Frontier efficiency measurement in deposit-taking financial mutuals: A review of techniques, applications, and future re

1. Frontier efficiency measurement in deposit-taking financial mutuals: A review of techniques, applications, and future research directions Professor Andrew Worthington Griffith University Paper presented at the Abacus–Melbourne Centre for Financial Studies Research Workshop on Financial Mutuals, 28 April 2008, Sydney.

2. Introduction • Frontier efficiency measurement techniques have been increasingly used to financial institution efficiency. • A small but steadily increasing number of studies are concerned with deposit-taking financial mutuals, especially credits unions (CU), building societies (BS) and savings and loans (S&L). • A variety of contexts but concentrated in Australia (CU and BS), the US (CU and S&L) and the UK (CU and BS). • Several now rather dated surveys of frontier efficiency techniques in financial institutions now exist, but these mostly relate to large banks in the US.

3. Efficiency concepts • Technical efficiency is the productive resources in the most technologically efficient manner. •  the maximum possible output from a given set of inputs or the minimum possible inputs for a given level of output. • Allocative efficiency is the ability of an organisation to use these inputs in optimal proportions, given their respective prices and the available production technology. •  choosing between the different technically efficient combinations of inputs used to produce the maximum possible outputs. • Allocative efficiency and technical efficiency determine the degree of productive efficiency (or total economic efficiency). • Also cost efficiency, scale efficiency, revenue efficiency, and profit efficiency and the separation of productivity into the components attributable to efficiency and technological change.

4. Frontier efficiency approaches • All efficiency measures assume the production frontier of the fully efficient organisation is known. • A this is usually not known, the production frontier must be estimated using sample data. • Two approaches are possible: • a nonparametric piecewise-linear convex frontier constructed such that no observed point should lie outside it (the mathematical programming approach); or • a parametric function fitted to the data, again such that no observed point should lie outside it (the econometric approach). • These approaches use different techniques to envelop the observed data, and therefore make different accommodations for random noise and for flexibility in the structure of the production technology.

5. Specific approaches Econometric (parametric) techniques: • Deterministic frontier analysis (DFA) • Stochastic frontier analysis (SFA) Mathematical programming (non-parametric) techniques. • Data envelopment analysis (DEA) • Free-disposal hull (FDH) • Malmquist productivity indices (MI)

6. Econometric techniques • DFA usually restricted to single outputs. • In DFA no allowance for specification and data measurement errors • SFA adds information on prices and costs in addition to quantities. • Popular form for assessing cost efficiency. • Can use complex or simple functions. • SFA introduces a disturbance term representing noise, measurement error, and exogenous shocks. • The efficiency of mutuals are measured against some theoretical standard – normally find no fully efficient firms. • Difficult to include inputs and outputs not specified in dollars or prices.

7. Mathematical programming techniques • Non-stochastic and non-parametric. • Allows multiple inputs and outputs specified in various measures ($, #). • Can impose a large number of additional constraints. • Especially useful in contexts where strict profit maximisation is the not the objective. • This has been used to justify its use for mutuals (along with hospitals, education, police, etc.) but equally in favour for bank studies. • DEA most favoured approach.

8. Conceptualising mutual behaviour • production approach views mutuals as producers of deposit accounts and loans; defining output as the number and type of accounts and their associated transactions. Inputs are calculated as the number of employees and capital expenditures on fixed assets and other material. • intermediation approach conceptualises mutuals as intermediators, converting and transferring financial assets, inputs are labour and capital costs, and the interest payable and the value of deposits and other borrowed funds, with the outputs denominated in loans and financial investments. • asset approach conceptualises a institutions primary function as the creation of loans: closely related to the intermediation approach except that outputs are strictly defined by loan assets.

9. Deciding upon a specification • Intermediation approach dominates existing work. • Useful for comparing mutuals at the industry level with relatively modest data requirements. • Production approach regarded as potentially most useful at branch level but would rely on in-house information. • Problem is whether any of these should apply to mutuals.

10. Explaining efficiency differences • the benefits and costs of the mutual form • regulation, organisational and legal structures • the role of branches and membership • merger activity

11. Directions for future research • Combine comparable institutions from different sub-sectors (say, small banks with building societies and credit unions) or institutions from different national contexts (like UK and Australian building societies) in a single study. • Consult with industry and regulators on the nature of the behavioural objectives in deposit-taking financial mutuals and the extent to which they differ (if any) from other organizational forms. • Apply other measures like revenue and profit efficiency not previously found in the mutual literature. • Consider productive efficiency at the branch/sub-unit level