Problem loans and cost efficiency in commercial banks

TLDR

The study examines the underexplored link between problem loans and bank cost efficiency. The authors aim to test four hypotheses about how loan quality, cost efficiency, and bank capital influence each other using Granger causality. The study uses Granger‑causality analysis to examine the causal relationships among loan quality, cost efficiency, and bank capital. Problem loans and cost efficiency exhibit bidirectional causality, with capital reductions at thinly capitalized banks preceding increases in problem loans, suggesting cost efficiency may predict future problem loans while leaving uncertainty about controlling for problem loans in efficiency estimates.

Abstract

This paper addresses a little examined intersection between the problem loan literature and the bank efficiency literature. We employ Granger-causality techniques to test four hypotheses regarding the relationships among loan quality, cost efficiency, and bank capital. The data suggest that problem loans precede reductions in measured cost efficiency; that measured cost efficiency precedes reductions in problem loans; and the reductions in capital at thinly capitalized banks precede increases in problem loans. Hence, cost efficiency may be an important indicator of future problem loans and problem banks. Our results are ambiguous concerning whether or not researchers should control for problem loans in efficiency estimation.