Banking & Research IX - Global Financial Architecture

The financial architecture of the world has been undergoing drastic changes for the last two decades. The collapse of the communist economic systems has only speeded up the transition of countries from a regulated economy to market economy. Several developing countries have been struggling to restructure their fragile banking system. It is firmly believed for the last 200 years that weakness in the banking sector may have wider effects as the problems in one bank could spill over into more widespread difficulties in the sector. The very nature of contracts, such as, short-term deposits and longer-term loans that banks hold, exposes them to the possibility of runs. Banks being the backbone of the payment system of a country, their failure will spell higher costs to the economy. From a macro point of view, the efficiency, of the banking system impacts the intermediation costs while from a micro-perspective, efficiency is critical to the very survival of banks in the competitive world. Poorly functioning banking systems impede economic progress and can even destabilize economies while well functioning banks are known to accelerate economic growth. In view of this, there is a need for constant assessment of banks’ effectiveness, particularly, the banking systems of transitional economies. But the existing literature on efficiency levels in banking system is mostly confined to OECD countries.

The paper “Banking Efficiency in Transition Economies: Evidence from Central and Eastern European Banks”, written by Stefania P S Rossi, Markus Schwaiger, and Gerhard Winkler, investigates cost efficiency and its determinants in the Central and Eastern European countries, namely, Czech Republic, Estonia, Hungary, Lithuania, Latvia, Poland, Romania, Slovenia, and Slovakia, over the period 1995-2002. The paper also examines if there are any significant variations in efficiency among the banking systems that emerged during the transition period. The authors have produced a well fitting cost function through a stochastic frontier analysis using a Fourier flexible form, and controlling for country effects. The study reveals that banks have more discretion in handling capital expenses, compared to labor expenses. It is also found that ‘producing’ loans is more cost intensive than ‘producing’ deposits. The efficiency estimates arrived at, through the stochastic frontier approach, exhibit a generally low level of cost efficiency in CEE countries. There are also large variations in the cost function and efficiency estimates across countries. The study identifies the decreasing size, increasing non-interest business, lower problem loans, and bank typology as the determinants of efficiency levels in the CEE markets.

It is commonly perceived that private ownership of firms results in better intrafirm allocation of resources, leading to existence of more efficient firms. Researchers have also been arguing that managers of privately owned firms can be induced to perform efficiently by way of ‘takeover threats’, while a public sector manager is, quite often, found to be immune to such disciplining. There is also enough empirical evidence coming from China, East European countries, etc., fortifying this belief. Ironically, there is also enough empirical evidence to the effect that private firms may not always take decisions that are consistently in congruence with the motto of ‘profit maximization’. For instance, literature on mergers and acquisitions reveals that no additional performance of the predator and target firms was noticed after the merger, as these decisions were said to be mostly based on factors that maximize the payoffs of the managers. So, one section of economists argues that privatization is not the sole panacea for efficient performance. Emboldened by these realities, these economists strongly argue that state-owned businesses can as well be made efficient by increasing competition and hardening budget constraints. These observations are found to be equally applicable to financial intermediaries like banks. However, a few studies that analyzed the relative performance of state-owned and private-owned banks do not indicate a strong relationship between ownership and performance. The article, “Are Foreign Banks Active in Emerging Credit Markets? Evidence from the Indian Banking Industry”, undertakes a systematic study of the lending behavior of foreign banks in India, in relation to domestic banks, by making use of the data for the years 1995-96 to 2000-2001 and stochastic frontier analysis. The authors have estimated an efficient frontier with regard to their ability to disburse credit, and also calculated the distance between each bank and the efficient frontier. The study has shown that there is a steady improvement in the technical efficiency of domestic banks with respective credit disbursals and, over a period, have even surpassed the efficiency levels of foreign banks. The authors also points out that the domestic de novo banks outperform the others, both in profitability and technical efficiency, in credit disbursal. The impact of liberalization of the banking industry and the resultant competition are also palpable. The authors finally conclude that competition, rather than foreign ownership per se, is more likely to be the panacea for the banking sector in developing countries.

The article, “GARCH Effect and Asymmetric Impact of Information on Exchange Rate Volatility”, estimates the GARCH model for a set of exchange rate series of three major currencies, viz., the US Dollar, UK Pound and Japanese Yen, against the Indian Rupee by taking daily data from 1993-2003. The study revealed a significant ARCH and GARCH effect in the three exchange rates studied. The empirical evidence shows that the change in volatility, with the arrival of news—good or bad, is significantly asymmetric for all the three currencies. Among the three currencies studied, volatility under Dollar and Yen is found to be more sensitive to bad news than to the good.

The behavior of the overnight market for unsecured loans is critical to monitory authorities, since this market hosts the first step in the monetary transmission mechanism. However, much of the literature that studied this mechanism assumes that the central banks have a direct control on short-term interest rate. Against this backdrop, the paper, “Interest Rate Determination in the Interbank Market”, constructed a theoretical model of the money market to analyze how this control is actually exerted. The authors have also studied the linkages between the statistical problems of equilibrium in the overnight market and the operational framework of monetary policy. They have used the EONIA panel database that includes daily information on the lending rates applied by contributing commercial banks. The study reveals an increase in both the time series volatility and the cross section dispersion of rates, towards the end of the reserve maintenance period. Similar patterns were noticed both in volumes traded and the usage of the two standing facilities provided by the central banks. The theoretical model has also shown that the operational frame work of the monetary policy causes a reduction in the elasticity of supply of funds by banks, throughout the reserve maintenance period. The elasticity is high, declines gradually over time and becomes low on the last day of the period. Market segmentation and heterogeneity are also found to generate the distribution of rates and trade across banks.

IJBM Vol 3 No. 4