Bad Management, Skimping, or Both? The Relationship between Cost Efficiency and Loan Quality in Russian Banks

Abstract

This paper investigates the relationship between operating cost efficiency and the loan quality of Russian banks. It tries to answer the question whether it is always beneficial for banks to be highly cost efficient (the “bad management” hypothesis) or whether this higher cost efficiency could mean inadequate spending on borrower screening, which could subject banks to higher credit risk exposures in the future (the “skimping” hypothesis)? Our main result implies that, while the “bad management” hypothesis holds on average for the banking sector as a whole, the “skimping” hypothesis could be the case for those Russian banks that are not just highly cost efficient, as predicted by Berger and DeYoung (1997) for US banks, but that at the same time pursue aggressive strategies in the market for loans to households and non-financial firms, especially during the pre-crisis periods when banks are too optimistic to pay increased attention to the quality of borrowers in order to extract higher profits in the short run. Interestingly, we show that the “skimping” strategy is not the case for those Russian banks that demonstrate a lower equity-to-assets ratio and that are highly cost efficient at the same time because, as we believe, higher financial leverage forces these banks to filter out low quality borrowers to be able to repay borrowed funds. From perspective of regulatory policy, these conclusions provide clear arguments in favor of differential prudential regulation in Russia, which could, if being implemented, positively affect the loan quality of both banks that are skimpers (through restricting loans growth by higher capital adequacy requirements and/or increased payments to the Russian Deposit Insurance Agency) and banks that are not (through eliminating incentives to grow too fast), thus improving the stability of the banking sector as a whole.