Efficiency and risk in Japanese banking

This paper investigates the impact of risk and quality factors on banks’ cost by using the stochastic cost frontier methodology to evaluate scale and X-inefficiencies, as well as technical change for a sample of Japanese commercial banks between 1993 and 1996. Loan-loss provisions are included in the cost frontier model to control for output quality, with a financial capital and a liquidity ratio included to control risk. Following the approach suggested in Mester (1996) we show that if risk and quality factors are not taken into account optimal bank size tends to be overstated. That is, optimal bank size is considerably smaller when risk and quality factors are taken into account when modelling the cost characteristics of Japanese banks. We also find that the level of financial capital has the biggest influence on the scale efficiency estimates. X-inefficiency estimates, in contrast, appear less sensitive to risk and quality factors. Our results also suggest that scale inefficiencies dominate X-inefficiencies. These are important findings because they contrast with the results of previous studies on Japanese banking. In particular, the results indicate an alternative policy prescription, namely, that the largest banks should shrink to benefit from scale advantages. It also seems that financial capital has the largest influence on optimal bank size.