Managerial Finance

Bank performance measurement in a developing economy: an application of data envelopment analysis

O. Felix AyadiArinola O. AdebayoEddy Omolehinwa
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 Volume 24 Number 7 1998 5

Bank Performance Measurement in a

Developing Economy: An Application of Data
Envelopment Analysis.
O. Felix Ayadi, School of Business and Economics, Fayetteville State University,
Fayetteville, Arinola O. Adebayo, School of Business, Virginia State University, Pe-
tersburg, and Eddy Omolehinwa, Faculty of Business Administration, University of
Lagos,Akoka, Lagos, Nigeria
Abstract
In the wake of banking distress in Nigeria, this paper represents an attempt to deter-
mine the quality of bank management using data envelopment analysis (DEA). The
results are consistent with Doguwa (1996), who concludes that the weakness of Nige-
rian banks is attributed mainly to poor management which manifests in excessive
Downloaded by University of Ghana At 15:57 27 June 2016 (PT)

credit and liquidity risk, poor loan quality and sluggish ability to generate capital in-
ternally. The results are also certainly in consonance with those reported by Alawode
(1992) who concludes that the expanded powers granted commercial banks as a result
of deregulation pose threats to the safety of the system by placing heavier demands on
the regulatory/supervisory authorities. Finally, the banks that are found to be rela-
tively efficient in this study are those that have been in existence for a long period of
time.
1. Introduction
The banking sector in most economies is so critical that it attracts much attention from
the public as well as regulatory authorities. According to Mauri (1983, 1985), Bhatt
(1989), Askari (1991) and Yue (1992), banking institutions perform intermediation
functions and consequently influence the level of money stock through their ability to
create deposit liabilities. Therefore, it is critical for depositors, investors, regulators
and the public at large to have vested interest in the performance of banking institu-
tions.
The driving force for monitoring the performance of banks is to gain an insight
into their objectives. According to Oral and Yolalan (1990), performance evaluation
of banks should be linked to decision models so as to associate the results obtained
with the decision. Barr and Siems (1994) note that the recent increased trend in bank
failures raises many questions regarding the safety and soundness of institutions that
operate in the banking industry. According to the authors, this ominous situation
raises important questions such as: Why has there been a sudden increase in the
number of bank failures? How can the likely collapse of banking institutions be antici-
pated and prevented? What remedies can the regulatory authorities put in place to
slow down the rate of bank failures?
In an attempt to monitor the performance of banks, financial economists have
used financial ratios. Yeh (1996) notes that the major demerit of this approach is its re-
liance on benchmark ratios. These benchmark ratios may not be suitable and thus, can
mislead an analyst. Moreover, Sherman and Gold (1985) and Oral and Yolalan
(1990), note that financial ratios represent short-term measures of operating perform-
 6 Managerial Finance

ance rather than the more relevant long-term performance. According to them, finan-
cial ratios are not appropriate because they aggregate many aspects of performance
such as operations, marketing and financing.

Several other studies (Doguwa, 1996; Nyong, 1994; Jimoh, 1993; Espahbodi,
1991; Jordan and Henderson, 1990; and Abrams & Huang, 1987) have applied
econometric models such as probit, logit, discriminant and ratio analyses as early-
warning signals for identifying distressed banks. These approaches have predictive
power only when a priori groups are available for the basis of comparison (Yeh,
1996). In the United States, the Federal Reserve System uses a risk index called,
CAMEL rating to dichotomize banks into different categories. The CAMEL rating is
based on capital adequacy (C), asset quality (A), management (M), earnings (E), and
liquidity (L). Cole and Gunther (1995) note that in addition to CAMEL, the Federal
Reserve instituted in 1993 an off site monitoring system under the Financial Institu-
tions Monitoring System (FIMS). These mechanisms are put in place in order to mini-
mize the cost to the society of the collapse of a financial institution.
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In a recent treatise, Doguwa (1996), notes that banking institutions in Nigeria

faced a serious upheaval in the early 1990s. This period witnessed a considerable in-
crease in the number of problem banks. For example, about 16 banks were classified
as distressed in 1992, 29 in 1993 and over 30 in 1994. A joint study by the Central
Bank of Nigeria and the Nigeria Deposit Insurance Corporation in 1995 attribute the
reasons for distress to include the prevailing economic recession, policy induced
shocks, an increase in the level of risk assumed by banks, poor quality of loans and ad-
vances, mismanagement and fraud.

In 1992, the Central Bank instituted an early-warning performance-based sys-

tem that uses capital adequacy ratio, loans-to-deposit ratio, liquidity ratio, minimum
paid-up capital and sectoral credit allocation. An early-warning mechanism is desir-
able because it helps regulatory authorities to put in place a remediation program ei-
ther to prevent a bank from failing or limit the loss to depositors and/or tax payers of a
failing bank. Unfortunately, none of the aforementioned ratios directly measures
managerial ability to convert a set of inputs into a set of outputs (Barr and Siems,
1994).

Barr, Seiford and Siems (1993) proposed a proxy for managerial quality using a
multiple-input, multiple-output model. According to Barr and Siems (1994), data en-
velopment analysis (DEA) is applied to compute an index of efficiency that focuses
on the financial intermediation function of banks. The objective of this paper is to ap-
ply DEA to Nigerian financial data from 1991 through 1994 with the hope of unravel-
ling the contribution of bank managers to the distress condition of banking institutions
in Nigeria. This study is relevant considering the fact that several bank executives are
in jail in Nigeria for bankrupting their banks. Moreover, Agu (1992) notes that at-
tempts to reform financial markets in many emerging economies have had some im-
pact on the competitive environment.

2. The Banking Sector and the Structural Adjustment Program (SAP) in Nigeria

The years preceding economic reforms in Nigeria witnessed a financial system that
was characterized by inefficiency and obsolescence. According to Osundiji (1993),
 Volume 24 Number 7 1998 7

the economys lack of competitiveness was a result of government policies and regu-
lations which created a breeding ground for a culture of complacency and arm-chair
banking.1
In 1986, the Nigerian financial services industry began to experience a broad re-
structuring as a part of the Structural Adjustment Program (SAP). The major objec-
tives of the program are to restructure and diversify the productive base, and achieve
fiscal and balance of payments viability. Other objectives are to lay a basis for non-
inflationary sustainable growth and improve public sector efficiency.

In pursuance of the aforementioned objectives, the government adopted a strat-

egy which includes deregulation of interest rates, rationalization and restructuring of
public expenditure and custom tariffs, adoption of a realistic exchange rate policy and
adoption of appropriate pricing policies in all sectors of the economy. Among other
specific policies, the monetary authority introduced the auction-based trading system
for federal government treasury bills and certificates. The Nigeria Deposit Insurance
Corporation (NDIC) was established and the Second-Tier Foreign Exchange Market
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(SFEM) was also opened.

According to Ahmed (1987), the main elements of the SAP envisaged not only
strengthening demand management policies but also adopting measures to stimulate
domestic production and broaden the supply base of the economy. The program has
also been described as a home grown reform package designed to make Nigeria at-
tractive to international money lenders. Since the policies were put in place, the finan-
cial sector has recorded a tremendous growth in terms of increase in the number of
banks and non-bank financial intermediaries.2 The reform results in some changes in
the structure of the economy. In addition to the growth in the number of commercial
and merchant banks, the number of primary mortgage institutions rose to 252 in 1993.
Moreover, the number of community banks increased to 401 in 1992 and 879 in 1993.
The Peoples Bank increased its branching network to 271. During this period, there
was also a marked increase in the number of bureaux-de-change. The CBN adopted
an auction-based system of trading in government securities during the last quarter of
1989. This auction-based system replaced the former system of administrative deter-
mination (fixing) of rates.
Nigeria operates a multiple branch banking system. Thus, most of the banks op-
erate throughout the country through their multiple branching network. For example,
there were 25 commercial banks with 1,108 branches in 1983. The number of com-
mercial banks operating in the country rose to 28 while their branch network in-
creased by 55 from 1,242 in 1984 to 1,297 in 1985. As at the end of 1986, there were
twenty-nine commercial banks with a total of 1,367 branches all over the country. By
the end of 1991, there were 65 commercial banks operating through a network of
2,023 branches.3 As Ojo (1994) notes, as at the end of 1992, there were 120 banks op-
erating in Nigeria. Other institutional developments in the banking industry include
the setting up of specialized institutions such as, Nigeria Export/Import Bank
(NEXIM), the Educational Bank, Urban Development Bank, and the Maritime De-
velopment Bank.
The structural adjustment program also brought some dynamic changes to the
economic environment. The Central Bank of Nigeria Decree #24 and Banks and other
 8 Managerial Finance

Financial Institutions Decree #25 (BOFID) both of 1991 were expected to consolidate
and streamline the control of the banking industry as well as strengthen the regulatory
power of the CBN over the financial sector. Moreover, these decrees gave the CBN its
independence from the control of the Federal Ministry of Finance.

While acknowledging the satisfactory growth in the number of banks, branching

network and bank assets, Ojo (1994) notes the deficiency in the performance of Nige-
rian banks. He identifies the following as major ailments of the system: (1) The
adopted banking system in Nigeria is the Anglo-Saxon which Ojo argues is unsuitable
to Nigeria. He prefers the German/Japanese banking model. (2) The Nigerian banking
model is too commercially-oriented rather than being industrially-oriented. (3) Banks
in Nigeria do not generally lend funds to long-term users and this hurts any effort to in-
dustrialize. (4) There is an increasing incidence of unprofessional banking practice.
(5) There is a rising incidence of frauds, insider abuses and unethical practices. (6)
The rising wave of bank failures and defaults has resulted into an erosion of confi-
dence in the banking system. (7) Lack of cooperation from bankers who take deliber-
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ate actions that render ineffective monetary policy and foreign exchange management
measures. (8) Actions and policies of regulatory authorities that are ill-conceived and
thus deficient in effectiveness.

In view of the above, it becomes necessary for financial economists to study the
Nigerian banking system with the objective of proposing possible solutions to the
aforementioned problems.

3. Methodology

3.1 Data

The data used in this study are the financial characteristics of ten commercial and mer-
chant banks that are listed on the Nigerian Stock Exchange. These financial character-
istics are: interest income, non-interest income, total deposits, total expenses (interest
plus non-interest) and total loans. The sample period is from 1991 through 1994. In
this paper, a bank is referred to as a decision making unit (DMU). Each DMU operates
by transforming a set of m different inputs into s different outputs. According to Yeh
(1996) and Oral & Yolalan (1990), the inputs are the interest paid on deposits, as well
as expenses on personnel, administration etc. and total deposits. The outputs are total
loans, interest and non-interest incomes. The data for this study were obtained from
Analysis of Corporate Performance in Nigeria, 1990-1994 by Oyebanjo.

3.2 Data Envelopment Analysis (DEA)

DEA is a non-parametric mathematical programming approach which measures the

relative ratio of a DMUs total weighted outputs to total weighted inputs. Data envel-
opment analysis (DEA) is applied to each DMU to determine its measure of transfor-
mational efficiency. The index of transformational efficiency is used to proxy the
quality of management (Yeh, 1996; Yue, 1992; Barr & Siems, 1994 and Oral & Yola-
lan, 1990). It should be noted that the DEA approach is a relative measure of effi-
ciency because it compares a firms observed outputs and inputs and identifies the
best practice firm(s) in a group. Each firm in a group is then measured relative to the
best firm.
 Volume 24 Number 7 1998 9

Thus, a firm that is considered efficient in one group might not be when put in an-
other group. Mathematically, DEA is set up as:
s

u
r =1
r yr0
Max E 0 = m
(1)
v i x i0
i =1

Subject to
s

u
r =1
r y rj
m
1; ur 0 , v i 0
v
i=1
j
x ij
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For i = 1,2 ........, m; r = 1,2,.......,s; j= 1,2 ........, n

In the model above, ur are the output weights for r = 1,2,....., s; vi are the input
weights for i = 1, 2 ..... , m. The outputs in the model are denoted as yr0 while the inputs
are represented by xij. It should be noted that the model represented be Equation 1 is a
non-linear fractional mathematical programming problem. Charnes et al (1994) de-
veloped an alternative linear equivalent that is amenable to estimation via linear pro-
gramming of the form:
s
Max Y 0 = r y r 0 (2)
r =1

Subject to

i =1
i x i0 = 1

s m

r =1
r y rj x ij 0
i =1

i , and r ; for i = 1,2,...... m; r = 1,2...... ,s; and j = 1,2...... ,n

The subscript 0 in the model above denotes the DMU that is being evaluated, xij is in-
put i, and yrj is output r of DMUj. An arbitrary number (), is introduced to ensure that
all the observed inputs and outputs have positive weights. In the linear programming
problem above, r = tur and i= tvi where t-1= i vi xij.
The DEA version applied in this paper examines n banks each producing s dif-
ferent outputs using m different inputs. Our focus is to determine the relative effi-
ciency Y0 of the benchmark bank with respect to the banks in the sample. The relative
 10 Managerial Finance

efficiency is defined as the ratio of the weighted outputs (that is, virtual output) of the
benchmark bank to its weighted inputs (virtual input). The benchmark bank is as-
signed the highest efficiency index of 1.00. Thus, the most efficient banks in the sam-
ple get an index of 1.00 while others score less than 1.00 because they are relatively
inefficient.

Oral & Yolalan (1990) and Yeh (1996) note that a careful identification of inputs
and outputs is critical to the application of DEA. In a sample of n banks, a complete
DEA analysis involves the application of linear programming as formulated in Equa-
tion 2 to n different weight sets. In each program, the constraints are held constant
with the objective function changed for each DMU. As stated earlier in this section,
bank inputs are the interest paid on deposits, as well as expenses on personnel, ad-
ministration etc and total deposits while outputs are defined as total loans, interest in-
come and non-interest income.

4. Results
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The authors employed Schrages (1991) LINDO program. Table 1 contains the re-
sults of the application of DEA Equation 2 to data on the ten banks included in this
study. The results show that Banks 1 and 2 consistently recorded an index of 1.00 in
1991 through 1993. Bank 3 on the other hand recorded an index of 1.00 in 1991, 1993
and 1994. On a year-by-year basis, the relative efficiency scores range from 0.16 to
1.00 in 1991. In 1992 the range is from 0.03 to 1.00 and 0.07 to 1 in 1993.

In 1991, only three of the ten banks in the sample are classified as efficient. This
number declined to two in 1992, only to increase to three in 1993. In 1994, as a result
of incomplete data, only two banks are analyzed. Of these two, one is efficient while
the other is not. As noted earlier, Banks 1 and 2 are consistently rated efficient
throughout the sample period. Bank 3 lost it efficiency rating only in 1992. Bank 4

Table 1: DEA Efficiency Scores of Sampled Banks, 1991-1994

BANK 1991 1992 1993 1994
Bank l 1.00 1.00 1.00
Bank 2 1.00 1.00 1.00
Bank 3 1.00 0.96 1.00 1.00
Bank 4 0.16 0.22 0.27 0.37
Bank 5 0.18 0.10 0.38
Bank 6 0.24 0.19 0.25
Bank 7 0.36 0.23 0.29
Bank 8 0.61 0.55 0.85
Bank 9 0.03 0.07 0.12
Bank 10 0.09 0.12
 Volume 24 Number 7 1998 11

started off with a rating of 0.16 in 1991 but experienced an improvement every year
thereafter. Banks 5, 6, 7, and 8 all recorded a decline in rating in 1992.

5. Discussion

The Nigerian banks enjoyed a period of increased profitability even prior to deregula-
tion in the 1980s. This situation became a concern for many scholars of financial eco-
nomics who wondered why banks recorded a higher level of profitability than
non-bank institutions. Obanya (1990), Ibe (1992), Agu (1992) and Ayadi (1996) ex-
amine the source of banking profitability especially in the 1980s. Agu (1992) argues
that Nigerian banks were highly profitable because of governments monetization of
crude oil earnings. Prior to the early 1990s, the practice in Nigeria was for the govern-
ment to keep deposits with commercial banks. Essentially, these banks were receiv-
ing almost free funds from which they made loans and investments. It is logical to
understand why banks were extremely profitable at the time. This trend was reversed
a few years ago when the federal government decided to move all its deposits with
commercial banks to the Central Bank of Nigeria. Ayadi (1996) reports results that
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suggest that Nigerian banks recorded huge profits by exploiting their customers lack
of knowledge of banking laws and also by circumventing government regulations es-
pecially those that relate to service fees. Little wonder that Obasanjo (1991) refers to
this way of making money as banditry.

However, the fortunes of banks in Nigeria changed a few years ago. According
to Ojo (1994), there is an increase in the incidence of unprofessional banking practice
which includes frauds, insider abuses and unethical practices. Agu (1992) also identi-
fied the federal government policy of transferring its deposits from commercial banks
to the central bank as a cause of banking problems in Nigeria. All these led to a rising
wave of bank failures and defaults which resulted in an erosion of confidence in the
banking system. A study of the banking industry sponsored by the Central Bank of Ni-
geria and the Nigeria Deposit Insurance Corporation also identified mismanagement
of one of the factors responsible for the observed level of distress.

This paper represents an attempt to determine the quality of bank management in

Nigeria. The results are consistent with Doguwa (1996), who concludes that the
weakness of Nigerian banks is attributed mainly to poor management which mani-
fests in excessive credit and liquidity risk, poor loan quality and sluggish ability to
generate capital internally. The results are also certainly in consonance with those re-
ported by Alawode (1992). Alawode argues that the expanded powers granted com-
mercial banks as a result of deregulation pose threats to the safety of the system by
placing heavier demands on the regulatory/supervisory authorities.

The banks that are found to be relatively efficient in this study are those that have
been in existence for a long period of time. This result is consistent with Mesters
(1996) proposition that a banks age is highly correlated to its level of efficiency be-
cause of the possibility of learning by doing.

A cursory examination of the banking industry also revealed that the govern-
ments play a significant role in distress conditions of several banks. According to
Ugwu (1997), many state governments own majority shares in many banks and use
this leverage to select unqualified persons as managing directors. Such managing di-
 12 Managerial Finance

rectors are often obligated to their employers and consequently would not refuse the
employers requests, no matter how much illegality is involved. Ugwu notes that the
debt owed the distressed banks by state governments were not processed within nor-
mal banking rules. Bank executives are also found to be intimidated by several state
government officials. Ugwu opines that political interference is responsible for the
demise of government-controlled banks such as African Continental Bank, Progress
Bank and Mercantile Bank. This author also presents ample evidence of state govern-
ment indebtedness to banks which according to Baba-Ahmed (1995) has implications
on bank performance.

Finally, there is no doubt that the Nigerian banking industry is in a crisis situa-
tion. The government constitutes a significant part of the problem. It regulates the op-
erating environment, participates in managing banking institutions, flouts banking
rules by intimidating bank executives and then turn around to prosecute uncoopera-
tive bank executives for minor infractions. The bank performance monitoring mecha-
nism is weak as the results of this paper show. Many of the banks sampled should have
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either been liquidated or put under intense scrutiny by the NDIC but the authors are
not aware of any concrete effort to this effect. Therefore, any effort to sanitize the
banking industry should begin with the removal of government interference and an
improved bank performance monitoring mechanism.
 Volume 24 Number 7 1998 13

Endnotes

1. Osundiji does a review of the various measures taken by the federal government
and their impact on the Nigerian economic and banking environment. More specifi-
cally, he assesses the impact of these measures on treasury management. For more de-
tails on this analysis, see, Osundiji, K.A., An overview of contemporary issues in the
Nigerian economy and banking environment and their impact on treasury manage-
ment, First Bank Monthly Business & Economic Report, October 1993, pp. 1-14.
G.O. Nwankwo is the first financial economist to use the term, arm-chair banking to
describe the practice of banking in Nigeria. The term describes Nigerian bankers who
are quite passive in terms of promoting banking habit in Nigeria. They seat lazily in
their arm chairs and wait for customers to come. For more on this concept, refer to
Nwankwo, G.O., The Nigerian Financial System, Low Cost Edition, London: Mac-
millan Publishers, 1987.

2. For a more comprehensive discussion of the rationale and elements of financial re-
Downloaded by University of Ghana At 15:57 27 June 2016 (PT)

form in Nigeria, refer to Oyewole (1993, 1994). Oyewole documents a detailed cata-
log of the various innovative financial instruments introduced into the financial
system after deregulation. Oresotu (1992) and Sobodu and Chide (1991) also docu-
ment the behavior of interest rates under the Nigerian financial reform program. Tella
and Okosun (1993) discuss the different ramifications of the phenomenon of banking
deregulation in Nigeria. They also analyze the effects of interest rate deregulation on
savings, investment and capital flows.

3. Ibe (1992, p. 245-248) contains a more extensive description of the Nigerian bank-
ing industry. Ojo (1994) also contains a detailed characterization of the structure of
banking in Nigeria.
 14 Managerial Finance

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