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Performance Evaluation of Banking Industry in Bangladesh Essay

Performance Evaluation of Banking Industry in Bangladesh Essay

Banking is an essential industry that affects the welfare of all other industry and the economy as a whole. In fact, growth and development of a country significantly depend on the level of growth and development attempted by the banking sector. There is a consensus regarding the positive role played by the financial sector in promoting economic development (Gerschenkron, 1962; Patrick, 1966; Galbis, 1977). In Bangladesh, banking sector has flourished a lot compared to other sectors of the economy. But the role of this key sector in national development is not satisfactory.

There is not only an extremely strong capital stock but the rate of capital formation is also very meager.

The current rates of domestic savings and investments as a % of GDP are 20.2 and 24.4% respectively (Bangladesh Bank Annual Report 2004-05). In the past, the rate of savings and investment were much lower than the present rate. Therefore, development plans of Bangladesh have been largely aid development. Between 1972-73 and 1981-82, aid has financed on an average of 75% of fixed investments and the lions share of the development budget (ERD).

Under these Circumstances, internal resource mobilization is an urgent necessity for a self-reliant Bangladesh. Towards this end, banking Industry may play a crucial role in mobilizing community’s savings and channeling the same into the socially desirable sectors of the economy.

As financial intermediaries, banks can play a crucial role in of most economies. In the absence of effective functional securities market, the banking sector in Bangladesh takes the lead in mobilizing resources and allocating funds to profitable ends. The effectiveness of financial intermediation can affect economic growth. The financial intermediation affects the net return to savings and gross return to investment. The prominence of financial institutions for rapid economic growth is unanimous. The bank based view of financial system highlights the positive role of bank in mobilizing resource, identifying good projects, monitoring managers and managing risks. The role of banking institutions as intermediary between the investor and entrepreneur is of vital importance in a developing country like Bangladesh.

The evaluation of Banks performance is a complex process involving interactions between the environments, internal operations, and external activities. In performing this evaluation concerned authorities in the banking sector prior to independence felt for resource mobilization and using the same in the desired sectors. For this reason all the commercial banks were nationalized immediately after independence (Bhattacharjee, 1989). Development of private sector is essential to cope with the challenges of globalization. But considering the socio-economic condition of Bangladesh, extreme privatization, particularly in the banking sector, may not be desired.

Because, even though, the number of private banks (local & foreign) are increasing and the number of nationalized banks are decreasing, still the NCBs occupy a dominant place in the banking sector of the country and play a pioneering role in capital formation, stimulating the level of industrialization, poverty alleviation and human development and in the overall economic development. NCBs provide loans to productive and priority sectors both public and private covering agriculture, industry, trade and commerce. On the contrary, private banks mainly operate in towns and metropolitan cities and do business with noted entrepreneurs and with the affluent sections of the society; while foreign banks operate only in the cities and do business with the elite section of the society. Hence, this paper focused on the performance of the banking sector in general with a wider lance.

As financial intermediaries, banks can play a crucial role in the most economies. In the absence of effective functional securities market, the banking sector in Bangladesh takes the lead in mobilizing resources and allocating funds to profitable ends. The effectiveness of financial intermediation can affect economic growth. The financial intermediation affects the net return to savings and gross return to investment. The prominence of financial institutions for rapid economic growth is unanimous. The bank based view of financial system highlights the positive role of bank in mobilizing resource, identifying good projects, monitoring managers and managing risks. The role of banking institutions as intermediary between the investor and entrepreneur is of vital importance for a developing country like Bangladesh. So the study is a demand of the time for better progress towards a developed future.

2.0 Conceptual Background of the Study Performance indicates the degree of management’s success in allocating the sources of the firm’s capital to productive use and is focused in the in the market value of the firm’s capital. Performance may be defined as the accomplishment of the goals which are taken into consideration. The word performance may be the synonym of efficiency in the context of business phenomenon. Many scholars opined that performance of a firm may be considered as the term managerial performance. An evaluation of performance indicates to what extent an enterprise achieves its target. Evaluation is a judgment worth of something and like all judicial matters, it calls for justice, equity and good conscious on the part of the person making the evaluation. It is to be considered an integral part of the management control on a continuous and systematic basis.

Performance evaluation is an essential tool of management. It is relevant both in seeking answer to various questions to be asked about area of activities in which performance might be improved. The main purpose of performance evaluation is to assist in decision on two levels i.e. at a lower level. It can be used to inform the day to day decision making of the management indicating how to maintain the efficiency and effectiveness of the banks in short term. At a higher level it can be used to inform the annual planning and budgeting process in which decisions are taken about the long term deployment of resources and target for achievement. Thus it can be said that performance evaluation means a method under which the performance of an organization is evaluated differently.

In Bangladesh performance of banking sector was considered with a very high note from the very beginning. It was felt that new born liberated country will need the performance of banking sector to keep the economy live. In doing so, after the war of liberation, the banks operating Bangladesh(except those incorporated abroad) were nationalized. These banks were merged and grouped for achieving the goal of government and people. With the passage of time the number and types of bank expanded and the area of banking support is also enlarged vividly. For this, study becomes a necessity to find out loop holes as well as areas so that service can be expanded towards all necessary ends. For doing so banking industry plays a pivotal role in capital formation and stimulate the level of industrialization, poverty alleviation and human development.

In a sense, healthy banks and healthy economies seem to go together. Therefore, performance of such organizations particularly; operational efficiency, management soundness, productivity, profitability and social profitability are of great concern. An in-depth study to analyze the performances of the banking industry of Bangladesh by applying the most widely used indicators of bank performance could be worth while. The banking industry of Bangladesh is composed of five types of banks viz. Nationalized Commercial Banks(NCBs), Specialized banks(SBs), private Commercial Banks(PCBs), Foreign Commercial Banks(FCBs) and Islamic Banks(IBs) differ in their motives. Different types of banks give priority to different stakeholders. So, performance analysis as a whole can make the industry more creative and more supportive to achieve their organizational goal as well as can help the nation to avoid poverty and learn to lead prospective lives. Because , performance analysis as a whole will bring out all loop holes for back benchers in this sector and allow them with information to go ahead with prospective mentality.

3. Objectives of the Study The broad objective of this proposal is to make a comprehensive analysis of growth, productivity, profitability and performance of the banking industry in Bangladesh and to suggest measures for improving their performance. The specific objectives of the proposal are as follows: • To analyze and compare the growth trends of banking facilities/services and output of banking sector as an industry. • To measure and compare the productivity trends of banking sector. • To compare overall performance of the cross section of banks from various angles. • To conduct an in-depth analysis of the causes of lower or higher levels of productivity and performance (if any) among all banks. • To evaluate existing remittance disbursement system and direct its profitable utilization through proper planning and action. • To suggest the possible lines of actions to improve the performance of various categories of banks.

4. Justification of The Study 1. Literature Review From a detail literature review it is found that a good number of researches were conducted in the field of performance evaluation in banking sector. But unfortunately, Performance Analysis of Banking Industry in Bangladesh as a whole was not conducted. As such the literature review of the following articles, journals and research work compelled me to have a distinct idea that a research of having a complete picture of Banking industry is a demand of the time. As such my literature review found following ideas:

Abedin, Roy and Mustafi(1989) in a study titled, “A Preliminary Note on Measurement of Productivity in the Commercial Banks of Bangladesh,” mentioned that there was a steady growth of bank output during 1975-1988. The output was measured as the volume of working fund handled per employees. There were variations in the levels of productivity of different types of banks. They also mentioned about a falling trend of productivity index of private banks with little variations during 1985-88. In case of Foreign banks they reported a sharp fall of productivity index from 100 in 1985 to 37 in 1986, then a rising trend. The limitations of his study were that he did not considered the social aspects of the Banks.

The data on working fund were not comparable with any published data of Bangladesh Bank (BB) due to using the end June and end december figures of every year. The study neither attempts to analyze the causes of lower or higher productivity of banks nor strongly suggests the measures for increasing the levels of the banks productivity. Cookson(1989) in his article titled, “Productivity in the Banking Industry in Bangladesh” stated that productivity in the banking industry is very difficult to estimate by using available data. He also said that the conceptual difficulties limit comparisons among the banks in Bangladesh. In this paper the author tried to give a proper definition of labor productivity in commercial banking. He pointed out that the productivity of the total commercial banking system was stagnant. However, he took a partial approach for measuring productivity of the banks. In no way it reflected the total productivity scenario of the banking sector.

Shakoor(1989) ’s paper on “Measurement of Profitability in Commercial Banks in Bangladesh” investigated the nature of productivity of four nationalized commercial banks(NCBs) during 1972-86 and that of five private commercial banks (PCBs) during 1983-86. The paper focused on some selected indicators of general productivity and profitability, such as deposits, advances, income, spread, expenditure etc. per employee and per branch. He used some statistical measures such as averages, standard deviation and coefficient of variations both NCBs and PCBs. The other statistical measures like, trend, correlation, regression analysis etc. were not used by the author. He observed that the productivity of the NCBs in Bangladesh had an increasing trend during 1972-86 and the productivity of the selected private banks showed better situation when compared with that of NCBs during the period under study.

But, his study had limitations and in no way that reflected the total productivity trend of the commercial banking sector as a whole. Bhattacharjee and Saha(1989) in their joint eff0rt titled, “An Evaluation of Performance of NCBs In Bangladesh” tried to measure the performance of NCBs for th1973-1987. They analyzed the performance of NCBs on the basis of five sets of indicators. They are: (a) General business measures in terms of total business, deposit, advances, gross income and net profit; (b) Social profitability measures in terms of deposit mobilization (time deposit), branch expansion. (number of branches) and employment generation; (c) Branch Performance Measures in terms of profit per branch, deposit per branch, business per branch and gross income per branch; (d) Employee performance measures in terms of profit per employee, income per employee and business per employee; (e) Profitability measures in terms of rate of profit on equity, profit per unit of deposit and profit per unit of advances.

The authors found upwards trends in almost all the performance measures. Besides, inter bank and intra bank variations in performance measures were also observed by them. Observing ‘means’ and ‘standard deviations’ of selected measures in NCBs , the authors reported that the NCBs could maintain the rising trends. They mentioned that in spite of disinvestment of two NCBs and growing importance attached to the development of private banking, the NCBs still played a dominant role in the banking sector. They hoped that achievement of the NCB sector may further be enhanced if due care is taken to improve the existing planning and monitoring system of relative operational performance aspects of thee banks.

Abedin(1990) in his book titled “Commercial Banking in Bangladesh: A Role of commercial Study of Disparities of Regional and Sectoral Growth Trends(1846-1986),” examined the role of commercial banks under the private ownership(1846-1970) in increasing regional and sectoral disparities in rendering the banking services in Bangladesh. He also investigated the part played by the commercial banks under the public ownership(1971-1986) in mitigating any such disparities. In this perspective the author tried to critically examine the growth trends of banking facilities in Bangladesh for the period from 1846 to 1986. This study analysed the impacts of nationalization of commercial banks on different regions and sectors of Bangladesh economy after the independence of the country. The author identified some factors influencing credit deployment such as legal requirements of cash reserve, political pressure on the bank executive etc.

There are some other important factors, which should not be overlooked. Such as, motivation factor of the bank executives, job security, honesty etc. The study rightly identified that, regional economic disparities led to the growth of regional imbalances in the distribution of banking facilities. The political economy of the monetary policy and banking was also responsible for this(page 260). To discuss about limitations it can be said that, within the scope of a single thesis, to deal with a large number of issues is neither possible nor desirable. The author admitted that many current issues of banking operations could not be analyzed in this dissertation. It would be more worthy and specific if some of the key issues were mentioned.

Chowdhury(1990) in his dissertation titled “An Evaluation of the Performance of Commercial Banks in Bangladesh” assessed the overall contribution of the commercial banks in the financial development of Bangladesh. He analyzed the trend of commercial bank’s branch expansion, deposit mobilization and deployment of credit for the period 1972-86. The productivity and profitability aspects of the Nationalised Commercial Banks (NCBs) and Private Commercial Banks(PCBs) for the period 1983-1986(covering a period of four years) were also examined in the dissertation. The study covered all commercial banks excluding foreign and Islamic banks and used secondary data. The study stated that the growth pattern of the financial development and the contribution of commercial banks towards financial development in Bangladesh was not only uneven but also very slow.

The study observed that the growth and development of commercial banking in Bangladesh during 1972-86 was not satisfactory. The author observed that the trends of profits, profitability and productivity of the commercial banks, over the entire reference period, were characterized by uneven variations indicating unsystematic and unplanned business expansion of the commercial banks. The study identified that the frequent variations in the ‘burden’ of the commercial banks was mainly responsible for the uneven trends in profits and profitability.

Like any other study , the study had also some shortcomings. The post denationalization and privatization period 1983-86 (four years) was too short in comparison to the pre denationalization or nationalized period 1972-1982 (11 years). The period considered (1983-1986 i.e. four years)for the comparative analysis between the performance of NCBs and PCBs was very early to mature. Since the study measured the productivity and profitability performance using single measures such as ratio of net profit volume of working fund, ratio of total income to total expenditure and ratio of total income to manpower expenses, those measures had limits to justify the results. If some additional measures had been used, then the results might be more realistic. So this study has some limitations and inadequacies which are expected to be minimized in the present study.

Moniruzzaman and Rahman(1991) made a comparative study of pre and post denationalization periods in the article titled, “Profitability Performance of Denationalized Banks- A Comparative Study of the Pre and Post Denationalization Periods.” They Observed that the profitability performance of Uttora Bank Limited and Rupali Bank Limited became unsatisfactory after denationalization. But in the case of Pubali Bank Limited, they observed a Decreasing trend before denationalization and increasing trend after denationalization. The limitations of the paper are that, they had taken into consideration a very short period of three years before and three years after denationalization of the two banks. They did not try to find out why profits of those denationalized banks (Uttora, and Rupali Bank limted) were falling. They used the variables like total expenses , total income, net income and total assets only. They ignored other important variables, such as deposits, advances, number of Bank branches, number if employees etc. So the study was very limited and incomplete.

Efficiency Measurement and Data Envelopment Analysis

This section provides a comprehensive review of the literature in the area of Efficiency measurement and Data Envelopment Analysis. Measuring Commercials banks efficiency has emerged across the globe, which the literature review aspect has been explored in great amount by economists and numerous scholars. Many theoretical an empirical study showed that Commercial banks in UK plays an important role in the financial market of the UK economic and hence it is important to measure whether this commercial banks operate efficient on not. The preferred method used in this is study is Data Envelopment Analysis (DEA); which have been used by various writers to examine the efficiency of banks across the world and there are a number of papers that have used non-parametric methods for measuring the efficient banks; for example, Berg et al (1991); Berger et al (1993); Ferrier and Lovell (1990) and Fucuyama, H., 1993. Technical and scale efficiency of Japanese commercial banks: a non parametric approach. Appl. Econ. 25, pp. 1101–1112.Fucuyama (1993) and in Berger and Humphrey (1997) they surveyed 130 studies that applies frontier efficiency method to financial institutions in 21 countries, although their research is limited to efficient frontier techniques (e.g. DEA, stochastic frontier analysis). Furthermore, ever since that time, numerous papers have been published and in Seiford (1994) study of DEA there was 472 published articled on DEA Bibliography listed. In this study using DEA to measure UK commercial banks, can be differentiated on the basis of the data sample of this banks and the number of banks used, methodology, and considered variables and the analysed result.

This study used the methods that are developed by Allen N. Berger and David B. Humphrey (1992). In their paper “Measurement and Efficiency Issues in Commercial Banking”, they carried out three alternative methods which are, The Asset, The User Cost, and the Value-added method in choosing bank outputs. Under the asset methods according to Sealey and Lindley (1977), Loans and other assets are considered to be bank outputs; while deposits and other liabilities are inputs. The User Cost methods is basis of its net contribution to bank revenue and Hancock (1985a, 1985b) and Fixler and Zieschang (1990) used the user cost method to determine the weights applied to bank asset and liability. While the Value-added method

In this literature review, we address these issues in four main ways, first, we extensively review several research studies on the causes and consequences of efficiency measurement, secondly, we will introducing the non-parametric Data Envelopment Analysis and deal with the motivation behind choosing Data Envelopment and the result of our findings and contributions, thirdly we will given a brief comparisons of nonparametric data envelopment analysis (DEA) and the parametric stochastic frontier analysis (SFA) the two main method of measuring efficiency and come to the conclusion why the method that is used in the study is preferable and fourthly, analyze cross-border banking efficiency on data envelopment analysis (DEA) in a single county ad also in more than one country, drawing to the final review of by looking at various view from analysts and economist that has contributed to the data envelopment analysis (DEA) mainly for banks purpose

Firstly, we will look at the overview of efficiency measurement by looking at previous studies on several different perspectives in measuring efficiency in Banks

In the USA, Sherman and Gold (1985) used the DEA method to measure the efficiency of savings bank with 14 branch offices. In their findings, DEA results showed that six banks branches were operating inefficiently and these branches should explicitly consider the mix of services provided and the resources used to provide services by the other efficient operating bank branches. Relative study was carried out by Parkan (1987), he found that eleven banks branches out of thirty-five banks braches were relatively inefficient.

Using DEA methods to measured the efficiency in U.S. banking on the sample of 322 independent banks, Ferrier and Lovell (1990) in their study, found that the average bank used 21 percent more inputs than necessary, approximately three-quarters of which was technical inefficiency

Alsi Aly, Grabowski, Pasurka, and Rangan (1990) they used DEA in their study; and found that banks could have employed 35 percent fewer inputs without reducing output.

As well, Elyasiani and Mehdian (1990) used the DEA method; also found that banks over employed inputs by about 12 percent.

In the Barr et al. (1992, 1993, 1994, 1997, 1998, and 1999) Using the DEA model, a bank is a transformer of multiple inputs into multiple outputs and a bank’s DEA efficiency score from this captures the essential financial intermediation functions of a bank.

Fernandez-Castro and Smith (1994) study using the nonparametric DEA method for ratio analysis. In their result it was showed that corporate efficiency is multidimensional in nature and that there exist a variety of indicators of corporate efficiency.

Berg, Forsund and Jansen (1992) & Zaim (1995) studies of measurement of the efficiency change in the banking industry during the deregulation period 1980-1989. In their studies using the Norwegian and Turkish banks sample, they suggested that financial improvement can improve efficiency and that banks can experience improved efficiency after deregulation.

Measuring the technical efficiency of 201 large sized US Banks, Miller and Noulas (1996), result show an overall technical efficiency of around 97 percent; nonetheless, majority of these banks were too large and experiencing decreasing returns to scale. And their second-stage regression study showed that pure technical efficiency is positively related to these large bank sizes and their profitability.

Using DEA Method, Peristiani (1996) and DeYoung (1997) both found that measuring cost efficiency can be positively related to examiners’ ratings of bank management quality. Moreover, later study found that banks’ management ratings were more strongly related to their asset quality ratings than to any of their other examination ratings.

Measuring the efficiency of Nigeria banks, Ayadi et al (1998) using the DEA method to study ten banks by using the financial data from 1991 to 1994. Using the input and output variable selection; (input: interested paid on deposit, total expenses and total deposit) while (output: total loan interest and non-interest income), in their find they showed that banks in long period of existence are relatively efficiency than new bank.

Using DEA with three inputs and two outputs, Chu and Lim (1998) measured the cost and profit efficiency of a panel of six Singapore banks during the period 1992- 1996. In their result, it was showed that during this period the six banks have higher overall efficiency of 95.3% compared to profit efficiency of 82.6%. In addition, they also showed that the large Singapore banks have higher efficiency of 99.0% compared to the 92.0% for the small banks.

Alirezaee et al. (1998) using DEA method to study the efficiency of 1,282 bank branches in Canada, in their results from the total number of inputs and outputs; they found that the average branch efficiency score varies inversely with the number of branches . The cause of this bias in efficiency scores; as they advice was as a result of using relatively small sample sizes (three inputs and three outputs).

Using DEA method during the period of 1997, Leon (1999) measured the cost frontier estimation of 23 Mexico banks. And from her result it showed that the system average was 39% inefficiency; and mostly the large banks and the foreign banks that indicate to be the inefficiency ones.

Alam (2001), study of nonparametric DEA method to measure the efficiency of large U.S. banks from the period of 1980-1989 and in his findings he reported that a statistically significant efficiency for these large U.S. banks. This was mainly caused by the technological change rather than the changes in overall technical and scale efficiencies.

By using DEA method Cook and Hababou (2001) studied both the sales and service efficiencies of bank branches and using the linear programming DEA modelling method they were able to derive the best efficiency scores by accounting for the bank branch resource inputs.

In the UK, Drake and Howcroft (2002) measured the relative efficiency of the clearing bank branches using DEA method. Their study used the basic efficiency indices and extended the analysis by examining the relationship between size and efficiency

Akhtar (2002) used the DEA method on 40 sample commercial banks of Pakistan to measure the efficiency. In his study, it was found that under the constant returns to scale (CRS) DEA, the overall efficiency score for Pakistani commercial banks for the year 1998 was 80%. In comparison to this study the Pakistan efficiency score are lesser than the world mean efficiency.

In addition, Kumbhakar and Sarkar (2003) study the relationship between deregulation and efficiency improvement using data from the Indian banking industry over a 12-year period from 1985 to 1996. In their finding it showed that private banks efficiency improves in response to the deregulation measure and these does not affect public

In contrast, studies from Bauer et al (1993); Elyasiani and Mehdian (1995) and Halkos and Salamouris (2004) that used DEA to measured the efficiency of the Greek banking sector during 1997-1999, which is when various financial reforms took place, and they find that financial reform has no capability lead to efficiency effectiveness.

Using the sample period of 1992 – 2002, Zuniga (2005), developed a non-parametric cost function method to solve the section and simultaneity problem. In his result it was showed that the average efficiency was approximate highly by 15% in comparison to the beginning of the period.

Recently, Lo and Lu (2006) used a two-stage DEA method that included profitability and marketability to study the efficiency of financial holding companies (FHCs) in Taiwan. Their aim was to identify the most important inputs/outputs and to distinguish those FHCs which are treated as benchmarks. In their Results it is showed that big-sized FHCs are generally more efficient than small-sized ones.

Das and Ghosh (2006) used DEA to measure the efficiency of Indian commercial banks during the period of 1992-2002. They found that medium-sized public banks performed reasonably well and efficiency improved.

In Wu et al. (2006) study of DEA and neural networks (NNs) methods in measuring the relative bank branch efficiency of a large Canadian bank. In their results it was proposed that the measuring of efficiency using the DEA-NN method has good correlation with that of measurement using the DEA method, also they showed that their measurement of efficiency using the DEA-NN method was also a good alternative to the traditional DEA method that every economist are familiar with.

Chuling (2009) studied the efficiency of banks in Sub Saharan African using DEA. In his work, these banks could save 20 – 30% of their total cost if they were operating efficiently (operating on the frontier), and in addition to his finding the foreign-owned banks are more efficient than the public banks and domestic private banks.

General used of DEA measuring of efficiency and the motivation behind choosing Data Envelopment and the result of our findings and contributions

DEA studies have been used to measured efficiency in different field/ industry besides the commercial banking industries which these study focus on and there is a wealth of literature on both basic and applied research in DEA. For example, in Dimitras et al. (1996) study, various DEA techniques were used in the prediction of business failures but their focus was on industrial firms. Using DEA Smith and Gupta (2000) provide a discussion of the application of neural networks in business problems.

Board et al. (2003) survey O.R. applications in the financial markets. Zhou and Poh (2008) provide a recent survey of DEA applications but they focus on energy and environmental studies. More recently, Cook and Seiford (2009) review the methodological developments of DEA over the last thirty years. However, they do not discuss applications of DEA. The above reviews are quite general and they do not focus on applications in banking.

Thirdly brief comparisons of nonparametric data envelopment analysis (DEA) and the parametric stochastic frontier analysis (SFA) and come to the conclusion why the method that is used in the study is preferable

Literature review on efficiency study is controlled by the two most popular methods: the nonparametric data envelopment analysis (DEA), which the focus of the main study and the parametric stochastic frontier analysis (SFA), which we will look into very briefly. Literature reviews on banks efficiency studies on both methods are fairly abundant by now. For example Weill (2004), Ferrier and Lovell (1990), Sheldon (1994), Resti (1997), Bauer et al. (1998), Casu and Girardone (2002), Weill (2004) and Beccalli et al. (2006) are all Studies that compare parametric and non-parametric techniques using an identical data set.

During the late sixties stochastic frontier analysis (SFA) method experienced large popularity due to the influential work of Aigner and Chu (1968) that developed the econometric regression approaches and Aigner et al. (1977) and Meeusen and van den Broeck (1977), among others. The model is denoted in logs as ln(yj) = lnxj_+vj−uj , where xj denotes an input vector for firm j, vj depicts random error added to the non-negative inefficiency term, uj . This is stochastic because the upper limit is determined by the stochastic variable exp(xj_ + vj).

In Ferrier and Lovell (1990), they study the cost structure of 575 US banks for the year 1984 using both the SFA and DEA methods. In their result they find higher efficiency scores with DEA compared to SFA, namely 80% and 74%, respectively; concluding that DEA is sufficiently flexible to envelop the data more closely than the translog cost frontier.

However, efficiency scores are not significantly correlated thus indicating that other factors not controlled for may drive the obtained wedge between the two measures. European evidence is provided by

Sheldon (1994) study the cost efficiency of Swiss banks with SFA and DEA in the period from 1987 to 1991. In his results, DEA shows that the average degree of cost efficiency is about 56%, compared to SFA 3.9% mean efficiency.

Using two-stage DEA method, Bhattacharya et al. (1997), study the impact of Liberalization on efficiency of the Indian banking industry. During the first stage, a technical efficiency score was calculated, and in the second stage a stochastic frontier analysis was used to attribute variation in efficiency scores to three sources: temporal, ownership and noise component.

Also using a two stage DEA method, Seiford and Zhu (1999) study the performance of the top 55 US banks and their results showed that relatively large banks performed better on profitability, while the smaller banks performs better with respectively to marketability.

Likewise, Amel et al (2004), using both the SFA and DEA methods, he reports insignificant rank-order correlation of 1%, that showed no relationship between the two efficiency methods scores.

And Resti (1997), studying the cost efficiency of 270 Italian banks over the period 1988-1992. By comparing the parametric and non parametric efficiency, find out that econometric and linear programming results (SFA and DEA is statistically significant at the 1% level and ranges from 44% to 58%) do not vary significantly. and Furthermore, contrary to Ferrier and Lovell (1990) and Sheldon (1994), he reports higher efficiency scores between 81% and 92% for SFA as opposed to DEA scores between 60% and 78%.

Berger and Humphrey (1997), study of efficiency by using the nonparametric DEA and parametric SFA methods. In their result they found that the mean efficiency of nonparametric was 0.72 compared to the mean efficiency of parametric method which is 0.84. in Addition to their result, they noted that the rankings of these banks often found to be relatively different: foe example; in one study the rank correlation coefficients between rankings from parametric and nonparametric models were found to be 0.02 and in another study it was between 0.44 to 0.59.

In a more recent study, Casu and Girardone (2002), using SFA and DEA during the 1990s to measure the cost, profit efficiency of Italian financial banks. Their result shows that there are reasonably similar in Efficiency measures from stochastic and deterministic frontiers.

Also Weill (2004) using SFA and and DEA to measure the cost efficiency of 688 banks from five European countries: France, Italy, Germany, Spain, and Switzerland during 1992 to 1998. He finds that Efficiency scores do not vary significantly across these methods and there is no positive relationship between any parametric method and DEA.

And Beccalli et al. (2006) using SFA and DEA to measure cost efficiency of Stock-market listed European banks in 1999 and 2000. Finds that DEA efficiency scores are more dispersed compared to SFA and Furthermore, SFA scores of 85% are slightly higher than DEA scores 83%

To draw these arguments to a close and as per Bauer et al. (1998) conclusion and looking at the above debate from various economists study, there is no single correct approach to identify with an efficient frontier, although both methods SFA and DEA look to respond to varying degrees of individuality of the data.

Fourthly, we will take a looks at data envelopment analysis (DEA) in a single county ad also in more than one country

Using DEA Method, Yildirim (2002), Study the efficiency of Turkish commercial banks between 1988 and 1999. His results suggested that during these sample periods; that both pure technical and scale efficiency measures showed a great variation and the Turkish commercial banks did not achieve sustained efficiency gains.

Favero and Papi (1995); by using the non-parametric (DEA) method to study the cross section of 174 banks in 1991, they measure the technical and the scale efficiencies of the Italian banking industry. In their empirical findings, the north-Italian banks were more efficient than south-Italian banks; and their efficiency measured was best explained by the bank Size and to a lesser extent by location.

By using DEA to measure the efficiency of one largest commercial banks in the eastern province of Saudi Arabia, sample of 15 bank branches using a one year data, Al-Faraj et al. (1993) found out that these banks branches were efficient based on eight inputs and seven outputs identified.

Also, Al-Faraj et al (2006) using DEA to study the efficiency of the Saudi commercial banking industry in the 2002 by comparing the Saudi commercial banks with the world mean efficiency scores. Their study for the Saudi commercial banks efficiency score compares very well with the world mean efficiency scores. They further recommended that Saudi banks should continue to adapt to new technologies and providing more services in order to sustain competitive advantages.

Nonparametric data envelopment analysis (DEA) in More than one country

Casu and Molyneux (2003) used DEA to study efficiency of European banking systems and their sample geographical coverage in that study included France, Germany, Italy, Spain and the United Kingdom from the period 1993 and 1997. The aim of the study was to find out if the productivity efficiency in that area has improved and meet a common European frontier. But in their results, it was pointed out that these country banking systems were in a low average efficiency levels. Nevertheless, slight improvement was detected in the scores over the period of analysis for most of the banking systems; with the exception of Italy.

Conversely, in Casu, Girardone and Molyneux (2004) study of efficiency using DEA in European banking systems, geographical coverage of France, Germany, Italy, Spain and United Kingdom from the period 1994 – 2000, they found out that Italian banks has increase it efficiency level by 8.9%, and the reason for this improvement in efficiency was due to the cost reduction that the banks managed to attain. Further attained respected was achieved by the other country banks; Spanish banks increased by 9.5% , Germany banks increased by 1.8%, French banks also increases 0.6% and the English banks increased by 0.1% respectively.

Using a cost function method Allen and Rai (1996) study surveyed was fifteen countries financial institution: Australia, Austria, Canada, Switzerland, Germany, Denmark, Spain, Finland, France, Italy, United Kingdom, Sweden, Belgium, Japan and US. In their result; large banks showed the largest measure of input inefficiency and had anti-economies of scale; Italian banks, along with French, UK and US ones were found less efficient from Japanese, Austrian, German, Danish, Swedish and Canadians ones while the small banks had significantly lower inefficiency measures.

In Altunbas and Molyneux (1996), study of efficiency in France, Germany, Italy and Spain banking system, for economies of scale and scope; their result showed that there are differences among the four banking system regarding economies of scale. However, the Italian banks were indicated as significantly efficiency as they succeeded in lowering costs.

Pastor, Perez and Quesada (1997) study of efficiency using the non-parametric DEA method together with the Malmquist index, they compared the efficiency of United States, Spain, Germany, Italy, Austria, United Kingdom, France and Belgium banking system for the year 1992. Their study used the value added approach and in their results; the France banking system had the highest efficiency level followed by Spain, while UK banking system was presented to be lowest level of efficiency.

In Bikker (2001) study of the banks efficiency using a sample of European banks in various countries, along with Italy bank, during the period 1989-1997. In his result is was showed that the Spanish banks, followed by the French and the Italian banks; were the most inefficient banks; while the most efficiency banks were the one in Luxemburg, in Belgium and in Switzerland.

Also studying the efficiency of European Banking industry by Schure, Wagenvoort and O’Brien (2004) from the period 1993-1997; they found out that larger commercial banks were more efficiency on average than smaller banks. However, the Italian and the Spanish banks were found to be the in-efficient.

In the literature review, it can be seem that various studies have attempted to measure the efficiency of banks in the West and other parts of the world, although only few studies has focused on measuring the efficiency in the UK Commercial banks. Hence the aim of the dissertation will be to fill this research gap by empirically measuring the efficiency in the UK Commercial banks using the nonparametric DEA method.

Managing Credit Risk in Banking

Chapter 2

Literature Review

2.1 Introduction

As discussed in chapter one, the main objective of this research is to portray the contemporary practices of managing credit risk in banking industry and comparing the practices between banks in UK and Bangladesh. To achieve the prime objective the research will also critically investigate the nature of credit risk for banks and evaluate the risk as a cause of major bank failures in history. The study will also explore various methods of bank credit risk management especially the Basel framework. Finally the research will try to formulate a set of best practices for credit risk management in Bangladeshi and British banks. This section of the study contains the relevant literatures and review of previous works on bank credit risk management which are present as following.

2.2 An Overview of Risks in Banking Business

Risk denotes uncertainty that might trigger losses. As our financial system is market based, it requires an effective risk management framework. Risks in financial markets have changed in the past three decades reflecting the changing nature of financial intermediation (Machiraju, 2008). A modern bank has to deal with various types of risks. These major categories of risks are credit risk, interest rate risk, foreign exchange risk, liquidity risk, operational risk and systematic risk. A brief discussion on these risks are presented below –

2.2.1 Credit Risk

Credit risk is the risk of losing money when loans default (Machiraju, 2008). When the borrowers fail to repay the loan or interest it becomes bad. Bad loans are one of the prime reasons of bank losses. Credit risk is the largest element of risk in the books of most banks which if not managed in a wiser way, may break down individual banks or may cause widespread financial instability by endangering the whole banking system (Jackson and Perraudin, 1999). For this reason in banking industry credit risk is a critical issue and needs careful management.

2.2.2 Interest Rate Risk

Interest rate risk management may be approached either by on balance adjustment or off-balance sheet adjustment or a combination of both. On-balance sheet adjustment involves changes in banks portfolio of assets and liabilities as interest rates change. When medium or long-term loans are funded by short-term deposits, a rise in the rate of interest will increase the cost of funds but the earnings on the assets will not, thereby reducing the margin or spread on the assets.

2.2.3 Liquidity Risk

Liquidity risk refers to the bank’s ability to meet its cash obligations to depositors and borrowers. A liability sensitive position than to assets of interest rates reduces the liquidity position of a bank. The mismatch between short-term liabilities and long-term assets creates a severe funding problem as the liabilities mature. Again if the duration of assets exceeds the duration of liabilities the ability to realize liquidity from the assets of the bank is reduced. Liquidity needs are increasingly met by deposit and non-deposit sources of funds paying market rates of interest (Machiraju, 2008).

2.2.4 Operational Risk

Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems from external events. Operational risks -include – information technology risk, human resources risk, loss to assets risk and relationship risk (Balthazar, 2006).

2.2.5 Foreign Exchange Risk

Foreign exchange risk arises out of the fluctuations in value of assets, liabilities, income or expenditure when unanticipated changes in exchange rates occur. An open foreign exchange position implies a foreign exchange risk.

2.3 Credit Risk and its Categories

Credit risk, as discussed above, is defined as the probability that borrower of a bank or counterparty debtor will fail to meet its obligations in accordance with agreed term (Bessel, 1999). It may also be defined as the risk arising from the uncertainty of an obligor’s capability and willingness to carry out its contractual obligations. Here obligors are any party that has direct or indirect financial obligations inside the contract. Following are major categories of credit risk –

2.3.1 Risk of Default

Traditional credit risk is involved with default on a repayment of loans. And a likelihood of the default is called the probability of default. When a default occurs, the amount at risk may be as much as the whole liability, which can be recovered later, depending on factors like the creditors’ legal status. However, later collections are generally difficult or even impossible in that huge outstanding obligations or losses are usually the reasons why organizations fail.

2.3.2 Pre-settlement Risk

The possibility that the counterparty may default once a contract has been entered into but a settlement is still to occur is called pre-settlement risk. Through this period, the contract will have unrealized gains. This signifies the risk. The probable loss to the bank is dependent on the magnitude of change in market rates after the origination of the original contract. Such risk can be assessed in terms of existing and probable exposure to the organization (Horcher, 2005).

2.3.3 Risk of Counterparty Settlement

Settlement risk is common the interbank market and the risk arise when one party to a contract fails to pay funds or deliver assets to other one during the time of settlement. Such risk can be associated with any timing differences in settlement (Casu et al, 2006). Counterparty settlement risk is usually associated with foreign exchange trading, where “payments in different money centers are not made simultaneously and volumes are huge”. German bank Herstatt failure in 1974 created similar scenario as it received payments from its foreign exchange counterparties but never made payments to counterparty financial institutions as it ceased to operate before that.

2.3.4 Sovereign Risk

Sovereign risks are borne from the impact of crises in economic and/or socio-political situation in foreign severing nations. Such risk is prevalence on transactions with overseas nations and refers to the uncertainty when governments for some reason declares debt to foreign lenders void or adjust the profit, interest and capital movement (Casu et al, 2006). Evidence demonstrates that sovereign governments have both temporarily and permanently exercised controls on capital, stopped cross-border payments and cancelled debt repayments.

2.4 Fundamental Risk Management Practices in Banks

Banking industry has its own methods of managing different types of risk. A brief summary of each risk management practice is given below –

Risks in Banking Business

Standard Risk Management Practices

Credit Risk

Raising credit standards

Using guarantees and collateral

Monitoring the borrower behaviour after loan made

Transferring credit risk by selling standardised loans

Diversifying credit portfolio

Interest Rate Risk

Using adjustable interest rates on loan

Using various non-traditional financial instruments referred to as derivatives such as futures, options, swaps or creation of synthetic loans through use of futures.

Liquidity Risk

Liability management

Using mathematical model for matching asset and liability terms

Foreign Exchange Risk

Forward contracts

Money market alternative

Foreign currency futures

Currency swaps and

Foreign currency options etc.

Table 2.1: Standard Methods of Bank Risk Management

2.5 A Closure Look on Credit Risk Management Techniques

Hennie (2003) states that despite innovations in the financial services sector over the years, credit risk is still the major single cause of bank failures, for the reason that “more than 80 percent of a bank’s balance sheet generally relates to this aspect of risk management”. The consultative paper issued by Basel (1999a) also points out that the major cause of serious banking problems continues to be directly due to the loose credit standards for borrowers and counterparties, poor portfolio risk management and so on. All such evidence proves the extremely vital role credit risk management plays in the whole banking risk management approach as well as the sustainable success of the organization. In this section, the goal and principles of banking credit risk management will be summarized briefly, which together with the above part on the identification of the existing credit risk in banking activities, will provide a basic framework for the understanding and discussion of banks’ credit risk management practices. The standard credit risk management processes are discussed as following –

2.5.1 Developing and Using a Sound Credit Granting Process

A sound credit granting process requires the establishment of well-defined credit granting criteria as well as credit exposure limits in order to assess the creditworthiness of the obligors and to screen out the preferred ones. A bank’s credit criteria are designed to shape the types and characteristics of its preferred obligors, and they should set out who are eligible for the credit, the amount of the credit and the relative terms and conditions (Monetary Authority of Singapore 2006). These criteria, together with the credit exposure limits on single and groups of counterparties that usually base on internal credit rating, should help banks to generate sufficient information on credit risk profiles and instruct the safe credit approval process, which are applicable to credit extension activities as well.

2.5.2 Maintaining an Appropriate Credit Administration, Measurement and Monitoring Process

Credit administration can play a vital role in the success of a bank, since it is influential in building and maintaining a safe credit environment and usually saves the institution from lending sins. Therefore, banks should never neglect the effectiveness of their credit administration operations (Wesley, 1993). Then talking about credit risk measurement in banks, it is required that banks should adopt effective methodologies for assessing the credit risk inherent both in the exposures to individual borrowers and credit portfolios, and this will be explained in details later. The last focus in this area of principles is related to credit risk monitoring, which is definitely a must in banks’ risk management procedure. Banks should keep track on the borrowers’ current financial conditions and ensure their compliance with the covenants. Both cash flows and collateral adequacy should be ensured and the potential problem credits should be considered. In this way, banks are well in control of their credit qualities as well as all the related situations, and can react to any future changes timely and readily.

2.5.3 Transferring Credit Risk

Once loans are made Banks may use credit derivatives to transfer credit risks. There are different types of credit derivatives – credit default swap, credit linked note and total return swap. Other forms of risk transfers include trading loans, securitizations and bank or insurance guarantees. However there are regulatory concerns over these methods.

2.6 Bank Risk Exposure and Causes of Bank Failures

Generally, credit risk is related to the traditional bank lending activities, while it also comes from holding bonds and other securities. Basel (1999a) reports that for most banks, loans are the largest and most obvious source of credit risk; however, throughout the activities of a bank, which include in the banking book as well as in the trading book, and both on and off the balance sheet, there are also other sources of credit risk. Various financial instruments including acceptances, interbank transactions, financial futures, guarantees, etc increase banks’ credit risk. Therefore, it is indispensable to identify all the credit exposures– the possible sources of credit risk for most banks, which can also serve as a starting point for the following parts of this work.

2.6.1 On-balance Sheet Exposures

Commercial and industrial, real estate, consumer and others are the most common types of loans. Commercial and industrial loans can be made for periods from a few weeks to several years for financing firms’ working capital needs or credit needs respectively. Real estate loans are primarily mortgage loans whose size, price and maturity differ widely from C&I loans. Consumer loans refer to those such as personal and auto loans while the so called other loans include a wide variety of borrowers such as other banks, nonblank financial institutions and so on.

Credit risk is the predominant risk in bank loans. Over the decades the credit quality of many banks’ lending has attracted a large amount of attention. The only change is on the focus of the problems from bank loans to less developed countries and commercial real estate loans to auto loans as well as credit cards, which is an American example. Since the default risk is usually present to some degrees in all loans (Saunders and Cornett 2006), the individual loan and loan portfolio management is undoubtedly crucial in banks’ credit risk management.

Besides lending, credit risk also exists in banks’ traditional area of debt securities investing. Debt securities are debt instruments in the form of bonds, notes, certificates of deposits, etc, which are issued by governments, quasi-government bodies or large corporations to raise capital.1 In general, the issuer promises to pay coupon on regular basis through the life of the instrument and the stated principal will be repaid at maturity time. However, the likelihood that the issuer will default always exists, resulting in the loss of interest or even the principal to banks, which can be a damaging impact.

2.6.2 Off-Balance Sheet Exposures

Since the 1980s, off-balance sheet commitments have grown rapidly in major banks, among which there are swaps, forward rate agreements, bankers’ acceptances, revolving underwriting facilities, etc. (Hull 1989). Those commitments give rise to new types of credit risk from the possibility of default by the counterparty. In this section, some of the off-balance sheet credit exposures will be introduced, among which the first one is related to derivative contracts.

(a) Derivatives Contracts: According to Saunders and Cornett (2006), banks can be dealers of derivatives that act as counterparties in trades with customers for a fee. Contingent credit risk is quite likely to be present when banks expand their positions in derivative contracts. Since the counterparty may default on payment obligations to truncate current and future losses, risk will arise, which leaves the banks unhedged and having to substitute the contract at today’s interest rates and prices. This is also more likely to happen when the banks are in the money and the counterparty is losing heavily on the contract. Comparatively, the type of credit (default) risk is more serious for forward contracts and swap contracts, which are nonstandard ones entered into bilaterally by negotiating parties. While trading in options, futures or other similar contracts may expose banks to lower credit risk since contracts are held directly with the exchange and there are margining requirements. However, the credit risk is also not negligible.

(b) Guarantees and Acceptances: Bank Guarantee is an undertaking from the bank which ensures that the liabilities of a debtor will be met, while a bankers’ acceptance is an obligation by a bank to pay the face value of a bill of exchange on maturity (Basel 1986). It is mentioned by Basel (1986) that since guarantees and acceptances are obligations to stand behind a third party, they should be treated as direct credit substitutes, whose credit risk is equivalent to that of a loan to the ultimate borrower or to the drawer of the instrument. In this sense, it is clear that there is a full risk exposure in these off balance sheet activities.

(c)Interbank Transactions

Banks send the bulk of the wholesale dollar payments through wire transfer systems such as the Clearing House InterBank Payments System (CHIPS). The funds or payments messages sent on the CHIPS network within the day are provisional, which are only settled at the end of the day. Therefore, when a major fraud is discovered in a bank’s book during the day, which may cause an immediate shutting down, its counterparty bank will not receive the promised payments and may not be able to meet the payment commitments to other banks, leaving a serious plight. As pointed out by Saunders and Cornett (2006), the essential feature of the above kind of settlement risk in interbank transactions is that, “banks are exposed to a within-day, or intraday, credit risk that does not appear on its balance sheet”, which needs to be carefully dealt with.

(d) Loan Commitments

A loan commitment is a formal offer by a lending bank with the explicit terms under which it agrees to lend to a firm a certain maximum amount at given interest rate over a certain period of time. In this activity, contingent credit risk exists in setting the interest or formula rate on a loan commitment. According to Saunders and Cornett (2006), banks often add a risk premium based on its current assessment of the creditworthiness of the borrower, and then in the case that the borrowing firm gets into difficulty during the commitment period, the bank will be exposed to dramatic declines in borrower creditworthiness, since the premium is preset before the downgrade.

2.6.3 Causes of Bank Failures

Over the last century many banks failed and the reasons were also varying. In following sections major causes of bank failures are present with examples.

Cause of Bank Failures

How Fails


Improper credit evaluation, poor selection of borrowers

If the credit evaluation is poor, loans are given to borrowers not having enough repayment capacity. As a result the volume of loans disbursed increases which may initially strengthen the asset portfolio of the bank. But at the same time it carries with itself the risk of Non Performing Assets. If there are no stringent regulations regarding specific provisioning of NPAs, provisioning made is insufficient. Hence the impact is that banks do not address the problem of NPAs until it is reached an alarming level.

Subprime Mortgage Crises – Mortgage borrower was not evaluated diligently

Excessive exposure to real estate industry

One of the types of securities banks accept is the Immovable Property. Once the property is mortgaged in the bank’s name, the bank enjoys an exclusive control over it in case the borrower defaults in repayment of the loan. But real estate in itself has limitations such as the liquidity problem and risk of decline in the prices. Banks tend to give more and more loans against real estate when the market is at boom. Over a period of time the market stabilizes, real estate prices fall thereby reducing the value of collaterals in bank’s commercial loan portfolios.

Subprime Mortgage Crises – Banks over-invested in Housing industry

Foreign Exchange Risk

Banks may get into trouble if they undertake large and risky foreign exchange business. Losses may result if the bank has incurred liability in terms of a foreign currency and there is an unanticipated appreciation in that specific currency. The risk is higher especially in the environment of floating exchange rates. If the transactions are entered into with a fixed currency exchange rate the future liability is known in advance.

Herstatt Bank failure in 1974

Management Frauds

Managerial personnel are in whole charge of the bank’s funds and are responsible for proper channelisation of the same. But in cases managers divert bank funds from banks to businesses owned by them or the main shareholders. Also in cases the latter acquires assets of the banks for less than true value or sells assets to banks at excessive prices. In addition finance extended by the banks is used for speculative real estate or industrial projects by the firms of the bank’s own groups.

Bank failures in Spain

Other causes of bank failures are –

Deterioration in bank’s capital position:

Although it is recognized that bank’s capital position should be improved, it is not always possible. The reasons are inadequate retained earnings, which actually should be the primary source for strengthening bank’s capital position a faulty dividend policy and insufficient provisioning for bad debts results into reduced retained earnings.

Heavy Expenditure on Bank’s Fixed Assets

Heavy expenditure on assets especially on the office building requires huge investment. This may endanger the liquidity of bank funds.

Huge Operating Costs

Sometimes banks open deposit counters which are a Cost Unit but not definitely a profit center. Due to excessive number of branches not only the time and demand liabilities of the bank but also operating costs like staff salaries and maintenance are pushed up.

Lack of Supervision

BCCI failure is a very good example of lack of supervision. In July 1991 the Bank of Credit and Commerce International failed because of wide spread fraud. BCCI had a very complex structure involving branches over 70 countries. Its complex group structure made it difficult to conduct effective supervision and audit. It is believed that BCCI’s financial statements had been falsified from its establishment in 1972. A scheme of deception was developed to conceal lending losses. To achieve this BCCI failed to record deposit liabilities and created fictitious loans that generated substantial but fictitious profits. Frauds also took place in BCCI’s treasury position.

Inadequate regulatory capital

The regulatory capital should be in line with the economic capital. It will help to strengthen the solvency of banks. The correct measurement of risk would enable it to be better managed. It is also important that capital requirements should cover operational risks including fraudulent operations. This risk is nearly always present in banking crisis of some size and its coverage with capital should help reduce it. The banks should be required to maintain sufficient control over the risks associated with their business such that their survival is not jeopardized.

2.7 Basel I and II: A Comprehensive Credit and Other Management Approach

Basel Committee of Banking Supervision (BCBS) in 1988 came out with idea of risk weighted capital adequacy standards. The standard is called Basel I. The main objectives of the accord were to bolster the soundness and stability of the international banking system and diminish the existing sources of competitive inequality among international banks (Blathazar, 2006). The accord has classified the bank capital in two tiers (See Table 1).

Tier 1

Paid-up Capital

Disclosed Reserves (Retained Profits, Legal Reserves)

Tier 2

Undisclosed Reserves

Asset revaluation reserves

General provisions

Hybrid instruments (must be unsecured, fully paid-up)

Subordinated debt (max. 50% Tier 1, min. 5 years – discount

factor for shorter maturities)


Goodwill (from Tier 1)

Investments in Unconsolidated Subsidiaries (from Tier 1 and Tier 2)

Table 2.2: Classification of Bank Capital for Capital Adequacy Calculation

Source: Balthazar, L (2006). “Basel 1 to 3: The Integration of State-of-the-Art Risk Modeling in Banking Regulation, P-18

The rules under the accord were designed to define a minimum capital level. This capital level is to be compared with risk weighted assets (see table 2).

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Claims on OECD central governments

Claims on other central governments if they are denominated and funded in the national currency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


Claims on OECD banks and multilateral development banks

Claims on banks outside OECD with residual maturity<1 year

Claims on public sector entities (PSE) of OECD countries


Mortgage Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


All other claims: claims on corporate, claims on banks outside

OECD with a maturity>1 year, fixed assets, all other assets

Table 2.3 : Risk Weights of Assets

Source: Balthazar, L (2006). “Basel 1 to 3: The Integration of State-of-the-Art Risk Modeling in Banking Regulation, P-18

The standard level of the capital adequacy ratio was set to 8% (See the equation below).

However sovereign regulators have the flexibility to implement stronger requirements. The Accord was primarily proposed for internationally active banks. But only nationally active banks are free to adopt the accord.

The major weakness of the Basel I was that its concentration on only credit risk. It also had the following limitations (Machiraju, 2008):

It was not risk sensitive as it did not take care for different magnitude of different corporations;

It kept an opportunity for banks to create artificial arbitrage because of unequal treatment of short-term and long-term loans;

It was applied to all portfolios in same way irrespective of the diversification in the portfolio.

In answer to these limitations BCBS introduced market risk in the accord in 1996. Market risk was defined as the risk of losses in on- and off balance sheet positions arising from movements in market prices (BCBS Document, 1996). Later in 2004 full proposal in name of Basel 2 was published which had three pillars –

Table 2.4: Three Pillars of Basel 2 Accord

Pillar One

Pillar Two

Pillar Three

Solvency Ratio, Capital:RWA where assets are weighted for credit, market and operational risks;

Supervisory Review and Internal Assessment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Market Discipline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Basel 3 is in progress in response of the recent financial crises and widespread bankruptcies during 2008 and onward.

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2.7.1 Importance of Basel Capital Accord

The modern capital adequacy standard is a sensible regulation that is essential for maintaining harmony in international banking mechanisms in at least two ways –

Maintaining Soundness and Stability of International Banking System: Example of German bank Herstatt failure can be reviewed to better understand how new capital accord can maintain soundness and stability of international banking system. The 2 billion DEM asset bank Herstatt was involved in foreign exchange during post-Bretton Woods era when currency market was extremely volatile. In 1974, the bank speculated against the dollar and the speculation went wrong. To cover its losses the bank became involved in taking further positions. Eventually the bank ended up with open position of 2000 million DEM which was three times the bank’s capital. Finally when the regulators ordered the bank to close its position the bank’s losses were equal to four times its capital and it was declared bankrupt. The day when Herstatt was declared bankrupt, many other international banks had released payments in DEM that arrived at Herstatt in Frankfurt. However, because of time zone difference corresponding dollar amount was never sent to New York (Balthazar, 2006).

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Now let’s examine if Basel capital accord was in effect at that time what would happen –

Herstatt could not have entered into positions which would reduce the capital adequacy ratio;

If adequate capital was kept in accordance with Basel accord, the international banks those sent USD to Herstatt could have been paid after it went bankrupt;

Regulators would have been informed in time when the bank was taking excess risk putting the depositors’ funds in risk.

Thus capital adequacy standards can harmonize the international banking sector and helps avoiding losses of international banks in similar scenarios.

Diminish Existing Sources of Competitive Inequality: International banks compete in the same global business arena however regulated by the national regulators. As discussed earlier, regulations have a negative relationship with bank profitability. When a national regulator puts excess regulatory pressure on a nation’s internationally active banks, it may lose competitiveness in international banking arena if regulators in other countries are not doing the same thing. For example, Royal Bank of Scotland in UK and Bank of America in US both may compete in the same international market but regulated by separate authorities. The differences in regulations in two geographical locations are sources of competitive inequality. The internationally accepted capital adequacy standard is therefore essential for diminishing such inequality in competition.

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2.8 Managing Credit Risk: Differences between Bangladesh and United Kingdom

The major difference between the credit management techniques in banks in Bangladesh and United Kingdom can summarised as following:

Areas of Difference


United Kingdom

Use of Credit Derivatives. . . . . . . . . . . . . . . . . .

The practice of credit derivatives is rare in Bangladeshi Banks

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Many British banks uses credit derivatives excessively in credit risk management

Use of Information Technology

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Use of technology like credit rating system, customer credit checking mechanisms are still impossible in Bangladesh

Banks in UK have long been using high-end information technology solu

The Basel Accord and Basel II Norms

The review of expansion in the Nigeria banking and financial system shows that the banking sector has undergone remarkable changes over the years, in terms of ownership structure, the number of institutions, as well as the level of operations. This is mainly motivated by the deregulation of the financial sector in order to obey the rules of international standards. As at the end of June 2006, the number of insured banks stood at 25 with different sizes and degree of soundness (Adams J. A. 2005).

The vitality of the international economic environment demands a more robust skills and tools to reduce risk emanating from the rapid development of the financial sector. In other to meet up with the ever dynamic financial landscape, advancement in, as well as the wide use of communication/information technology, a more effective risk management approach is required.

Although, effective risk management has always been fundamental to safe and sound banking activities. For two main reasons effective risk management has assumed added importance. Firstly technological advancement, product and services innovation, size and speed of financial transactions have transformed the nature of banking. Secondly in other to meet up with international banking standard, there is the need to abide fully with the Basel core principle on supervision and to set up an enabling environment for the implementation of the New Capital Accord.

The above mentioned amongst other formed the basis for the adoption of the Capital Adequacy Standard. Capital Adequacy ratio (CAR) is a robust, proactive and sophisticated supervisory requirement for risk management. It is essentially based on risk profiling of a bank. It enables the regulatory authorities to prioritize effort and focus on significant bank with high risk and low CAR.

The nature of banking business involves risk taking CAR is a risk based system that enables bank to adequately provide the necessary buffer for counterpart risk. The major risk faced by banks in the course of business includes but not limited to market, credit, liquidity, operational, legal and reputational risk. Practically bank business activities come with various combinations of these risks depending on the nature and scope of the particular activity undertaken.

In Nigeria the objectives of the regulatory authorities includes the promotion of stable, secure and sound financial system, ensuring and efficient payment system, necessary for the achievement of the broader economic objective of welfare improvement, ensuring effective consumer protection and the reduction of financial risks among others.

There have been numerous empirical attempts to measure the impact of capital adequacy of the financial reforms in Nigeria (see Alawode and Ikhide 1994, Ikhide 1998, Adekanye and Soyinbo 1992, Subdue and Akiode 1994 among others). There are previous studies that assess the capital ratio of the financial sector reforms in Nigeria in contrast to other countries in Sub-Sahara Africa (for example, Soyinbo 1994, Aryeetey 2000, Emenuga 1998, Aryeetey and Senbel 1998 among others).

Surprisingly, none of these studies has given a comfortable pass mark for the financial sector reforms in Nigeria.

They opined that capitalization may raise liquidity in the short term but will not guaranty a conducive macroeconomic environment necessary to guaranty high asset quality and good profitability.

Capital adequacy has traditionally been regarded as a sign of strength of the financial system in Nigeria. A sound banking system is a system in which each bank accounting for most of the system’s transactions are solvent, and meet capital adequacy requirements (Josefsson M 2002). Ensuring the soundness of individual banks – what regulators (Basel committee on Banking supervision) now call the “micro-prudential perspective” is however, only part of guaranteeing a sound financial system. Bank supervisors also talk of the “macro prudential perspective”, (Ryback 2006) outlines the major characteristics of the macro-prudential perspective as follows:

It intends to limit the distress to whole financial systems rather than to individual institutions

Its principal aim is to circumvent large and burdensome costs to the economy such as expensive bank bailout rather than aiming to protect more narrowly the depositors of an individual bank.

It is based largely on the postulation that at least some of the risk faced by the banking system collectively differ from those faced by individual banks. In other words, the risk to the system is not simply the sum of risk to individual banks

It aims to look at risks arising from the interaction banks as part of a financial system rather than on bank-by-bank basis.

In an effort to assess and predicts the possible impact of the Basel ii criterion of capital adequacy of banks in Nigeria financial system, experience is drawn from related literature for the purpose of this study.

2.1 The Basel Accord…………………………………………………………………………………………………………………

The Basel committee on banking supervision introduced in 2006 a new risk-based requirement for international active (and other significant) banks. The new accord is meant to replace the existing Basel I

2.2 Basel II Norms

Basel II is the second of the Basel Accords recommendation on banking laws and regulations issued by the Basel Committee on Banking Supervision. The aim of Basel II is to create an international standard that banking regulators should apply when creating regulations about the level of capital banks need to put aside to guard against the types of financial and operational risks to which the banks are likely to suffer should things go wrong. Expose Basel II is a much broader framework of Banking Supervision. It does not deal with Capital to Risk Weighted Asset Ratio CRAR calculation, but has also got provisions for supervisory review and market discipline.


2.3 Three Pillar Approach

The structure of the new Basel Accord-II(Hubert, E 2004) consist of three mutually reinforcing pillars approach. Pillars I dwell on Minimum Capital Requirement (MCR), while Pillars on Supervisory Review Process and Pillar III stands on Market Discipline. Pillar II and III are expected to complement the requirement of Pillar I

2.3.1 PILLAR I

The first pillar established an approach to quantify the MCR. While the new framework maintains both existing capital definition and minimum capital ratio of 8%, (Hubert 2004) significant changes have been introduced in the measurement of the risks. The MCR is worked out for the combined effort of credit, market and operational risk based on a particular approach. The Basel II Accord provides options to measure the risk in reverence to all the three risks as outlined below:

*Credit Risk

Credit risk is the likelihood that the counterpart fails to honour the financial obligation on agreed terms. There are two approaches for credit risk measurement- the Standardized Approach (SA) and Internal Rating Basel (IRB) Approach. In SA, credit risk is measured in the same method as in Basel I, but in a more sensitive manner, i.e., by linking credit ratings of credit rating agencies to risks of the assets of the individual bank. In IRB approach, banks will be allowed to use their internal estimates of credit risk, subject to supplementary approval to determine the capital charge for a given (Hubert 2004). This world entails estimation of numerous parameters such as the Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Effective Maturity (M) in correspondence to a particular portfolio

*Market Risk

Market risk is the likelihood of loss caused by the fluctuations in the market variable. Banks have the option of two approaches to select from, and they are the Standard Approach and Internal Model Based (IMB) approach. Under the SA, interest rate risk, foreign exchange risk, equity position risk, commodity risk and option risk are the distinct sources identified and the accord provides comprehensive treatment to be adopted by the banks depending on the degree of risk to which banks are exposed for each of these sources. Banks have adopted standardized duration method for calculation of capital charge for market risk from March 2006. And IMB approach allows banks to develop their own internal models to calculate capital charge for market risk by using the notion of value at risk (VaR)

*Operational Risk

Operational risk is defined as the risk of direct or indirect loss as a result of inadequate process or failed internal process, people and systems or from external circumstances. In order to calculate the capital charge for operational risk, three approaches – Advanced Measurement Approach (AMA), Basic Indicator Approach (BIA), and Standard Approach- have been suggested. In BIA, an estimate of the capital charge for operational risk is arrived at by averaging over a fixed percentage of positive annual gross income of the bank over the last three years. In this estimate, negative incomes are excluded under Standard Approach; at first, the banks’ business activities are grouped into eight business lines. For each business line, a capital charge is calculated by multiplying the gross income of the business line by a factor. A capital charge for each business line is thus calculated for three consecutive years. The overall capital charge is calculated as the three year average of the simple summation of the charges across business line in each year. Under Advanced Measurement Approach (AMA), a bank can be subjected to supervisory approval, use its own method for determining capital requirement for operational risk.


Pillar II forms part of the supervisory review process (Hubert 2004). The supervisory review process needs supervisors to ensure that each bank has its sound internal processes in place to assess the adequacy of its capital based on a comprehensive evaluation of its risks. The role of supervisory review process is viewed as a critical component of other two pillars capital requirement and market discipline. The new accord stresses the importance and the need for supervisors of bank to take a comprehensive view on how banks have gone about in tackling the risk-sensitive issues, risk management, capital allocation process etc. this internal process would then be supervisory reviewed and intervention wherever is necessary.


Pillar III guidelines enhance the disclosure requirement with addition of risk management characteristic to the otherwise monopoly of financial number disclosures. Financial statement disclosure is primarily driven by statute and best practices. The Basel Committee has recommended for market discipline in a way of public disclosure so that market participants take well informed decision as far as banks’ risk and capital structure are concerned. Pillar III consists of disclosure on capital structure, accounting policies concerning valuation of assets, features of capital instruments liabilities, assets classification and provisioning income recognition, qualitative and quantitative information on risk exposure and strategic on risk management, CAR calculation as well as related items. This approach enhances the overall transparency and adequate disclosure of the financial reporting system of banks.

2.6 Differences between Basel I and II

Basel I and II are the result of Basel committee which consists of a group of eleven nations. The formation was a result of the liquidation of the Cologne-based bank Herstatt. The committee decided to form a cooperation council to harmonize banking standard and regulations between and within all member states. Their objectives as stated in the founding document of the Basel committee is to extend regulatory coverage, promote adequate banking supervision, and ensure that no foreign banking establishment can escape supervision (international convergence 9)


1998: BASEL I

2004: BASEL II

Focus on single measure capital

Pillar I; minimum capital requirement

Pillar II; supervisory review process

Three pillars

Pillar I; minimum capital requirement

Pillar II; supervisory review process

Pillar III; Market Discipline Requirement

One size fits all

Menu of approaches

Greater of risk sensitivity

The first Basel accord, Basel I was revolution in its own period and did much to promote regulatory harmony and growth of international banking across the region of the G-10 nations and the world alike (Bryan, J 2008). On the other hand, its limited scope gives bank excessive flexibility in their interpretation of its rules and consequently allows financial institution to take improper risk and hold unduly low capital reserves.

Basel II, on the other hand seeks to extend the breath and precision of Basel I, it factors in operational risk, market-based discipline, surveillance and regulatory mandates (Bryan J 2008)


Recapitalization of banks in Nigeria is not a new phenomenon (Adegbaju and Olokoyo 2008). Right from 1958 after the first banking ordinance in 1952 the colonial government then raised the capital requirement for banks especially the foreign commercial bank from 200,000 pounds to 400,000 pounds. Rights from then the issue of bank recapitalization have been a continuous occurrence not only in Nigeria but also generally around the global economics especially as the world continues to witness interdependence among national economies

Recapitalization in Nigeria comes with every amendment to the existing banking laws. Capitalization for banks as at 1969 was N1.5million for foreign banks and N600,000 for indigenous commercial banks (Adegbaju and Olokoyo 2008). Thereafter in 1979, when Merchant banks came on board the Nigeria banking scene, it has a capital base of N2million. As from 1988, there had been continuos increase in the capital base, coupled with the liberalization of the financial system and the introduction of Structural Adjustment Programme (SAP) in 1986

In February 1988, the capital base for commercial bank was raised to N5million (NDIC 2000) while that of the Merchant bank was stood at N3million. In October the same year, it was raised up to N10m for commercial bank and N6million for Merchant banks operating within the country. In 1989, there was a further increase to N20m for commercial bank and N12m for Merchant bank.

In acknowledgement of the fact that well-capitalized banks would strengthen the banking system for efficient monetary arrangement, the monetary authority increased the minimum paid-up capital of commercial and merchant banks in February 1990 to N50 and N40 million from N20 and N12 million respectively. Distressed banks whose capital fell below existing requirement were expected to comply by 31st March, 1997 or face liquidation (Adegbaju and Olokoyo 2008). Twenty-six of such banks comprising 13 each of merchant and merchant banks were distressed in January, 1998. Minimum paid up capital of merchant and commercial banks was raised to the equal level of N500 million with effect from 1st January 1997 and by December 1998, all existing banks were to recapitalize.

The CBN brought into force the risk weighted measure of capital adequacy recommended by the Basle Committee of the bank for International Settlements in 1990. Before then capital adequacy was measured by ratio of adjusted capital to total loans and advances outstanding. The CBN in 1990 introduced a set of prudential guidelines for licensed banks, which were complementary to both the capital adequacy requirement and statement of Standard Accounting Practices. The prudential guidelines, among others, designed the criteria to be used by banks for classifying non-performing loans.

In 2001, when the Universal banking was adopted in principle, the capital base was further raised up to N1billion for existing bank and N2billion for new banks. But in July 2004, the new governor of the CBN announced the need for banks to increase their capital base to N25billion all banks are expected to comply by December 2005.

Prior to the recent reforms, the state of the Nigeria banking sector was very weak. According to (Soludo, 2004, p.19), “The Nigeria banking system today is fragile and marginal. The system faces enormous challenges which, if not addressed urgently, could snowball into a crisis in the near future. He identified the problems of the bank, especially those seen as weak as persistent illiquidity, unprofitable operations and having a poor assets base”

(Imala, 2005) posited that the objectives of banking system are to guarantee price stability and facilitate swift economic development. Regrettably these objectives have remained basically unattained in Nigeria as a result of various deficiencies in our the banking system, these includes; low capital base, as average capital base of Nigeria banks was $10 million which is very low, poor rating of a number of banks, a large number of small banks with relatively few branches, the dominance of a few banks, insolvency as evidence by negative capital adequacy ratios of some banks, weak corporate governance evidence by inaccurate reporting and non compliance with regulatory requirement, eroded shareholders fund caused by operating losses, over dependence on public deposit and foreign exchange trading and the neglect of small and medium scale private savers (Adegbaju and Olokoyo 2008).

The Nigeria banking sector plays marginal role in the development of the real sector. (Soludo 2005) observed that many banks appear to have neglected their essential intermediation role of saving mobilization and inculcating banking habit at the household and macro enterprise levels. The unresponsiveness of banks towards small savers, particularly at the grass-root level has not only compounded the problems of low domestic saving and high bank lending rates in the country, it has also hindered access to relatively cheap and stable funds that could provide a reliable source of credit to the productive sectors at affordable rates of interest.

(Imala 2005) also observed that the present structure of the banking system has promoted tendencies towards a rather sticky bahaviour of deposit rates, particularly at the retail level, such that while banks lending rates remain high and positive in real terms, most deposit rates, especially those on savings are low and negative. In addition savings mobilization at the grass-root level has been discouraged by the unrealistic requirements by many banks for opening accounts with them.

The issue of recapitalization is a major reforms objective; recapitalization literarily means increasing the amount of long-term finances used in financing the organization and increasing capital adequacy ratio (CAR) of banks.

Recapitalization involves increasing the debt stock of the company or issuing additional shares either through existing shareholders or new shareholders or through a combination of the both. It could even take the form of merger and acquisition or foreign direct investment (FDI). Whichever form it takes the end objectives is that the long term capital stock of the organization is increased substantially and significantly to sustain the current economy trend in the global world.

(Asedionien 2004) posited that “Recapitalization may raise liquidity in short term but will not guaranty a conducive macroeconomic environment required to ensure high asset quality and good profitability” in his comment, (Soludo 2004) said that low capitalization of the banks has made them less able to finance the economy and more prone to unethical and unprofessional practices. These include poor loan quality up to 21 per cent of shareholders’ fund compared with 1-2 percent in Europe and America; overtrading abandoning the true function of banking to focus on quick ventures such as trading in foreign exchange and tilting their funding support in favour of import-export trade instead of manufacturing; reliance on unstable public sector funds for their deposit base; forcing their female marketing staff in unwholesome conduct to meet unjustifiable targets in deposit mobilization; and high cost of funds.

Jika (2004) as cited in Aminu and Aderinokun (2004) maintained that raising the capital base of banks in Nigeria would strengthen them and in process deepen activities within the industry. “Growing the Nigeria economy is about the number of banks that have the capacity to operate in all the states of the federation, fund agriculture and manufacturing concerns and in the process generate employment for Nigerians” quoting Alarape (2005) as cited in Ologbondiya and Aminu (2005), “We see a very rosy future beyond the next two years or 2007 when profitability will grow and all the adjustments that the industry needs to go through in the macro-economy including legislation that would be put in place to support the new type of business especially retail banking would have been put in place”

The importance of the financial in an economy which comprises banks and non-banks financial intermediaries, the regulatory framework and the ever dynamic financial products in stimulating economic growth is widely recognized particularly in developmental economics.

(Uboh, 2005), set the pace for the landslide of other works on the interdependent relationship between banks and economic growth. Stressing further that the pioneering shows that financial intermediaries, monetization and capital formation determine the path and pace of economic development.


2.8 Macroeconomic implication of capital adequacy

Quantifying financial soundness within the framework of banking regulation and supervision has generated more questions than answers (Mingo)’. Although soundness is often interpreted to correspond to several measurements of capital adequacy as set out in the Basel Accord, it has equally been observed that capital adequacy depends on the ratio of capital to the risk it should be prepared to absorb (Estraita*, et al Berger’, el al). At least four types of risk exist for banks; interest rate risk (market risk), operational risk credit risk and reputational risk.

Historically, the major area of risk for bank losses exists in credit losses (Cantor, R 2001). Credit risk is difficult to evaluate, an argument can be made that the loan default disclosure alternative for credit risk may also give an indication of operational risk related to management decision making. However, it has been observed that managerial weakness for failed banks include inadequate supervision of loan portfolios and overly insistent strategies for growth in loans and deposits. It is shown in Djiwandono that efforts to strengthen the banking system would be guided by four principles.

*the soundness of a bank is primarily the responsibility of its owners and managers and yet the soundness of a banking system is a public policy concern.

*bank soundness is significantly linked to sound macroeconomic policies

*sound banking framework must include structures to support internal governance and market discipline as well as official regulation and supervision.

*an international cooperation can play a vital role not only in strengthen the global financial system but also in improving the soundness of the national banking system. However, many researches have clearly indicated the close link between banking system soundness and monetary policy. It is sited in Djiwandono that good monetary policy for achieving monetary stability or well, managed macroeconomic policies for achieving growth and stability, cannot be sustainable without the existence of a sound banking system. It is further argued that banking soundness should be treated as an objective for monetary policy together with price and exchange rate stability.

In this view point system bank soundness is now seen as an element of monetary management as a complement to macroeconomic policy in general and as a policy objective in its own right or the pursuit of economic stability and balance.


The Governor of Central Bank of Nigeria, Soludo, after resuming office in 2004 announced a 133 point reform program for the Nigerian banks. The primarily objective of the reform is to meet the Basel II criterion of capital adequacy and guarantee an efficient and sound financial system. The reform are designed to enable the banking system develop the required flexibility to support the economic development of the nation by efficiently performing its function as the pivot of financial intermediation (Lemo, 2005) Thus the reforms were to ensure a diversified, strong and reliable banking industry where there is safety of depositors’ fund and position banks to play active developmental roles in the Nigeria economy.

According to (Soludo 2004) The key elements of the reform programme include:

*Minimum capital base of N25 with a deadline of 31st December 2005

*Consolidation of banking institutions through merger and acquisitions

*Phased withdrawal of public sector funds from banks beginning from July 2004

*Adoption of a risk-focused and ruled-based regulatory framework

*Zero tolerance for weak corporate governance misconduct and lack of transparency

The reform in the banking sector proceeded against the back drop of banking crisis due to highly undercapitalization deposit taken banks, witness in the regulatory and supervisory framework, weak management practice and the tolerance of deficiencies in the corporate governance behavior of banks (Uchendu 2005)

Banking sector reform and capital adequacy have resulted from deliberate policy response to correct apparent or loaning banking sector crisis and subsequent failure. A banking crisis can be triggered by weakness in banking system characterized by persistent illiquidity, insolvency, undercapitalization, high level of nonperforming loans and weak corporate governance, among others.

Similarly, extremely open economies like Nigeria, with weak financial infrastructure can be vulnerable to banking crisis emanating from other countries through ineffectively.

Banking crisis frequently starts with inability of the bank to honour its financial obligation to its stake holders (Adegbaju 2008). These in most cases precipitate runs on banks, the banks and their customers engage in massive credit recalls and withdrawals which sometimes force central bank liquidity support to the affected banks.

Some terminal intervention mechanisms may occur in the form of consolidation (mergers and acquisitions) recapitalization use of bridge banks, establishment of assets management companies to assume control and recovery of banks assets and outright liquidation of non redeemable banks.

Bank capitalization, which is at the core of most banking system reform programmes, occurs some of the time independent of any banking crisis irrespective of the cause, however bank capitalization is implemented to reinforce the banking system, embrace globalization, improve healthy competition, exploit economies of large scale, adopt advanced technologies, raise efficiency and improve profitability. Ultimately, the goal is to strengthen the intermediation role of banks and to ensure that they are able to perform their developmental role of enhancing economic growth, which subsequently leads to improved overall economic performance and societal welfare.

Effects of Foreign Bank Entry on Domestic Banking



During the last one and a half decade, the Indian Banking system has witnessed many changes such as institutional changes, regulatory changes as well as technical changes. These years have also witnesses an increased presence of foreign bank operations in India. During the year 2001, foreign banks occupied about 42% of the total banks and controlled more than 8% of the total assets of India’s banking system (RBI). Among other things the increase in foreign bank operations was due to the fact that since the early 1990s the Indian Government had started implementing financial sector reforms which allowed foreign banks to set up branches and domestic banks to be privatized, that were earlier regulated.

A number of questions are raised due to the increased presence of foreign banks, about their effects on the domestic banking sector. On the positive side, foreign banks entry makes domestic banks less fragile and less prone to crisis, it encourages adoption of best practices in the domestic banking system and stabilizes overall credit market in emerging economies, since domestic banks are highly sensitive to local conditions. On the negative side, foreign banks take the best credits and leave the worst for domestic banks and they tend to increase lending in good times and provide less in bad times. This study aims at empirically evaluating the effect of foreign banks presence on the operations of domestic banks in India, particularly on public sector banks. The selection of only public sector banks for the study is motivated by two reasons:

Prior to 1992, public sector banks operation were heavily regulated than the other domestic banks which resulted in low profitability and low efficiency ; the subsequent banking reforms were aimed at improving their profitability and efficiency by inducing competition and practicing deregulation policies. Allowing more foreign operations was one of them.

Public sector banks were allowed to control more than 70% of the total assets, deposits and branches of the Indian Banking system. The econometric analysis is based on the bank level data for 27 public sector banks for the period 1996-2007. And investigate how foreign bank entry will influence operations of the Indian public sector banks.

This paper presents a review of literature on the effects of foreign bank entry on domestic bank operations. It also explains the methodology employed and the database. Subsequently it presents the empirical results. Finally the paper gives the conclusion.

Review of Literature

In literature, several studies have examined the issue of the effects of foreign bank entry on the domestic financial institutions, markets and the economy as a whole. In the brief literature survey there is a focus on the effects of the foreign bank entry on the domestic banking industry. Several studies have mentioned the potential benefits as well as the costs associated with foreign bank entry for domestic banks.

As far as the arguments on the benefits of foreign bank entry are concerned, studies by a number of researchers have highlighted the advantages of foreign bank entry. The advantages are:

The presence of foreign banks creates a greater competition in the home country that stimulates the domestic banks to reduce their costs, improve efficiency and increase the diversity of financial services.

Since domestic banks have to retain their market share in the presence of the foreign banks, they are pressurized to improve the quality of their services by putting an end to the old style of banking operations.

Foreign bank entry may lead to spill-over effects. To begin with, foreign banks come with new financial services and modern technology, because of their expertise in those areas, and which are new to the domestic banks. The introduction of these services and technologies may stimulate the domestic banks to also come up with such new services for improving the efficiency of financial intermediation.

Foreign banks may also help to improve the management of domestic banks by participating in the stream of takeover or joint venture practices. This may directly or indirectly contribute to help managerial efficiency.

Foreign bank entry may also lead to the development of the domestic banks’ supervisory and legal framework, as these banks may demand improved system of regulation and supervision from the regulatory authorities.

Foreign banks presence may also reduce political influence on the domestic banks since the latter may demand operational freedom to be able to compete with the former.

The presence of foreign banks may also increase the quality of human capital in the domestic banking system either by importing high skilled labor or by training the local employees. More clearly, to start a business either by setting up a new branch or by acquiring an existing domestic bank, a foreign bank requires quality personnel in the domestic country. To meet their needs they may either go for importing highly skilled managers or they may go for training local people. Therefore, this increase in quality of available human capital for the domestic banks will improve the efficiency of the domestic banks as well.

All these effects may lead to more efficient domestic banking practices, which may in turn lead to reduced costs.

There have been a number of arguments on the costs associated with the entry of foreign banks. These have been sided by a number of researchers like Stiglitz (1193), Peek and Rosengren (2000), etc. These studies point towards the following points:

Cost reductions may occur only in the long run, since banks need to invest first in introducing new services, improving the quality of existing services, adopting new management techniques and upgrading their staff

The presence of foreign banks will weaken the domestic banks due to increased competition, the domestic banks will have to compete with large international banks

The presence of foreign banks will diminish the ability of the domestic regulatory authorities to influence the banking sector as well as the economy, since foreign banks are less sensitive to their desires

The presence of foreign banks may also make domestic banks more vulnerable to adverse foreign shocks

The presence of foreign banks may also lead to neglect of the financial needs of the local entrepreneurs, since foreign banks usually concentrate on the multinational firms.

As far as the empirical evidence with respect to the effects of foreign bank entry on domestic bank operations is concerned, it is quite limited and rather mixed.A study using a large sample of 80 countries was conducted. The study showed that the increased presence of foreign banks is associated with reduction in profitability, non-interest income and overall expenses of domestic banks, besides revealing the positive efficiency effects on domestic words. A study by Denizer (2000) where he examined the effect of foreign bank entry on Turkey’s domestic banks, showed that met interest margins, return on assets and overhead expenses of domestic banks decreased after foreign bank entry. The study concluded that even though the foreign banks had a market share in the range of 3.5-5%, they put much pressure on the domestic banks. A study on the Columbian banking system found that foreign bank entry increases competition, deteriorates loan quality and increases intermediation spreads of domestic banks. A study involving 14 developed countries, 8 of which allow foreign bank entry, found that foreign bank entry is associated with lower interest margins, lower pre-tax profits and lower operating costs. Another study examining the impact of foreign banks in Hungary found no evidence to support that foreign bank entry improves performance of domestic banks. A study of the impact of foreign bank entry on the Polish banking sector found that foreign bank entry brought greater competition that led to the Polish banks lowering the total credit supply to the economy, thereby affecting the business environment of the country.

A study reviewing the banking systems of East Asian countries with respect to the effects of foreign bank entry, found that, in Korea, foreign banks compete with the domestic banks and they are not interested in sharing their risk management techniques with the Koreans. The study, in general also observed that foreign banks seem to ‘cherry pick’ the best credit and leave the worst for the domestic banks and are likely to increase lending in good times but decrease it in bad times. Chantapong (2005) examined the performance of domestic and foreign banks in Thailand after the East Asian financial crisis. The study found that profitability of foreign banks is much higher than domestic banks, and the improved competition with greater foreign bank entry provided advantages to domestic banks in technological and managerial adjustments. Using a sample of 48 countries, a study found that the effect of the foreign bank entry depends on the economic development in the host country. At the lower level of economic development, the study found that foreign bank entry is generally associated with higher costs and higher net interest margins, while at higher level of economic development foreign bank entry is negatively associated with costs, profits and net interest margins of domestic banks. A study examined the performance of foreign and domestic banks in the UK and found that domestic banks perform better than the foreign banks in terms of higher net interest margin, higher pre-tax profits and lower loan loss provisions. The study concluded that foreign banks operating in a developed country may not have much impact over domestic bank operations because of certain explicit or implicit barrier such as organizational diseconomies of operating or maintaining an institution from a distance, difference in language, etc. A study by Peria and Mody (2003) analyzed the impact of foreign bank participation on bank spread in Latin America and found that foreign bank entry is associated with higher competition, lower costs and lower spreads.

The above literature review reveals the following research gaps:

The empirical findings of these studies disclose rather inconclusive or mixed findings as some of the studies reveal the positive effects and some find negative or indifferent effects of foreign bank entry on domestic activities

The majority of the studies concentrate on banking systems of the developed countries such as the US and Europe, where the effect may differ

Such studies in emerging countries like India are rare; infact not even a single study exists with respect to the Indian banking system. Therefore, the present paper attempts to deal with this issue in depth. The findings may have policy implications for regulatory authorities on allowing more foreign bank operations in India.

Methodology and Data

The empirical analysis aims at examining the effects of foreign bank entry on the operations of the public sector banks. To examine this issue, we first need variables that account for the presence of foreign banks in the country. The measure FB_SHARE, that is, the ratio of the number of foreign banks to the total number of banks in the country, reflects the intensity of the foreign banks’ presence.

Next, we need variables that reflect operations of public sector banks. The following variables are used to measure the income, profitability and costs of the public sector banks:

Net interest margin to total assets (NIM)

Non-interest income to total assets (NINTINC)

Profits before tax to total assets (PROF)

Overhead expenses to total assets (OVERHEAD)

Non-performing loans to total loans (NPL)

The first two ratios show the accounting value of the bank’s income. In order to reflect the profitability of the bank, PROF is considered. The last two ratios show the costs of banks in the form of entire overhead and bad loans. Changes in these variables may be associated with changes in the presence of foreign banks through competition and/or efficiency.

The model is defined as :

Δπit =α0+βΔ FB_SHAREt +ϒΔBSit +ΔδMEt + εit


πit is the dependent variable (e.g. NIM or PROF) of interest for bank i at time t;

FB_SHAREt is the share of the foreign banks at time t;

BSit is a set of bank-specific control variables for public sector bank I at time t;

MEt is a set of macroeconomic control variable at time t.

α,β,ϒ and δ are coefficients to be estimated

The above model is estimated by Ordinary Least Squares (OLS) method.

In order to capture the structural characteristics of the bank, we include the following bank-specific variables as control variables:

Capital: The ratio of book value of equity capital to total assets, which captures the strength of capital in the bank. It expected the higher the ratio, lower the need for external funding and therefore higher the profitability. On the other hand, holding large equity ratios either on a voluntary basis or as a result of regulation can be costly for banks. Therefore, the expected relationship between capital and dependent variables are unpredictable.

Deposits: The ratio of total deposits to total assets. Deposits are the main source of funds for banks. Higher the deposit ratio, higher is the availability of funds for the bank. If a bank is able to turn those deposits into earning assets, then the bank income will increase. On the other hand, holding large deposit ratios either on a voluntary basis or as a regulatory requirement (eg. Cash reserve ratio) can be costly for banks. Moreover, pressure of large deposit ratios may lead to indiscriminate bank lending which may result in high non-performing loans. Therefore, again, the expected relationship between deposits and our choice of dependent variables is unpredictable.

Liquidity: The ratio of non-interest earning assets (such as cash in hand, balances with the RBI and balances with other banks) to total assets. High liquidity ratios, either self-imposed for prudential reasons or as a result of regulation (eg. Reserve or liquidity requirements), impose a cost on banks since they have to give up holding higher-yielding assets. The kind of relationship this variable will have with our dependent variables depends on what extent the banks are able to transfer this opportunity cost to borrowers. Therefore, again this relationship is uncertain.

Overhead: The ratio of overhead expenses (such as payments to and provisions for employees) to total assets. It reflects employment as well as total amount of wages and salaries and is an indicator of the management’s ability to control personnel expenses. This variable is expected to have a negative impact on the bank’s income and profit variables because efficient bank management is expected to operate at lower costs.

In order to capture the macroeconomic environment in the country we also include the following macroeconomic variables as control variables:

GDP Growth: The annual growth rate of Gross Domestic Product (GDP). In the short run the level of economic development may play a role in determining the effects of foreign bank entry on the domestic banking system. This is because, less developed countries generally have under developed financial systems and lower levels of human capital. Therefore, there may be room for the improvement of domestic banking practices when foreign banks enter the market. This may have positive effects on the operations of domestic banks in the long run. However the short-run costs may increase and the lower the level of economic development, the greater the short run costs.

Inflation: The annual rate of inflation estimated using the GDP deflator. Inflation will raise both costs and revenues of banks. Higher inflation affects banks by making it difficult for banks to adjust their operating expenses with rising inflation. However, the effect of inflation on banks; performance depends on whether banks’ expenses rise faster than the revenues , which in turn depends on to what extent an economy is matured to predict the upcoming inflation. Therefore, the relationship between inflation and the choice of the dependent variables is uncertain.

Interest: The real rate of interest is defined as annual interest rate on government securities minus annual inflation. Higher interest rates are associated with higher interest margins, especially in developing countries, where demand deposits frequently pay zero or less than market rate of interest rates. On the other hand, higher interest rates also increase the cost of borrowing in the market. Therefore, again, the expected relationship with my choice of dependent variables is uncertain.

This study consists of a panel of 27 public sector banks with a total of 324 observations for the period 1996-2007. All the statistical data was obtained from the Annual Accounts Data of Scheduled Commercial Banks, Statistical Tables relating to Banks in India, reports on Trend and Progress of Banking in India, published by RBI.

Results and Discussion

The summary statistics of the selected banks are given in Table 1. Mean value of variables indicate that public sector banks, on an average, have around 3% of net interest income margin; about 2% of non interest income; about 1.77% of overhead expenses; about 2.15% of equity capital; around 84% of deposit sand about 10.73% of liquid assets to their total assets. Public sector banks on an average, get about 0.63% of returns on assets and some of the banks also experience negative returns. Public sector banks, on an average, have about 5.85% of non-performing loans in their total loans and some of the banks have very high non-performing loans. Mean value of foreign bank share indicates that the foreign banks account for more than 38% share in Indian banking system. The mean values of GDP growth, inflation and real value of interest indicate that the Indian economy annually, on an average, evidenced about 6.45% of growth in GDP, about 5.75% of inflation and about 4.4% of real interest rates, respectively. Standard deviation of variables indicated that there is a very slight variation in the dataset and it is slightly higher in case of non-performing loans to total loans, deposits total assets and foreign bank share.

Table 1: Summary Statistics



Std. Dev.



Net Interest Income/TA





Non Interest Income/TA










Return on Assets





Non-performing Loans/TL





Foreign Banks Share










Deposits/ TA










GDP Growth










Real Interest Rate






The OLS estimates of Equation (1) are presented in Table 2. To see if the specified model is valid we conduct diagnostics tests and the results are as follows: statistical significance of F-test is all the specifications support the overall significance of the model; failure to reject the null hypothesis of RESET supports that the model specification is adequate; and failure to reject the null hypothesis of White’s test reveals that residuals are white noise.

Table 2: Regression Results on Change in Foreign Bank Presence and change in Public Sector Bank Performance


Panel 1

Panel 2

Panel 3

Panel 4

Panel 5

Δ Net Interest Margin / TA

Δ Non Interest Income / TA

Δ Return on Assets

Δ Overhead / TA

Δ Non-Performing Loans / TL


ΔForeign Banks Share

ΔCapital /TA




ΔGDP Growth


ΔReal Interest Rate

Adj R2

F-Statistic (p-value)

RESET (p-value)

White test (p-value)


The results indicate that the foreign bank entry is significantly associated with an increase in public sector bank profitability (Panel 3), overhead expenses (Panel 4) and non-performing loans (Panel 5). Foreign bank entry seems to have negative effects on net interest margin and non-interest income of public sector banks. However the results do not reveal any statistically significant relationship of net interest margin and non-interest income with foreign bank entry. The results imply that foreign bank entry is associated with greater profitability in public sector banks. This high profitability may be due to increasing competitive conditions in the banking industry with increasing presence of foreign banks. The high overhead expenses may reflect managerial inefficiency and stubborn organizational structures. More clearly, public sector banks feel much pressure from the re-structuring of the entire financial system due to foreign bank entry and increasing competition. This increase in competition forces public sector banks to upgrade their inferior personnel skills to compete with technologically advanced and service efficient foreign banks in order to retain their market share. For this, the public sector banks need to invest in training their managers, which results in increasing overhead expenses. Higher overhead expenses may also be due to the payment of higher salaries on par with the foreign banks to employ skilled managerial personnel. In the long run, foreign bank entry may enable public sector banks to reduce costs as they incorporate many superior practices of foreign banks and foreign banks may force public sector banks to give up their protected ‘quiet life’ and may stimulate them to reach cost-efficiency. The higher non-performing loan may be due to the fact that foreign banks usually lend more to multinational firms and neglect small entrepreneurs and priority sectors. With government intervention, public sector banks lend to these neglected sectors at low interest rates or subsidized interest rates which not only decreases the interest income of public sector banks, but also results in higher default rates since these sectors are less developed and more vulnerable to seasonal factors.

Turning to control variables, capital and deposits are positively associated to profitability. Liquidity is negatively associated to the net interest margin, non-interest income, profitability and overhead expenses. Overhead expenses are positively associated to net interest margin and negatively associated to profitability. We interpret these results to mean that higher capital and deposits will increase profitability of public sector banks. Other factors remaining constant, holding higher liquidity may adversely affect the bank’s income and profitability since the assets lie idle in the form of required reserves. Interestingly, we find that higher liquidity reduces overhead expenses of public sector banks. A higher overhead expense increases net interest income. This may be due to the fact that higher provisions and salaries to bank personnel stimulate and motivate employees to use their abilities efficiently in collecting deposits and keeping them in high return loan portfolios and they may also follow standard monitoring practices which help the banks to improve their interest margins.

Turning to macroeconomic control variables, growth rate of the economy is positively associated to the net interest margin and overhead expenses and negatively associated with non interest income. Inflation is positively associated with the profitability and the overhead expenses and the rate of interest is positively associated to the non-performing loans. These results indicate that during economic prosperity, banks may get numerous opportunities to increase their interest incomes and increasing incomes with rising economy will also put pressure on overhead expenses. Moreover, contrary to the earlier studies, we find that as the economy grows, costs of banks increase and incomes decline, as evidenced by increasing overhead expenses and decreasing non- interest income. It is also evidenced with negative sign in the profitability equation; although it is not statistically significant. The result implies that there is much room for public sector banks to improve their profitability and efficiency and the entry of foreign banks increases the costs of public sector banks. Further, a higher inflation not only leads to higher profits but also to more overhead expenses; higher interest rates lead to more default loans


This paper investigates the effect of foreign bank entry on the operations of public sector banks in India. The empirical results reveal that foreign bank entry usually increases competition in the banking industry as is evidenced by increasing profitability of banks. The increased competition seems to be deteriorating the loan quality as evidenced by increasing default loans. Foreign bank entry also increases the overhead expenses of public sector banks. Besides foreign bank presence is negatively associated with net interest margins and non-interest income of public sector banks, even though the relationship is statistically weak. Therefore, the empirical results, in general, suggest that foreign bank entry in the Indian banking system adversely affects the operations of public sector banks.

Financial Liberalization and Bank Efficiency in China


Financial liberalizations have been implemented in developing countries for several decades, bringing substantial changes for banking sectors against excessive government restrictions. Consequently, the sector has acquired more autonomous rights, less state-controlled, broad access to foreign banks and private institutions, and restructured national banking systems as well (Fry, 2005). As a result, numbers and types of financial institutions are both increased and banking sectors are more competitive. As Williams and Nguyen (2005) state, banks should be more efficient under competitive environments, reducing costs and increasing revenue, hence, coordinating limited resources effectively.

Both the economic growths in China and India are tremendous over the last decade and have been taking more important roles in globalization of trade. To boost internal liberty and external competitiveness in banking sectors and to provide stable capital resources for the overall economic constructions, the financial liberalizations have been implementing for several decades. In china, the promulgating of “Reform and Open up” policy in the late 1970s symbolizes the beginning of economic reform. The reform then speeded up in the early 1990s. In the meantime, Indian carried out their comprehensive economy reforms as well. As the two countries successively entered WTO, reforms measures are put an emphasis on generating a competitive banking system as the entry of foreign banks and more liberalized financial environment.

A great deal of empirical focuses has been put on exploring the effects of economic policies conducted on the financial market as well as the practical results (Jayaratne and Strahan, 1996, Wurgler, 2000, Beck et al., 2000, Levine, et al., 2000). Summarily, there are mainly two purposes. One is to seek a better way to establish a more sustainable and healthier financial system, which could possibly lead to an economic growth. The other is to protect the development of financial market as expected by every level of society. As studies reveal that, economic growth in developing countries is highly positively linked to more efficient financial market (King and Levine, 1993; Beck et al., 2005; Jappelli et al., 2005). There are also findings suggest that the growing up of financial infrastructure requires banks to have stability to support the development, such loans, credit scores, collateral (Berger and Udell, 2006).

In recent years, parts of researches are conducted to consider the effect of financial liberalization on bank efficiency in emerging economies. These studies examine the relationship by comparing bank efficiency before and after the initial financial reforms. The results are mixed. Some indicate significant improvements in banking efficiency have been achieved when comparing with the pre-reform period. While others show the performance of banks does not become better. Some studies have extended the research method with a two-step procedure. In the first step, bank efficiency scores are measured and then, by employing a censored regression, a set of explanatory variables are regressed, such as a dummy variable representing the reform and a number of bank-specific variables as well (Hao et al., 2001; Lski and Hassan, 2003; Ataullah et al., 2004).

As a follow up study, this paper conducts a comparative study by estimating commercial banking industry after the financial reforms in China and India. While most previous studies present the effect of financial liberalization as a whole by using all the variables relevant, this paper employs two components of the financial reforms, the improvement of competition level and the appearance of foreign banks, to estimate the effect on bank efficiency.

With this purpose, the analysis is divided into two procedures. First, utilizing the approach of Bhattacharyya et al., (1997) and Ataullah and Le (2006), Data envelopment analysis (DEA) technique is employed with a common “grand frontier” to make a comparative analysis for the two countries. The data covers 2003 to 2008, which is a crucial post-reform periods for both of the countries. The efficiency scores are measured by two-stage input-output models, a combination of a loan-based model and an income-based model. Finally, ordinary least squares are applied to examine the correlation between the DEA and two factors of financial reform elements as mentioned above. Furthermore, a set of internal bank-specific characteristics are included in the regression, bank size, operating expenses, return on assets (ROA)

The results suggest

Main empirical focus is put on the influences of minority foreign ownership and competition level in China and India. The results manifest that

To address these issues, the rest of the paper are structured with parts: section 2 displays main procedure and characteristic of the financial reforms in China and India, especially putting an emphasis of the entrance of foreign ownership. Section 3 reviews empirical researches on the relationship between financial liberalization, bank efficiency and performance in emerging economies, particularly China and India. Section 4 describes the methodology and data. Section 5 presents the empirical results, and Section 6 demonstrates the empirical findings. Section 7 concludes.

Literature review

In recent years, considerable exhaustive surveys of literatures examining banks efficiency and performance exist. Meanwhile, topics relevant are fairly broad and embedded. While some studies focus on determinants of efficiency such as size, capitalization, profitability, loans to assets (Casu and Girardone, 2004; Ariff and Can, 2008; Fethi and Pasiouras, 2009), abundant literatures pay attention to the relationship between bank efficiency and macro-economy under different economic and political systems throughout the world. The fields of macro-economy involve stock returns (Beccalli et al. 2006; Kirkwood and Nahm, 2006), bank ownership (Isik and Hassan, 2003a; Sathye, 2003), mergers and acquisitions (Wheelock and Wilson 2003; Hahn 2007a) and regulation liberalization (Ataullah and Le 2004; Chen et al., 2005) as well. Berger and Humphrey (1997) conducted an excellent review to consider the relationship between financial deregulation and the efficiency and productivity of bank operating. However, it’s still necessary to penetrate into the studies referring to emerging economies.

2.1 Financial liberalization, bank efficiency, and productivity in emerging economies

Since early 1980s, financial liberalizations have been implementing in many developing countries. It’s fairly obvious that studies about its impact on efficiency and productivity became more concerned since late 1990s. A certain number of studies make hypotheses that regulatory reforms have a positive relationship with bank efficiency and productivity. It is postulated that deregulation encourages more competitive and flexible environments, under which banks pay more attention to the operations.

However, globally, empirical evidences are mixed. In Turkey, Yildirim (2002) applied non-parametric DEA to measure technical efficiency of banks from 1988-1999 and the result shows that the efficiency after deregulation is not sustainable. In contrast, Isik and Hassan (2003b) concurred that a positive relationship exists between liberalization and banks’ X-efficiency, examining DEA of Turkish banks between 1980 and 1990. Gilbert and Wilson (1998) discover that as to comply with privatization and regulation reform in early 1990s, Korean banks essentially modified the mix of inputs and outputs, meanwhile, made a combination with advanced technology, and hence, effectively promoted productivity of banks. In contrast, Hao et al. (2001) confuted the findings of Gilbert and Wilson (1998) with a time invariant data, which from 1985-1995. By using a parametric Stochastic Frontier Approach (SFA), the researchers found that the financial reforms in Korea made little or no contribution to Korean’s bank X-efficiency. In addition to this, Hao et al. (2001) pointed out that the positive relationship may exist intertemporally and could also just be in a short-term. Moreover, the authors illustrate relationships between ownership and bank efficiency. The study indicates a positive relationship between bank efficiency and the numbers of foreign banks and it reveals a negative one when related to the amount of state-owned banks.

Ataullah and Le (2004) point out that financial liberalization is beneficial for foreign banks to conquer the barrier of being “foreignness” and promote the efficient use of resources. With the increscent amount of foreign banks in banking system of emerging market, it is believed that superior practices of management and technology are brought to banks in developing countries, which affirmatively enhance efficiency and productivity (Clasessens et al., 2001). In accord with the observation, Isik and Hassan (2003a) demonstrate that foreign banks in Turkish have better efficiency in bank operating than private domestic banks. Later on, Isik (2008) estimates TFP growth and the results support the previous findings. Similarly, Leightner and Lovell (1998) find that state-owned banks were less productive than foreign banks in Thailand.

2.2 Financial liberalization and bank efficiency in China

Studies exploring financial reform and Chinese bank efficiency in China are relatively limited and the results are mixed and contradictory. However, bank ownership is a common topic in most literatures investigating Chinese banks.

Chen et al. (2005) examine the effect of reforms initiated in 1995 on bank efficiency. 43 banks’ panel data are used to examine the efficiencies of cost, technology and allocation, covering the period 1993-2000. It is revealed that Big Four banks, which is state-owned and smaller joint-equity banks are both more efficient than medium-sized banks in cost. Meanwhile, with the reform, deregulation made a positive effect on bank efficiency.

On the contrary, it is continuously proved by a certain amount of studies with different approaches that state-owned banks are less efficient than smaller-sized banks in China. Applying an input distance function which covering a longer time period, 1993 to 2002, Kumbhakar and Wang (2005) demonstrate that relatively small scale banks are more efficient than Big Four banks. The study also indicates that deregulation doesn’t significantly promote bank efficiency. Consistent with the findings of Kumbhakar and Wang, Fu and Hefferman (2006) explore the cost X-efficiency in china from 1985-2002, by using a stochastic frontier approach. As the research shows, state-owned banks are less efficient than joint-stock banks. However, the first period of bank reforms, cost efficiency is higher.

Besides, Berger et al. (2009) estimate the change of ownership’s structure of Chinese banks and its effect on bank efficiency in China between 1994 and 2003. The study enlarges the concept of profit efficiency by embracing revenues and loan performance, instead of costs only. Moreover, as an emerging market, the effect of the entrance of foreign ownership on Chinese banking system is also checked. The results show that large state-owned banks are the least efficient of all the types of ownerships while foreign banks come out on top. Furthermore, a small number of foreign ownership prominently promotes the enhancement of bank efficiency as a whole.

There are two apparent characteristics in the studies about financial reform and bank efficiency and productivity. First, the results are considerably mixed. It is not necessarily that financial liberalization and deregulation give rise to the enhancement of bank efficiency and productivity. To a great extent, the results of reforms depend more on industry conditions than deregulation, fluctuating in different countries and also diverse reform levels (Fu and Heffernan, 2007). Secondly, there is only a small quantity of cross-country studies. It’s regrettable that until now there are no cross-country about Chinese bank efficiency and financial reforms. Lots of valuable information could be supplied by cross country studies, such as bank competitiveness in different countries, which is fairly important in the financial world with globalization (Berger and Humphrey, 1997).

2.3 Financial liberalization and bank efficiency in India

Although literatures about bank efficiency in India are productive, topics considering the relationship between financial reform and the change of bank efficiency are limited. While a little amount of the researches explore the relevance, the studies are presented either in pre-liberalization period, such as Bhattacharyya et al. (1997) or in post-liberalization period, like Sathye (2003) and Tabak and Tecles (2010). There are three studies examines the impact of financial reform. Interestingly, the results are mixed.

By using a translog cost function, Kumbhakar and Sarkar (2003) examine TFP growth of 50 banks in India from 1985-1996. 27 of the banks are private domestic banks and 23 are public sector banks, while no foreign banks are included. The evidence show there are little evidence show the reform facilitates bank productivity, particularly in state-owned banks.

By employing DEA, Atalullah et al. (2004) conduct a comparative analysis of India and Pakistan to examine the relationship between financial liberalization and bank efficiency. The study shows after the implement of reform, bank efficiency in both countries increased. Hence after, Atalullah and Le (2006) examine the effect of economic reform on bank efficiency. The reform comes down to three aspects, fiscal reforms, financial reforms and private investment linearization. The research conducted with a two-stage model. On the first stage, use DEA to analysis the relationship, and on the second stage, censored regression is used as the OLS and the GMM to examine the DEA scores. It is revealed that financial liberalization (economic reforms) positively promotes the increasing of bank efficiency.

Banking system and financial liberalization in China and India

China and India are fairly similar in economically and physically. Both have experienced tremendous growth rates over the last two decades. Since 1980, GDP of China and India grow at annual rates approach to 10% and 6%, respectively. Even after the Asian financial crisis in 2007 and global recession since 2007, China and India still keep a strong momentum of with positive growth while in most of western countries, negative GDP rates and sluggish markets. Some studies indicate that the growth capacity are strong and will be definitely continued in the two countries.

It is generally accepted that financial intermediaries effectively influence the growth of economy by coordinating limited financial resources in the economic market (Levine, 1997). Reflectingly, Fry (1995) demonstrates that as a matter of fact, it is commercial banks that play a vital role in all of the financial intermediations other than financial institutions and markets, which undertake an inessential mission in developing countries. The importance of commercial banks reveals that it’s extremely crucial for authorities of developing countries to ameliorate the economical environment which promote the bank efficiency and in return, enlarge the volume of intermediation and strength service and product quality (Ataullah and Le, 2006).

The history of banking system in China and India contribute to understanding of the general pattern of financial reforms in the two emerging economies.

3.1 China

In China, the financial reform and the change of banking system can mainly be divided into three parts.

3.1.1 1979-1992

Before 1978, China implemented socialist economic and financial system. People’s Bank of China (PBOC), the central bank, takes the role of issuing currency and the Economic Plan in each state. Since 1978, aiming to promote economic efficiency and optimize resource allocation an economic reform, China bring an economic reform into force and banking system. Naturally, the banking system was the focus of the significant, however, gradual reforms. To support the PBOC and the Big Four, in 1978, several large state-owned commercial banks were established. In 1985, the Big Four state-owned banks [1] , the Bank of China (BOC), Agricultural Bank of China (ABC), China Construction Bank (CCB) and Industrial and Commercial Bank of China (ICBC). Between 1985 and 1992, the Big Four were authorized to compete in all sectors and small and medium sized commercial banks were allowed to provide deposits and loans services to households and corporations. Thus, the first stage ended in 1992.

3.1.2 1992- WTO Entry in December 2001

The second stage started in 1993 until present. It is announced in the document “Decision on Financial System Reform” (Almanac of China’s Financial and Banking, 1994). One object of reform was to establish a competitive environment for commercial banks, in which state-owned coexist with other financial institutions. Hence, large quantities of reform measures were put into effect.

In 1990s, most of the loans from banks were allocated to state-owned enterprises (SOEs), which led to large of assets exacerbated. On one hand, SOEs were basically had no intend to repay. On the other hand, there is no specific deposit insurance and it’s pervasive that Chinese government stepped up to help the banks with financial problems, writing-off their bank loans or paying off the outstanding debts, so as to avoid the bank failure. In order to mitigate the deterioration of assets and improve the quality, in 1994, three policy banks were set up to take over the national projects from state-owned banks. In 1998, 270 billion RMB (US ¼„32.6 billion) government bonds for 30 years were released to raising capital for the Big Four.

In 1995, two reforms with legal restrictions were carried out. PBOC was approved by “The 1995 Central Bank Law of China” as have the role of central bank and the power of local government to allocate the credit were weakened in substance. “The 1995 Commercial Bank Law of China” determined the nature of state-owned banks as commercial banks and pointed out the operate direction is commercial business. It shows a preference to market principles rather than policy oriented.

Before 1994, only in Shenzhen, a Special Economic Zones, could foreign banks open several branches and the restrictions of aspect of area. After that, foreign banks were permitted to operate in 23 cities and the scope of business extends continuously. At the end of 1999, total assets reached to 272 billion RMB (US ¼„32,844 million).

While concern of bank taxes, as Xu and Zhang report (1995), there is no explicit uniform tax laws, corporations made a contract with government about the tax. The reform started in 1994 and in 1997, a 33% tax rate was settled down for all commercial banks.

3,1.3 After WTO entry

A series of new reforms measures were established after the entrance of WTO in December 2001 and some original regulations were revised to adapt to the requirement of WTO. In line with the agenda, interest rate should be more liberate, tax rates should be fairer to all the players, loosen the restriction to M&A and ownership control and more freedom of Chinese banking industry scope, both in operation and geography.

The Big Four are realized partial privatization by accepting a portion of foreign ownership. Bank of America and Singapore investment firm owns 9% and 5.1% shares of CCB. Royal bank of Scotland and Temasek both enjoy 10% stakes separately of BOC in 2006. For ICBC, three foreign banks reached a deal to share 10% stakes in total with ¼„3.78 billion. Moreover, as one of the shareholder, Goldman Sachs offers employee training, assists risk control and direct in internal controls and corporation supervision.

Furthermore, to improve the efficiency of banking operating, Chinese banks are encouraged to have its stock listed so as to be monitored externally. Since 2005, Big Four banks have realized listed one after another, inside or outside mainland China. Notably, even the shares are issued in Hong Kong or other areas outside the mainland China; it is not subject to the foreign ownership with limitation of 25%.

3.2 India

In India, the main development process of banking industry can be divided in two periods, one is from 1950s to 1990, and the other period is post-crisis period, after the financial crisis from 1991-1992 in India, a magnitude of reforms have been done which produce the modern banking system of India today.

3.2.1 1950s-1990

Before 1950s, there was considerable limited government control in Indian financial system. Nevertheless, restrictions by the Reserve Bank of India, the central bank, were exerted gradually, yet, severely in the 1960s. The main implement was the control of interest rate. After noticing the inequitable distribution of bank credit, the government tightened its control over the credit allocation process. The statutory liquidity ratio was raised from 25% in 1966 to 38% in 1989.The cash reserve rate increased considerably from 3% to 15% during the same period. These high liquidity and reserve requirements enabled the Bank to purchase government securities at low cost. The extent of directed credit programs has also increased significantly since the nationalization of the 14 largest private banks in 1969. A number of priority lending rates were set at levels well below those that would prevail in the free market. This process culminated in the late 1980s when directed lending was more than 40% of the total.

3.2.2 After 1991-1992 financial crisis

The major phase of financial liberalization was undertaken in 1991 as part of the broader economic reform in response to the balance-of-payments crisis of 1990–91.The objective was to provide a greater role for markets in price determination and resource allocation. Consequently, interest rates were gradually liberalized, and the reserve and liquidity ratios were reduced significantly. However, despite this liberalization, the Indian financial system has continued to operate within the context of repressionist policies through the provision of subsidized credit to certain priority sectors. Liberalization of the directed credit programs is only limited to deregulation of priority lending rates, whilst significant controls on the volume of directed lending remain in place. Furthermore, the Bank has tightened supervision and regulation in recent years to ensure that these priority sector requirements are met.

Research Methodology

4.1 Methodology statement

A series of methods have been employed in banking performance assessment (Bauer et al., 1998), which can be mainly divided into two categories. One category is parametric approach, which is on basis of econometric techniques. The method is usually involved with estimation of a presupposed stochastic production, cost or profit function and the derivation of the measured scores by confirming whether it’s from residuals or dummy variables (Bauer et al., 1998). Stochastic frontier analysis is a popular application of this technique. In this approach, each decision-making unit (DMU) corresponds to a single optimized function.

While in another category of methods, on the contrary, performance measure of DMU is optimized. The non-parametric approach does not demand a specific function for the frontier. It is a piecewise linear program, in which an actual function envelops all the data in the sample (Thanassoulis, 2001). With such a function, efficiency scores can be measured by estimating the distance between the observations and the ‘envelope’ and the possibility of misspecification in the process of setting production function could be ruled out (Bauer et al., 1998). Data Envelopment Analysis (DEA) is representative for the method.

Both of the techniques hold strength and weakness. The parametric approaches allow the existence of noise when measuring efficiency scores; nevertheless, a specific functional form or abnormal efficiency distribution, such as exponential, gamma and half-normal distribution should be applied (Isik and Hassan, 2003b). While referring to the non-parametric approaches, though no pacific function or distribution of efficiency is required, two shortcomings are obvious. It is assumed the data measured without error and statistical noise. In addition, the technique has a large sensitivity to outliers (Berger and Mester, 1997; Yildirim, 2002). While numerous studied are conducted with the measurement of bank efficiency with different frontiers, it still cannot be conclude that which approach is exactly the best-practice frontier.

In this paper, a two-step procedure is employed to evaluate the effect of several elements of financial liberalization on bank efficiency. In the first step, the efficiency scores of commercial banks in China and India are measured by the Data Envelopment Analysis (DEA), covering 2002-2008. In the second step, the scores are regressed with a variety of variables in internal and external of bank sectors using OLS estimations to obtain a more veracious result.

4.1.1 Step 1— efficiency estimation by DEA

The DEA is applied to measure the efficiency of commercial banks in India and China during 2002-2008. DEA can be carried out by supposing constant returns to scale (CRS) or alternatively, variable returns to scale (VRS). Charnes et al. (1978) put forward a DEA model to estimate the overall technical efficiency (OTE) of banks, assumed CRS. However, it is debated that CRS is only applicable when the optimal scale is offered to all firms. As Coelli et al. (2005) propose, in real markets, a series of adverse factors obstruct a firm’s operation at optimal scale, such as imperfect competition, financial restriction and government regulations, etc., among others. Therefore, Banker et al. (1984) post variable returns to scale (VRS). In imperfect market, using CRS will lead to measurement error of technical efficiency (TE), in which scale efficiency (SE) contains. However, by using VRS, efficiency scores can be divided into two components, pure technical efficiency (PTE) and scale efficiency (SE). Hence, TE wouldn’t be affected by SE. SE is the difference between VRS TE and CRS TE, so SE can be regarded as a “residuals” (Coelli, 1997).

By using DEA, the best-practice production frontier of a sample of firms is structured through a set of correspondent input-output data with piecewise linear combination. This linear combination envelops all the firms with correspondent input-output data in the sample (Thanassoulis, 2001).

Following Bhattacharyya et al., (1997) and Ataullah and Le (2006), a single “grand frontier” is constructed to envelop the pooled input-output data of all the banks throughout the years in the India and China, covered in the study, that is, from 2002-2008. A best-practice benchmark is provided by this grand frontier. The efficiency of each bank in each year is measured against this benchmark. It is proposed that if the financial liberalizations have improved the bank efficiency, the efficiency scores will have a trend of increase. That is, the most efficient observations are of recent vintage.

Two advantages appear when using grand frontier approach. The key benefit is that trends of bank efficiency can be revealed with aggregated data which would not be available if the data is measured annually due to the benchmark are capable of changing in every year. The other advantage of applying the grand frontier instead of annual frontiers is that the former approach allows “an increase in degrees of freedom” which is extraordinary important for the efficiency measures using the DEA.

There are two main reasons for the employment of DEA in this paper. First, some existing studies exploring bank performance and efficiency have already use parametric techniques the measurement the situation of India and China. Hence, it’s worthy of exploring the effect of financial liberalization on the bank performance in China and India by DEA calculation so as to estimate whether the results support the previous studies. Second, Bhattacharyya et al. (1997) indicate that input/output prices may possibly be distorted attribute to the regulations and market imperfection in developing countries, especially excessive reform regulations on banking industry in the past decades. Therefore, employing parametric approaches may result in increased complexity of the cost and/or profit function measurement.

It is also feasible to acquire the efficiency trends by constructing a Malmquist (1953) productivity index, an approach which is generally used to reveal the tendency of change for bank productivity. Though the grand frontier approach is relatively less used, the single benchmark it provides contributes to a clearer trend throughout time. In consideration of the environment of reforms in China and India which features interim and transformable in a long term, the grand frontier approach is a better choice.

To measure the efficiency of banks, let the input data for commercial banks in the two countries be represented by

Where f = 1, 2, 3, … , F indexes banks, t = 1, 2, 3, … ,T indexes time periods, and, j = 1, …, J indexes inputs that banks in the two countries employ.

Let the output data be represented by

…, …,)

Where k = 1, 2, 3,…, K indexes outputs that banks in the two countries produce.

Then, the pooled production possibility set R for all the banks included in the years covered for the two countries can be represented as

R = { ( ,):

k= 1, 2, 3, … , K

j = 1, 2, 3, … , J

f= 1, 2, 3, … , F; t = 1, 2, 3, …, T

=1} (1)

Where the are intensity variables enable the production of convex combinations of observed ( , ). R represents the production technology, showing variable returns to scale and disposability of inputs and outputs.

To obtain the efficiency score of banks, it is presumed that banks pursue output maximization, given the inputs at their disposals. An output-oriented efficiency of each bank f in year t, E ( ,), is measured as the reciprocal of the solution to the DEA problem:

Max = [ ]-1 (2)

Subject to

, k = 1, 2, 3, …, K,

¼Œ j = 1, 2, 3, …, J,

0, f = 1, 2, 3, …, F, t = 1, 2, 3, …, T

= 1

The efficiency scores could be acquired once with each bank, countries and year. should be scaled up in sequence for bank with data ( , ) by the optimal value of . By so, the convex production frontier can be reached. Because of 1, it can get that 0 1. For example, 0.9 efficiency score of a bank indicates that the bank only produced 90% of the output should be produce, if the best practice in the industry was taken as the standard.

4.1.2 Step 2— OSL estimation by regression analysis

While the bank efficiency of the post-reforms period in China and India are measured, in the second step, factors crucial in the financial liberalization in both countries are examined so as to explore the effected factors to the variances of the scores.

The following model is used to generate a regression function:

= f ( ) (3)

Where stands for the technical efficiency of f-th banks in t-th time period with output orientation. represents the set of bank-specific variables with P factors. is the set of macroeconomic variables in financial liberalizations with Q elements. As mentioned above, the value of ranges from 0 to 1, so that Hao et al., (2001) demonstrate that it’s possible to use the logistical function for model (3) as:

= (4)

Where and are vectors of corresponding parameters. are individual variables of bank effects. are error term for white n

Review of Internet Banking in Thailand

The rapid growth of the internet has had a significant impact on the business world including the banking industry. The internet offers an alternative channel to distribute products and services to customers. One emerging channel is internet banking or online banking. It allows customers to conduct several kinds of electronic financial transactions such as transferring funds between accounts, checking monthly statements, paying bills, applying for loans, etc. via a telecommunication network by using a personal computer (Parsons and Oja, 2009). Internet banking service benefits both banks and their customers. For the bank, it helps to reduce operational costs by replacing the physical bank branch and also improving the quality of the customer service (Furst et al., 2000). The bank will require less time and fewer staffs to deliver products and services to customers because the internet allows the bank to deal with hundreds of customers at the same time (Seitz and Stickel, 2001). Moreover, the web site can be used not only to provide useful information, but also to sell various range of products. In Thailand, according to Tangkitvanich (1999), the cost of fund transfer via traditional counter service is around £0.6 per transaction, while internet costs only £0.05 to £0.1. From the customers’ perspective, personal internet banking offers time and cost saving since the services are available 24 hours a day and 7 days a week. Thus, they can execute transactions anywhere and do not have to travel and wait for services like they do in physical branches or at the automated teller machines (ATMs) (Seitz and Stickel, 2001). In addition, the information is up to date and most internet banking web sites are compatible with sophisticated programs, for example, rate alerts, account aggregation, and Quicken. These will help customers to make more effective funds management decisions (Tan and Teo, 2000). Lastly, many customers are attracted by a greater control over service delivery process since financial transactions can be executed without having front-line personnel (Karjaluoto et al., 2002; Polasik and Wisniewski, 2009).

Although internet banking is widespread in many parts of the world especially in developed countries such as Finland, Sweden, and the United States (Karjaluoto et al., 2002; Nilsson, 2007; Berger, 2003), adoption of internet banking in developing countries including Thailand appears to be quite rare (Abdul et al., 2007; Ongkasuwan and Tantichattanon, 2002). This could be the result of some drawbacks embodied within this option. The most noticeable, and may be the hardest requirement for the banks in using internet banking is that it requires the restructure of the organization, which would cost not only money, but also time and effort, in order to achieve it (Dimaggio et al., 2001). What is more, an adoption of the internet banking also needs to be monitored carefully with respect to the government policy and the legislation (Weiser, 2003). Finally, it is still uncertain that internet banking would bring about the positive effects in the operation of the banks, especially in the small banks, and it could even affect their operation adversely (Berger, 2003). From the viewpoint of the customers, there are several potential disadvantages that may arise from internet banking usage (Remenyi, 2007). Firstly, internet banking can be difficult to understand for first timers. It takes time to learn how the system works through tutorials and navigation tools. In addition, most banks periodically upgrade their online programs by adding new features and products. This means that customers are required to re-familiarize themselves with new programs many times. Lack of security and privacy are found to be major obstacle of growth in the number of internet banking users (Howcroft et al., 2002; Flavian et al., 2006; Rotchanakitumnuai and Speece, 2003). There are fraud and proxy web sites that offer imaginary services or items. These web sites can hack and misuse important information such as credit-card numbers, username, and password. Therefore, large losses of money may have been incurred without knowing until the owner receives his or her bank statement (Sukkar and Hasan, 2005). What is more, some customers prefer to do transactions with employee of the bank who provides personalized services (Rotchanakitumnuai and Speece, 2003). Especially, when problems or queries occur, it is easier to find certain solution via face-to-face contact compared to online customer support from the bank web site. Moreover, internet channel is perceived to be unreliable (Kuisma et al., 2007). As stated by Remenyi (2007), internet banking customers are always uncertain whether their transactions processed successfully and they will only be confident after the transaction appeared on the bank statement. Lastly, a lack of specific laws and regulations support from the government is another reason of a low internet banking adoption (Chong et al., 2010). Customers need to assure about an organization that will be responsible if financial losses occurred in internet transactions (Thomas et al., 1998).

2.2 Internet banking in Thailand

Because of Asian financial crisis in 1997, many Thai banks experienced significant net losses from non-performing loans and bad debts. They were forced to shift their strategies in order to increase efficiency and reduce operational costs (Ongkasuwan and Tantichattanon, 2002; Poungkin, 2004). This situation results in the aggressive competition in the banking market. Importantly, the Bank of Thailand (BOT), as the central bank, is responsible for regulation setting in the banking sector. Being aware of the crucial role of electronic transactions in the future economic development of the country, since 2000 the BOT has permitted commercial banks in Thailand to provide the similar kinds of transactions via the internet like the transactions that are offered in the physical branch (Jaruwachirathanakul and Fink, 2005). As a result, several commercial banks in Thailand began to use internet banking as a new service channel. The banks expect that internet banking will generate higher long-term profits, reduce costs, and provide better service quality to customers in the same way it is anticipated by banks in other countries (Gerrard and Cunningham, 2003). Internet banking was first implemented in 1999 by the Siam Commercial Bank Plc (Jaruwachirathanakul and Fink, 2005). And, other three leading Thai banks which consist of Thai Farmers Bank (TFB), Bank of Asia (BOA), and Krung Thai Bank (KTB), have decided to launch internet banking services in the beginning of 2000 (Ongkasuwan and Tantichattanon, 2002).

The number of internet users is one of the most important factors that influences customers’ internet banking adoption (Samphanwattanachai, 2007). According to the World Bank (2010), the number of internet users in Thailand was around 2.3 million in 2000. In 2008, there was a dramatic increase to 16.1 million. In other words, the growth rate across the period 2000 and 2008 was approximately at 600 per cent. With this rapid growth rate, there is a huge market potential for banks in Thailand to explore and gain competitiveness by introducing internet banking services. Although the level of internet accessibility is increasing, internet banking adoption rate among customer is quite low. And, the development of internet banking in Thailand is still in its early stages. In 2007, there are 34 commercial banks operating in Thailand but only 16 banks provide internet banking services (Hamid et al., 2007). As claimed by Wungwanitchakorn (2002), many banks have launched web sites merely to provide information about financial products and services. For most banks that have been implementing and developing internet banking, the systems are not complete and the services primarily provided to customer are standard services, such as checking account balances, requesting bank statements, transferring funds, bill payments and asking frequency asked transactions (Rotchanakitumnuai and Speece, 2004). On the other hand, additional and integrated services, for instance, international fund transfers, transferring funds to the third party accounts, and stopping checks are only available in the few leading banks (Prompattanapakdee, 2009).

Adoption of internet banking in Asian countries is different from the West in some aspects. Firstly, several studies revealed that Asian cultures give precedence to relationship in business (Rotchanakitumnuai and Speece, 2003; Poungklin, 2004; Siam Commercial Bank, 2006). Similarly, personal relationships, collectivism, and socialization are crucial in Thai culture. Prompattanapakdee (2009) found that many Thai customers value friendly personalized services of the bank officers. This is supported by Sammapan (1996) and Chatchawanwan et al. (2009) who cited that individual customers prefer informal and personal relationship-based communication. They believe that their needs are better understood compared with self-service technologies and the personal relationships will be loss if they use internet-based financial services. In addition, customers in Thailand are strongly influenced by their colleagues and friends. Furthermore, security, privacy, and lack of government support are also significant factors that discourage the successful implementation of internet banking in Thailand (Rotchanakitumnuai and Speece, 2004). From customers’ viewpoint, the infrastructure of web security systems is insufficient (Leelapongprasut, 2005) so they are reluctant to use the web for financial transactions. Even though, Thai banks have invested in many security measures, for example, firewall, intrusion detection software, automatic sign-off, 128 bit encryption, and VeriSign Secure system (Prompattanapakdee, 2009). What is more, privacy is important as customers concern that their personal information might be accessed or misused by unauthorized personnel over the internet (Rotchanakitumnuai and Speece, 2004). Legal support is another major issues associated with internet banking acceptance. Since Thailand has announced the first electronic commerce law in 2002, customers strongly believe that the government is unable to protect bank customers in cases of financial loss through internet banking. And, internet fraud cases might not be resolved effectively (Rotchanakitumnuai and Speece, 2003; Rotchanakitumnuai and Speece, 2004; Hamid et al., 2007; Chatchawanwan et al., 2009). Currently, Thailand has been improving policies on ICT to assist the people by increasing their use of computers and the internet. For example, there are 1st National ICT Master Plan (2002-2008) and 2nd National ICT Master Plan (2009-2013) which aim to provide equal accessibility on high speed network with affordable prices (Phantachat and Anan, 2009).

Overview of previous studies of internet banking

Internet banking has gained a special attention in academic studies for the past decade. In the search to investigate the determinants of acceptance and use of new information technologies, various studies have been conducted in nations by using different theoretical approaches and models. Three significant models that are widely used to provide an explanation of internet banking users’ behavior are Technology Acceptance Model (TAM), Theory of Planned Behavior (TPB), and Decomposed Theory of Planned Behavior (DTPB). The main features of each theoretical model will be discussed below.

Technology Acceptance Model (TAM)

The Technology Acceptance Model (TAM) was proposed by Davis in 1986. The objective of TAM is to identify the factors or determinants influencing individuals’ acceptance of technology-based product and service (Davis et al., 1989). The framework proposed that two particular beliefs, perceived usefulness and perceived ease of use, can be used to predict the attitude towards using new technology, which in turn affects the behavioural intention to use the system directly. And, finally, behavioural intention to use leads to actual system use (Venkatesh et al., 2003) as presented in figure1. According to Davis et al. (1989), perceived usefulness is defined as “the degree to which a person believes that using a particular system would enhance his or her job performance”, while perceived ease of use refers to “a person believes that using a particular system would be free of physical and mental effort.”

  • Perceived Usefulness
  • External Variables
  • Attitude Toward Using
  • Behavioral Intention to Use
  • Actual System Use
  • Perceived Ease of Use

Figure1: The Technology Acceptance Model (TAM)

Source: Davis et al. (1989)

Attitude toward using means the individual user’s positive or negative feelings about using the system. And, behavioural intention to use reflects the strength of an individual’s intention to use particular system. The advantages of TAM are its predictive power and the small amount of constructs to forecast intention (Agarwal and Prasad, 1999). In addition, it is general and capable of explaining user behaviour across a wide range of technologies in different situations such as time and culture (Davis et al., 1989; Lee et al., 2003). For example, Adam et al. (1992) examined TAM by using five different technologies: voice mail, electronic mail, word processors, spreadsheets, and graphics. The study demonstrated that TAM maintained its consistency and validity in explaining users’ information system acceptance behavior. And, both perceived usefulness and perceived ease of use were two important determinants of system use. Similarly, Szajna (1996) claimed that TAM is a valuable tool for predicting intentions to use an electronic mail system. Hu et al. (1999) also applied TAM to study physicians’ decisions to accept telemedicine technology in public hospitals in Hong Kong. Perceived usefulness appeared to be a significant determinant of attitude and intention but perceived ease of use was not. In addition, TAM has been used to examine users’ acceptance of online shopping which is an activity that is similar to online banking in many aspects. For instance, Pavlou (2003) used TAM as a based model to predict consumer acceptance of online transaction. Trust and perceived risk were integrated in the proposed model. Likewise, Ha and Stoel (2009) studied consumer acceptance of online shopping by integrating online shopping quality, enjoyment, and trust into TAM. The finding revealed that online shopping quality influences enjoyment, trust, and perceived usefulness which in turn determines customers’ attitudes toward online shopping, while perceived ease of use does not affect attitude toward online shopping. Moreover, they claimed that TAM provides a useful foundation for research examining consumer acceptance of online shopping. Therefore, TAM could be suitable theoretical model for studying the usage of internet banking. In recent years, numerous banking studies have used TAM to explain individuals’ acceptance of internet banking.

However, many researchers suggested that TAM itself may not fully explain users’ acceptance of every kinds of technology, therefore TAM is widely used as a base model and extended model by adding additional variables to the original model depending on the type of technologies that are studied (Chong et al., 2010). Importantly, various extensions to TAM were also conducted in the study of internet banking. For example, Suh and Han (2002) believed that original TAM which consists of two beliefs, usefulness and ease of use, is insufficient to explain internet banking users’ behaviour. So, trust was added in the model and the result showed a significant impact on the adoption of internet banking. Wang et al. (2003) also used TAM as theoretical framework and introduced perceived credibility and computer efficacy. The result demonstrated the significant effect of computer self efficacy on the intention of internet banking users via perceived usefulness, perceived ease of use, and perceived credibility. As suggested by Pikkarainen et al. (2004), extended TAM model indicated that perceived usefulness and information provided through internet banking website were the main variables influencing online banking acceptance in Finland. Similarly, Karjaluoto et al. (2002) adapted TAM model and found that prior experience of computers and technology as well as demographic factors impact internet banking users’ behaviour in Finland. Generally, online banking users were well educated, relatively young, and have high level of income. In addition, Luarn and Lin (2005) had extended TAM by putting perceived credibility, perceived self-efficacy and perceived financial cost into the framework and the finding was that TAM and added factors influence users’ intention to adopt electronic banking. In another study, Eriksson et al. (2005) modified TAM and applied it to internet banking users in Estonia. They stated that perceived usefulness have the strongest effect to users’ acceptance of the technology since perceived ease of use will not result in increased use of internet banking without perceived usefulness. In other words, users might not adopt a well-designed and easy to use internet banking if it is not perceived as useful.

2.2.2 Theory of Planned Behavior (TPB) and Decomposed Theory of Planned Behavior (DTPB)

Theory of Planned Behavior (TPB) is another model considered beneficial in predicting factors that affect the adoption of information technology among users. The TPB is an extension of well-known Theory of Reasoned Action (TRA) by incorporating an additional construct which is perceived behavior control in the model for situation where person does not have complete control over his behavior. According to Ajzen (1991), an individual’s behavior can be explained by his or her intention to perform behavior. And, intention is jointly influence by three factors: attitude, subjective norms, and perceived behavioural control as showed in figure 2. Attitude refers to how favourably or unfavourably an individual views about the performance effect of the particular behavior. The second factor is subjective norms. It means an individual’s perceptions of other people’s opinions, such as family and friends, on whether he should or should not perform the behavior. Thirdly, perceived behavioural control reflects person’s belief of the availability of resources or opportunities necessary for performing a specific behavior (Ajzen and Madden, 1986).

  • Attitude Toward Behavior
  • Intention to Use
  • Usage Behavior
  • Subjective Norm
  • Perceived Behavioral control

Figure 2: The Theory of Planned Behavior (TPB)

Source: Ajzen (1991)

Another version of TPB is called Decomposed Theory of Planned Behavior (DTPB). The DTPB was introduced by Taylor and Todd (1995) who decompose concepts from two distinct theories: Theory of Planned behavior (TPB) and Innovation Diffusion Theory. As proposed by Taylor and Todd (1995), traditional TPB beliefs are decomposed to provide better explanatory power, clearer, and more understandable of individuals’ behavior compared to TAM and original TPB models. In DTPB, attitudinal beliefs are broken down into three dimensions: perceived usefulness, complexity, and compatibility. For normative beliefs structure, it is divided into two groups: peer and superior influences. Lastly, control beliefs are decomposed into three dimensions: individual self-efficacy, resource facilitating conditions, and technology facilitating conditions. The DTPB model is presented in figure3.

  • Perceived usefulness
  • Attitude
  • Complexity
  • Compatibility
  • Subjective norm
  • Behavioral intention to use
  • Normative influence
  • Perceived behavioural control
  • Self-efficacy
  • Facilitating conditions

Figure3: Decomposed Theory of Planned Behavior (DTPB)

Source: Taylor and Todd (1995)

In recent decade, information system researchers have conducted several studies by using TPB and DTPB to investigate factors that influence users’ acceptance of information technology systems. For instance, Liao et al. (1999) examined the adoption intention of virtual banking of Hong Kong users. The TPB and innovation diffusion model were selected. They concluded that TPB was only partially applicable in predicting individuals’ adoption intention in the research setting. Also, Tan and Teo (2002) adapted DTPB framework to identify whether three factors: attitude, subjective norms, and perceived behavioural control would affect the adoption of internet banking in Singapore or not. The findings showed that attitude and perceived behavioural control factors have stronger effect to internet banking users than subjective norms. In addition, Luarn and Lin (2005) studied users’ acceptance of mobile banking in Taiwan by combining TPB and TAM. Perceived credibility, perceived self-efficacy, and perceived financial cost were added to the model. The results revealed perceived credibility found to be significant to users more than traditional TAM variables which are perceived usefulness and perceived ease of use. This means easy to use system alone is insufficient to attract users. The system should have trustworthiness in order to protect the security and privacy of the users.

Although both TPB and DTPB are well-accepted model that have been successful in predicting human behavior across numerous information technology because they include constructs that do not appear in TAM such as subjective norm and perceived behavioural control which lead to superior and more precise explanatory power of the antecedents of behavior and may offer more effective guidance to information technology managers and researchers interested in the study of system implementation(Taylor and Todd, 1995), the disadvantages of the model can also be seen. Firstly, dimensions of the beliefs structures of TPB vary in different situations. Thus, TPB is difficult to be generalized across various settings (Wu and Chen, 2005). In other words, TPB is not specific to information system usage and less parsimonious than the TAM (Luarn and Lin, 2005). Moreover, even though DTPB is better than the TAM in explaining behavior intention of individuals, the difference is not large (Chau and Hu, 2001). To demonstrate, Taylor and Todd used their DTPB to examine users’ behavioral intention to use particular information system. The model consists of 17 constructs and able to explain 60 per cent of the variance in behavioral intention. On the other hand, TAM includes only 5 constructs but can explain 52 per cent of the variance. Hence, in order to obtain small increase in predictive power, researcher has to bear a relatively substantial increase in model complexity (Luarn and Lin, 2005).

Research Model and Hypotheses

Based on the literature review, the model for this study will be based on Technology Acceptance Model (TAM) since it provides greater benefits compared to other theories such as TPB and DTPB. Firstly, TAM is the most widely used model that has been chosen to examine the users’ acceptance in the internet banking context. This provides opportunity for researcher to compare the research findings with other findings from various countries. In addition, TAM is much simpler and easier to use as it contains only 5 main variables to explain users’ acceptance across a broad range of technologies (Hubona and Cheney, 1994). Moreover, although TPB and DTPB give fuller explanation than TAM, there is a high trade-off between slightly increase in explanatory power and complexity of the model (Lee et al., 2003). Mathieson (1991) found that TAM consistently explains a considerable amount of variance approximately 40 per cent in usage intention and behavior. Finally, there are a few previous studies of internet banking in Thailand which have adopted the TAM as the theoretical model.

Perceived UsefulnessIn order to increase the explanatory ability of TAM, the original TAM will be extended by including important variables which researcher posits to have an effect on acceptance of internet banking in Thailand. A research model of this study is illustrated in figure 4. Like many studies on internet banking adoption that use TAM as their base model, attitude was removed (Hernandez and Mazzon, 2006; Eriksson et al., 2005; Pikkarainen et al., 2004; and Chong et al., 2010). This renders simpler and more parsimonious framework. But, intention was retained in the model since the adoption of personal internet banking is voluntary. Then, attitude and intention are highly positively correlated (Venkatech et al, 2003).

  • Perceived Ease of Use
  • Individual Characteristics
  • (gender, age, income, education)
  • Intention to use internet banking
  • Usage of internet banking
  • Subjective norms
  • Trust
  • Government Support

Figure 4: The research model

Perceived usefulness and perceived ease of use

As mentioned in the literature review, perceived usefulness and perceived ease of use are significant factors affecting acceptance of an information system (Davis et al., 1989) and also important determinants in adoption of internet banking (Wang et al., 2003; Eriksson et al., 2005 and Pikkarainen et al., 2004). Davis defined perceived usefulness as the degree to which an individual believes that using a particular system would enhance his or her performance. Therefore, in the internet banking context, individuals will adopt internet banking if they consider that this channel is more beneficial compared to other ways of conducting banking transactions such as physical branch, automatic teller machine and mobile banking. The advantages of internet banking include time and location convenience.

Therefore, researcher hypothesizes similar effect in the following hypothesis.

Hypothesis 1: Perceived usefulness has a positive effect on individual intention to adoption internet banking

Perceived ease of use refers to an individual believes that using a particular system would be free of effort (Davis et al., 1989). In other words, how easy it is to learn to use the system. Many studies revealed positive and significant effect of perceived ease of use on actual usage either directly or indirectly through its impact on perceived usefulness, for example, Wang et al. (2003) and Luarn and Lin (2005). The system that perceived to be easier to learn and use than another is more likely to be adopted by users. Conversely, Pikkarainen et al. (2004) and Eriksson et al. (2005) found that perceived ease of use did not have an effect on users’ acceptance of internet banking. Thus, researcher will examine how perceived ease of use influence Thai customers’ adoption intention.

Hypothesis 2: Perceived ease of use has a positive effect on individual intention to adopt internet banking.

Hypothesis 3: Perceived ease of use has a positive effect on individual perceived usefulness of internet banking.

Individual Characteristics

Individual characteristics have been found to be associated with users’ acceptance of internet banking based on factors such as gender, age, income, and educational level (Karjaluoto et al, 2002; Prompattanapakdee, 2009; Hernandez and Mazzon, 2007; Howcroft et al., 2002; Wan et al., 2005; Mattila et al., 2003). Generally, more males than females tend to use internet banking. This is supported by Polasik and Winniewski (2009) who indicated that women were less likely to conduct their banking transactions online. Studies have also linked age and adoption of internet banking. For example, as suggested by Karjaluoto et al. (2002), younger person is more likely to adopt the new technology. What is more, many older consumers have a more negative attitude to accept new innovation (Trocchia and Janda, 2000). In addition, increase in income and education tends to be positively related to the adoption of internet banking. Mattila et al. (2003) found that over 30 per cent of high income, well-education mid-aged males use internet banking as their primary channel to make payments. Moreover, Hernandez and Mazzon (2007) stated that younger males with high educational level and high income are more likely to adopt internet banking. Hence, based on previous evidence, researcher posit that

Hypothesis 3a: Males are more likely to adopt internet banking than females.

Hypothesis 3b: Younger people are more likely to adopt internet banking than older people.

Hypothesis 3c: The higher the customer income level, the more likely that internet banking will be adopted.

Hypothesis3d: The higher the customer educational level, the more likely that internet banking will be adopt.

Subjective norm

Subjective norm refers to the person’s perception that most people who are important to him think he should or should not perform particular behavior (Ajzen, 1991). For instance, individual can be influenced by his family, friends, and superior. For this study, subjective norm describes the social influence that may persuade a person to use internet banking services. Importantly, Taylor and Todd (1995) highlighted that subjective norm will become more significant in the early stages of innovation implementation because individuals still lack of direct experience that is needed to develop attitudes. And, internet banking is relatively new to users in Thailand. Thus, researcher proposes that

Hypothesis 4: Subjective norm has a positive effect on individual intention to adopt internet banking.


Trust is one of the most important determinants of internet-based application adoption as well as users’ internet banking acceptance. Prompattanapakdee (2009) concluded that customers in Thailand do not trust personal internet banking due to four reasons which are security, privacy, provider’s reputation, and risks regarding with the reliability of the services. In this study, researcher will focus on two aspects that most customers are concern about: security and privacy. So, trust refers to an individual belief that internet banking is safe and private. Hernandez and Mazzon (2007) also determined the effect of trust on internet banking in Brazil and discovered that both security and privacy influencing customer intention behavior. Similarly, Manzano et al. (2009); Pikkarainen et al. (2004); Howcroft et al. (2002); Wang et al. (2003) found that security and privacy issues have a direct effect on internet banking adoption. Because, users are usually reluctance to admit a system which they do not have complete control over their own behavior and the system which is perceived to be risky (Pikkarainen et al., 2004). Thereby, researcher posits that

Hypothesis 5: Security and privacy has a positive effect on individual intention to adopt internet banking.

Government support

As suggested by Goh (1995), the government plays a crucial role by intervening and encouraging the expansion of emerging innovation in Singapore. Likewise, Tan and Teo (2000) denoted that government support for internet commerce considerably affects users’ intention to adopt internet banking service. In Thailand, government is also important in the development of electronic commerce and major driving mechanism in internet banking adoption (Jaruwachirathanakul and Fink, 2005). However, Thai government policies and laws related to internet banking issues are unclear to most people. Hence, improvements on these areas might be able to encourage more customers to adopt internet banking. The above arguments lead to following hypothesis.

Hypothesis 6: Government support has a positive effect on individual intention to adopt internet banking

Literature Review on Islamic Banking

In 1963, Islamic banking came into existence on an experiment basis on a small scale in a small town of Egypt. The success of this experiment opened the doors for a separate and distinct market for Islamic banking and finance and as a result, in 1970s Islamic banking came into existence at a moderate scale and a number of full-fledge Islamic banks was introduced in Arabic and Asian countries. Most of these Islamic banks were in Islamic countries. Having started on a small scale, Islamic banks and non-banking financial institutions are now operation even on more intensive scale. Today, Islamic banks are operating in more than sixty countries with assets base of over $166 billion and a marked annual growth rate of 10%-15%. In the credit market, market share of Islamic banks in Muslim countries has risen from 2% in the late 1970s to about 15% today. These facts and figures certify that Islamic banking is viable and efficient as the conventional banking. (Aggarwal and Yousaf 2000).

Islamic banking is regarded as a fastest growing market, on the other side, it is not free from issues, problem, and challenges. Numerous studies have been performed since the inception of the modern Islamic banking and finance. Conceptual issues underlying interest free financing (Ahmad 1981, Karsen 1982) have been the prime focus of these previous studies on Islamic banks. It is hard to find enough coverage in the existing literature on the issues of viability of Islamic banks and ability to mobilize savings, pool risk and facilitate transactions (Hassan & Basher 2005). However, there are few studies that have focused on policy implications of eliminating interest payments. (Khan and Mirakhor 1987)

2.2 Ratio Analysis

Kader & Asarpota (2007) applied financial ratio analysis to assess the performance of the Malaysian Islamic bank and UAE Islamic banks respectively. Similarly, to measure efficiency of Islamic banks in Bangladesh, Sarkar (1999) utilized banking efficiency model and claimed that Islamic banks can stay alive even within a traditional banking architecture in which Profit-and-Loss Sharing (PLS) modes of financing are less dominated. Sarkar (1999) further claimed that Islamic financial products have different risk characteristics and consequently different prudential regulations should be in place.

Samad (1999) evaluated the relative efficiency position of the Islamic bank during 1992-1996, and compared it with the conventional banks in the country. His finding was that Bank Islam Malaysia enjoyed relatively higher managerial efficiency than the conventional banks.

Samad and Hassan (2000) evaluated inter-temporal and interbank performance in profitability, liquidity, risk and solvency, and community involvement of an Islamic bank (Bank Islamic Malaysia Berhad (BIMB) over 14years for the period 1984-1997. The study is inter-temporal in that it compares the performance of BIMB between the two time period 1984-1989 and 1990-1997. This is not a new method (Elyasiani 1994). To evaluate interbank performance, the study compares BIMB with two conventional banks (one smaller and one larger than BIMB) as well as with 8 conventional banks. Using financial ratios to measure these performance and F-test and T-test to determine their significance, the results show that BIMB make statistically significance improvement in profitability during 1984-1997, however, this improvement when compared with conventional banks is lagging behind due to several reasons. This result is consistent with that of Samad (1999) and Hassan (1999). The study also revealed that BIMB is relatively less risky and more solvent as compared to conventional banks. These results also conform to risk-return profile that is BIMB is comparatively less profitable and less risky. Performance evaluation of BIMB indicates that it is more liquid as compared to the group of 8 conventional banks. Results of the primary data gathered by surveying 40% to 70% bankers identify that lack of knowledgeable bankers in selecting, evaluating and managing profitable project is a significant cause why Musharaka and Mudarabah are not popular in Malaysia.

Abdus Samad (2004) in his paper examined the comparative performance of Bahrain’s interest-free Islamic banks and the interest-based conventional commercial banks during the post Gulf war period 1991-2001. Using nine financial ratios in measuring the performances with respect to (a) Profitability, (b) liquidity risk, and (c) credit risk, and applying Student’s t-test to these financial ratios, the paper concludes that there exists a significant difference in credit performance between the two sets of banks. However, the study found no major difference in probability and liquidity performances between Islamic banks and conventional banks.

Kader and Asarpota (2007) utilized bank level data to evaluate the performance of the UAE Islamic banks. Balance sheets and income statements of 3 Islamic banks and 5 conventional banks in the time period 2000-2004 are used to compile data for the study. Financial ratios are applied to examine the performance of the Islamic banks in profitability, liquidity, risk and solvency, and efficiency. The results of the study show that in comparison with UAE conventional banks, Islamic banks of UAE are relatively more profitable, less liquid, less risky, and more efficient. They conclude that there are two important implications associated with this finding. First, attributes of the Islamic profit-and-loss sharing banking paradigm are likely to be associated as a key reason for the rapid growth in Islamic banking in UAE. Second, UAE Islamic banks should be regulated and supervised in a different way as the UAE Islamic banks in practice are different from UAE conventional banks.

According to Munawar Iqbal (2001) there is a serious lack of empirical studies on Islamic banking. This research attempts to fill that gap to some extent. Using data for the 1990-1998 periods, several hypotheses and common perceptions about the practice of Islamic banking have been tested. The performance of Islamic banks has been evaluated using both trend and ratio analyses. For this purpose, some objective “benchmark” for various ratios has been developed for the first time. The performance of Islamic banks has also been compared with a ‘control group’ of conventional banks. It has been found that in general Islamic banks have done fairly well during the period under study.

Studies which used financial ratio analysis have generally found, contrary to the earlier hypotheses, that Islamic banks are more efficient than conventional banks in terms of resource use, cost effectiveness, profitability, asset quality, capital adequacy and liquidity ratios than conventional banks (Iqbal 2001, Hassan and Bashir 2005). Commercial banks, however, have a more favorable operations ratio. (Hassan and Bashir 2005).

According to Muhammad Jaffar and Irfan Manarvi (2011), the study examined and compared the performance of Islamic and conventional banks operating inside Pakistan during 2005 to 2009 by analyzing CAMEL test standard factors such as capital adequacy, asset quality, management quality, earning ability, and liquidity position. The financial data for the study was mined from the bank’s financial statements existing on state bank of Pakistan website. A sample of 5 Islamic banks and 5 conventional banks were selected to measure and compare their performance. Each year the average ratios were considered, because some of the young Islamic banks in the sample do not have 5 years of financial data. CAMEL test which is a standard test to check the health of financial institutions was used to determine the performance of Islamic and conventional banks. The study found that Islamic banks performed better in possessing adequate capital and better liquidity position while conventional banks pioneered in management quality and earning ability. Asset quality for both modes of banking was almost the same, conventional banks recorded slightly smaller loans loss ratio showing improved loan recovery policy whereas, UNCOL ratio analysis showed nominal better performance for Islamic banks. Jill Johns, Marwan Izzeldin and Vasileos Pappas, examined efficiency in Islamic and conventional banks in the GCC region (2004-2007) using financial ratio analysis (FRA), Islamic banks are less cost efficient more revenue and profit efficient than conventional banks.

Siti Rochmah Ika (2008) investigated whether the financial performance of Islamic banks in the period before fatwa is different from that in the period after fatwa. Furthermore, this study intends to examine the comparative financial performance of Islamic banks and conventional banks in the period both before fatwa and after fatwa. In evaluating bank’s performance, this study used various financial ratios categorized as profitability, liquidity, risk and solvency, and efficiency. To determine the difference, this study used t-test. The result of this study indicates that, in general, comparison of financial performance of Islamic banks in the period before fatwa and after fatwa does not show statistically difference. Likewise, the result of interbank analysis also indicates that there is no major difference in performance between Islamic banks and conventional banks in the period both before fatwa and after fatwa.

Studies which use financial ratio analysis have generally found, contrary to the earlier hypotheses, that Islamic banks are more efficient than conventional banks in terms of resources use, cost effectiveness, profitability, asset quality capital adequacy and liquidity ratios than conventional banks (Iqbal 2001, Hassan and Bashir 2005). Commercial banks, however, have a more favorable operations ratio (Hassan and Bashir 2005).

Factors Affecting Customers Adoption of Online Banking


This research is conducted at Barclays Bank with an aim to identify the factor affecting customer adoption online banking service at the Barclays Bank. This research is conducted on the online banking service of the Barclays Bank The first chapter presents the overview of the organization (Barclays Bank), its offline and online products. Second chapter gives an insight of thorough and in depth study of literature review where the effort is made to highlight contemporary issues, practices, concepts and theories of online banking services. The third chapter described the research methodology adopted by the author that includes the effort which is made to discuss the type of methodology, which includes sampling, research philosophy, approach and design. Fourth chapter provides the analysis and findings along with some interpretations. Fifth chapter depicts the relationship of analysis of findings with aim and objectives, literature review and methodology of this research paper. Sixth chapter discusses the recommendations and conclusion on the basis of analysis of the finding and the literature review.

For the past two decades, there has been a paradigm shift in the banking industry with regard to its amalgamation with the online world/internet. Globalization has made it even more tempting for the companies to go online. When it comes to banking industry, words like customer convenience, trust and accessibility are note-worthy. Going online has for sure its pros and cons. A customer would want nothing more than perfection from his/her point of concern. From stereotypical methodology of banking to the Click banking, the rift has always been there. Convenience has always been the matter of concern for the banking world but the change in trends has made things a lot more complex. Reluctance from customer end is not a surprise anymore with respect to the financial matters across the web. There are a number of factors which clearly depicts the customer reluctance in adopting the online banking services.

The customer has a great influence on the adoption of Internet Banking. The article central focus is on the possible factors which affect customers in adopting the web banking. The needs and wants vary to a great extent with regard to the geographical factors. The customer of Europe would certainly have a completely different need in comparison to the customer of South-Asia. Moreover customers of Europe and US are a lot more internet savvy than the ones in Sub-Continent. The awareness amongst the customer is the first and foremost factor. Secondly customers may encounter poor standards of customer services over the internet because most of the times there is a very intimate and cordial relationship with the banking staff which you wont find over the internet.


This research was conducted by the author on Barclays Bank with an aim to identify that,

Factor affecting customer’s adoption online banking service.


This research has an objective to scrutinize factor which affect customer adoption of Barclays Bank online banking system and how this issue can be resolve. In order to check that the research have the following objectives from which it is easy to know about the effectiveness of the online banking system of the organization.

The objectives of my study are as follow:

  • To establish the key factor of the Barclays Bank online banking system and the extent that it varies.
  • To determine the impact of the online banking service on customer adoption.
  • To examine the extent that implementation of the online banking system strategy has a positive/negative impact on customer adoption.
  • To identify and evaluate factor which affect customer adoption.
  • To determine that what do customer feels in regard to improve online system?

Barclays Bank

Having a history of almost 300 years Barclays plc is now being recognized as one of the UK’s largest financial service group. The company is working in banking, investment banking, and investment management and operates about 2,000 domestic branches and nearly 850 international branches in over 60 countries across the orb. Barclays is structured into seven business units: Barclays Africa, Barclaycard, Barclays Capital, Barclays Global Investors, Barclays Private Clients, and UK Banking. The company has above 4.5 million registered online bankers and over 10.6 million Barclaycard customers in United Kingdom. Barclays was ranked as the world’s ninth-largest bank based on market capitalization in 2003.

Early History

Barclays was symbolized as the spread eagle in1728. With the addition of three new partners James Barclay, Silvanus Bevan and Silvanus Bevan; the bank was given a name that could be used for more than a century: Barclays, Bevan & Tritton. a fair amount of legislative changes were brought in late 19th century that gave rise to a new working climate which made the survival of Barclays and other such banks at stake. The reason was that the Bank Charter Act of 1826 allowed banks with more than six partners to be formed only outside London, geographical restrictions were eliminated, Stockholders of new joint-stock companies were granted limited liability and joint stock associations were allowed to convert to a limited-liability structure.

Barclays Mergers

When these legislative changes took place many limited liability banks merged with private banks. Barclays along with Jonathan Backhouse & Company and Gurneys Birkbeck, Barclay & Buxton and 17 smaller Quaker-run banks merged together so as to form a larger bank that could resist all the takeover attempts. Francis Augustus Bevan the grandson of Silvanus Bevan served as the new Barclays first chairman. He served the bank for 20 years. Frederick Crauford Goodenough worked as first secretary and served the bank for 40 years. Until 1987 the bank remained under the chairmanship of family. Goodenough was the first chairman recruited from United Bank of London. Recruiting an outsider soon proved its merits. he made the member banks independent and eliminated the decentralized approach. this give rise to long term good relationships between partners and Barclay. he also started doing mergers with many more banks and sooner the bank was recognized one of the largest bank of Great Britain. During this period Barclays merged with 45 British banks and its deposit base rose to £328 million. Soon mergers were not approved if they resulted in a overlapping in the constituent banks areas without countervailing benefits to customers

Expansion in International Market

Goodenough attention was grabbed towards international banking operations. He wanted networking of all the Barclays banks across the globe. In 1916 he started working on establishment of world wide banking mechanism.

After World War I Goodenough also began to negotiate with the National Bank of South Africa Ltd. and the Anglo-Egyptian D.C.O irrespective of all the opposition from the Bank of England which feared that Barclays would become overextended. Domestic growth of the bank remained limited however the bank expanded globally. Despite the stagnation and later the Great Depression Goodenough’s plan did not result in a terrible overextension of the bank’s resources. Goodenough was replaced by William Favill Tuke in 1934 that was in turn replaced by Edwin Fisher in 1936. Fisher worked with Barclays through the boom years of World War II. When Fisher died in 1947, he was replaced by William Macnamara Goodenough.

After the retirement of William Macnamara Goodenough in 1951, Anthony William Tuke, the son of William Favill Tuke, became the chairman. A.W. Tuke encouraged innovations even those he personally disliked but which were potentially beneficial to the bank. Under his leadership Barclays became the Britain’s largest bank. It surpassed the Midland Bank in the late 1950s. Barclays was also a pioneer to introduce new banking technology. In 1959 Barclays was the first British bank to use a computer in its branch accounting. It also introduced world’s first automatic cash-dispensing machine and started a plastic mutiny in Britain by introducing the Barclay cards in 1966.

Barclays in U.S.

When the competitor banks were working to strengthen their international operations Barclays was enjoying a splendorous head start. Barclays entered US market to offset its high exposure to international market. At first it established Barclays Bank of California in 1965 then in 1971 Barclays Bank of New York was formed. These two banks gave Barclays the sole benefit of having retail banking operations on both U.S. coasts. Another advantage Barclays enjoyed was the exemption from legislation of 1978 which exempted foreign banks from operating branches in more than one state. When the National Board for prices ad incomes allowed mergers to rationalize existing networks, Barclays quickly took advantage and merged with the venerable Martins Bank in November 1968. it raised Barclays 700 branches in Northern England.

A.W. Tuke became chairman in 1973 by Anthony Favill Tuke, William F. Tuke’s grandson. A.F. Tuke served until 1981 when he left Barclays to serve a British mining company. His tenure was most vital for Barclay’s expansion in North America. In the late 1970s, a series of Barclays branches were opened in major U.S. cities. In the early 1980s, Barclays Bank International diversified itself into commercial credit by acquiring the American Credit Corporation and was renamed as Barclays American Corporation (BAC) in May 1980.

Barclays Restructuring

Timothy Bevan set about restructuring domestic operations in1981 with the chairman of UK Deryk Weyer. Senior manager roles and responsibilities were also needed to be revised. Weyer was inclined to establish a strategy of making three basic devisions to represent main markets of Barclay. These three divisions include he large corporate market, the middle market of small-to medium-sized businesses and the traditional individual-customer and mass-consumer market. Barclays converted from a joint-stock bank to a public limited company in 1981 and its present name in was finalsied in 1984. In 1985 Barclays became a holding company and all of its assets were transferred in exchange for stock, to its operating subsidiary. Barclays Bank International Ltd. was simultaneously converted to a public limited company and renamed Barclays Bank plc. In 1986, Barclays acquired Visa’s traveler’s check operation and became the third largest issuer of the world with 14 percent of the market share.

Challenging Environment

Chairman John Quinton faced a number of challenges in the late 1980s. Domestic banking always remained Barclays’ strength but the bank faced increasing competition in late 1980’s. National Westminster Bank had an edge of assets over Barclay. The building societies threatened base deposits of banks by offering high interest on savings. American and Japanese banks entered the commercial lending market and pose a threat to British banks. The bank continued to rationalize its branches to better serve the three major banking service markets. Barclays also planned to spend more than £500 million on technological advancement including the introduction of the first electronic debit card in the United Kingdom.

Barclays faced uncertainty in international banking. It faced a disastrous drop in the subsidiary’s earnings from 1984 to 1986 and loosed the lucrative student market in Britain as Barclays’ presence in South Africa became more unpopular at home. The continuous drop of African economies also posed a hazard. In addition, Barclays Hong Kong and Italian operations both suffered large losses in 1980s and performance of Barclays American operations was consistently disappointing. In the early 1980s Barclays expanded rapidly and tried to build earnings quickly through an aggressive lending policy. Consequently, branches picked up a large volume of low-quality loans. Bad-debt ratios were very high, costs were difficult to control and American operations only started to show a profit in the late 1980s. As a result, Barclays began offering specialized services in the US in an attempt to improve its position. Nevertheless, after years of continuous struggle to make it profitable Barclays sold its California banking subsidiary in 1988 to Wells Fargo. The following year, Barclays also sold its U.S. consumer finance unit to Primerica.

On the other side Barclays investment banking operations remained good. BZW expanded its operations by purchasing 50 percent of Mears and Phillips an Australian brokerage firm. Barclays also formed a new bank in Geneva Barclays Bank S.A., to develop capital markets with BZW.

Change in Strategy

Although in earlier 1990’s Barclays was expanding but the bank was soon forced to withdraw its efforts. Extended recessions on both sides of the Atlantic led to various bankruptcies, and many banks including Barclays suffered huge losses from bad loans. Barclays was forced to set aside £1.55 billion in 1991 and £2.5 billion in 1992 against the bad debts. Profits were already less due to continuous high operating costs. Barclays actually posted a pretax loss of £244 million in 1992.

The bank’s difficulties led to the earlier departure of Quinton who was expected to stay on for a couple more years. Andrew Buxton who was a descendant of one of the company founders became CEO in April 1992 and then added the chairmanship at the beginning of 1993.

Amongst all management changeovers, Barclays began a retrenchment which continued into the mid-1990s. It reduced its far-flung operations in selected countries and regions which undertook a massive cost-cutting program. Barclays dramatically reduced its troubled U.S. operations. it started with the exit from U.S. retail banking in May 1992, through the sale of its remaining branches and assets to Bank of New York Co. The most visible aspect of the cost-cutting program was the abolition of 18,000 jobs between 1990 and 1995. The majority of these cuts were made in the UK. By 1994, Barclays domestic branch network had been cut to 2,080. the reduction was of 21.5 percent since 1989.

Like most U.K. banks, Barclays benefited from the improved economic conditions of the mid-1990s. As a result the bank was able to enhance its loan portfolio. Barclays had to set aside only £396 million in 1995 and £215 million in 1996 for bad debts. Barclays continued to restructure and concentrated on its Asset Management Group. In 1995 the bank bolstered its presence in the Asia-Pacific region by purchasing Wells Fargo Nikko Investment Advisers, which was integrated into the Asset Management Group. Barclays neared the turn of the 21st century in its strongest position in years. The bank’s restructuring of domestic retail banking network seemed to be a success. As Europe slowly moved toward integration Barclays smartly separate from many of its non-European operations while seeking opportunities for continental expansion.

Late 1990s and Beyond

Many Large mergers including the tie up of Morgan Stanley and Dean Witter and the merger of Salomon Brothers and Smith Barney left Barclays unable to compete in the global investment banking industry. The company opted to sell off parts of its BZW unit in 1997. Credit Suisse First Boston purchased the European and Asian investment banking portion of the business while ABN Amro snatched up its Australian and New Zealand operations. Barclays decided to keep BZW’s debt business and renamed it as Barclays Capital. Barclays strived to retain the market share over the next several years. Several managerial changes also took place. Selling off BZW was considered as highly controversial among Barclays’ shareholders. Matthew W. Barrett was named CEO in 1999 while Middleton remained chairman. With a stable management team now in place, Barclays continued to revamp its organization. In 1999 announcement was made that 6,000 jobs would be eliminated from U.K. workforce and to shutter up, up to 200 rural branches by 2000 so as to focus on online banking. The company continued to eye growth and moved to acquire Woolwich plc in a $7.96 billion deal. Barclays has more online customers than any other bank in the U.K., Woolwich’s Internet service was considered far more advanced.

Chairman Middleton announced that he would retire at the end of 2004, leaving Barrett to take over as chairman. for the post of CEO John Varley was to be considered. The company targeted on increasing revenues, controlling costs and maintaining a cautious approach to risk management. While it looked to organic growth to bolster sales and profits, Barclays did not rule out the possibility of future merger activity. Pre-tax profits rose by 20 percent in 2003. This indicated that Barclays actions were paying off.

Chapter 2:

Literature Review

Use of internet being popular among the masses it has developed the new market for buyers, sellers and intermediaries. Technology changes the modes of doing business and now industries are moving toward online market. Use online banking is used for the payment of bills, transfer money and analyzing your budget. It takes 10-20 minutes to set up vendors’ lists of payees, addresses, and account information.  After that, it takes sheer seconds to set up a bill payment. Big business houses may also be offered ‘PC banking’. This may become possible by installation of particular banking software on the computer you use to manage your account. It offers more effectual solution if you have a fat degree of transactions and if your accounting system linked with your bank.

In banking industry clicks and mortar is being adopted by banks rapidly. There are several modes for online banking but each of them is not fully satisfactory, they have pros and cons

Firstly the advantages of online banking are contending. Convenience is at foremost priority for bank’s customer in online banking. Customer can access their account 24 hours a day, 7 days a week. With the use of online technology the bank working hours are no more restricted, as the customer can access their account , check balance, transfer money by using laptop, PDA, notepads etc.

Secondly Time saving is another factor to be considered because online banking is very agile and swift it can produce efficient and effective results. Now the customers are not compelled to visit bank for payments of bill, transfer of funds, ordering cheque books, and for account information as well

You are not bound to wait in queue.

You are not compelled to follow bank’s hours.

You can look at your balance whenever you want, not just when you get a statement

By keeping close tabs on your funds, you’ll remained informed about your bank account tractions

Thirdly online banking is cost-effective. Online banking tractions charges are often lower than for regular accounts and these accounts may offer higher interest rates. Banks offer online banking services at no additional cost. By using online banking we can avoid ourselves from worry of searching for perpetually lost dishonored checks and bank statements we can also save our money. Now a days most credit unions offer online banking services and online statements, etc. to their client without any charges with direct deposit or a qualifying account.

Fourthly online banking is considerably more convenient than waiting for your bank statement manually. Tractions record in maintained automatically and account holder can check it easily. By using online banking system you are better able to track and keep an eye on your cash flows. You may find yourself easier to follow avoid overdraft charges w because you have a detail of your banks tractions and your spending.

Fifthly in Online banking system the banker do t have to bear expenses like location; personnel and energy. Which mean it is cost effective from banker point of view .consequently the benefits driven from that will be transferred to consumer in form of high interest rate. the hidden benefit of high interest rate and cost effectiveness will result in economy development through different modes of investment.

Online banking helps to control and manage your account efficiently and effectively it will make you to feel running your accounts like a small business which can be controlled at any time wherever you are, the location does not matter. Once you get started, you’ll be hooked. Soon enough you’ll be checking your bank account as often as your e-mail.

To get loan it is not necessary to visit bank branch it can be applied though modern technology. By using online bank account you can buy and sell securities and shares. Trough online banking Even new accounts can be opened; old accounts can be closed without doing tiresome formalities. With the acceptance of digital signature internet banking has become more secure faster and easier all over the globe. It is not mere favorable for customers but for bankers as well.

When your business falls under clicks and mortar category you have to spend too much time on internet such type of business will not allow you to visit bank branch time to time in such a case internet banking is the best tool to save your time and enhance your business. There are no more geographical boundries in virtual business you can operate your business in all over the world for business purpose by using e banking. This will blossom your business yield

Frustration has caused depression among the masses which leads to the illicit and deceptive activities if you have an internet banking account you can check your debits and deposits and if your account is accessed by an unauthorized person you will most likely notice it immediately. You can take precautionary measures to prevent such activities

according to Melissa Wilt ” Although the benefits of online banking are undeniable, there are some inconveniences and concerns of which customers should be aware. Many people have difficulty relying on the security of online transactions, fearing the very real possibility of identity theft. If you have these concerns, obtain safety information and guarantees in writing before beginning an account. There may be a waiting period between signing up for online banking and receipt of the ID and password necessary for account activation. Make other arrangements in case you are temporarily denied access to you bank account. Remember that it may take some time acclimate yourself to the bank’s website and set up account information. Have at least an hour available to complete the process. If you choose to pay bills online, make sure that recipients are capable of processing electronic payments. Otherwise, it may take several days for the payment to be credited to your account, which could result in accumulated late charges. You can also avoid this problem by making all payments several days in advance of the due date. For these and any other online money transactions, remember to print out a hard copy. In the event of errors, this will be your only proof. Obviously, you will not be able to make deposits or withdraw cash from your account unless you go to a bank branch. Another occasional problem with online banking occurs when the website is down, either for scheduled maintenance or because of technical problems. Make sure that you are provided with a bank phone number in case you cannot access your account.

Clearly, the choice of whether or not to bank online depends on many variables. Even if a person can see the benefits, they may be unwilling if they do not trust or have much experience with the internet. On the other hand, people may only sign up for limited services like account viewing. This will save them from safety concerns but will still give them daily access to account activity. If you decide that online banking is right for you, be sure to review the offers of several banks. Each has different fees and benefits that can make a big difference in how much online banking costs you. By comparing deals and educating yourself, you will find an online banking service that suits your needs.

Central Banks and Movements in Stock Market

The behaviour of central banks towards movements in the stock market has been an interesting issue amongst researchers in recent decades. While there has been a central agreement that inflation and output gap are major targets in central banks’ monetary policies, the consideration of stock prices in these policies has been taken with more sceptical attitude. The motivation behind examining this issue is that being able to identify the actions central banks take in order to eliminate macroeconomic volatilities, financial panics will disappear and overall economy will improve due to more transparency in monetary policies. Also, the importance of responding to stock market movements will be explored, which means a better guidance for monetary policy decisions. The main issue addressed here is whether central banks should target changes in stock prices explicitly in their monetary policies as was suggested by Cecchetti et al. (2000) or implicitly only when they affect the forecasts of inflation and output gap as was suggested by Bernanke and Gertler (1999, 2001). The effect of this is a proposition of a monetary policy that is very close to the actual policy conducted by central banks and therefore, a better identification of policy reactions that will eventually contribute to the economy’s welfare. A review of the current literature will help to accentuate the main variables studied in this paper and to construct an initial theoretical framework which is modified in a later section to reflect the results of the empirical analyses. The most appropriate model to consider here that will help in the empirical study of this paper appears to be the Taylor rule. Data from the United States will be used, hence the focus will be on the behaviour of the Federal Reserve. Tests of robustness will be conducted for different specifications of the Taylor rule to confirm that they are well specified. In addition, subsamples will be created to highlight any breaks in the sample studied. Finally, the endogenous relationship that is apparent between stock prices and monetary policy responses will be examined to give a clearer picture about the mechanism of monetary policy behaviour.

The paper proceeds as follows. Section 2 reviews the literature available on the topic covering the main and most relevant issues addressed in relation to this study. Section 3 is the theoretical framework providing a better visualisation of the relationship between the variables studied. Section 4 describes the data and gives its descriptive statistics. Section 5 presents the different specifications of the empirical model used in the paper. Section 6 presents the results from all the empirical tests and analyses conducted. Section 7 concludes the main points and findings of the research paper.


Justifications and objections to respond to stock market movements

History is full of examples where large swings in the stock market coincided with lasting booms and busts. The ultimate objectives of monetary policy are of macroeconomic benefits relating to inflation, economic growth and employment. Swings in asset prices can affect central banks’ goals of low inflation and real growth. Hence, some economists have argued that responding to asset prices directly can improve macroeconomic performance (Lansing, 2003). Cecchetti et al. (2000) reiterates that policy makers can exploit information about the economy carried by asset prices and this will help them improve macroeconomic stability. Additionally, Bernanke and Kuttner (2005) point out that stock markets are seen as a source of macroeconomic volatility that policymakers may wish to respond to. These arguments suggest that by identifying a set of actions that appropriately responds to stock market movements beside other goals of the central bank, economies will be stabilised almost immediately and financial panics will disappear. Therefore, identifying a nominal anchor – a basis monetary policy for central banks – will contribute to the welfare of economies. From the point of view of market participants, this is also important to make effective investment and risk management decisions. On the other side, the endogeneity problem [1] that exists between monetary policy and stock market movements makes it difficult to estimate the monetary policy reaction (Rigobon and Sack, 2003). Also, a number of other variables including news about the economic outlook are likely to affect stock prices (Rigobon and Sack, 2004). This in effect is the revision in expectations about future monetary policy as a result of news about changing economic conditions.

Endogenous relationship

It is important to highlight that the relationship between monetary policy and stock market movements is endogenous. That is, in any model of monetary policy estimation, the values of the variables are determined by the equilibrium of a system. In other words, the direction of causation might be from monetary policy to stock market movements or from stock market movements to monetary policy. This issue has been addressed in the works of Rigobon and Sack (2003, 2004). In their 2003 paper, they argue that it is difficult to identify the monetary policy response to the stock market due to the simultaneous response of the stock market to policy decisions. They find that when monetary policy reacts to low stock market prices by reducing interest rates, the stock market simultaneously reacts to low interest rates by increasing stock market prices, and vice versa. In their 2004 paper, they look at the other side of the relationship – how asset prices react to changes in monetary policy –. Their findings confirm that stock prices have a significant negative reaction to monetary policy; an increase in the short-term interest rate results in a decrease in stock market prices, with the effect being reduced for longer time maturities. So, when the effect runs from stock prices to interest rates, there appears to be a positive reaction. Whereas, when the effect runs from interest rates to stock prices, there appears to be a negative reaction.

In light of what most of the literature has been available on, I will concentrate on discussing the response of monetary policy to stock market movements, and not the other way round. The main question that needs to be addressed here is: how should central banks respond to stock market movements as part of their monetary policy imposed? Or, what is the appropriate monetary policy to be imposed so that volatility in stock prices will have the least impact on the macroeconomy? There has been an extensive literature covering the topic with many views and models in proposition. The works of leading researchers on the topic are summarised below.

Taylor rule

Since his breakthrough paper which was published in 1993, Taylor has attracted a vast attention to his simple, yet surprisingly accurate characterisation of the Federal Reserve’s monetary policy. It expresses the federal funds rate as a linear function of current inflation’s deviation from an inflation target and the output gap. This was not only a good description of monetary policy in the U.S. but also a reasonable policy recommendation (Osterholm, 2005). His findings are consistent with the agreement that monetary policy rules should increase short-term interest rates if the price level and real income are above target and decrease them if the price level and real income are below target. This in effect was also his guiding principle behind the rule, which was disclosed in the Federal Reserve’s Annual Report for 1945 describing the implicit predominant purpose of Federal Reserve’s policy. Taylor (1993), however, concludes that following his rule mechanically is not practical and policymakers should be discretionary in their application. Greenspan (1997) emphasises on that by saying: “these types of formulations are at best ‘guideposts’ to help central banks, not inflexible rules that eliminate discretion”. Svensson (2003) opposes the use of Taylor rule as guidance for monetary policy conduct and argues that such simple rule is not representative of what the world’s most advanced central banks are using to optimise macroeconomic benefits. He argues that other variables beside inflation and output gap might also be important to achieve the central bank’s objectives. These include the real exchange rate, terms of trade, foreign output and foreign interest rate. Meyer (2002) states: “my experience during the last 5-1/2 years on the Federal Open Market Committee (FOMC) has been that considerations that are not explicit in the Taylor rule have played an important role in policy deliberations”. Incorporating more relevant variables in the central bank’s reaction function promises better results than adopting the basic Taylor rule. Osterholm (2005) also doubts Taylor’s explanation of how monetary policy is conducted after testing the parameters in the rule’s regressions and finding them inconsistently estimated. Although he concludes that Taylor rule provides an accurate description of U.S. monetary policy during the 1960s and 1970s, it didn’t show much consistency in more recent decades. Orphanides (2003) finds similar results and concludes that Taylor’s simple rule does not appear as a reliable estimate of monetary policy over the past twenty years.

Inflation targeting

Inflation targeting approach was first introduced by Bernanke and Mishkin in 1997. In simple terms, it is the future inflation level that the central bank will strive to hold. More practically, it is defined by Bernanke and Gertler (1999) as an approach which “dictates that central banks should adjust monetary policy actively and pre-emptively to offset incipient inflationary or deflationary pressures”. Then how is this exactly related to the monetary policy response due to changes in stock prices? The idea here is that inflationary asset prices will increase interest rates and deflationary asset prices will decrease interest rates, all via affecting household wealth and in turn consumption spending. Therefore, they extend the definition of inflation targeting to include: “policy should not respond to changes in asset prices, except insofar as they signal changes in expected inflation”. In their 2001 paper, they summarise important findings from their work on the topic. They conclude that responding to changes in asset prices through aggressive targeting of inflation stabilises both inflation and output, and that responding to asset prices will not add significant benefit to the policy decision. In other words, the more central banks increase nominal interest rate by more than one percentage point in response to one percentage point increase in expected inflation, the better the reaction is and therefore, the greater the reduction is in the economic effects of volatility in asset prices. The final conclusion that has been drawn is: monetary policy that targets inflation aggressively without considering stock prices, unless they help in forecasting inflationary or deflationary pressures, works best. Fuhrer and Tootell (2008) have similar conclusion based on finding little evidence that stock prices affect monetary policies directly. Bernanke and Mishkin (1997) support the inflation targeting approach by presenting a number of its advantages. First, inflation targeting is not a rule, but rather a framework that allows central banks to consider other issues in the economy such as unemployment and exchange rates besides inflation. Therefore, inflation targeting is not a rigid tool which allows for discretionary policies in the short run and other concerns of the central bank. Second, the announcement of inflation targets by central banks reduces uncertainty between the general public regarding central banks’ intended actions after stock price movements. This is an important aspect because uncertainty about central banks’ intentions causes volatility in financial markets. Therefore, inflation targeting allows for more transparency in monetary policies. Third, inflation targeting approach is relatively easy to understand, unlike other policy strategies such as money growth targeting. This is because the general public, certainly, find it more difficult to understand growth rate of monetary aggregates than to understand growth rate of consumer prices.

Consideration of asset prices in monetary policies

Contrary to what Bernanke and Gertler (1999, 2001) have argued, Cecchetti et al. (2000) point out the importance of including asset prices in the monetary policy rule. This stems from their findings that asset prices include important information that can be used by policymakers to better stabilise the economy. They conclude that a central bank will have superior performance when it targets not only inflation and output gap (or their forecasts), but also asset prices. This will reduce the volatility of output and the likelihood of asset price bubbles, therefore, reducing the risk of booms and busts. In fact, their findings suggest that in the majority of cases, interest rate adjustment to asset prices in the presence of a bubble is necessary. The reason for different conclusions between the two sides is that Cecchetti et al. (2000) seem to cover a wider range of possible policy responses. Rigobon and Sack (2003) agree with Cecchetti et al. and clarify that stock market movements, through their influence on the macroeconomy, can be useful guidance to monetary policy responses. However, it is difficult to identify these responses due to the simultaneous reaction of stock prices to policy decisions. Christiano et al. (1999) also observes that unlike prices and output which react to changes in federal funds rate within more than a quarter, stock prices respond to them within minutes. Yet, being highly sensitive to economic conditions and among the closely monitored asset prices, stock prices are not only important in understanding the conduct of monetary policy but also the potential economic impact of policy actions and inactions (Ioannidis and Kontonikas, 2008). Lansing (2003) presents the results of Cecchetti et al. (2000) in a simple way by plotting two graphs that show how using stock prices in the Taylor rule increases the fit between actual and proposed monetary policy. The problem in Cecchetti et al.’s proposal is that misalignments should also be taken into account when reacting to asset prices. This is deemed impractical. The reasons being, asset prices are too volatile to be helpful in determining monetary policy, their misalignments are very difficult to identify, and systematically reacting to them may be destabilising (Cecchetti et al., 2000). Nevertheless, the researchers defend their position by arguing that measuring misalignments is not as difficult as measuring the output gap and therefore, stock prices should not be ignored on this basis. According to Goodhart and Hofmann (2000), disregarding asset prices not only results in ignoring information contained in them regarding future demand conditions, but also introduces empirical biases that may mean that monetary policy is based on a mis-specified model of the economy. Bernanke and Gertler (2001) criticise the work of Cecchetti et al. (2000) by saying: “effectively, their procedure yields a truly optimal policy only if the central bank (i) knows with certainty that the stock market boom is driven by non-fundamentals and (ii) knows exactly when the bubble will burst”. Their criticism reflects the fact that Cecchetti et al. (2000) base their tests on one scenario which is: asset prices are driven by bubble shocks that last five years, and not by any other means.

Proactive and reactive

According to Kontonikas and Ioannidis (2005), there are two ways in which monetary policy responds to asset price movements, either proactive or reactive. A reactive approach is consistent with inflation targeting policy that focuses on price stability and according to it, the central bank should see if asset price reversal occurs first, and if it does, react accordingly to the extent of influence on inflation and output stability. A proactive approach, on the other hand, is consistent with the views of Cecchetti et al. (2000) and according to it, the central bank should target inflation, output and asset prices in its policy rule. This is in effect a Taylor rule with extra variable considered in it. In simple economies, Taylor rule would be optimal with the interest rate being a function of current and lagged inflation rate and output gap. However, in open economies, reaction to movements in asset prices is significant (Goodhart and Hofmann, 2000).


From the literature review it can be extracted that researchers have identified three main variables that can be considered in monetary policy rules to identify the behaviour of central banks towards macroeconomic volatility. These are inflation, output and asset prices. The figure [2] below depicts the relationship between these three variables with the interest rate.

Figure 1: Theoretical framework

Independent variables Dependent variable


Interest rates


Asset prices

The figure shows that inflation, output and asset prices have direct impact on interest rates. According to Stock and Watson (2003), because asset prices are forward-looking, they constitute a class of potentially useful predictors of inflation and output growth. Hence, there appears to be a relationship between the independent variables. This relationship is, however, not clear as of yet and to be tested and illustrated in the coming sections. For now, the mechanism, in simple words, seems to work as follows: when there are inflationary pressures, wealth, demand and output increase raising stock prices. As a result, central banks will increase interest rates to offset the macroeconomic variability. The opposite applies when deflationary pressures occur. In regards to asset prices, the focus in my research will, obviously, be on stock prices. The main hypothesis to be tested in this paper is whether monetary policy rules target stock prices explicitly, or implicitly only through their effects on forecasts of inflation and output.


United States quarterly data for federal funds rate, consumer price index (CPI), gross domestic product (GDP) and Standard & Poors (S&P) 500 stock index covering the period from 1990 to 2009 is used. The source of data is the International Monetary Fund. Federal funds rate is the interest rate banks are charged for borrowing loans from other banks overnight and is a closely watched barometer of the tightness of credit market conditions in the banking system, and is therefore the stance of monetary policy (Mishkin, 2010). CPI estimates the average price of a market basket of goods and services purchased by households. The percentage change in CPI is a measure of inflation. GDP is the market value of all products and services made within a country in a year and is therefore a measure of its output. Data and empirical study are analysed using EViews software. The table below shows the descriptive statistics of the data.

Table 1: Data descriptive statistics

Federal Funds Rate



S&P 500





















Std. Dev.






























Federal funds rate and CPI appear to be more normally distributed than GDP and S&P 500 according to the probability values of Jarque-Bera statistic. Data will be divided into two subsamples to highlight any change in monetary policy reflecting the change in the serving chairman of Federal Reserve during the sample period.


The statistical model am going to use is the Taylor rule. There are several reasons for the choice of this estimation method of central banks’ behaviour. First, the concept of Taylor rule was deduced from the implied practice of the Federal Reserve, which is tightening policy during booms and easing policy during busts. Second, the fundamental Taylor rule targets both inflation and output, which is in effect an aggressive inflation targeting approach. Third, stock prices can be easily added to Taylor rule as another variable to test the difference in its effectiveness as an indicator of central banks’ behaviour compared to the fundamental one. The last two justifications replace the need for another rule to expand the research. Taylor’s (1993) original rule is shown in equation (1):


where is the federal funds rate (short-term nominal interest rate), is the equilibrium real interest rate, is the observed inflation rate (yearly percentage change in CPI), is the targeted inflation rate (assumed to be zero [3] ), is the real GDP (output) and is the potential output. The latter is in effect the smoothed version of real GDP calculated using Hodrick-Prescott Filter which eliminates short-term business cycle fluctuations and thereby highlights long-term trends in the variable’s time series. The difference between and represents the percentage deviation of inflation rate from a target. The difference between and is the output gap (expressed as a yearly percentage change). and are arbitrary parameters, and a good monetary policy implies that they are equal to 0.5 each. This will be tested in the next section.

The Federal Reserve Board explained in its first Annual Report for 1914: “[A reserve bank’s] duty is not to await emergencies but by anticipation, to do what it can to prevent them”. Therefore, as early as the founding of the system, Federal Reserve officials have always described the formulation of monetary policy as a forward-looking process, and policy rules that fail to incorporate such information into historical analyses of policy decisions could easily prove inadequate (Orphanides, 2003). Having that in mind, a good modification of the Taylor rule is to replace current inflation and output with expected values as follows:


where is the expected value conditional on information available at time and is an error term. The added to the variables denotes the forecasted period. Fuhrer and Tootell (2008) suggest a good method to create expected values for inflation and output gap based on estimating the following formulas respectively:



In words, we are forecasting inflation and output gap one-quarter ahead by including measures of inflation, output gap and stock prices lagged one-quarter. After estimating the equations, the residual series from equation (3) is taken and subtracted from the inflation series to give inflation forecast. Likewise, the residual series from equation (4) is taken and subtracted from the output gap series to give output gap forecast.

Incorporating stock prices into the Taylor rule requires the use of the following formula which is also called the ‘augmented Taylor rule’:


where denotes the yearly percentage change in stock prices and the length of lag.


Fundamental Taylor rule

The first step is to plot inflation and output gap against the federal funds rate to see if they are correlated and move together. The following graph depicts the relationship.

Graph 1: Federal funds rate, inflation and output gap movementsfirst equation.jpg

It can be seen that the three variables are roughly moving together, and that inflation and output gap are particularly correlated throughout the whole sample period, with federal funds rate showing better correlation with the other two variables after 2001. Second, estimation of equation (1), which is the basic Taylor rule, using Ordinary Least Squares (OLS) estimator is needed to compare the actual and proposed policy response. This estimator chooses the regression coefficients so that the estimated regression line is as close as possible to the observed data (Stock and Watson, 2007). Results are shown in the following table and graph.

Table 2: Estimation output of equation (1)Darbin-Watson.jpg

Graph 2: OLS estimation of equation (1)basic taylor rule.jpg

The graph shows how Taylor rule (dotted line) is roughly in line with the actual rule (connected line) of the Federal Reserve, with only few periods where the fitted interest rate is over- or under-estimated from the actual interest rate. Additionally, the coefficients associated with inflation and output gap in Table 2 are significant, which means that they have considerable effect on interest rates. Nevertheless, the goodness of fit of the regression which is measured by R-squared (also reported in Table 2) explains only 49% of the variability in interest rates. Moreover, the variables do not seem independent and identically distributed (i.i.d.), i.e. they do not seem to have the same probability distribution with being mutually independent. Therefore, to ensure that the standard Taylor rule is well specified, the following tests are performed based on equation (1). To begin with, the arbitrary parameters in the Taylor rule need to be tested. Wald coefficient test verifies whether the joint null hypothesis of = 0.5 and = 0.5 holds. The results of the test are shown below.

Table 3: Wald test statisticsWald test.jpg

From above we can see that both F-statistic and Chi-square statistic have p-values of 0, which indicates that we can safely reject the null hypothesis that both restrictions hold. However, Wald tests are only valid when the error terms are normally distributed. Hence, there is a need to test for that. Jarque-Bera statistic is used for this purpose. It measures the difference between skewness and kurtosis from the sample series with those from a normal distribution.

Figure 2: Normality test statisticsJarque_Bera test.jpg

Since the p-value associated with Jarque-Bera statistic is smaller than 0.05, the null hypothesis of a normal distribution at the 5% level is rejected. This confirms that the restrictions of = 0.5 and = 0.5 in the Taylor rule do not hold. The next step is to test whether the residuals of the regression are spherical by testing for heteroskedasticity and serial correlation. If there is heteroskedasticity, then OLS estimates are still consistent but not efficient, i.e. OLS is not the best linear unbiased estimator (BLUE) and hence, the standard errors are no longer valid. According to Stock and Watson (2007), the error term is homoskedastic if the variance of the conditional distribution of given is constant for = 1, …, and in particular does not depend on . Otherwise the error term is heteroskedastic. The test of the null hypothesis of homoskedasticity against the alternative of heteroskedasticity is White test. The results of the test are reported in the following table.

Table 4: White test statistics for equation (1)White heteroskedasticity test.jpg

According to the F-statistic and R-squared measures, it can be concluded that there is a strong evidence of no heteroskedasticity, i.e. the null hypothesis of homoskedasticity cannot be rejected. To test for serial correlation, the Durbin-Watson (DW) test statistic reported in the estimation output of equation (1) is used. is said to be autocorrelated or serially correlated if it is correlated with for different values of s and t (Stock and Watson, 2007). DW statistic tests for first-order serial correlation versus no correlation. If the residuals are autocorrelated, OLS is no longer BLUE and the standard errors computed are not correct. It can be seen from Table 2 that there is a strong first-order serial correlation because the value of DW statistic is below 1.5 given more than 50 observations in the sample. This test statistic, however, is a rule of thumb and has few limitations including: (i) it is not valid in the presence of lagged dependent variables, (ii) it only tests for first-order serial correlation and (iii) results are not always conclusive. A more general test would be the Breusch-Godfrey Lagrange Multiplier (LM) test. It can be used to test for higher serial correlation and in the presence of lagged dependent variables. The null hypothesis of LM test is no serial correlation against the alternative of order-p serial correlation. The results of the test are shown below.

Table 5: LM test statistics for equation (1)Lm for basic.jpg

It is clear from both F-statistic and R-squared measures that we can confidently reject the null hypothesis of no serial correlation, i.e. there is first-order serial correlation. Since the residuals from the regression are homoskedastic but serially correlated, OLS is still not BLUE. Re-estimating the regression model by OLS but computing the covariances differently to account for autocorrelation is appropriate. Newey-West [4] covariance estimator is used for this purpose.

Table 6: Estimation output of equation (1) with Newey-West covariance estimator

newey-west eq 1.jpg

Results are very similar to the ones obtained by normal estimation of equation (1) – in Table 2 –. Also, variables are still entering the regression significantly. Therefore, it can be concluded that the model is well specified now.

Taylor rule with expected values

As was mentioned in the previous section, a forward-looking rule is preferred to a rule with current values for the variables. Therefore, the next step in the analysis is to estimate equation (2) using OLS. The results are illustrated below.

Table 7: Estimation output of equation (2)est eq 2.jpg

Graph 3: OLS estimation of equation (2)eq 2.jpg

The graph shows that there is a very slight improvement in the fit between proposed and actual interest rates, particularly in the period from 1995 to 2000. However slight the improvement in fit is, it supports the arguments of Orphanides (2003) and Fuhrer and Tootell (2008). Nevertheless, the proposed policy behaviour in this case tends to fluctuate more during the whole period, especially from 2001 to 2009. This might be due to the increased uncertainty stemmed from forecasts. Coefficients of the variables are also highly significant as Table 7 indicates. Yet, their significance is a bit lower than what has been obtained from estimating the fundamental Taylor rule – equation (1) –. The following table summarises the results of White and LM [5] tests applied to equation (2).

Table 8: White and LM tests statistics for equation (2)

White Heteroskedasticity Test

F-statistic 2.486938

Obs*R-squared 11.43993

Breusch-Godfrey Serial Correlation LM Test

F-statistic 238.3915

Obs*R-squared 57.20317

The table shows that both heteroskedastisity and serial correlation are present, and that OLS is, therefore, not BLUE. Setting Newey-West in the estimation of equation (2) gives the following results.

Table 9: