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Bank efficiency in Latin America
Philip Molyneux and Jonathan Williams
Bangor Business School, Bangor University, UK
1.1 Introduction
Across Latin America, the period from the mid-1980s is characterised by fundamental shifts in public policy that have led to a reconfiguration of the industrial structure of national banking sectors. Policies associated with financial repression, namely interest rate controls and directed lending, were replaced by liberal policies that sought to increase competition and bank efficiency. Amendments to entry and exit conditions, the privatisation of state-owned banks and repeal of restrictions on foreign bank entry led to changes in bank ownership and the reform of governance (Carvalho, Paula and Williams, 2009). Improvements to bank governance that temper the risk-taking behaviour of bank owners are expected to lead to increases in bank efficiency (Caprio, Laeven and Levine, 2007; Laeven and Levine, 2009).
Latin America was badly affected by regional banking crises during the mid-1990s. The resolution of the crises required extensive government intervention that led to increases in market concentration (Domanski, 2005). Intervention involved a restructuring process that included the nationalisation of banks; transfer of ownership to healthy institutions; liquidation of bankrupts; and use of public funds to recapitalise and give liquidity to distressed banks. As a result, Latin American banking sectors operate under conditions of monopolistic competition (Gelos and Roldós, 2004). In terms of efficiency, increases in concentration may stifle competition because concentrated markets lack market discipline, which leads to lower efficiencies (Berger and Hannan, 1998). In spite of this concern, across the region there was an implicit assumption that private ownership would lead to a more efficient outcome, especially as public banks had served political and social purposes (Carvalho, Paula and Williams, 2009). Public ownership of banks is a feature of institutional and financial underdevelopment (La Porta et al., 2002), and the state’s share of banking sector assets had been around 45% and 50% in Argentina and Brazil in the early 1990s (Carvalho, Paula and Williams, 2009). At this time, public ownership of banking sector assets amounted to 100% in Mexico following the 1982 nationalisation in response to the debt crisis (Haber, 2005). According to Ness (2000), public ownership created moral hazards between the government’s economic and political goals and bank’s business goals, and the relatively large size of public banks conferred a too-big-to-fail status that required frequent use of public funds to support ailing institutions.
To facilitate competition and improve efficiency, and to recapitalise distressed banks, governments repealed restrictions on foreign bank entry. The sale of local banks to foreigners is based on an assumption that private ownership is more effective in resolving agency problems (Megginson, 2005), and foreign banks possess superior management skills and technological capabilities that let them export efficiencies from home to host. Foreign bank entry is expected to boost banking sector efficiency because incumbent domestic banks must improve efficiencies or face losing market share. Operational diseconomies associated with distance from the home headquarters and cultural difference between the home and host countries can raise costs and lessen efficiencies at foreign banks (Berger et al., 2000; Mian, 2006). There is evidence to suggest foreign bank penetration in the post-restructuring period in Latin America did improve competition particularly when more efficient and less risky foreign banks entered the market (Jeon, Olivero and Wu, 2010). Efficiencies may be adversely impacted because foreign banks could ‘cherry pick’ the best customers and force local banks to service higher risk customers; foreign banks face information constraints and are less effective at monitoring soft information, which suggests credit to the private sector may be lower and certain sectors could face financial exclusion under conditions of increasing foreign bank penetration.
In order to investigate bank inefficiency in Latin America, we use a relatively new approach that deals with the problems associated with firm heterogeneity over time. Bank inefficiency is measured in terms of a bank’s deviation from a best-practice frontier that represents the underlying production technology of a banking industry. Best-practice or efficient frontiers can be estimated by parametric and/or non-parametric methods. The most popular approaches are stochastic frontier analysis (Aigner, Lovell and Schmidt, 1977; Meeusen and van den Broeck, 1977) and data envelopment analysis (Farrell, 1957; Banker, Charnes and Cooper, 1984). The results reported later in this chapter apply the former approach to estimate bank efficiency and utilise methodological advances in efficiency modelling to account for an anomaly that can ‘seriously distort’ estimated inefficiency (Greene, 2005a, 2005b; Bos et al., 2009). As just noted, the anomaly is how to treat cross-firm heterogeneity. Standard panel data approaches confound any time-invariant cross-firm heterogeneity with the inefficiency term. The problem may be resolved using so-called true effects models and random parameters models that are adapted to stochastic frontier analysis. This class of model is attractive because it relaxes the restrictive assumption of a common production technology across firms (Tsionas, 2002).
The remainder of this chapter outlines the bank efficiency literature on Latin America and then briefly presents our results on four systems – Argentina, Brazil, Chile and Mexico – from 1985 to 2010 using modelling approaches that deal with the problem of firm heterogeneity in panel estimations.
1.2 Privatization and foreign banks in Latin America
Bank privatisation and foreign bank penetration altered the market structure of national banking sectors and transformed the governance structure of banks as new, private owners (domestic and foreign) assumed control of banks. Formerly, Argentina and Brazil had extensive state-owned banking sectors, but privatisation offloaded banking sector assets onto the private sector that was expected to manage the assets more efficiently (Carvalho, Paula and Williams, 2009). State-owned banks had served political and social purposes but their characteristics included weak loan quality, underperformance, and poor cost control. Yet, privatisation outcomes are variable. In Argentina and Brazil, privatised bank performance improved post-privatisation (Berger et al., 2005; Nakane and Weintraub, 2005). In contrast, the failed 1991 Mexican bank privatisation programme cost an estimated $65 billion (Haber, 2005). Across the region, foreign banks have acquired large, local banks, many under temporary government control for restructuring. Some evidence finds a positive association between foreign bank penetration and bank efficiency. There are caveats: the need to distinguish between the performance of existing foreign banks and local banks acquired by foreign banks; and to disentangle the effects of foreign bank entry from other liberalisation effects that could impact bank efficiency.
Studies report differences in performance between local, private-owned and foreign-owned banks. Foreign banks achieved higher average loan growth (in Argentina and Chile) with loan growth stronger at existing foreign banks compared to acquired foreign banks. This suggests management at foreign bank acquisitions focused on restructuring their acquisitions and integrating operations with the parent (foreign) bank. The cautious nature of foreign bank strategies explains why foreign banks, and foreign bank acquisitions in particular, achieved better loan quality than local banks (Clarke, Crivelli and Cull, 2005), although stronger provisioning and higher loan recovery rates translated into weaker profitability at foreign banks. Foreign banks are relatively more liquid, rely less on deposit financing and produce stronger loan growth during episodes of financial distress than domestic banks. It is suggested that the greater intermediation efficiency of foreign banks arose because they were more able to evaluate credit risks and allocated resources at a faster pace than their local competitors (Crystal, Dages and Goldberg, 2002).
Evidence from Argentina shows state-owned banks underperformed against private-owned and foreign-owned banks due partly to poor loan quality associated with direct lending and subsidised credit. Bank privatisation produced efficiency gains because of falling non-performing loans and higher profit efficiencies. However, local M&A activity and foreign bank entry exerted little effect on bank performance (Berger et al., 2005). These findings do not generalize to Brazil where foreign banks faced difficulties in adapting to the peculiarities of the Brazilian banking sector, which is dominated by local, private-owned banks (Paula, 2002). The empirical record offers no support to suggest foreign banks are more or less efficient than domestic banks (Guimarães, 2002; Vasconcelos and Fucidji, 2002). This is unsurprising in the light of evidence that the operational characteris...