BANK EFFICIENCY AND NON-PERFORMING LOANS

The banking sector is still the primary form of fi nancial intermediation in the Asian and Pacific region, and as such is the largest conduit for the mobilization of domestic savings, the main source of external capital to fi rms and the key player in the payment system.

Consequently, the development of an effi cient banking sector is crucial for the growth of the economies in the region. As liberalization of the banking sector around the world continues apace, banking markets in different countries are now becoming increasingly integrated.

Moreover, foreign banks are allowed to set up branches in other countries, subject to the regulations of the home country. Furthermore, banking competition in the ASEAN region is expected to be more intense in the future with the realization of ASEAN Free Trade Area (AFTA).

In Malaysia and Singapore, both governments have been promoting consolidation of domestic banks to prepare them for the anticipated arrival of new foreign competition. As foreign banks take a greater role in the market, the strength of the local banks will be put to the test.

How these increased competitive pressures will affect banks depend in part on their ability to adapt and operate effi ciently in the new environment. Banks that fail to do so will be driven out of the market by the more effi cient ones.

That is, the most effi cient banks will have a competitive advantage. Therefore, information on banking effi ciency when compared across nations is important, as this will enable policy makers to formulate appropriate and sound policies to direct their banking industry.

Despite these facts, cross-country comparisons of banking effi ciency in developing countries are lacking in the literature.

At the same time, due to the Asian fi nancial crisis, growth and innovation in both Malaysia and Singapore are constrained by banks whose capital has been eroded by the accumulation of non-performing loans (NPL).

Although the non-performing loan ratios in Malaysia have fallen recently, the reduction in non-performing loan ratios were largely brought about by the transfer of NPLs from banks to public asset management companies.

The question here is how non-performing loans affect the cost effi ciency of banks. It is argued that it will have a detrimental effect since such banks will exert additional managerial effort and give additional expense dealing with these problem loans.

These extra operating costs include, but are not limited to,

additional monitoring of the delinquent borrowers and the value of their collateral,
the expense of analyzing and negotiating possible workout arrangements,
the cost of seizing, maintaining, and eventually disposing of collateral if default later occurs, and
the diversion of senior management attention away from solving other operational problems.

Faced with an exogenous increase in non-performing loans, even the most cost-effi cient banks have to purchase the additional inputs necessary to administer these problem credits.

By estimating the relationship between non-performing loans and bank effi ciency, we can determine whether an increase in problem loans have a negative impact on bank effi ciency. The rest of the paper is organized as follows.

Section 2 reviews the literature. Section 3 provides an overview of problem loans in Malaysia and Singapore. The hypothesized relationship between non-performing loans and cost effi ciency is discussed in Section 4.

Section 5 discusses the methodology and the data used. Section 6 presents the empirical results. Finally, Section 7 concludes.

Review of Literature

Issues of non-performing loans and cost effi ciency are related in several important ways. First, a number of researchers have found that failing banks tend to be located far from the best practice frontier3 (e.g. Berger and Humphrey, 1992; Wheelock and Wilson, 1994).

Thus, in addition to having high ratios of problem loans, banks approaching failure also tend to have lower cost effi ciency. A number of other studies have found negative relationships between effi ciency and problem loans even among banks that do not fail (Kwan and Eisenbeis, 1995).

A positive relationship between asset quality and cost effi ciency (DeYoung, 1997) suggests that the negative relationship between problem loans and cost effi ciency holds for the population of banks as well as for the subset of failing banks.

Tsai and Huang (1999), by utilizing a translog cost function, examined the relationship between management quality and cost effi ciency within Taiwan’s banking industry.

They discovered that asset quality and cost effi ciency are related; the non-value-added activities of bad assets incur a negative consequence on the operating performance. In recent years, studies on bank effi ciency have taken into account asset quality, specifi cally non-performing loans.

The omission of such a variable might lead to an erroneous bank effi ciency measure (Mester, 1996). This is particularly true since a large proportion of non-performing loans may signal that banks use fewer resources than usual in their credit evaluation and loans monitoring process.

In addition, non-performing loans lead to ineffi ciency in the banking sector as found by Altunbas et al. (2000), Fan and Shaffer (2004) and Girardone et al. (2004). This is because effi cient banks are better at managing their credit risk as highlighted by Berger and DeYoung (1997).

By taking into account risk and quality factors into the estimation of banks’ cost effi ciency in the Japanese commercial banks for the period 1993 to 1996, Altunbas et al. (2000) fi nds that the level of non-performing loans are positively related to bank ineffi ciency.

Furthermore, banks tend to experience a decrease in their scale effi ciency level after controlling for risk factors. This result is also consistent with the study of bank effi ciency levels in the U.S. by Hughes and Mester (1993) and on the evaluation of cost effi ciency in the Italian banks by Girardone et al. (2004).

On the other hand, Fan and Shaffer (2004) analyzed profi t effi ciency of large commercial banks in the U.S. by accounting for non-performing loans. They fi nd that, although non-performing loans are negatively related to banks’ profi t effi ciency, it is not statistically signifi cant.

Overview of Problem Loans in Malaysia and Singapore

Non-performing loans have been a hindrance to economic stability and growth of economies. In Malaysia and Singapore, non-performing loans continued to improve, underpinned by higher reclassifi cation of non-performing loans to performing status and recoveries, as well as efforts to achieve healthier balance sheets via loan write-offs.

As a result, net non-performing loan ratios in the Malaysian banking system, since the Asian fi nancial crisis, has gradually been in decline from a high of 13.6% (3-month classifi cation) in December 1998 to 3.2% in 2007 (Table 1).

The bulk of the banking system’s non-performing loans is in the business sector (56% of total non-performing loans) followed by the household sector (41%). In terms of banking system loans, the household sector accounts for the majority of total loans at 55%, while the business sector accounts for 40%.

In Singapore, non-performing loans peaked for most banks in 1999 following the 1997 Asian fi nancial crisis. The non-performing loan ratio for all banks (including multi-nationals with branches in Singapore) was 4.3% in 2005, down from 8.3% in 2001 (Monetary Authority of Singapore, 2006).

This fi gure is much lower than in Malaysia. Table 2 presents the loan disbursement and non-performing loans by sector in Malaysia.

The ratio of non-performing loans to the total loans disbursed by sector clearly indicate that the education and health sector exhibit the highest ratio among other sectors with reported ratios of 16.83% in year 2006 and 14.20% in year 2007.

This is followed by fi nance, insurance and business activities with 12.02% in year 2006 and 7.26% in year 2006. These sectors are mostly dominated by individual households borrowing for educational, health, and investment purposes.

This is consistent with the BNM report; a large part of the non-performing loans comes from the household sector.

Theoretical Relationship between Non-performing Loans and Bank Effi ciency

From the point of view of management accounting, bank asset quality and operating performance are positively related. If a bank’s asset quality is inadequate (e.g. the loan amount becomes the amount to be collected), the bank will have to increase its bad debt losses as well as spend more resources on the collection of non-performing loans.

This increase in non-performing loans in the banking industry can be due to external events, such as adverse situation in economic activities (Berger and DeYoung, 1997, refers to it as bad luck hypothesis).

When banks list the loan amount for collection, banks will incur extra operating costs from non-value-added activities to handle and supervise the collection process.

These non-value-added activities consist of constantly tracking the debtor’s fi nancial status, being cautious of the collateral value, discussing the amortization plan, paying expenses for contract negotiation, calculating the costs to withhold, deposit and dispose of collateral at the time the loans become non-payable.

The costs include winning the trust from management and the public, preserving the banks from being rated poor as a consequence of external affairs, declining deposits because of a loss in credibility, and extra costs to monitor loan quality.

Furthermore, higher future costs are generated by the ignorance of the problems from other operations when the loan quality issues grab the attention of the senior management. This escalation in cost, in turn, deteriorates bank effi ciency.

On the other hand, Berger and DeYoung (1997) also suggest that effi ciency of the banking fi rms might affect the non-performing loans in the banking industry. The bad management hypothesis was developed to explain this relationship.

Berger and DeYoung (1997) argue that bad management of the banking fi rms will result in banks ineffi ciency and affects the process of granting loans. The banks’ management might not thoroughly evaluate their customers’ credit application due to their poor evaluation skills.

In addition, the problem of asymmetric information between lenders and borrowers further complicates the matter. Besides that, the management might not be effi cient in managing loan portfolios.

Consequently, this leads to lower credit ratings for the approved loans and high probability of default resulting in higher non-performing loans. Therefore, banks’ ineffi ciencies might lead to higher non-performing loans.

Location: Indonesia