Section II:
Business in Jordan The Effect of Financial Liberalization on the Efficiency of Financial Institutions: The Case of Jordanian Commercial Banks
Aktham Maghyereh
Aktham Maghyereh is affiliated with the Faculty of Economics & Administrative Sciences, Hashemite University, P.O. Box 150459, Zarqa, Jordan (E-mail:
[email protected]).
SUMMARY. Jordan undertook major financial sector liberalization starting in the early of 1990s. The effect of this reform on the efficiency of the banking sector is evaluated. A non-parametric method of Data Development Analysis (DEA) has been used to arrive at the efficiency scores for a panel data sample covering eight Jordanian commercial banks over the period 1984 to 2001. The findings suggest that liberalization program was followed by an observable increase in efficiency. Another finding of the study is that large banks demonstrated the faster productivity growth during the liberalization. The study has important implications such as guiding the government policy regarding deregulation and liberalization.
[Article copies available for a fee from The Haworth Document Delivery Service: 1-800-HAWORTH. E-mail address: <[email protected]> Website: <http://www.HaworthPress.com> © 2004 by The Haworth Press, Inc. All rights reserved.] KEYWORDS. Jordan, Data Development Analysis, financial institutions, Jordanian commercial banks, commercial banks, financial liberalization
From the early 1970s through the 1980s, Jordanian banking institutions essentially served as agents of the government, channeling investment funds to selected sectors under the countryâs economic development policy. The governmentâs extensive involvement in the banking sector during this period led to serious imbalances in the financial markets and in the structure of the economy. As overall financial repression intensified, the deadweight costs associated with excessive regulation adversely impacted the efficiency of the financial system and resource allocation more generally. Restrictions on bank lending, with favored loans to large family controlled firms and strategic projects, caused small and medium sized firms to turn to the informal sector for financing. An additional and perhaps more important implication of excessive government involvement in the banking system was the erosion of effective credit evaluation and risk assessment policies. As has been well documented, Jordanian banks had little discretion in allocating funds, and therefore little incentive to screen and monitor the activities of corporate customers. As a result, the banking sector became increasingly vulnerable to unbridled corporate expansion. When the economy experienced the recent downturn Jordanian banks suffered immensely. The subsequent ballooning of non-performing loans on bank balance resulted in banking crises. For example, by the end of the 1980s, the share of uncollectible loans of Jordanian banksâ portfolios was estimated at 30 percent.
Beginning in the early 1990s the government, in response to the IMF and World Bank economic adjustment program, undertook a series of steps to liberalize the financial system. Key among the steps were: removal of restrictions on interest rates, reduction of government direct lending, expanded product deregulation, and reduction of restrictions on foreign exchange transactions, among others. Additional reforms were implemented in 1997 to further liberalize the finance system: interest rates were further deregulated, greater autonomy was given to bank managements, increased capital adequate requirements, promoted bank mergers and acquisitions, induced the inter-bank market, and further liberalization of foreign exchange transactions and foreign investment was undertaken. Despite this important reform, there have been no attempts to investigate the impact of the liberalization program on the efficiency of the Jordanian banking sector.
Further, in spite of the significant structural changes and deregulations which have taken place within emerging economies banking sectors, however, it remains relatively under-researched in comparison to the vast amount of research into the efficiency of industrialized countriesâ banking sectors. Recent examples of this type of research in industrialized countries include Berg et al. (1991), Elyawsiani and Mehdian (1995), Hunter and Timme (1995), Mitchell and Onvural (1996), Griefel-Tatje et al. (1996, 1997), Humprey and Pulley (1997), Avkiran (1999, 2000), Ragunathan (1999), Drake (2001), and Sathye (2002).
Although the primary goal of deregulation and liberalization in emerging economies has been to improve banksâ efficiency, earlier results have been mixed; in particular, the short-term effects of liberalization have been discouraging (Leightner and Lovell, 1998; Harker and Zenios, 2000). Zaim (1995) reports efficiency gains in Turkish banks after the 1980s liberalization program. Leightner and Lovell (1998) investigated the Thai banking industry from both the banksâ and the governmentâs perspective from 1989-1994. They found that the average Thai bank had a rapid productivity gain based on its own objectives, but that during this period productivity gains from the liberalization program could not help advance the government objectives (overall economic growth). Gilbert and Wilson (1998) and Hao et al. (1999) examined Korean banking institutions and found that most Korean banks experienced efficiency gains during this period as government controls were lifted. On the other hand, it was found that in Tunisia (Cook et al., 2000) and in Turkey (Yildirim, 2002) liberalization and deregulation does not affect efficiency.
It will be prudent to keep in mind that the consequences of liberalization may differ across countries and may also depend on the sectoral deregulation. In addition, the economic environments are likely to differ significantly across countries and these differences could induce important differences of bank efficiency through different channels. For instance, differences of the per capita, or differences of the density of population across countries could produce significant differences in the nature of the householdâs demand for banking products and services (Dietsch and Lozano-Vivas, 1996). Furthermore, it should be noted that most of these studies investigated the efficiency after and during the deregulation period without covering the period before and after liberalization programs. This may have altered the real impact of such programs. Extending the evaluation to before and after liberalization could show the real impact of liberalization programs on efficiency.
In this paper, we use a non-parametric mathematical programming model (DEA) for each year from 1984 to 2001 to determine whether or not the liberalization program has improved the efficiency of the Jordanian banking sector. It is hypothesized that after liberalization with the new entries and relaxed regulation competition will intensify, which in turn will discipline banks in resource management and force them to be more efficient. In this paper we also investigated the determinants of efficiency in the Jordanian commercial banks using second-stage regressions. Specifically, we considered the effect of bank size, profitability, loan quality, market power, and capital adequacy ratio on the efficiency.
The examination of efficiency in banking has important public policy implications in the Jordanian context. Firstly, the principal aim of the liberalization program is to achieve a more competitive and efficient financial system. The banking industry is a vital part of the financial system in any country. Thus, its successes or failures strongly affect the health of the economy. Secondary, it is interesting to study the determinants of efficiency, as it is extremely useful for managers in improving organizational performance and it also helps the policy-making bodies create, if needed, an appropriate regulatory environment. Lastly, despite the importance of efficiency studies, the literature on efficiency in Jordanian banking does not exist. So a great work is needed on measuring and comparing the efficiency of Jordanian banks. In view of the above, a study of efficiency in Jordanian banks is useful to various interest groups such as the Government, Central Bank of Jordan, and the community. Hence, the present project proposes to address this important issue in Jordanian banks.
The rest of the paper is organized as follows. The second section gives a brief overview on the Jordanian banking system. The third section introduces the methodology. The selection variables and the reasons behind the selection are presented in the fourth section. The fifth section reports the empirical results. The paperâs conclusions are summarized in the sixth section.
A Brief Overview on the Jordanian Banking System
In Jordan, there were 28 banks, of which 14 were commercial, 5 branches of foreign banks, and the rest were development and investment banks. These 28 banks had 466 branches and 144 banking offices. That means approximately one branch for each 10, 000 inhabitants in 2001. Commercial banks are the dominant institution in the Jordanian banking system. The commercial banks in Jordan are completely private ownership. Because of less developed capital markets, the banks are the main source of funding for the industrial and commercial business. Although the newly developing capital markets are able to compute with the banking sector, banks are still dominant in the financial system, as in other developing countriesâ financial systems. Development banks, on other hand, obtain funds from the government or other international institutions like the World Bank. The acquired funds have traditionally been used to make medium and long term loans to selected economics sectors.
The Jordanian banking system was heavily regulated with respect to market entry and interest rates before the 1990s. To increase efficiency and create competition in the financial system, the Jordanian government announced and undertook a series of steps to liberalize the financial system in 1993. The main objective of this program was to establish a Western-type free market economy and competition. Key among the steps were: removal restrictions on interest rates, reduction of government direct lending, expanded product deregulation, and reduction of restrictions on foreign exchange transactions, among others. Additional reforms were implemented in 1997 to further liberalize the finance system: interest rates were further deregulated, greater autonomy was given to bank managements, increased capital adequate requirements, promoted bank mergers and acquisitions induced the inter-bank market, and further liberalization of foreign exchange transactions and foreign investment was undertaken.
There have been also several important technological developments in the industry in recent years. Banks have started computerizing all their operations and have introduced Automatic Teller Machines (ATMs), on-line system of communication and PC banking. They have also changed their product mix and introduced new products to the markets. Therefore, the period between 1984 and 2001 seems to be most suitable for studying the effect of the liberalization program on the performance of the Jordanian banking system in terms of efficiency, since the fundamental institutional changes was established approximately in the middle of this period.
Methodological Issues
The DEA Methodology
There are two basic approaches to the measurement of efficiency: parametric (or econometric) and non-parametric (mathematical programming).1 These two approaches employ different techniques to develop a data set with different assumptions for random noise and for the structure of production technology. These assumptions generate the strengths and weaknesses of both approaches. Firstly, the econometric approach is stochastic and attempts to distinguish the effects of noise from the effects of inefficiency; it is based on sampling theory for the interpretation of essentially statistical results. The programming approach is non-stochastic, and hence groups noise and inefficiency together and calls this combination âinefficiency.â It is built on the findings and observation of population and assesses efficiency relative to other observed units. Secondly, the econometric approach is parametric and confounds the effects of misspecification of functional form with inefficiency. The programming approach is non-parametric and population-based and hence less prone to this type of specification error.
In this paper we used the non-parametric frontier approach to estimate the efficiency of Jordanian banking sector. The parametric approach includes stochastic frontier analysis, the free disposal hall, thick frontier and the Distribution Free Approaches (DFA), while the non-parametric approach is Data Development A...