.e. the managerial efficiency. In the
second case, our estimates provide us with a gross measure of efficiency since firmspecific (i.e. measured as mean at the national industry level) and macro-economic factors
are considered as determinants of inefficiency effects to account for country differences.12
Chart 1 displays the estimated mean cost and profit efficiency levels as calculated in the
three alternative models. In line with the (predominantly commercial) bank efficiency
literature (see Berger and Mester 1997 for a review, Maudos et al. 2002), the mean cost
efficiency scores are on average higher than the profit ones in all models. Moreover,
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
CASE I
CASE II
BASE MODEL
11
As usual one dummy (Canada) is dropped from the model to avoid multicollinearity. So, we have a total of
seven country dummies.
12
Only the combination of structural characteristics and environmental ones allows us to capture the industry
efficiency and explain national differences.
93
Table 4 Environmental factors affecting the shape of the cost and profit functions (Case I). CAR = equity
over assets; LIQ = liquid assets over assets; SR = total securities over total assets; IR = (1 + average ROE)/
SDROE
Variable
Description
Z1 (CAR)
Capital risk
1.1357***
0.1547
Z2 (LIQ)
Liquidity risk
0.0542***
0.0808***
Z3 (SR)
Securities risk
0.0823***
0.0884***
Z4 (IR)
Insolvency risk
0.0652***
0.0122
estimated efficiency scores also suggest marked differences in efficiency across the
countries included in our sample (see Table A1 in the Appendix).
Results show that, on average, the efficiency scores estimated using the base model are
generally similar to those derived from Case I for both cost (panel a) and profit (panel b). In
contrast, Case II shows substantial differences in average values for all countries for both
cost and profit efficiency. Furthermore on the profit side, it seems clear that average
efficiency scores are consistently underestimated in the base model.13 Our results are
consistent with Coelli et al. (1999) who found that Case I efficiency estimates are generally
lower than those obtained under Case II and these differences are mostly explained by the
way in which the environment variables are included in these models. We also agree with
Coelli et al. (1999) in preferring the Case II estimates for two reasons: first, these estimates
represent the outer boundary of the production possibility set; and second, gross efficiency
measures obtained from Case II are the closest to the intuitive notion of efficiency being
about converting physical inputs into physical outputs.
Regarding Case I, we focus on bank risk-taking variables (omitting to consider macroeconomic variables) by including these in the deterministic portion of the stochastic frontier
function. We posit that bank risk-taking variables have a direct impact on bank cost and
profit efficiency, while macro-economic variables and industry-level features only impact
on the distribution of the inefficiency components, but not on the efficiency of a single bank
(i.e. these variables influence in the same manner the efficiency to all banks in the same
nation). We found all risk variables significant at 1% level in the cost case, while on the
profit side we found statistically significant (at the 10% confidence level or less) the
coefficients for liquidity and securities risk exposure (Table 4). Since these variables are
measured at the bank level, coefficient estimates can be directly interpreted to measure the
relationship between these factors with cost and profit efficiency estimates.
Specifically, coefficient estimates are negative (and high) for the capital risk and security
risk exposures, while are positive for the liquidity risk and insolvency risk exposures. In the
profit function estimation, coefficients for liquidity and securities risk are found to be
statistically significant (the first is positive and the second is negative), while the other two
risk exposure measures are insignificant. These results provide evidence that capital and
securities risk have a positive effect on the cost efficiency while the relationship with
liquidity and insolvency risk exposures is negative. The liquidity risk has also a positive
effect on profit efficiency while the securities risk has a negative impact.
13
Statistically testing which model would best fit the data is not straightforward. As suggested by the
relevant literature (see for example Coelli et al. 1999), one would need to create an artificial nested model.
Due to data constraints and to different set of environmental variables used in the two models, we can only
decide on the basis of theoretical motivations.
94
Table 5 Environmental/Firm-specific factors determining the inefficiency distribution (Case II). CAR =
equity over assets; LIQ = liquid assets over assets; SR = total securities over total assets; IR = (1 + average
ROE)/SDROE; AD = 1- |(Net loansOther earning assets)/Total earning assets|; BAS = total assets;
CONC = sum of the squares of market shares for all banks; ID = 1- |(Net interest income - Other
operating income)/Total operating income|; OBS = off-balance sheet items over total assets; The bank is
publicly listed or otherwise, where 1 = listed; 0 = non-listed; ROA = Net profits over total assets; ROE = Net
profits/Shareholders equity (total assets - total liabilities)
Variable
Description
Capital risk
1.1209***
5.1352**
Z2 (LIQ)
Liquidity risk
1.2875***
12.0503***
Z3 (SR)
Z4 (IR)
Securities risk
Insolvency risk
0.1234
0.1101
0.1456
0.6277*
Z5 (AD)
Asset diversification
0.6730
3.1355***
Z6 (BAS)
0.1355**
0.4820**
Z7 (CONC)
Concentration
0.5905***
1.4813***
Income diversification
0.0535
8.5812***
Z9 (OBS)
OBS business
0.0928
0.5467***
Z10 (LB)
Listed banks
1.2976***
3.9457***
Z8 (ID)
Macroeconomic Conditions
Z11 (PD)
Population density
0.3283**
0.4003
0.8065***
1.9647***
Z13 (FDII)
FDIs inflows
0.1929***
0.5770
Z14 (FDIO)
FDI outflows
0.0879
1.5560***
Z12 (GDP)
Profitability
Z15 (ROA)
Return on Assets
2.6002**
39.7617*
Z16 (ROE)
Return on Equity
-0.1681***
0.5750
0.7228
Country dummies
Z17
France Dummy
1.6615***
Z18
Germany Dummy
1.4109***
0.8338
Z19
Italy Dummy
0.5187
9.5681***
Z20
Japan Dummy
0.3711
0.6215
Z21
Switzerland Dummy
2.0076***
8.6367***
Z22
UK Dummy
1.8746***
7.2744***
Z23
US Dummy
6.5516***
20.7140***
95
impact on profitability. On the other hand, if a banks capital level decreases, managers
have an increasing incentive to take on excessive risk, engaging in activities that fail to
create value for shareholders.14 During periods of increased uncertainty, financial
institutions may decide to diversify their portfolios and/or raise their liquid holdings in
order to reduce their risk: this would have a negative impact on bank cost efficiency, but
will result in higher profits (less risk, less opportunity cost of capital).
Turning to the results on Case II (Table 5), environmental variables are measured at the
industry level so coefficient estimates can be interpreted as a measure of the relationship
between the national industry features (e.g. the mean level of capital risk exposure in the
country considered) and cost and profit efficiency estimates: this analysis provides
particularly useful insight for economic policy-makers and regulators. The influence of the
environmental variables on the inefficiency is in line with our expectations and a number of
variables have been found statistically significant at the 10% confidence level or less.
Regarding the four risk variables tested in Case I, estimated coefficients for capital and
liquidity risk exposures are negative and positive (statistically significant at the 1%
confidence levels) in cost and profit inefficiency estimates, respectively. These results
provide evidence that the mean industry level of capital ratio and the liquidity risk
exposures have a positive impact on cost efficiency (by reducing the mean of the cost
inefficiency component), while have a negative influence to profit efficiency (by increasing
the mean of the profit inefficiency component). Capital risk exposure results in both Case I
and II are strongly consistent with each other confirming that higher capital level increase
the cost efficiency (e.g. enhancing internal auditing systems and managers motivation) and
reduce the profit efficiency (e.g. reducing the financial leverage effect). Our results for bank
liquidity risk exposure are slightly different: banks working in countries with a higher level
of liquidity have a positive impact on cost efficiency, while have a negative impact in profit
efficiency. A possible explanation is that banks operating in more liquid banking systems
find it cheaper to manage liquidity so that these benefit from lower costs. However, cost of
funds and credit spreads will be probably low and this would negatively impact on bank
lending by reducing profits.
Concerning the remaining environmental factors, Table 5 shows that in the majority of
cases the chosen variables are highly significant. This gives a preliminary (although rather
crude) indication that failing to account of these additional factors can potentially bias the
estimated efficiency scores.
Focusing on the cost side (column 1 in Table 5), the magnitude of the coefficients
is particularly high for the dummy of listed banks (LB) and the profitability ratio
(ROA). Indeed, listed companies seem to have a negative relationship with both cost
and profit inefficiency, thus providing strong evidence that on average banks that are
quoted in stock markets tend to be less inefficient.15 On the other hand, our findings
for ROA suggest that the most profitable banks are less cost and more profit
efficient.
Turning to the inefficiency effect in profits (column 2 in Table 5), asset and income
diversification (AD and ID respectively) seem to be remarkably high and significant.
Nevertheless, they are both insignificant on the cost side and they seem to have an opposite
effect on profit efficiency. This is likely due to the higher volatility of income streams, and
the possibility that more diversified banks may have been affected by trading losses over
14
15
96
the studied period. However, banks doing more OBS business seem to be more profit
efficient on average.
Special attention should be paid to bank asset size (BAS) and market concentration
(CONC): our evidence implies that size matters for both cost and profit efficiency;
however, this is not necessarily reflected in more efficient concentrated markets.16
These findings have some interesting implications. First of all because they give further
support to the assumption that efficiency and performance are amongst the main motives
for bank mergers and acquisitions,17 and secondly, because they indicate that on average
more concentrated markets are less likely to be cost and profit efficient.18
Lastly, the macroeconomic variables included in the models (PD, GDP and FDI)
seem to affect the inefficiency levels in various ways. Focusing on the most significant
and larger coefficients, it seems that investment banks operating in more developed
economies (with higher GDP per capita) present higher profit and lower cost
inefficiencies. Finally, the sign and magnitude of the coefficient estimate for FDI
outflows suggests that the most efficient investment banks are more likely to operate
abroad (for similar findings see e.g. Beccalli 2004).
4.1 Robustness checks
In order to further confirm the aforementioned findings, a number of robustness checks
were conducted by testing alternative models. Firstly, we investigate the impact that banks
size has on efficiency: as shown in Table 5, investment banks size is found to be an
important efficiency determinant. To further confirm this conclusion, we consider two subsamples of the largest and smallest banks, i.e. the fourth and first quartile of the size
distribution as reported in Table 6.
Table 6 shows that for the cost case, smaller investment banks are more efficient than
larger banks, at the 10% significance level.
Secondly, we create a cluster sample by investment bank type to provide some
additional analysis of the obtained efficiency results for the investment banking
industry. The aim is to distinguish between boutique investment banks (BIB) and full
Table 6 Small versus big investment banks: robustness test. Small = smallest investment banks, Big =
biggest investment banks (fourth and first quartile of the size distribution). The table reports the two sample
t-test of differences in mean between Small and Big, under the assumption of unequal variance. H0:mean
(Small)-mean(Big) = 0; H1:mean(Small)-mean(Big) 0
Small (Mean) 200 Obs
Mean Diff.
t-Stat
p-Value
Cost
0.6861
0.6216
0.0644
2.6133
0.0093a
Profit
0.5522
0.5120
0.0401
1.6450
0.1008
Case II Model
To further confirm these results, we carried out several robustness tests. Specifically, we carried out a t-test
to the two subsamples of the largest and smallest banks in the sample (i.e. the fourth and first quartile of the
size distribution). Results are robust only for the cost case where smaller investment banks are more efficient
then larger banks at 10% significance level.
17
For an extensive review see DeYoung et al. (2009).
18
Actually these findings could even be signaling some evidence of the validity of Hicks quiet life
hypothesis in investment banking and thus should be explored in more detail (Hicks 1935).
16
97
Country
# of FSIB
# of BIB
Total
Canada
France
Germany
4
7
5
9
9
16
Italy
10
Japan
11
15
26
Switzerland
24
35
59
UK
25
15
40
USA
19
26
Total
95
95
190
service investment banks (FSIB).19 Despite the obvious differences in relative size
across these alternative types of financial institutions, we expect them to be driven by
fairly different strategic objectives. Namely, we assume that while boutique investment
banks specialize in particular segments of the market in order to achieve greater
profitability and survive competitive pressure from their larger peers in the industry, full
service investment banks strive to control their cost base in order for to maximize their
share of revenue. Table 7 shows the breakdown by country in terms of number of FSIBs
and BIBs.
As illustrated in Table 8, in the cost case FSIBs are significantly more efficient than
boutique investment banks, while the results are opposite in terms of profit efficiency.
These results can be explained by the better cost management and stronger base (in
terms of different operational areas) within these institutions. In the profit efficiency case
we find that BIBs display higher efficiency scores, therefore confirming the theoretical
premises,20 where ensuring high and persistent profitability is the only way for them to
remain competitive and survive inside highly concentrated markets.
Thirdly, our sample comprises from a relatively high proportion of Swiss investment banks
(317 observations out of 800), and accordingly we run another robustness test to verify whether
these banks would have driven the main results. Namely, we dropped Swiss banks from the
sample and re-estimated both cost and profit efficiency. As shown in Table 9, new efficiency
Table 8 Full service investment banks versus boutique investment banks: robustness test. The table reports
the two sample t-test of differences in mean between FSIB and BIB, under the assumption of unequal
variance. H0:mean(FSIB)-mean(BIB) = 0; H1:mean(FSIB)-mean(BIB) 0
Case II Model
Mean Diff.
T-Stat
P-Value
Cost
0.6727
0.6231
0.0495
2.8431
0.0046a
Profit
0.5047
0.5949
0.0902
5.6493
0.0000a
19
FSIBs offer clients a range of services including underwriting, merger and acquisition advisory services,
trading, merchant banking and prime brokerage. BIBs specialize in particular segments of the market.
Typically they do not offer a broad range of services and are not part of larger financial institutions. For more
details see Davis (2003), and Gardener and Molyneux (1995).
20
For more readings see Liaw (2006); and Gardener and Molyneux (1995).
98
Table 9 Cost and profit efficiency scores by model and by country (excluding Switzerland)
Country
Cost Efficiency
Canada (16)
France (30)
Germany (55)
Italy (25)
Japan (114)
UK (132)
USA (111)
Switzerland (317)
Mean
Profit Efficiency
Canada (16)
France (30)
Germany (55)
Italy (25)
Japan (114)
UK (132)
USA (111)
Switzerland (317)
Mean
Base
Case I
Case II
0.6198
0.5432
0.5863
0.5328
0.6374
0.5729
0.6564
/
0.6065
0.6509
0.5544
0.5296
0.5279
0.6102
0.5745
0.6510
/
0.5942
0.6041
0.3982
0.4724
0.3483
0.6794
0.3859
0.8479
/
0.5772
0.4670
0.4057
0.3636
0.5464
0.4669
0.3854
0.4337
/
0.4256
0.4895
0.4203
0.3617
0.5235
0.4775
0.3681
0.4874
/
0.4359
0.6527
0.4839
0.3870
0.6825
0.5870
0.4256
0.5818
/
0.5196
estimates are very similar with those discussed in the result section,21 so we can conclude that
our main results are not driven by the inclusion of Swiss bank in the sample.
5 Conclusions
The recent financial turmoil has uncovered a number of weaknesses of the banking
industry and has left the international community with challenging questions about the
evolving role of (commercial and investment) banks in the economy and the primary
objective of ensuring financial stability. Over the last two decades investment banks
operations, functions and strategies have been increasingly market-driven and have
contributed to the emergence of an unprecedented system of compensations, a highly
leveraged industry and a pervasive risk culture. It is expected that post-crisis investment
banks will have to comply with new constraints thus the evaluation of their operating
efficiency will likely gain a new impetus, particularly on the cost side. In this context,
the description of modern investment banks production process should reflect the
changes in their business focus. As well, it should account for risk and other
environmental and regulatory factors.
This paper investigates the operating efficiency of the investment banking sector over
20012007 for the G7 countries (Canada, France, Germany, Italy, Japan, UK and US) and
Switzerland. We follow Coelli et al. (1999)s methodology to adjust the estimated cost and
profit efficiency scores for environmental influences including key banks risks, bank- and
21
We assess the similarity between the two set of efficiency estimates using both the Spearmans rho
correlation and Pearson correlation coefficients (for all models). All estimated coefficients are constantly
greater than 90%.
99
Appendix
Base Model
Case I
Case II
Canada (16)
France (30)
0.6183
0.5245
0.6801
0.5844
0.5965
0.3131
Germany (55)
0.5658
0.5235
0.4307
Italy (25)
0.5021
0.5030
0.4062
Japan (114)
0.6494
0.6291
0.6665
UK (132)
0.5682
0.5877
0.4167
USA (111)
0.6956
0.7056
0.8602
Switzerland (317)
0.6588
0.6726
0.7565
Cost Efficiency
Profit Efficiency
Canada (16)
0.4559
0.4527
0.6205
France (30)
0.4089
0.4087
0.4559
Germany (55)
0.3537
0.3548
0.3809
Italy (25)
0.5362
0.5367
0.6624
Japan (114)
0.4742
0.4744
0.5728
UK (132)
0.3750
0.3650
0.3972
USA (111)
0.4241
0.4716
0.5345
Switzerland (317)
0.4918
0.4871
0.6319
100
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