A STUDY OF FACTORS AFFECTING EFFICIENCY OF PUBLIC SECTOR BANKS

Journal of Services Research, Oct 2008-Mar 2009 by Rao, Nageshwar, Tiwari, Shefali
Banking industry in India is all poised for a major leap in coming years. The year 2004 witnessed some major positive changes in this industry. Falling interest rates, a pick up in demand for loans, chiefly in retail sector and good spreads in treasury transactions caused a substantial face lift to all players in the banking sector. All top rated banks have succeeded in reducing their NPA's by around 65% to 100%. The growth in business is also an impressive 24-41%. But, one thing that is sending alarm signals is that stronger banks are becoming stronger and weaker ones are in the process of being wiped off. This calls for an in depth study of efficiency in the public sector banks, the factors responsible for success and failure of banks. The present study aims at finding answers to similar questions and reveal efficiency determinants amongst public sector banks in India. This study has evaluated the factors affecting the efficiency of public sector banks using twenty-three variables, employing product moment correlation. INTRODUCTION Since the process of liberalization and reform of the financial sector were set in motion in 1991, banking has undergone significant changes. The underlying objectives of these were to make the system more competitive, efficient and profitable. A decade of economic and financial sector reforms has strengthened the fundamentals of the Indian economy and transformed the operating environment for banks and financial institutions in the country. The sustained and gradual pace of reforms has helped avoid any crisis and has actually fuelled growth. As pointed out in the RBI Annual Report 2004-05, GDP growth in the 13 years after reforms i.e. 1992-93 to 2004-05 averaged 6.9% against 5.8% recorded during 1980-81 to 1989-90 in the pre-reform period (Ramkumar, 2005) . The most significant achievement of the financial sector reforms has been the marked improvement in the financial health of commercial banks in terms of capital adequacy, profitability and asset quality as also greater attention to risk management. Further, deregulation has opened up new opportunities for banks to increase revenues by diversifying into investment banking, insurance, credit cards, depository services, mortgage financing, securitisation, etc. At the same time, liberalization has brought greater competition among banks, both domestic and foreign, as well as competition from mutual funds, NBFC's, post office, etc. Post-WTO, competition will only get intensified, as large global players emerge on the scene. Increasing competition is squeezing profitability and forcing banks to work efficiently on shrinking spreads (Bhaskaran, 2005).

Positive fallout of competition is the greater choice available to consumers, and the increased level of sophistication and technology in banks. As banks benchmark themselves against global standards, there has been a marked increase in disclosures and transparency in bank balance sheets as also greater focus on corporate governance. In face of this increasing competition individual banking companies and the banking industry as a whole are striving to find greater efficiencies in their day-to-day operations. In large banking companies, some of these efficiencies are sought by merging entities and therefore in the process, eliminating redundancies in all aspects of operations. For smaller institutions, efficiency gains are usually achieved by controlling costs and generating more diverse and higher levels of non-interest revenues (Verma, 2000). Well being of a nation depends upon its efficiency growth. Efficiency rise means all round prosperity. Waste reduction and efficient utilization of resources accounts for higher profitability of the industrial units. Efficiency leads to better utilization of human, material and technological resources. It can be either overall efficiency or partial efficiency. An efficient management of banking operations aimed at ensuring growth in profits and efficiency requires up-to-dated knowledge of all those factors on which the bank's efficiency depends. This is only possible through research. A lot of research work has so far taken place. Some studies have been undertaken for measuring the productivity and operational efficiency of banks. Forster and Shaffer (2005) have tried to establish relationship between banking efficiency and size or market share. Bonin, et. al. (2005) investigated the impact of privatization on bank efficiency. Giradone, et.al. (2004) investigated the main determinants of Italian banks cost efficiency over the period of 1993-1996. Pal, Mukherjee and Nath (2000) studied the efficiency of 68 major Indian commercial banks for the year 1999. They took 27 public sector banks, 20 private sector banks and 21 foreign sector banks for their study. They also identified weak banks. Five output variables were taken. They were: deposits, net profits, advances, non-interest income and spread. Similarly, five input variables taken were net worth, borrowings, operating expenses, number of employees in the country and number of bank branches in the country. RESEARCH GAP 1. Few studies were conducted on only one bank of a particular sector and only one relationship i.e. cost and efficiency relationship for all the branches was analysed. 2. Studies including two or three sectors were conducted but again the numbers of variables considered were low, like only business per branch and per employee. 3. Few researches undertook input output approach to evaluate the efficiency among the three sectors. But the number of inputs and outputs were four or five. In this study an attempt has been made to bridge the gap between identification of efficiency indicating factors separately for public sector banks. Hence, twenty three variables are grouped and covered under five factors namely, Efficiency factors related to employees, Efficiency factors related to per branch, Efficiency factors related to

operations, Efficiency factors influencing liquidity and Efficiency factors influencing ultimate profits. DATABASE AND METHODOLOGY Out of the 27 public sector banks, a sample of 5 banks is selected. Five banks from the sector are selected as representative banks on the basis of size of deposits for the year 2005. The data is collected for a period of five years (2001-2005). The selected public sector banks in the subgroup are as follows: * Bank of India * Bank of Baroda * Canara Bank * Punjab National Bank * State Bank of India The variables considered for the study are classified into independent and dependent variables. Independent variable: The independent variables are deposits, assets and advances. Dependent variables: Dependent variables are classified into five categories namely: * Efficiency factors related to employees. * Efficiency factors related to per branch. * Efficiency factors related to operations. * Efficiency factors influencing liquidity. * Efficiency factors influencing ultimate profits. Efficiency Factors Related To Employees: Different measures as efficiency factors related to employees were taken because employees cost /labour cost is significant cost in total banking cost. This category deals with five different sub-factors, which are as follows:

* Operating Profit/Employee * Deposit/Employee * Credit/Employee * Spread/Employee * Business/Employee Efficiency Factors Related To Per Branch: Efficiency factors related to per branch are taken because efficient operations and performance of all the branches will determine the overall efficiency of the bank. This category deals with four different subfactors, which are as follows: * Operating Profit Per Branch * Spread Per Branch * Deposit Per Branch * Advances Per Branch Efficiency Factors Related To Operations: This category determines how efficiently the banks are utilizing the funds available to them and also what is the robustness of the income generated by operations. It refers as to how efficiently a bank manages its business. This category deals with six different subfactors, which are as follows: * Interest Income/Average Working Funds * Non Interest Income/Average Working Funds * Operating Expenses/Operating Income * Cost of Deposits * Spread / Average Working Funds * Capital Adequacy Ratio (CAR) Tier I and Tier II Efficiency Factors Influencing Liquidity:

This category of dependent variables represents the level of liquidity maintained by the banks to meet the liabilities. This category deals with three different sub-factors, which are as follows: * Statutory Liquidity Ratio (SLR) * Cash Reserve Ratio (CRR) * Liquid Assets /Total Assets Efficiency Factors Influencing Ultimate Profits: This category indicates the profitability of the banks at different stages to give a meaningful idea of efficiency at each stage. This category deals with five different subfactors, which are as follows: * Operating Profit Margin * Net Profit Margin * Operating Profit/Average Working Funds * Return on Capital Employed * Credit/Deposit Ratio The data relating to these variables have been collected from the audited Balance Sheet and Income and Expenditure Statement of each bank for a period of five years (20012005). Absolute values were collected and twenty-three ratios under the study were calculated separately for each bank and for each year. Product Moment Correlation was used for the data processed as above, using SPSS 11.0. The audited Balance Sheet and Income and Expenditure Statement of each bank was collected from data base on Indian Banks published by the Indian Bank's Association, website of the Reserve Bank of India (www.rbi.org.in) and website of individual banks. Twenty-three ratios separately for each bank and for each year are given in Table 1, Table 2, Table 3, Table 4, and Table 5. RESULTS Relationship Between Efficiency Factors Related To Employees With Deposits, Assets And Advances: Among the different sub-factors of efficiency factors related to employees, none were found to be significantly correlated at 0.05 level of significance with deposits, assets or advances, the three output constructs of efficiency (table 6). This means that the factor, comprising of all these sub-factors, itself is not significantly correlated to the deposits,

assets and advances. Thus, the efficiency factors related to employees or employees related sub-factors are not significantly influencing the efficiency of public sector banks. Relationship Between Efficiency Factors Related To Per Branch With Deposits, Assets And Advances: In case of different sub-factors of 'per branch' factor, operating profit per branch was found to be significantly correlated with deposits, assets and advances at 0.05 level of significance. The product moment correlation coefficient came out to be 0.91, 0.91, 0.90, respectively (table 7). This indicates a significant positive relationship between operating profit per branch and the output constructs of bank efficiency. Further, it can be inferred that efficiency factors related to per branch are significantly correlated to output constructs of efficiency and hence it is an important factor influencing the overall efficiency of public sector banks. And among different sub-factors of 'per branch' factor, operating profit per branch is most significantly related to efficiency constructs of public sector banks. Relationship Between Efficiency Factors Related To Operations With Deposits, Assets And Advances: Among the different sub-factors of 'operations' factor, cost of deposits was found to be significantly correlated with deposits, assets and advances at 0.05 level of significance. The product moment correlation coefficient came out to be 0.97, 0.97, 0.96, respectively (table 8). This indicates a significant positive relationship between cost of deposits and the output constructs of bank efficiency. Further, it can be inferred that efficiency factors related to operations are significantly correlated to output constructs of efficiency and hence it is an important factor influencing the overall efficiency of public sector banks. And among different sub-factors of 'operations' factor, cost of deposits is most significantly related to efficiency constructs of public sector banks. Relationship Between Efficiency Factors Influencing Liquidity With Deposits, Assets And Advances: Among the different sub-factors of efficiency factors influencing liquidity, none of them were found to be significantly correlated at 0.05 level of significance with deposits, assets and advances (table 9). This means that the factor, comprising of the three sub-factors, itself is not significantly correlated to the deposits, assets and advances. Thus, the efficiency factors influencing liquidity or liquidity related sub-factors are not influencing significantly the efficiency of public sector banks. Relationship Between Efficiency Factors Influencing Ultimate Profits With Deposits, Assets and Advances: Among the different sub-factors of efficiency factors influencing ultimate profits none were found to be significantly correlated at alpha level 0.05 with deposits, assets and advances (table 10). This means that the factor itself is not significantly correlated to the

deposits, assets and advances or the efficiency constructs. Thus, the efficiency factors influencing ultimate profits are not influencing significantly the efficiency of public sector banks. Out of the five factors, only two factors i.e. efficiency factors related to per branch and efficiency factors related to operations are significantly correlated to efficiency for public sector banks. Hence, they play significant role in influencing the overall efficiency of public sector banks (table 11). DISCUSSION * Efficiency factors related to employees are not having a significant correlation with any of the efficiency output constructs i.e. deposits, assets and advances. The probable reason might be that since they are present in the country much before the arrival of private and foreign sector banks, therefore, these banks have a broad employee base and this base is distributed among broad branch network, which generates highest business in the industry. Despite of generating highest business, the broad employee base nullifies the influence on efficiency. The other reason may be that efficiency factors related to employees do not have much variation across different public sector banks. Whereas, the deposits, assets and advances have a large variation across the very same banks. Hence, the employee related factors do not have a significant correlation with efficiency output constructs. The reason for efficiency output may be something else, which is not captured by employee related factors. * Per branch factor measures the contribution of per branch efficiency in overall efficiency of public sector banks. The efficiency factor related to per branch is significantly correlated to all the output constructs of bank efficiency i.e. deposits, assets and advances for public sector banks. Since, public sector banks existed in the country much before the arrival of private and foreign sector banks, the number of branches is higher than private and foreign sector banks, tapping rural and urban markets. This results into greater per branch business. Hence, the 'per branch' sub-factors influence significantly the overall efficiency of public sector banks. * 'Operations' related factors determine how efficiently the funds are deployed and converted into income. This factor determines the capability of the bank in generating good business. Since the public sector banks are involved in mass banking therefore they are not able to trap high net worth individuals and big corporate accounts. These banks generate deposits from small accounts. To maintain small accounts they have to incur high expenditure. This increases the cost of deposits, in turn increases the business also. Business means deposits and advances. Therefore, the cost of deposits and the 'operations' efficiency factor itself comes out to be positively correlated at alpha level 0.05. * 'Liquidity' related factors identify the bank's status to meet demanding situations. This factor shows the efficiency of banks to face liquidity related problems. It has been found

that the efficiency factors influencing liquidity are not having any direct impact on the output constructs of efficiency for public sector banks. The sub-factors of this factor are statutory liquidity ratio, cash reserve ratio and liquid assets / total assets. The insignificant correlation might be because of the fact that the above-mentioned subfactors are mandatory requirements which all the public, private and foreign sector banks have to maintain according to the size of their deposits, assets and advances. Being a policy matter, these sub-factors may not have significant role in influencing the efficiency. * The efficiency factors influencing ultimate profits discovers profitearning ability of the commercial banks through optimum deployment of funds at different stages. The efficiency factors influencing ultimate profits were found to be insignificantly correlated to any of the output constructs of efficiency for public sector banks. The reason for this might be that the sub-factors under this factor are dependent on some other variables, which may not be correlated to efficiency. For example, return on capital employed is dependent on profits as well as net worth. The public sector banks have excessive amount of owned funds i.e. capital and retained earnings which generate good amount of profits. But the profits get reduced as operating expenses of public sector banks is very high and the NPA level is also high due to priority sector lendings. Thus, the influence of return on capital employed on deposits, assets and advances respectively gets nullified. The same situation exists for the other sub-factors of this factor. In future if the public sector banks concentrate on the proper utilization of excessive funds mainly owned funds and reduce NPA's to cross the average level of efficiency, then this factor may enhance the deposits, assets and advances. SUGGESTIONS Based on the findings and discussion some guidelines for improving efficiency of public sector banks can be given. It was found that 'per branch' and 'operations' related efficiency factors are influencing the overall efficiency of public sector banks. Hence, the efficiency subfactors underlying the 'per branch' and 'operations' efficiency factors must be given emphasis in order to improve the overall efficiency of these banks. The efficiency indicators are operating profit per branch, spread per branch, deposit per branch, advances per branch, interest income/average working funds, non-interest income/average working funds, operating expenses/operating income, cost of deposits, spread/average working funds, capital adequacy ratio. Since, these sub-factors are enhancing the output constructs of bank efficiency therefore these ratios should be specifically looked into. For example, operating profit per branch, spread per branch, deposit per branch, advances per branch can be increased by shutting down the unviable branches. The rural branches can be restructured to yield better results. The rural branches must go beyond providing credit and extend a helping hand in terms of advice on a wide variety of matters related to agriculture. This restructuring will reduce the operating expenses as well as NPA's as the borrowers would be able to effectively utilize the loan with expert advice provided by banks. And if operating expenses are reduced, the per branch efficiency and operational efficiency of public sector banks will automatically increase which in turn will increase their overall efficiency. Voluntary

retirement scheme is also a right step. It is increasing the current operating expenses. But the benefits of the policy will be reaped in future. Increasing the 'interest earned' component can increase interest income/average working funds. This can be achieved if public sector banks stop relying only on long-term loans and advances and tap the other business opportunities available in retail finance and small and medium enterprises (SME's) finance. This sector is attractive because it is growing 10% annually and the profit margins are better than those in big corporate lendings. Lowering down cost of deposits can enhance the operational efficiency. This cost can be reduced by redefining the deposit mix i.e. by increasing the proportion of low cost deposits in total deposits. In order to increase the efficiency of employees these banks should adopt latest technology and also appoint trained computer experts to handle the banking services. Existing staff must also be trained on latest technical tools and techniques to cope up with the increasing customer demands of more speed, accuracy and quality service/product. The public sector banks should operate through the same existing branches instead of having separate branches for adding new services to their portfolio. The financial service mall is a cost-effective route. One can sell multiple products keeping the cost low and check the incidence of NPA's in a better way. It was observed that attitudinal change among bank employees has not so far occurred as demanded by the present market system. Therefore, the public sector banks must place emphasis on change management (Bodla and Verma, 2006). REFERENCES Bodla, B.S. and Verma, R. (2006) 'Determinants of profitability of banks in India: a multivariate analysis', Journal of Services Research, 6:2, 75-89. Bhaskaran, S. (2005) 'Changing faces of Indian banking', Professional Banker, 2, 32-36. Bonin, J., Hasan, I. and Wachtel, P. (2005) 'Privatization matters bank efficiency in transition countries', Journal of Banking & Finance, 29:9, 2155-2178. Forster, J. and Shaffer, S. (2005) 'Bank efficiency ratios in Latin America', Applied Economics Letters, 12:9, 529-532. Giradone, C., Molyneux, P. and Gardener, E. (2004) 'Analysing the determinants of bank efficiency: the case of Italian banks', Applied Economics, 36:.3, 215-227. Pal, M., Mukherjee, A. and Nath, P. (2000) 'Performance analysis of the Indian banks-an exploration', International Journal of Bank Marketing, 20:3, 122-139. Ramkumar, V. (2005) 'Core banking solutions', Chartered Financial Analyst, 50-54. Verma, D.(2000) 'Banking on change', ICFAI Reader, 11:6, 67-70. Nageshwar Rao is Director and Professor at Jawaharlal Nehru Institute of Business Management, Ujjain.

Shefali Tiwari is reader in the Department of Business Management, Govindram Seksaria Institute of Management and Research, Indore. Copyright Institute for International Management and Technology Oct 2008-Mar 2009 Provided by ProQuest Information and Learning Company. All rights Reserved Rao, Nageshwar "A STUDY OF FACTORS AFFECTING EFFICIENCY OF PUBLIC SECTOR BANKS". Journal of Services Research. FindArticles.com. 20 Jan, 2011. http://findarticles.com/p/articles/mi_7629/is_200810/ai_n32297931/ Copyright Institute for International Management and Technology Oct 2008-Mar 2009 Provided by ProQuest Information and Learning Company. All rights Reserved