Modelling risk in efficiency and productivity analysis of banking systems

We argue in this paper that the standard intermediation specification in the banking efficiency and productivity analysis literature has difficulty incorporating risk, and we first review the literature to discover alternative specifications of bank objectives in constructing risk based performance measures including the role of equity capital. We also show in this paper, however, that strong loan growth without complementary input change is consistent not only with scale efficiency improvement but also with weaker loan risk management, and that productivity component analysis may provide risk measures. We review some recent empirical work on European, Asian, and Russian banking systems to demonstrate these arguments. Finally, we argue that a different approach to modelling the activity of banking firms may be useful. Our suggested model is related to the investment trust performance literature where risk is treated as an input and return is an output.

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