Scale economies, cost complementarities and technical progress in Indian banking: evidence from fourier flexible functional form1

Abstract

This article uses a multi-product Fourier flexible cost function specification to investigate scale economies, cost complementarities and technical progress of Indian banks during the post reform period 1992 to 2003. The empirical results indicate that there exist significant economies of scale for all size classes of banks and there is no evidence of diseconomies of scale, even for larger banks. In particular, for small and medium-size banks, there is enough opportunity to increase output by either increasing the scale or merging with other banks to improve the average cost curve. The evidence is fairly robust even after controlling the impact of asset quality and overall risk exposure in the cost function specification. In addition, the statistical test confirms that the industry cost function does not have a Translog form. The results do not find any empirical evidence of cost complementarities between outputs. In terms of technical progress, Indian banks have experienced significant cost reduction which is as high as 5% for the recent period. However, the effects due to the scale augmenting and nonneutral components are found to be negligible. 1 Opinions expressed in this article are the sole responsibility of the authors and do not necessarily reflect the views of the institutions with which they are affiliated.