The Cost Efficiency of Commercial Banks in Hong Kong

Given banks' special role in channelling funds from savers to investors, their cost efficiency has a significant effect on the supply of credit and, in turn, on the overall economic performance. In addition, inefficiency would affect banks' earnings, thus hampering their ability to withstand shocks. The issue of banks' cost efficiency is therefore of interest to policy makers. Using the stochastic frontier approach and a panel dataset of retail banks, this paper assesses the cost efficiency of the banking sector in Hong Kong. The average cost inefficiency during the period 1992-2005 is found to be about 15% to 29% of observed total costs, which is largely in line with the experience of US and European banks. Cost efficiency is found to be correlated with macroeconomic conditions, with a significant rise in cost inefficiency triggered by the Asian financial crisis and the outbreak of SARS during the period 1998-2003, partly due to the lack of perfect flexibility by banks to adjust their factor inputs (labour, funds and capital) in response to falling outputs. Additional resources spent on risk control, new business initiatives and strengthening customer relationships may also have contributed. Nevertheless, the cost efficiency has started to improve by 2004 Q1, along with the recovery of the economy. This suggests also that the adjustments and streamlining by the banks in recent years may have begun to bear fruit. Empirical results also indicate that cost efficiency is positively correlated with bank size, suggesting large banks are on average more efficient than smaller banks. Efficiency is also observed to be sensitive to banks' business mix, with banks which focus more on lending business exhibiting a higher level of efficiency compared to banks that focus relatively less on loans. In addition, banks suffering from larger loan loss provisions are found to be less efficient, probably due to higher operational costs relating to credit risk and loan loss management.