Non-performing loans and bank efficiencies: an application of the input distance function approach

Abstract

This study tries to investigate how non-performing loans (NPL) affect Taiwanese commercial banks. We employ the input distance function approach to find the frontier of production possibility set and then apply the envelope theorem to calculate the shadow prices of NPL. The shadow price of NPL is the marginal cost of reducing NPL when banks are operating on the production frontier. Empirical results show that public banks have to spend more resources than private banks to cut NPL and both types of banks follow the similar trend through time. Compared to those established before deregulation, banks established after deregulation need almost 2.5 times more resources to reduce one unit of NPL. The marginal costs of reducing NPL for banks established before and after deregulation appear reverse trends during 1999–2001. Furthermore, Taiwanese commercial banks in average could increase their technical efficiencies by 34.57 percent provided that all banks operated on the production frontier.