Cost efficiency, determinants, and risk preferences in banking: A case of stochastic frontier analysis in the Philippines

Abstract

This paper examines the cost efficiency of Philippine commercial banks using stochastic frontier analysis and specifically incorporating risk and asset quality measures in the estimation. Consistent with earlier findings, the results show substantial inefficiencies among domestic banks and that risk and asset quality affect the efficiency of banks. The substantial increase in the cost inefficiency could be attributed to the adverse effects of the 1997 Asian financial crisis and the subsequent costs of banking reforms and regulatory changes which were enacted to stabilize and strengthen the sector. Macroeconomic instabilities, particularly banking crisis, could have distorted the incentive structure for banks, making resource allocation to achieve efficiency a more difficult task. From a policy perspective, this study highlights the economic importance of encouraging increased efficiency in the banking sector by tapping the potential for significant improvements in the banks’ cost efficiency.