Efficiency and risk management in Spanish banking: a method to decompose risk

Abstract

The single market programme has substantially increased the level of competition in the Spanish Banking System (SBS). This greater competition, though driving firms to improve their efficiency, may also encourage them to orient their businesses towards activities, sectors, and/or clients of higher risk. However, in spite of the importance of jointly evaluating efficiency and risk, the traditional measurements of efficiency do not take risk into account. Furthermore, the few studies that attempt to include risk do not separate the part of risk that is due to poor management (internal) from that which originates in the economic environment (external). This article proposes a new sequential DEA procedure to break down the main indicator of banking risk provision for loan losses (PLL)— into internal and external components, in order subsequently to obtain measurements of efficiency adjusted for risk. The analysis is illustrated by application to the SBS where deregulation, imposed by the Single Market Programme of the European Community, has affected banks conduct in terms of efficiency and risk.