Profit efficiency in the European Union banking industry: a directional technology

distance function approach

Author(s): Anastasia Koutsomanoli-Filippaki, Dimitris Margaritis and Christos Staikouras
Source: Journal of Productivity Analysis, Vol. 37, No. 3 (June 2012), pp. 277-293
Published by: Springer
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J Prod Anal (2012) 37:277-293
DOI 10.1007/sl 1 123-01 1-0261-z
Profit efficiency in the European Union banking industry:
a directional technology distance function approach
Anastasia Koutsomanoli-Filippaki
Dimitris Margaritis * Christos Staikouras
Published online: 10 December 2011
Springer Science+Business Media, LLC 2011
Abstract We employ the directional technology distance
function approach and present estimates of profit efficiency
in the 25 European Union (EU) member states over the
period 1998-2008. This method decomposes profit effi-
ciency into its technical and allocative components. We
investigate potential efficiency differences across the old
EU region and the new EU member states, across countries
and across banks of different size. Our results indicate a
significant level of profit inefficiency for the EU region,
which is predominantly attributed to allocative ineffi-
ciency. Our findings also suggest that banks operating in
the old EU region are, on average, more profit efficient than
credit institutions in the new EU member states. Overall,
we observe considerable variation of efficiency scores
across countries and different patterns in efficiency change
over time, as well as a negative relationship between bank
size and efficiency.
Keywords Profit efficiency Technical efficiency
Allocative efficiency European Union Data envelopment
analysis Directional distance functions
JEL Classification D24 G21 G28 P34
A. Koutsomanoli-Filippaki (E3)
Council of Economic Advisors, Hellenic Ministry of Finance,
5-7 Nikis St., Syntagma Square, 10180 Athens, Greece
e-mail: a.koutsomanoli@mnec.gr
D. Margaritis
The University of Auckland Business School, Auckland,
New Zealand
e-mail: d.margaritis@auckland.ac.nz
C. Staikouras
Athens University of Business and Economics, Athens, Greece
e-mail: cstaik@aueb.gr
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1 Introduction
The European banking industry has faced numerous chal-
lenges during the past decade culminated by the 2007
subprime and subsequent global financial crises while at
the same time undergoing an unprecedented wave of con-
solidation in response to changes in regulation and tech-
nology. The implementation of European Union (EU)
policies such as the Single Market Programme and the
European Monetary Union, aimed at enhancing the inte-
gration of banking and financial systems, have created a
more market oriented and competitive financial sector
throughout Europe. In particular, in relation to old EU
member states (EU- 15), as a result of the Second European
Banking Directive and the Single European Passport, the
speed of deregulation accelerated, and with the elimination
or lowering of barriers the market-entry costs substantially
decreased, favoring competition and the creation of a
unified banking market.
As the process of achieving full financial integration
among its member countries was evolving, the EU initiated
an eastward enlargement plan through the inclusion of two
Mediterranean countries and eight former socialist coun-
tries from Central and Eastern Europe (EU- 10). In March
1998 the EU formally launched a transition process that led
to the enlarged Union in May 2004. During this process,
the new EU member states, and especially the Central and
Eastern European (CEE) countries, have gone through a
significant economic and political transformation. In par-
ticular, a catching up process, characterized by rapid
financial development and high economic growth, has been
taking place. Since 1998 significant efforts were directed
towards improving the legislation related to the banking
sector in the transition countries, while there have been
a series of amendments on the banking supervision
Springer
 278 J Prod Anal
regulative framework aiming at its harmonization with the
EU regulative system and the international standards of
effective supervision. These laws increased the attractive-
ness of the banking systems for foreign investment,
strengthened prudent standards and practices in the banks'
operations, enhanced corporate governance and improved
efficiency in banking operations and supervision.
Research interest in the EU banking systems intensified
following the first and the second wave of the EU
enlargement. In light of the increased competition under
the Single Market for financial services, the ability of EU
credit institutions to compete and survive in an increasingly
integrated European financial landscape becomes even
more important. Moreover, the different structures and past
legacies of the acceded countries and the close ownership
ties between the EU- 15 and EU- 10 credit institutions due to
the increasing presence of the latter in the CEE banking
industry create additional challenges in terms of real con-
vergence in a unified European banking market. The
dominant role played by banks in the provision of financial
services in the European economy makes the performance
of the banking system crucial for economic development
and sound functioning of the industrial sectors, as attested
by the current financial and economic crisis. Indeed, an
improvement of banking performance indicates a better
allocation of financial resources, and therefore an increase
of investment that favors growth.
This paper investigates the profit efficiency of the EU-25
banking industries over the period 1998-2008. Although
research on the efficiency of banks and other financial
institutions in the US and other developed countries is
voluminous, this paper fills a gap in the literature by
departing from the traditional analysis of efficiency in a
number of important ways. First, we use the directional
technology distance function approach, a generalization of
the more familiar Shephard (1970) input and output dis-
tance functions, to measure technical and profit efficiency
by exploiting the duality between the directional distance
and profit functions.1 Unlike the Shephard functions that
scale either in the input or the output direction, the direc-
tional distance function simultaneously adjusts in the
direction of fewer input and greater output production as
much as it is technologically feasible. This entails an
extremely flexible description of technology without
restricting banks to optimize by either increasing outputs
1 DEA models based on Shephard distance functions have been used
extensively in EU banking studies (see for example, Pastor et al.
1997; Casu and Molyneux 2003; Lozano-Vivas et al. 2001, 2002;
Grigorian and Manle 2002; Casu and Girardone 2006). To our
knowledge, Devaney and Weber (2002) were the first to use a
directional technology distance function approach to estimate profit
efficiency for U.S. banks and Koutsomanoli-Filippaki et al. (2009a, b)
for CEE banks.
Springer
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(2012) 37:277-293
proportionately without changing inputs or by decreasing
inputs proportionally for given outputs. Secondly, our
method allows overall bank profit efficiency to be
decomposed into technical efficiency, which reflects the
ability of a firm to obtain maximum output from minimum
possible input use, and allocative efficiency, which indi-
cates the ability of a firm to use the inputs and outputs in
optimal proportions, given their respective prices and the
production technology.
In order to empirically estimate the directional distance
function, we employ a non-parametric linear programming
approach, Data Envelopment Analysis (DEA). This method
has the advantage of constructing a data-driven techno-
logical frontier that requires no specification of any par-
ticular functional form or error structure. Efficiency is
measured as the distance from the frontier. As the frontier
is data specific, there will be a new frontier for each year
rather than an average across years as it is common with
stochastic methods. A drawback of the DEA approach is
that it attributes all deviations of a firm's performance from
best-practice to inefficiency, as it makes no accommoda-
tion for statistical noise. We postulate a common techno-
logical frontier across all EU-25 banking sectors. We
believe this is a reasonable assumption to make in light of
(a) the significant level of harmonization in banking and
other financial services legislation that has taken place over
the past decade across EU Member States; (b) the reduction
of barriers to cross-border trade in EU banking services and
increase in financial integration; and (c) the close owner-
ship ties between EU- 15 and EU- 10 countries due to the
increasing presence of the EU- 15 banks in the CEE
banking region.
Using this methodology, we address a number of ques-
tions regarding banking efficiency in the EU countries. Are
bank choices of inputs and outputs consistent with profit
maximization? If bank choices of inputs and outputs are
not optimal, how much of the profit inefficiency is attrib-
uted to allocative or technical inefficiency? How has profit
efficiency evolved over time? Are there any differences
across the EU-25 countries? Does the size of financial
institutions matter for profit efficiency?
The rest of the paper is organized as follows. Section 2
presents a brief review of the literature on productivity in
the European banking sector. Section 3 describes the
methodology, while Sect. 4 provides the description of the
data. Section 5 discusses the empirical results, while con-
clusions are drawn in Sect. 6.
2 Literature review
A proliferation of studies on bank efficiency and produc-
tivity has emerged as a result of rapid changes in the
 J Prod Anal (2012)
structure of the financial services industry and advances in
financial and non-financial technologies (see Berger and
Mester 2003). A large body of literature exists on banking
efficiency concentrating in the US industry. Although
European research on efficiency has not matched the vol-
ume of US studies, this has begun to change recently.2
There are several reasons why banking efficiency has
attracted particular attention, as is documented by its long
tradition in the literature. Efficiency measures are not only
success indicators, by which the performance of individual
banks and the industry as a whole, can be evaluated, but
also influence the cost of financial intermediation and the
overall stability of financial markets.3
Banking efficiency is estimated by employing either
non-parametric or parametric techniques (Berger and
Humphrey 1997; Alam 2001; Berger and Mester 2003). A
large number of studies have computed efficiency mea-
sures by employing DEA techniques to estimate Shephard
(1970) type distance functions (see Berg et al. 1992). Using
DEA, Sheldon (1999) finds that larger, specialized EU
banks are more profit efficient than smaller, diversified
banks over the period 1993-1997. On the other hand, fol-
lowing the pioneering work of Aigner et al. (1977), several
studies have estimated distance functions using parametric
methods (see, for example, Cuesta and Orea 2002).
3 Methodology
We use the directional technology distance function pro-
posed by Chambers et al. (1996) to model the production
process and measure profit efficiency. We assume there are
k = 1, ..., K banks which use G R+ inputs to produce
3 1 e R+ outputs. Technology (7) for each bank is defined
as the set of all feasible input-output vectors:4
Tk = {(/,/) : X G R+,y G x can produce y}. (1)
The directional technology distance function completely
characterizes technology (i.e. it is equivalent to 7), it
2 Studies that have investigated efficiency in the European banking
industry, and particularly focus on cross-country comparisons,
include Allen and Rai (1996), Altunbas et al. (2001), Lozano-Vivas
et al. (2001, 2002), De Guevara and Maudos (2002), Maudos et al.
(2002), Vander Vennet (2002), Casu and Molyneux (2003), Casu and
Girardone (2004), and Koutsomanoli-Filippaki et al. (2009a, b).
3 According to Molyneux et al. (1996) "greater efficiency might be
expected to lead to improved financial products and services, a higher
volume of funds intermediated, greater and more appropriate
innovations, a generally more responsive financial system, and
improved risk-taking capabilities if efficiency profit gains are
channelled into improved capital adequacy positions".
4 It is assumed that the technology satisfies the axioms listed in Fare
and Primont (2003), among which are convexity and free or strong
disposability of outputs and inputs.
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37:277-293 279
allows firms to optimize by simultaneously adjusting inputs
and outputs, and it is a measure of technical inefficiency.
To define it we need to specify a directional vector,
denoted by g. This vector determines the direction in which
technical efficiency is assessed. Let a directional vector be
represented by g = (gx, gy), where gx G R+ and gy G R+,
while we no longer make use of the index, k. The
directional technology distance function seeks the
maximum simultaneous expansion of desirable outputs
(y), and contraction of inputs (x) for the directional vector,
g and provides a unifying structure, since it includes the
Shephard distance functions as special cases.5
T(x,y,gx,gy) = sup{/? : (x- gx, y + gy) el}. (2)
In this study, we use a common direction vector which is
set equal to: g = ( gXgy ) = (*,?) This directional vector
implies that the amount by which a bank could increase
outputs will be t (*, y, x, y) units of y and decrease inputs
by T(xi y ; x1 y) x units of x. For a bank that is technically
efficient and is on the frontier, the value of the directional
distance function would be zero. On the other hand, values of
Drix^y, gx , gy) > 0 indicate inefficient production.
One of the properties of the directional distance function
is that it is dual to the profit function. In particular, profit
maximization requires the simultaneous adjustment of
outputs and inputs, which is also characteristic of the
directional distance function approach. Given output prices
Pm R+ input prices wN G R+, and technology 7, we
define the profit function IT (p,w) as:
Il (p, w) = max{#y - wx : {x, y) T} (3)
This function is homogeneous of degree 1 in prices in
addition to being convex and continuous in positive prices.
Profit maximization implies that:
n (p,w) = py * - wx* >py - wx for all (. x , y) G 7 (4)
where y* and x* are optimal input and output vectors that
maximize profits. Since the directional technology distance
function is a complete characterization of technology, we
can substitute 7 with Dr^^&cg^in expression (4) [see
Fre and Grosskopf (2004) and Fare et al. (2008)]. By
rearranging we have:
n {p,w) -(py-wx) R
Pgy + Wgx
5 The Shephard output distance function optimizes over output
quantities, but not inputs. Hence if the directional vector g is set at (0,
y ) then the directional (output) distance function is equal to the
reciprocal of the Shephard output distance function minus one.
Similarly, the Shephard input distance function optimizes over input
quantities but not outputs and if we set g = ( x , 0) then the directional
(input) distance function is equal to one minus the reciprocal of the
Shephard input distance function.
Springer
 280 J Prod Anal (2012) 37:277-293

On the left-hand side we have the Nerlovian measure of K

profit efficiency, while on the right-hand side is the Y. Zkykm >ym,m = 1, - , Af,
k= 1
directional distance function. If we then add an allocative
K
efficiency component, AET , to the inequality in (5), we
arrive at our decomposition of profit efficiency as a strict 'Y^ZkXvkn<x,n- 1 - 1,
k= 1
equality, that is:
K

Tl(psw) - (py - wx) -* , v , -

~~ = , gX gy) v -h AEj , (6) ^2zkek<tk
Pgy + Wgx k= 1

k
The left-hand side of (6) is equal to the difference
Zk> 0,k= = 1
between maximum profit, II (p,w), and observed profit, (py- k= 1

wx), normalized by the value of the directional vector

( pgy -h wgx).6 On the right-hand side we decompose profit where the convexity constraint Y^Zk = 1 in the LP prob-
efficiency into technical and allocative efficiency by lems above imposes a variable returns to scale (VRS)
exploiting the duality between the profit function and the technology, effectively ensuring that an inefficient bank is
directional distance functions. benchmarked against banks of a similar size. In addition,
To empirically estimate the directional distance function imposing VRS in the maximum profit model (8) implies
and the profit function, we can either use an activity that perfect competition is not assumed, and hence maxi-
analysis approach (i.e. DEA) or a parametric distance mum profits may be different than zero.
function approach. In this paper, we follow Devaney and
Weber (2002) and opt for a non-parametric method. In
particular, we solve the following linear programming (LP) 4 Data description
problem:
Our dataset consists of banks operating in the EU member
max T(x,y;xv,0,) = (7) states and are listed in the IBCA-Bankscope database, over
subject to: the period 1998-2008.7 We confine our analysis to credit
institutions that report positive equity capital yielding a
K
sample of 30,101 bank-year observations. After reviewing
S>>W + fo,
*= i the data for reporting errors and other inconsistencies, we
obtain an unbalanced panel dataset of 29,587 bank-year
observations that we use for bank efficiency analysis.8 Our
k= 1 sample is quite extensive and covers the largest credit
K
institutions in each country as defined by their balance
sheet aggregates (i.e. bank assets).9
yj Zk^k < ejc
k= 1 While there continues to be a debate about the definition

k of bank inputs and outputs, we adopt the traditional inter-

Zk> o, k = 1, = 1 mediation approach as suggested by Sealey and Lindley
k= 1

7 This database reports published financial statements from banks

where x = ( xv,e ) and xv denotes N - 1 variable inputs and
e denotes a fixed input.
To estimate maximum profit, we solve the following
linear programming problem:
n(p, w) = ma x(py - wxv) (8)
subject to:
6 Note that the normalization in (6) means that this profit inefficiency
measure is independent of units of measurement and is also well
defined even if observed profit is zero or negative. The choice of
normalization is not arbitrary; rather it coincides with the value of the
Lagrangean multiplier associated with constrained profit maximiza-
tion as defined in (8) below.
worldwide, homogenized into a global format, which are comparable
across countries and therefore suitable for a cross-country study.
8 For each year the respective figures for the number of banks are:
2,270 (1998); 2,414 (1999); 2,508 (2000); 2,867 (2001); 2,829 (2002);
2,851 (2003); 2,176 (2004); 3,021 (2005); 3,004 (2006); 2914 (2007);
2733 (2008). The additions to the sample are not necessarily new
market entrants, but rather successful banks that are added to the
database over time. Exits from the sample are due primarily to either
mergers with other banks or bank failures.
9 Note that our efficiency estimates are based on unconsolidated data
and thus are bank-specific and do not take explicitly into account the
way the production is organized at the conglomerate level. However,
Berger et al. (2000) argue that despite the fact that it is not possible to
determine the extent to which transfer pricing, shared inputs, and
other intra-organizational arrangements might impact efficiency
assessments, most evidence suggests that this potential bias is not
significant.

Springer

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 J Prod Anal (2012)
(1977), which views banks as institutions that collect
deposits, using labor and physical capital, to transform
them into loans and other earning assets.10 Thus, the input
vector includes: labor (defined as total personnel expenses),
physical capital (approximated by the book value of fixed
assets) and total deposits.11 The output vector includes
loans (defined as total loans net of provisions) and other
earning assets.12 As in Berger and Bonaccorsi di Patti
(2006) we measure input and output prices as exogenous
market averages. The price of labor is defined as the
average price for labor a bank faces in the domestic market.
This is computed as a weighted average of personnel
expenses (wages and benefits) to the number of employees
of other banks in the domestic market excluding the bank's
own price, where the weights are each other bank's market
share. Other prices are similarly calculated in weighted
average terms. As is common practice in banking studies
(see Vander Vennet 2002), the price of physical capital is
calculated as other administrative expenses to fixed
assets,13 while the price of deposits is defined as the ratio of
interest expenses to total funds. Likewise, the price of loans
is expressed as interest income to total loans, while the
price of other earning assets is defined as the ratio of non-
interest income to other earning assets (see Mertens and
Urga 2001).
10 A variety of approaches have been proposed in the literature for
the definition of bank inputs and outputs; yet, there is little agreement
among economists as what unequivocally constitutes an acceptable
definition, mainly as a result of the nature and functions of financial
intermediaries. See Berger and Humphrey (1997) for a review of
studies on financial institution efficiency and the various methods
used to define inputs and outputs in financial services.
1 1 It was not possible to use the number of employees as a measure of
labor for each bank due to incomplete data on the number of
employees in the BankScope database. However, we have used this
information to construct the labor price data as explained below.
12 Note that recent studies (e.g. Clark and Siems 2002; Isik and
Hassan 2003; Casu and Girardone 2005) introduce off-balance-sheet
activities as an additional output, as arguably these activities may
have an effect on bank performance measures. However, the IBCA
database does not provide detailed information on off-balance sheet
activity and hence the inclusion of this variable would result in a
significant reduction of our sample. In addition, Becalli et al. (2006)
argue that the great variability in accounting practices across
countries, especially with respect to the treatment of off-balance-
sheet activities, may introduce a remarkable sample bias if off-
balance-sheet data are used in cross country studies.
13 As pointed out by an anonymous referee, caution needs to be
exercised with the use of the physical capital input in banking, as the
value of fixed assets included in bank balance sheets may be
underestimated when physical resources are leased and not owned.
These variations in the ownership-leasing mix coupled with differ-
ences in accounting practices for fixed assets across countries will
also have some effect on price measures defined in relation to fixed
assets. This may in part explain the significant variation in the price of
capital across countries observed in Table 1.
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37:277-293 281
Another issue in the efficiency literature is the treatment
of financial capital, which accounts for different risk
preferences. If financial capital is ignored, the efficiency of
banks that may be more risk averse than others and may
hold a higher level of financial capital would be mismea-
sured, even though they are behaving optimally given their
risk preferences.14 Apart from this, a bank's capital directly
affects costs by providing an alternative to deposits as a
funding source for loans (see Berger and Mester 1997). 15
Fare et al. (2004) found that using bank equity as a
quasi-fixed input in the analysis of bank profit efficiency is
sufficient to account for both the risk-based capital
requirements and the risk-return trade-off that bank owners
face. Thus, we include equity capital as a quasi-fixed input
in estimating the directional distance function. In this case
equity capital enters the directional distance function with a
directional vector value set to zero.
Table 1 provides summary statistics of the variables
used in this study for the whole EU-25, for the EU-15 and
EU- 10 regions, and for each country over the period
1998-2008. The sample is dominated by the small and
medium sized German banks representing about half of the
total observations. We observe considerable variations
across regions and countries in relation to both output and
input quantities and respective prices. Overall, the banking
sector in the old EU-15 region is dominated by larger
financial institutions than that of the EU- 10 area. EU-15
credit institutions have, on average, higher personnel
expenses, deposits, loans and other earning assets than the
EU-10 banks. On the other hand, EU-10 credit institutions
face much lower input prices; command higher output
prices and report, on average, higher profits than EU-15
banks. Nevertheless, there is considerable variation across
these statistics even within each EU region.
Finally, with regards to the price of loans and deposits,
we observe a higher price of loans but a lower price of
deposits for EU-10 compared to EU-15 banking systems.
In particular, the average price of loans for EU-10 coun-
tries is 11.91 compared to an average of 9.25 for EU-15,
while the average price of deposits is 3.80 for EU-
lOcompared to 4.51 for EU-15. This indicates a higher
interest margin for EU-10 countries compared to EU-15,
which is consistent with previous studies (see for example,
ECB 2005). Higher net interest rate margins in EU-10
reflect the relative strength of net interest income in the
14 (Hughes and Moon 1995) and Hughes et al. (1996) tested and
rejected the assumption of risk neutrality for banks. And risk taking
behavior is more than likely to have increased as more intense
competition in the enlarged EU market put a big squeeze on bank
profit margins.
15 German banks as well as banks from Luxembourg are more thinly
capitalized holding on average about half of the equity needed to
support their assets compared to other EU banks.
Springer
 282 J Prod Anal (2012) 37:277-293

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 284 J Prod Anal
"new" Member States compared to the "old" Member
States. Moreover, we observe that the standard deviation of
both the price of loans and the price of deposits is larger in
the case of EU- 10 banking systems, suggesting substantial
cross-country variations across new EU Member States
(see also, ECB 2005, 2010).
5 Empirical results
5.1 Profit efficiency estimates
Table 2 reports estimates of average profit efficiency and
its decomposition for the sample of banks from the EU- 15
and the EU-10 regions, over the period 1998-2008. The
difference between optimal and actual profits is equal to the
gain in profit realized by removing technical inefficiency
(i.e. the gain in revenue from any potential output increase
and the decline in costs from any potential reduction in
input use) and the gain realized by removing allocative
inefficiency (i.e. using an optimal input/output mix).
Table 2 also reports the number of banks on the efficient
frontier for each year examined, i.e. banks that have zero
technical inefficiency. We find that on average about 3
percent of the banks have been on the efficiency frontier
over the period 1998-2008.
Technical efficiency is estimated using a directional
vector equal to the mean values of outputs and (variable)
inputs in each year and a value of zero for the fixed input;
that is we set the directional vector, g = (jtv,0,;y). For
example, for year 1998 we have g - (jci,J2,J3, 2,^1,^2) =
(54.7, 69.0, 3888.1, 0, 2571.7, 2166.7). Thus, given that
the directional distance function gives the expansion in
outputs and contraction in inputs multiplied by the direc-
tional vector and since >i998e/-i5 = (x,y,z;gX9gy) = 0.7,
if the average EU- 15 bank were to operate technically
efficiently in 1998, it could expand loans by 0.233 x
2,571.7 = 599.2 (m); expand other earning assets by
0.2337 x 2,166.7 = 504.8 (m), while spending 0.2337 x
54.7 = 12.7 (m) less on labor, using 0.2337 x 69 = 16.1
(m) less physical capital and 0.2337 x 3,888.1 = 905.9
(m) less deposits. When we add the allocative component
of inefficiency, for the average EU- 15 bank to earn maxi-
mum profits outputs and inputs have to be reallocated and
lost profits as a proportion of the normalized value of the
directional vector, p x y -h w x x, is 0.7.
Table 2 shows that the average profit efficiency score
for the EU- 15 and EU-10 regions is estimated at 0.66 and
1.39, respectively, for the period 1998-2008. This suggests
that, on average, banks in the 'old' EU regime outperform
credit institutions in the new EU member states in terms of
profit efficiency. The efficiency gap observed between
Springer
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(2012) 37:277-293
"old" and "new" EU Member States could be the result of
a less competitive market structure in the EU-10 countries,
which is likely to allow banks to price the cost of inefficient
operation into interest rates thereby extracting oligopolistic
rents16 (see also Holo and Nagy 2006; Kosak and Zajc
2009). Our findings also indicate that allocative ineffi-
ciency tends to be a much larger source of potential profit
loss than technical inefficiency in both regions. In partic-
ular, the average technical efficiency score for the EU- 15
banks for the whole period under investigation is estimated
at 0.15, while the average allocative component is 3.5
times higher standing at 0.52. Similarly, for the EU-10
region, average technical efficiency is estimated at 0.23,
while the allocative efficiency estimate is 1.16. Hence,
overall profit inefficiency in the EU- 15 and EU-10 banking
industries may be attributed, to a much greater extent, to
choosing the incorrect input-output mix rather than to the
underutilization or wasting of resources.
Regarding the evolution of profit efficiency and its
components over time (see Figs. 1, 2, 3), we observe that
profit inefficiency in the EU-10 region has generally
deviated from the EU- 15 trend, and aside from a short lived
improvement in 2006/2007, this gap has generally widened
since 2003. More specifically, technical inefficiency in the
EU region decreased from 1998 to 2002, with efficiency
improvements being more pronounced for EU- 15 banks.
For EU-10 countries, these improvements are likely to
reflect the effects of an intensifying banking reform process
and increasing level of competition due to entry of foreign
investors, as a result of low government entry barriers,
particularly in nations that reduced their state bank
ownership.17
This period was characterized by unprecedented level of
consolidation through mergers and acquisitions aimed at
reaping profitability, reducing cost inefficiency, increasing
market power, and exploiting scale and scope economies.
However, these gains were short-lived and completely
reversed post 2002 as an increasing gap emerged between
EU-10 and EU- 15 credit institutions. According to the
European Central Bank (ECB 2003), the improved per-
formance of EU- 15 banks at the time was associated with
the introduction of organizational changes (e.g. outsourc-
ing); the centralization of information technology and
back-office activities, and the establishment of unified
platforms, aiming at reducing cost, standardizing operating
and information procedures and exploiting specialization
according to the customer segment.
16 This is consistent with the higher interest margin observed in EU-
10 countries compared to EU- 15 banking systems as discussed above.
17 Through an intense process of restructuring and growth in the
enlarged market, EU-10 banks adopted strategies aimed at improving
efficiency, expanding output and increasing the range of services
offered (Goddard et al. 2001).
J Prod Anal (2012) 37:277-293 285

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 286 J Prod Anal
Fig. 1 Profit Efficiency (EU- 15 vs. EU- 10)
Fig. 2 Technical Efficiency (EU- 15 vs. EU- 10)
Fig. 3 Allocative Efficiency (EU- 15 vs. EU- 10)
Table 3 presents more detailed information on the profit
efficiency for each EU banking sector. Overall, we observe
considerable variation of efficiency scores across countries
and different patterns in efficiency change over time. These
differences may in part be explained by interest rate dif-
ferentials between countries as well as changes in the
general level of interest rates overtime.
German banks appear, on average, to be the most profit
efficient, with an average efficiency score of 0.333 over
the sample period, followed by Austrian, Danish and
Springer
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(2012) 37:277-293
Swedish banks at 0.404, 0.408 and 0.464, respectively.
Latvian banks are on average the most profit efficient
among EU-10 banks with an average score of 0.501. 18
Greek banks with an average efficiency score of 3.001 and
Finish banks at 2.656 yield the highest average estimates
of profit inefficiency in the EU sample, closely followed
by Irish (2.648), Portuguese (2.395), Spanish (2.303) and
Hungarian banks (2.183).
Following a suggestion by an anonymous referee, we
have also computed ratios of actual to optimal (profit
maximizing) input use and output production to assess in
more detail banks' allocative efficiency performance. Our
estimates show that the majority of EU- 15 banks tend to
over utilize labor. This is particularly evident in the case of
banks in Austria, Belgium, France, Germany, Greece,
Luxembourg, Netherlands and Poland. On the other hand,
there is no evidence of labor overuse for the majority of
banks in EU-10 countries. In particular, we find that the
bulk of banks in Estonia and Latvia tend to underutilize
labor. We also find that most EU-25 banks tend to over
utilize physical capital. The main exceptions are banks in
Denmark, Ireland, Italy and Sweden. Moreover, our results
indicate that on average banks in all EU-25 countries
overuse deposits. With regards to output mix, we find that
banks in Belgium, Czech Republic, Latvia, Luxembourg,
Malta and Slovakia appear to under-produce loans relative
to other earning assets, while the bulk of banks in the
remaining EU countries appear to over-produce loans rel-
ative to other earning assets.
Regarding the evolution of efficiency scores, profit
efficiency displays diverging patterns across the EU
countries over the period 1998-2008. Profit efficiency
appears to be on the decline for the majority of EU member
states during that period. More specifically, the largest
declines are estimated for Hungary, followed by France,
Slovakia, Ireland and Poland and are almost entirely due to
a sharp increase in allocative inefficiency. While Hungar-
ian banks were not directly exposed to the toxic US sub-
prime market, they suffered immensely during the
2007/2008 global financial crisis as a result of foreign-
currency exposures but also as a result of a very weak
domestic economy characterized by large external and
government deficits. On the other hand, our results indicate
that Sweden exhibits the highest improvement in terms of
profit efficiency over time. This may in part reflect the
considerable effort that went into strengthening the coun-
try's banking system at the aftermath of a major banking
crisis in the early 1990s.
18 These countries, with the exception of Germany, also exhibit the
largest dispersion in profit efficiency scores as measured by the
coefficient of variation over the sample period 1998-2008. In
particular, according to our estimates, Latvia has experienced a
substantial drop in profit efficiency post 2005.
 J Prod Anal (2012) 37:277-293 287

Table 3 Decomposition of profit efficiency by country

Country 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 98-08

Austria TI 0.187 0.110 0.147 0.158 0.145 0.122 0.110 0.089 0.097 0.092 0.066 0.111
0.382 0.296 0.444 0.538 0.481 0.423 0.296 0.142 0.299 0.321 0.193 0.360
AI 0.168 0.254 0.162 0.244 0.401 0.337 0.271 0.335 0.286 0.197 0.493 0.293
0.849 0.623 0.247 0.333 0.964 0.515 0.886 0.621 0.720 0.361 1.066 0.702
Til 0.354 0.365 0.309 0.402 0.546 0.459 0.381 0.424 0.383 0.289 0.558 0.404
0.933 0.763 0.666 0.794 1.397 0.868 1.170 0.731 0.983 0.651 1.219 0.956

Belgium TI 0.294 0.409 0.322 0.162 0.080 0.294 0.170 0.182 0.094 0.113 0.119 0.180
0.213 0.752 0.808 0.440 0.128 1.005 0.152 0.171 0.170 0.174 0.153 0.539
AI 0.660 0.752 0.481 0.688 0.678 0.446 0.219 0.712 1.128 0.736 2.098 0.711
0.630 1.375 0.437 1.493 0.560 0.684 0.399 1.564 2.015 0.664 2.185 1.213
n' 0.954 1.161 0.803 0.850 0.758 0.740 0.389 0.894 1.223 0.849 2.217 0.891
0.792 2.095 1.171 1.628 0.635 1.632 0.467 1.589 2.015 0.724 2.189 1.478

Cyprus TI 0.405 0.235 0.235 0.233 0.242 0.296 0.295 0.345 0.336 0.450 0.347 0.307
0.624 0.396 0.380 0.444 0.454 0.492 0.557 0.709 0.718 0.783 0.696 0.563
AI 0.742 0.743 0.900 0.641 1.156 0.867 0.785 0.897 0.859 1.067 1.568 0.916
0.935 1.034 1.052 0.777 1.773 0.973 1.242 1.191 1.232 1.695 2.458 1.315
ni 1.148 0.977 1.135 0.874 1.398 1.163 1.080 1.243 1.195 1.517 1.915 1.223
1.528 1.360 1.405 1.167 2.221 1.414 1.795 1.895 1.932 2.402 3.147 1.827

Czech Rep TI 0.629 0.313 0.297 0.319 0.291 0.266 0.341 0.464 0.439 0.415 0.260 0.319
1.023 0.492 0.506 0.579 0.466 0.501 0.509 0.596 0.801 0.726 0.354 0.596
AI 1.053 0.982 1.121 1.191 1.163 0.759 1.439 1.603 2.299 1.223 2.545 1.426
1.121 1.087 0.916 0.810 1.978 1.223 2.413 1.859 2.195 1.028 2.516 1.723
n' 1.682 1.295 1.418 1.510 1.454 1.025 1.780 2.067 2.738 1.638 2.805 1.745
1.731 1.417 1.341 1.284 2.410 1.655 2.911 2.407 2.937 1.721 2.793 2.167
Denmark TI 0.213 0.114 0.092 0.084 0.097 0.074 0.052 0.075 0.085 0.113 0.080 0.099
0.616 0.317 0.272 0.232 0.312 0.178 0.135 0.169 0.171 0.276 0.160 0.292
AI 0.486 0.421 0.262 0.216 0.320 0.268 0.208 0.182 0.289 0.290 0.465 0.309
0.946 0.706 0.274 0.250 0.604 0.290 0.386 0.313 0.711 0.926 1.030 0.648
Til 0.699 0.535 0.354 0.300 0.417 0.342 0.260 0.257 0.374 0.403 0.544 0.408
1.419 1.006 0.468 0.447 0.805 0.440 0.444 0.380 0.747 1.135 1.067 0.834
Estonia TI 0.183 0.099 0.080 0.124 0.140 0.162 0.158 0.279 0.268 0.286 0.034 0.173
0.196 0.118 0.116 0.198 0.218 0.248 0.251 0.477 0.498 0.551 0.039 0.303
AI 1.770 0.967 1.207 1.397 2.025 0.740 1.116 0.516 1.031 2.236 1.382 1.308
1.812 1.388 1.518 1.712 2.952 1.127 1.949 0.453 1.404 3.110 2.166 1.803
Jl 1.953 1.067 1.286 1.521 2.166 0.902 1.274 0.795 1.300 2.522 1.415 1.463
2.005 1.500 1.629 1.903 3.169 1.374 2.199 0.912 1.441 3.638 2.204 2.006
Finland TI 2.332 0.945 0.300 0.656 0.265 0.668 0.405 0.531 0.489 0.779 0.870 0.769
3.232 1.320 0.000 0.970 0.151 0.961 0.508 0.523 0.492 1.007 1.325 1.099
AI 1.814 2.507 1.868 0.453 1.109 1.637 1.533 3.066 2.292 2.328 2.476 1.887
1.171 2.298 0.000 3.132 0.427 2.237 1.843 3.050 2.740 2.928 1.873 2.112
ni 4.146 3.452 2.168 1.109 1.374 2.305 1.939 3.597 2.781 3.107 3.346 2.656
4.404 3.618 0.000 2.245 0.578 3.198 2.351 3.572 3.232 3.934 2.932 2.743
France TI 0.424 0.412 0.367 0.339 0.310 0.346 0.281 0.434 0.517 0.488 0.425 0.391
0.558 0.619 0.492 0.446 0.372 0.427 0.313 0.548 0.800 0.689 0.440 0.536
AI 0.572 0.352 0.496 0.739 1.119 0.980 1.533 1.805 1.316 1.385 2.595 1.127
0.799 1.857 0.902 0.887 1.215 1.306 1.663 1.947 1.727 1.352 1.628 1.545
ni 0.995 0.763 0.862 1.078 1.429 1.326 1.814 2.239 1.834 1.873 3.020 1.519
1.060 1.725 1.253 1.187 1.456 1.494 1.856 2.300 2.040 1.747 1.919 1.769

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 288 J Prod Anal (2012) 37:277-293

Table 3 continued

Country 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 98-08

Germany TI 0.148 0.098 0.085 0.089 0.100 0.109 0.115 0.099 0.098 0.077 0.065 0.097
0.234 0.162 0.145 0.149 0.174 0.211 0.200 0.187 0.215 0.149 0.137 0.182

AI 0.242 0.202 0.119 0.110 0.182 0.178 0.252 0.341 0.262 0.271 0.389 0.236
0.386 0.310 0.227 0.218 0.499 0.511 0.589 0.490 0.504 0.543 0.690 0.486

ni 0.389 0.300 0.203 0.198 0.282 0.287 0.368 0.440 0.359 0.348 0.454 0.333

0.547 0.417 0.333 0.328 0.624 0.609 0.728 0.642 0.663 0.621 0.798 0.603

Greece TI 1.821 0.506 0.812 1.048 0.579 0.883 0.784 0.888 0.511 0.759 0.412 0.773

1.302 0.714 0.939 1.110 0.928 1.099 1.342 1.099 0.677 0.965 0.441 0.995

AI 1.856 4.242 2.772 2.278 2.180 1.938 1.997 1.660 3.597 0.709 1.814 2.234

1.514 3.198 1.646 2.182 2.542 1.315 2.512 1.755 2.379 0.926 1.090 2.119

ni 3.676 4.748 3.584 3.326 2.759 2.822 2.781 2.549 4.109 1.469 2.226 3.007
2.384 3.459 2.181 2.427 3.418 2.212 3.379 2.765 2.895 1.317 1.448 2.652

Hungary TI 0.439 0.201 0.223 0.218 0.229 0.296 0.420 0.524 0.412 0.416 0.475 0.338
0.622 0.277 0.244 0.260 0.282 0.336 0.364 0.545 0.306 0.293 0.271 0.360

AI 0.913 0.767 1.195 1.373 1.471 1.606 2.153 2.367 4.221 1.399 3.191 1.846

0.594 0.561 0.776 0.826 1.629 1.160 1.486 1.980 3.677 1.043 1.643 1.841

ni 1.352 0.968 1.418 1.591 1.700 1.902 2.573 2.891 4.634 1.815 3.666 2.183

0.927 0.758 0.948 1.011 1.902 1.452 1.836 2.513 3.877 1.309 1.894 2.086

Ireland TI 0.165 0.692 0.091 0.170 0.668 0.803 0.312 0.659 0.696 0.730 1.057 0.562

0.178 1.411 0.118 0.234 1.481 1.633 0.566 1.140 1.275 1.045 0.629 1.137

AI 2.351 2.522 2.151 2.600 2.508 2.783 0.637 0.003 2.019 2.943 4.275 2.086

0.798 1.569 1.384 1.909 2.198 1.492 0.516 2.492 1.668 2.880 2.245 2.179

ni 2.517 3.214 2.243 2.770 3.176 3.587 0.949 0.662 2.715 3.673 5.332 2.648
0.754 2.793 1.357 1.997 3.179 2.863 1.039 2.748 2.286 3.114 2.872 2.747

Italy TI 0.223 0.096 0.080 0.086 0.058 0.076 0.235 0.111 0.082 0.079 0.051 0.094
0.633 0.296 0.249 0.260 0.149 0.207 0.305 0.354 0.246 0.245 0.149 0.302
AI 0.572 0.623 0.593 0.630 0.706 0.761 1.624 0.615 0.853 0.285 0.595 0.642

0.777 0.805 0.929 1.020 1.238 1.165 1.741 0.801 1.283 0.930 1.111 1.062

ni 0.795 0.719 0.673 0.716 0.764 0.836 1.859 0.726 0.935 0.364 0.646 0.736
1.203 1.043 1.139 1.210 1.367 1.334 1.969 1.095 1.421 1.127 1.235 1.259

Latvia TI 0.024 0.013 0.021 0.030 0.037 0.040 0.060 0.075 0.084 0.074 0.074 0.051
0.051 0.018 0.028 0.038 0.049 0.055 0.077 0.104 0.097 0.093 0.072 0.072

AI 0.229 0.201 0.208 0.371 0.232 0.198 0.332 0.470 1.486 0.319 0.809 0.451

0.227 0.219 0.290 0.371 0.280 0.247 0.359 0.284 1.766 0.484 1.234 0.797

ni 0.254 0.215 0.228 0.401 0.269 0.237 0.392 0.545 1.570 0.393 0.883 0.501
0.273 0.235 0.317 0.407 0.327 0.300 0.435 0.379 1.857 0.552 1.275 0.846

Lithuania TI 0.104 0.046 0.041 0.042 0.056 0.077 0.111 0.167 0.138 0.149 0.140 0.098

0.119 0.065 0.058 0.064 0.070 0.097 0.117 0.173 0.144 0.151 0.132 0.117

AI 0.445 0.883 0.645 0.655 0.456 0.444 0.545 0.955 2.968 0.667 1.592 0.949

0.356 0.957 0.799 0.763 0.625 0.543 0.606 0.713 2.881 0.746 1.619 1.364
ni 0.548 0.929 0.686 0.696 0.513 0.521 0.656 1.122 3.106 0.816 1.732 1.047
0.447 1.022 0.853 0.826 0.692 0.637 0.718 0.880 2.995 0.841 1.729 1.441

Luxembourg TI 0.188 0.155 0.165 0.204 0.226 0.193 0.182 0.204 0.216 0.294 0.268 0.203
0.432 0.344 0.390 0.440 0.479 0.398 0.412 0.496 0.458 0.565 0.558 0.442

AI 2.081 1.094 0.825 1.115 1.727 1.211 1.672 2.033 2.333 1.984 2.841 1.609

2.466 1.676 1.095 1.305 2.424 1.885 2.468 1.971 2.278 1.865 2.738 2.069

ni 2.269 1.249 0.990 1.319 1.953 1.405 1.855 2.236 2.549 2.279 3.108 1.812
2.660 1.863 1.321 1.572 2.693 2.110 2.633 2.259 2.585 2.280 3.013 2.308

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 J Prod Anal (2012) 37:277-293 289

Table 3 continued

Country 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 98-08

Malta TI 0.238 0.203 0.164 0.177 0.174 0.154 0.160 0.176 0.188 0.139 0.136 0.171
0.249 0.209 0.202 0.217 0.211 0.206 0.212 0.238 0.220 0.184 0.156 0.192

AI 0.776 0.671 0.851 0.871 0.873 0.804 0.903 1.252 1.334 0.649 1.274 0.938

0.627 0.626 0.662 0.653 0.692 0.674 0.761 0.763 1.319 0.366 1.100 0.748

7cl 1.014 0.874 1.015 1.048 1.047 0.957 1.063 1.428 1.522 0.788 1.411 1.108

0.870 0.835 0.775 0.794 0.856 0.833 0.938 0.973 1.526 0.537 1.246 0.895

Country 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 98-08

Netherlands TI 0.567 0.457 0.405 0.503 0.288 0.317 0.258 0.491 0.323 0.158 0.227 0.366
1.240 0.776 0.803 0.885 0.518 0.747 0.565 0.965 0.635 0.162 0.295 0.745

AI 0.914 1.842 1.302 1.145 2.421 1.833 1.187 0.852 1.476 0.572 2.001 1.457
0.706 2.284 1.714 1.491 2.833 2.668 1.758 3.106 2.123 0.518 1.537 2.113

ni 1.481 2.298 1.707 1.647 2.710 2.150 1.444 1.343 1.799 0.730 2.228 1.825

1.647 2.690 2.097 2.158 3.066 2.740 1.991 2.626 2.357 0.579 1.697 2.312

Poland TI 0.582 0.294 0.329 0.421 0.201 0.288 0.324 0.342 0.385 0.507 0.327 0.363
1.011 0.464 0.458 0.581 0.243 0.437 0.343 0.357 0.361 0.530 0.301 0.519

AI 0.808 1.163 1.187 1.500 1.647 0.975 1.837 1.376 2.167 1.717 2.821 1.498

0.796 0.998 1.026 1.259 1.945 1.276 2.348 1.343 1.928 1.487 2.201 1.579

Tel 1.391 1.457 1.516 1.921 1.848 1.263 2.161 1.718 2.552 2.223 3.148 1.860

1.270 1.261 1.361 1.615 2.083 1.596 2.673 1.652 2.140 1.959 2.450 1.846

Portugal TI 0.987 0.427 0.689 0.918 0.212 0.380 0.689 0.262 0.360 0.349 0.298 0.522
1.617 0.666 1.190 1.422 0.245 0.551 1.409 0.246 0.334 0.286 0.262 0.940

AI 1.863 2.283 1.959 1.958 1.761 2.133 1.272 1.497 3.194 0.534 1.761 1.873
1.321 2.095 1.418 1.612 1.239 1.631 0.645 0.809 1.584 0.480 1.541 1.481
ni 2.850 2.710 2.648 2.876 1.973 2.513 1.962 1.758 3.554 0.883 2.060 2.395

2.715 2.474 2.553 2.979 1.436 2.122 1.550 0.931 1.771 0.744 1.784 2.132

Slovakia TI 0.113 0.119 0.133 0.148 0.147 0.151 0.201 0.196 0.215 0.198 0.252 0.176
0.118 0.187 0.171 0.179 0.191 0.190 0.242 0.251 0.277 0.218 0.226 0.210

AI 0.332 0.179 0.421 1.097 0.813 0.657 1.161 1.384 1.307 0.756 2.647 1.049

0.181 0.248 0.442 0.772 0.887 0.578 1.228 1.087 1.270 0.388 1.947 1.138

tcI 0.446 0.298 0.554 1.246 0.961 0.808 1.362 1.580 1.522 0.954 2.899 1.225
0.117 0.435 0.608 0.934 1.067 0.742 1.461 1.312 1.524 0.562 2.148 1.304

Slovenia TI 0.334 0.126 0.060 0.131 0.139 0.130 0.159 0.173 0.174 0.102 0.131 0.144
0.457 0.185 0.041 0.212 0.216 0.176 0.194 0.253 0.255 0.087 0.159 0.211

AI 1.306 1.102 0.770 0.914 0.903 0.820 1.098 0.872 2.291 0.389 1.372 1.073

0.706 0.820 0.551 0.656 1.173 0.734 1.234 0.520 1.972 0.343 1.476 1.135

Til 1.640 1.228 0.830 1.046 1.042 0.950 1.257 1.045 2.465 0.491 1.503 1.217
1.088 0.979 0.585 0.832 1.382 0.877 1.415 0.703 2.169 0.396 1.626 1.284

Spain TI 0.917 0.519 0.478 0.523 0.394 0.525 0.542 0.509 0.352 0.577 0.260 0.492
1.034 0.601 0.563 0.661 0.430 0.609 0.523 0.790 0.485 0.628 0.346 0.646

AI 1.563 1.813 1.585 1.384 2.249 2.278 2.515 1.260 2.399 1.571 1.698 1.811

0.968 1.129 1.170 1.701 1.926 1.564 1.851 1.286 2.345 1.916 2.088 1.753

7cl 2.480 2.332 2.064 1.907 2.643 2.803 3.057 1.769 2.750 2.148 1.958 2.303

1.586 1.538 1.609 1.882 2.300 2.020 2.215 1.961 2.760 2.379 2.398 2.153

Sweden TI 0.999 0.128 0.655 0.104 0.094 0.077 0.071 0.069 0.063 0.035 0.015 0.084
1.302 0.217 1.172 0.462 0.436 0.373 0.449 0.268 0.231 0.109 0.017 0.384

AI 2.260 1.967 1.446 0.283 0.556 0.371 0.167 0.381 0.347 0.326 0.133 0.379

1.887 1.938 1.304 0.611 1.643 0.901 0.486 1.272 1.232 1.247 0.141 1.124

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 290 J Prod Anal (2012) 37:277-293

Table 3 continued

Country 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 98-08

n' 3.260 2.095 2.101 0.387 0.650 0.448 0.238 0.450 0.410 0.362 0.147 0.464

2.442 1.970 1.631 0.874 1.913 1.071 0.930 1.511 1.451 1.328 0.155 1.349

UK TI 0.413 0.494 0.437 0.378 0.340 0.241 0.291 0.365 0.333 0.254 0.190 0.334

0.611 0.773 0.736 0.530 0.534 0.474 0.650 0.687 0.694 0.570 0.446 0.615

AI 1.732 1.953 1.902 1.717 2.025 0.917 0.793 1.233 1.221 0.843 1.160 1.372

1.437 1.607 1.568 1.287 2.435 1.221 1.434 1.321 1.428 1.307 1.369 1.571

ni 2.145 2.447 2.339 2.095 2.365 1.158 1.084 1.599 1.555 1.097 1.350 1.706

1.610 2.116 1.917 1.588 2.850 1.360 1.962 1.905 1.998 1.606 1.706 1.961

The table reports means and SD (in italics) of profit efficiency over time for each EU-25 country and its decomposition into technical and
allocative efficiency. TI denotes technical efficiency, measured by the value of the directional distance function; nl denotes profit efficiency; AI
denotes allocative efficiency

Overall, we find different patterns in efficiency change
over time in the EU banking markets. These diverging
trends may reflect the legacy of different banking regula-
tions and the different structures of the financial systems
across the member states but also the fragility of the dif-
ferent banking systems to domestic and international eco-
nomic developments. Our results offer no clear indication
supporting the view that an enlarged EU market for
financial services has given rise to far more robust banking
structures. In part, the problem may be that many of these
banking systems continue to be fragmented or lack effec-
tive supervision. But it may also be the case that a rapid
rise in cross border exposures has made these systems more
fragile to adverse external and internal shocks. The severity
of the recent financial and economic crisis is largely
associated with the combined effects of excessive risk-
taking and bad lending decisions of banks facing a squeeze
on profits as regulatory barriers were lifted and competition
became more intense.
percent of total observations, while most banks are clas-
sified as small (50 percent).
Table 4 presents the average profit efficiency scores
over time for credit institutions of different size categories.
Overall, we observe a negative relationship between size
and efficiency. Our results indicate that small banks appear
to be the most profit efficient and also the most technical
efficient, followed by medium-sized banks. This superior
performance by the small banks is evident throughout the
entire period under investigation. A possible explanation is
that small banks, which operate mostly in local (niche)
markets and have access to 4 soft' information about local
conditions, engage in relationship banking and exercise
some monopoly power, which allows them to earn more
profit.19 The large efficiency differentials we find between
large banks and smaller banks are of notable relevance to
the current regulatory policy debate on bank size.
6 Conclusion

5.2 Profit efficiency estimates by bank size

Although EU banks have similar organizational structure
and objectives, they vary significantly in size. Thus, as a
next step, we examine whether or not there is a relationship
between size and inefficiency levels. This issue is of direct
relevance in the current environment as regulators in many
countries seem to have an increasing aversion towards very
large banks mainly due the systemic risks they may pres-
ent. We divide banks into three subgroups according to the
size of their balance sheet aggregates: large (with assets
more than 10,000 million), medium (with total assets
between 500 million and 10,000 million) and small (with
assets less than 500 million). The large bank sample is
relatively small to ensure that only truly large banks are
included and represents about 6 percent of total observa-
tions. On the other hand, medium-sized banks represent 44
This paper investigates the profit efficiency of the Euro-
pean Union banking industry, using a non-parametric
directional technology distance function approach, over the
period 1998-2008. During this period, a number of sig-
nificant events took place, among them the most notable
being the EU enlargement with 10 new member states and
the 2007/2008 subprime and global financial crises. These
19 Following an anonymous referee's suggestion and given that our
sample is dominated by small and medium sized German banks, we
recalculated average profit inefficiency for banks of different size-
classes excluding German banks from our sample in order to assess
whether the over-performance of small banks is due to the institu-
tional/regulatory structure of Germany and not because of their small
size. Overall, our conclusions remain valid and average inefficiency
estimates for small and medium-sized banks remain broadly
unchanged. Nevertheless, when excluding German banks, average
profit inefficiency for large banks increases.

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Table 4 Decomposition of Profit Efficiency by bank size

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 98-08

Small (<500 mil.euros) TI 0.039 0.020 0.017 0.017 0.018 0.019 0.023 0.018 0.017 0.014 0.011 0.019
0.030 0.015 0.013 0.013 0.013 0.014 0.015 0.014 0.013 0.010 0.008 0.016

AI 0.154 0.150 0.104 0.111 0.117 0.120 0.082 0.211 0.119 0.066 0.098 0.123

0.195 0.170 0.136 0.145 0.138 0.158 0.071 0.102 0.138 0.055 0.082 0.139

ni 0.193 0.170 0.120 0.128 0.135 0.139 0.105 0.230 0.136 0.080 0.109 0.142
0.204 0.172 0.138 0.147 0.141 0.159 0.076 0.106 0.141 0.061 0.085 0.143

Medium (500 <... < 10, 000 mil. euros) TI 0.325 0.202 0.172 0.177 0.177 0.178 0.176 0.182 0.161 0.134 0.104 0.177
0.351 0.200 0.177 0.179 0.174 0.174 0.161 0.178 0.155 0.131 0.102 0.190

AI 0.770 0.658 0.556 0.610 0.760 0.656 0.633 0.736 0.893 0.468 0.819 0.689

0.803 0.725 0.724 0.767 1.084 0.838 0.881 0.704 1.152 0.421 0.858 0.847

ni 1.095 0.860 0.727 0.787 0.937 0.834 0.809 0.918 1.053 0.602 0.924 0.866
0.996 0.830 0.805 0.859 1.188 0.925 0.984 0.828 1.231 0.512 0.934 0.947

Large (>10,000 mil. euros) TI 1.957 1.217 1.135 1.188 1.042 1.106 1.017 1.263 1.071 0.958 0.698 1.108
1.389 1.025 0.910 0.962 0.931 1.041 0.935 0.972 0.962 0.829 0.549 0.977

AI 1.816 2.680 2.296 2.169 4.309 3.169 3.439 3.200 3.673 2.789 4.267 3.130

3.434 3.065 1.787 2.267 2.423 2.252 2.920 2.583 2.535 2.238 1.691 2.550

ni 3.773 3.897 3.432 3.356 5.352 4.274 4.456 4.463 4.743 3.748 4.965 4.238

3.640 3.066 2.154 2.491 2.714 2.431 3.124 2.870 2.698 2.466 1.869 2.709

The table reports means and SD (in italics) of profit efficiency over time for banks of different size classes and its decomposition into technical
and allocative efficiency. TI denotes technical efficiency, measured by the value of the directional distance; nl denotes profit efficiency; AI
denotes allocative efficiency

developments have raised questions about competitiveness,
bank size, ownership type and structure and the fragility of
credit institutions to global financial and domestic eco-
nomic conditions, and have brought the issue of bank
efficiency at the forefront. Profit efficiency is inextricably
linked with the ability of banks to absorb bad debts and
hence with the ability of banking systems to withstand
systemic shocks. This is a particularly sensitive issue in the
EU context. European rather than U.S. banks were the first
to be struck by the 2007 subprime crisis. And the European
Central Bank, not the US Fed, was the first central bank to
come to the rescue of banks through large scale emergency
lending. While European banks funding needs at present
far exceed those of any other banking system, rating
agencies have placed sovereign debt of some EU member
states close to junk status.
We address a number of issues related to bank perfor-
mance in the EU countries. Regarding the question of
whether bank choices of inputs and outputs are consistent
with profit maximization, our results show significant profit
inefficiency. This is mainly attributed to allocative ineffi-
ciency, that is choosing the incorrect input-output mix
rather than to the underutilization or wasting of resources.
EU- 15 banks appear, on average, to outperform their EU-
10 counterparts. We associate profit efficiency improve-
ments for the new EU member states in 1998-2002 with
the intense restructuring process that was in place during
that period and the increasing presence of foreign investors
that enhanced competitive pressures. However, our find-
ings indicate that there is overall a negative trend in profit
efficiency over the period 1998-2008 and this is more
pronounced for EU- 10 credit institutions.
Regarding the issue of whether there are differences in
bank profit efficiency across the EU countries, our findings
indicate considerable variation and different patterns in
efficiency scores across banks and banking systems. Our
results offer no clear indication that an enlarged EU market
for financial services has brought about robust beneficial
changes in most banking systems. We find that the gap
between the old and new Europe has widened rather than
shrunk and this is in spite of some signs of profit efficiency
convergence in 2001-2003 and the technical efficiency
gains EU- 10 banks made in 1998-2002.
We also investigated whether the size of financial
institutions has an effect on profit efficiency. Our results
show a negative relationship between size and efficiency,
as small banks appear to be the most profit efficient credit
institutions, while large banks are the most inefficient. This
is an interesting finding in view of the current policy debate
regarding bank size.
Overall, in light of increasing global financial pressures,
EU banks will need to further improve their performance in

Springer

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 292 J Prod Anal
order to respond to new challenges lying ahead and to
survive in a highly competitive global environment. While
a rationalization of the industry is currently under way and
authorities are tightening the regulatory regime, the out-
look for the EU economies is still uncertain and this
imposes further strains on the quality of the banks' loan
portfolios.
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