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).
Banks are business entities or firms that combine capital, labour, and other financial inputs to produce financial outputs (Wheelock and Wilson, 1999).In analyzing the efficiency of banks, the issue of variable selection (that is the ability to identify the appropriate outputs which banks produce and their inputs) poses some problems. For instance, the variable may present different information although they carry the same label; or the same information may be reported under different labels. credit
Humphrey identified three measures of banking output. These are:
a.    The number of transactions processed in deposit and loan accounts. This is a flow measure.
b.    The real or constant naira value of funds in the deposit and loan accounts, which is a stock measure; and
c.    The number of deposit and loan accounts serviced by banks. This is also a stock measure.
He noted that the preferred measure is the flow measure because output is a flow. However, in some instance, stock measures are used. This is the situation where the flow measure is unavailable or because the stock measure might be proportional (on average) to a flow measure.
Humphrey also noted that there is less controversy on measuring bank inputs. He recognizes labour (number of workers or total hours worked) and the real or constant naira value of physical capital (usually the book value of premises, furniture, and equipment deflated by some price index) clearly represents inputs needed to produce bank output; treating the real or constant naira value of loanable funds – core deposits plus purchased funds – as an input.