Measuring commercial bank efficiency : use and misuse of bank operating ratios

Measuring bank efficiency is difficult because there is no satisfactory definition of bank output. Neither the number of accounts nor total assets, total loans, nor total deposits provide a good index of output. Moreover, the value added of banks - given by their labor costs and profits - measures both the output and cost of banking. Many analysts use accounting data on bank margins, costs and profits as measures of bank efficiency. But the usefulness of such data is undermined by substantial structural and accounting differences across countries, among individual banks and over time. Great caution and extensive knowledge of local banking conditions are required to interpret bank ratios. The author uses three sets of operating ratios to discuss the impact of differences in structure and practice on bank performance: operating asset ratios; operating income ratios; and operating equity ratios. The author also uses return-on-equity (ROE) analysis to highlight the effects of differences in banking structure and practice. The author's analysis is applied to the performance of banks in OECD countries in the 1980s. The analysis has major implications for assessing bank performance in developing countries, where inflation, higher risk, and operating inefficiencies often cause cost and other bank ratios to be generally higher than in OECD countries.