The Technical Efficiency of Nigerian Banks: Determining Efficiency

The Technical Efficiency of Nigerian Banks: Determining EfficiencyIn 2003, the percentage of efficient banks declined to 22% which is the lowest of the four periods used. The worst bank (Omega Bank) has an efficiency level of 22.2%. Of the inefficient banks, 28.21% have their efficiency scores above the industry average of 64%. The decline in the percentage of efficient banks in this period is surprising being that liberalization had been done for eighteen years. Probably, most of the emerging and old banks were under capitalized. May be most of the banks were affected by the low technological advancement evidenced by low capital labour ratio. This meant that liberalization alone may not be enough to positively affect the efficiency of the individual banks. Thus, the consolidation exercises are welcome developments.
Fifteen banks of the 67 banks used in the analysis were used in the four periods. Of these, three were consistently efficient in all the four periods. These are First Bank, Citi Bank and Indo Bank. UBA was consistently efficient in the first two periods but declined in efficiency in 2000. It however, picked up again in 2003 reestablishing its efficiency. Investment Trust, Hallmark and Metropolitan banks were also consistently efficient in the periods they were used.
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The Technical Efficiency of Nigerian Banks: Determining Efficiency

Prior to liberalization in 1985, the result indicates that ten banks of the 29 banks used for the analysis were efficient. This means that they lie on the efficient frontier and had efficiency score of 1.000 each. The banks are Afri bank, Citi bank, Co-operative Bank, First Bank, Indo, MBC, NAL, Union, UBA and Lobi banks. This represents 34.48% of the banks. It is interesting to note that Afribank, which was one of the banks declared problematic by Sanusi but survived the Soludo consolidation exercise was efficient prior to liberalization. The rest of the banks used in that period, (65.52%) exhibited various levels of inefficiency. This ranges from as high as 87.5% level of inefficiency by IMB merchant which is the worst, to as low as 26.8% by Societe Generale Bank.
Out of the inefficient banks, 89.47% have their efficiency level below the industry average of 57%, while 10.53% have their efficiency levels above the industry average. These are Credit Lyonnas and Societe Generale banks. Furthermore, of the ten efficient banks three or 30% are merchant banks while the rest (70%) are commercial banks. The merchant banks are Indo, NAL and MBC.
With liberalization in 1995, the percentage of efficient banks increased to 35.71% leaving 64.28% of the banks as inefficient. The number of inefficient banks with efficiency level above the industry average is 25.93% as against 10.53% prior to liberalization. Furthermore, the level of inefficiency in 1995 ranged from as low as 2.5% for First City Monument Bank to as high as 74.8% for Societe General Bank. These results show improvements over the preliberalization era. The results suggest that liberalization did not only improve the average level of technical efficiency of the banking industry but also the technical efficiency of individual banks in 1995. Note that Afribank and Union banks were efficient during this period.
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The Technical Efficiency of Nigerian Banks: The Data Envelopment Analysis Model

The Technical Efficiency of Nigerian Banks: The Data Envelopment Analysis ModelFour periods namely 1984/1985, 1994/1995, 1999/2000 and 2003/2004, 1984/1985 was chosen to examine the technical efficiency of banks. This is to enable us examine the technical efficiency of individual banks in Nigeria during periods of pre and post liberalization and democratization. This is intended to give us a broader understanding of the efficiency of banks bearing in mind different policies and styles of government in Nigeria over-time. It will also shed light on the evolution of the degree of technical inefficiency over-time. Furthermore, considering that it is a study in retrospect, we chose years before the Soludo and Sanusi consolidation to enable further assessment of the banks and the actions taken.
A cross section of both commercial and merchant banks was used for each period. In selecting the banks, all the banks that have complete data for the four periods under review were selected. This is done in order to see the changes in efficiency of banks in the four periods. In order to select other banks, we used randomization. According to Ndiyo randomization gives “a more reliable and valid estimate of the population being studied than a sample which is composed by selection regardless of whether such selected sample is random or not”.
In obtaining the data, we used the Annual Reports of the banks in the Nigeria Banking, Finance and Commerce Books compiled by Research and Data Services Limited (Redasel), Lagos Nigeria for the periods of the study.
Following Nyong, we adopt the Grigorian approach – a variant of the modern approach of bank production in choosing inputs and outputs. Thus, we assume that the labour (personnel management, X1), fixed assets (computer hardware and premises) and also captured extensive branch network, X2 and interest expenses (leverage funds) X3. The outputs are revenues (emphasizes profit maximization, Y1), loans and advances (service provision Y2) and liquid assets including securities investments (liquidity services, Y3). The model is adapted from Ali and Seiford and Nyong.
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The Technical Efficiency of Nigerian Banks: Analytical Methodology

Another observation made about most of these studies is that some of them (e.g. Denizer et al, 2002) relied on a narrow set of data – short time series of an industry before and after deregulation or privatization which may not be sufficient for any meaningful conclusion. Further observation is the use of performance indicators instead of calculated efficiency scores. Efficiency indicators are observable factors which seem to determine the level of efficiency. At best, they (performance indicators) are approximations and introduce bias in the work (Eeckaut, Tulkens, and Jamar 1993.) Finally, most of the studies on banks examined the efficiency of the banking system, at the industry level, using time series. The present study will investigate firm level efficiency using cross-sectional data in pre- and postliberalization eras in Nigeria.
There are two approaches used to measure the efficiency of an entity. These are the parametric (econometric) approach and the non -parametric (mathematical programming) approach. This study will use the non -parametric frontier approach to estimate the relative efficiency of banks in Nigeria. This approach also known as Data Envelopment Analysis (DEA), is a mathematical programming technique that measures the efficiency of a decision making unit (DMU) relative to other similar DMUs with the simple restriction that all DMUs lies on or below the efficiency frontier (Seiford and Thall, 1990).
For the DEA, a parametric functional form does not have to be specified for the production function and thus, allows variable returns to scale (VRS). The focus of this methodology is both on each individual DMU and the average of the whole body of DMUs. It calculates the relative efficiency of each DMU in relation to all the other DMUs by using the actual observed values for the inputs and outputs of each DMU. It constructs the production frontier as a convex envelop of the observed points in the input/output space. The efficiency frontier is the section of the envelope of the production possibility set with a non – negative slope.
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The Technical Efficiency of Nigerian Banks: Technical Efficiency

The Technical Efficiency of Nigerian Banks: Technical EfficiencyThe shortcomings of this theory are as follows: First, interest rates vary from time to time so does the user cost. An item classified as input in one period may become an output in another period if the sign of its user cost changes (Grigorian, 2002). It is also difficult to measure marginal revenues and costs for each individual liability item. Thus, there are several measurement errors including changes in inputs or outputs overtime.
The Value Added Approach is an improvement over the asset or user-cost approaches (Berger and Humphrey, 1991, 1992),    is based on actual operating cost data. It recognizes the output characteristics of both the asset and liability categories of bank portfolios.
Those categories that have substantial value-added are treated as outputs while others are treated as inputs. Activities of banks create high value-added such as loans and advances (demand deposits), time and savings deposits are classified as outputs while inputs include labour, capital and purchased funds.
The modern approach has different variants. It integrates risk management and information processing into the classical theory of the firm. It is ratio based. It is represented by the CAMEL approach which stands for capital adequacy, asset quality, management, earnings and liquidity. These variables are however used in performance analysis and the index does not emphasize the efficiency of banking institutions (Ziorklui, 2001)
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The Technical Efficiency of Nigerian Banks: Microeconomic Theory

Six different views on what constitutes banks’ input and output are recognized. These are production approach (Shearman and Gold, 1985; and Frevier and Lovell, 1990), intermediation theory (Humphrey, 1985), asset approach which is related to financial intermediations theory (Nyong, 2005), user-cost approach (Humphrey, 1991), value-added approach and the modern approach (Ziorklui, 2001).
The Production Approach applied the traditional microeconomic theory of the firm to banking. It considers banks to be producers of bank deposits and loans. The actual output is specified as the number of bank deposit and loan transactions that are processed. Traditional production factors viz; land, labour and capital are used as inputs to produce outputs (Denizer, 2000), which are services for account holders. The output measure used is number of accounts or number of transactions (Nyong, 2005). Ziorklui went further to break down the total cost under this approach to include cost of supplies, expenditure on materials, occupancy costs and expenditure on furniture and equipment. Under this approach, it is believed that an efficient banking system may lead to a lower transaction cost of providing banking services to the public. One major set back of this approach is the measurement of outputs. Another criticism is failure to account for financial intermediation of banks.
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The Technical Efficiency of Nigerian Banks: Theoretical Framework

The Technical Efficiency of Nigerian Banks: Theoretical FrameworkThere are four measures of efficiency as identified by Nyong and Lovell that gives the actual values of efficiency. These are technical efficiency, cost efficiency, scale efficiency and allocative efficiency. Cost efficiency according to Nyong is concerned with determining whether a decisionmaking unit (DMU) produces a given output with minimum cost. It is price dependent. Scale efficiency measures whether a DMU produces at an optimal size of scale; while allocative efficiency ascertains if the inputs are the best ones to be used or whether the outputs are the best ones to be produced. It is also called price efficiency. It refers to the ability of a DMU to choose optimal input combination at given input prices. Technical efficiency refers to the ability of a firm to produce maximum output given its inputs. A technically efficient producer could produce the same outputs with less of at least one input; or could use the same inputs to produce more of at least one output. The measurement of technical efficiency (TE) is based on deviations of observed output from the best production or efficient frontier. Thus, if a firm’s actual production lies on the frontier, it is efficient; if it lies below the frontier, it is considered inefficient. The ratio of the actual to potential production is used to define the level of efficiency of the individual firm. For the purpose of this paper, efficiency is taken to mean TE. This is because it provides the common ground on which to compare performances of DMUs (in this case banks).
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The Technical Efficiency of Nigerian Banks: Literature Review

Bhattacharyya, Bhattacharyya and Kumbahakar found that deregulation and liberalization had a major impact on productivity and efficiency increase in various industries and the banking sector in some Eastern and Central European countries as well as China. Berg, Forsund and Jansen found that in Norway during 1980-89 the productivity of banks declined initially but eventually rose. Zaim reported efficiency gains in Turkish banks after the 1980 liberalization programme. In the case of Korea, Gilbert and Wilson found that most Korean banks experienced efficiency gains between 1980 and 1994 when government controls were lifted. It was however found that in the US and Spain, deregulation resulted in decline in efficiency (Humphrey and Pulley, 1997; Grifell-Tatje and Lovell, 1996).
In Nigeria, there have been some empirical a t t empts to assess the performance of the financial sector reforms (Ikhide and Alawode, 1994; Ikhide, 1998; Nyong, 2005). Most of the studies done for the Nigerian banking system, however, merely looked at the effect of liberalization on interest rate spread, transaction costs in assessing the impact of financial liberalization on the banking system. (Onwioduokit and Adamu, Adeoye and Adewuyi ). There was no effort at generating efficiency scores, which can be used as dependent variable against a set of explanatory variables.
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The Technical Efficiency of Nigerian Banks: Introduction

The Technical Efficiency of Nigerian Banks: IntroductionOne of the major issues among developing nations, and indeed all economies is how to achieve more with their scarce resources i.e. improving their technical efficiency. This has led to the adoption of various economic systems and policy options. The Nigerian economy in general and the banking sector in particular is not an exception to this. This is more so when banks, like most other production entities are profit oriented.
The role that banks play in the economic development process was demonstrated by McKinnon and Shaw. They showed that the financial sector could be a catalyst for economic growth and development if it is efficiently managed. This role relates mainly to earnings, mobilization of surplus financial resources and efficient intermediation in general. In recent times, banks have received a lot of attention among macroeconomic policy makers. This is because apart from the traditional roles enumerated above, banks are channels through which monetary policies are transmitted to the economy. Thus, the efficiency with which banks discharge their duties and their level of technical efficiency may feedback into the economy.
The Nigerian banking sector has gone through a lot of reforms in recent times. Before 1986, the sector was repressed due to regulation of the system by the Central Bank of Nigeria (CBN). However, with the introduction of the Structural Adjustment Programme (SAP) and the recommendations of McKinnon and Shaw, Nigeria embraced financial liberalization like most other nations. One of the rationales for financial liberalization is to improve the efficiency of the financial system. Chirwa notes that the McKinnon-Shaw hypothesis of financial liberalization has been popularized within the efficient financial system argument. This is because for the banking sector, studies have shown that the problems of inefficiency are more important than scale and scope issues (Berger, Humphrey, 1991; Berger, Hunter and Timme, 1993).Furthermore, Nyong attributes the various failures experienced by the Nigerian banks to technical inefficiency of these banks.
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