Efficient, Profitable and Safe Banking: An Oxymoron? A Panel VAR Approach

Abstract

Cost and profit efficiency (CE and PE) are key to evaluate bank performance. But efficiency improvements may imply deteriorating profitability and excessive risk-taking. The dynamic reactions of performance in response to efficiency changes remain unclear on both theoretical and empirical grounds. We use panel data provided by the German central bank to estimate impulse response functions derived from a vector autoregressive model to measure the response of profitability (ROA) and probabilities of default (PD) to efficiency shocks. A unit shift in efficiency reduces PD's and increases ROA. The long-run impact of PE on risk is larger than for CE, but the latter reduces PD's faster. CE has a slightly larger impact on profits than PE. In sum, efficient and stable banking do not contradict each other.