Incorporating Risk in the Efficiency and Productivity Analysis of Banking Systems

Among the many impacts of the credit crunch will be the necessity for economists to find a reformulation of models for performance measurement in banks. One of the most important issues to address is how to include risk in the measurement of the performance of banking systems. In this contribution, we review three different approaches to the incorporation of risk in measuring the efficiency and productivity performance of banking systems: the use of equity capital as an explanatory variable, the role of scale efficiency change as an indicator of risky behaviour and, finally, the use of second moment statistics to measure risk. The first two approaches can be regarded as indirect measures of risk in contrast to the third, which is a direct measure of it. We illustrate this with empirical work from Boucinha et al. (2009); Kenjegalieva and Weyman-Jones (2009) and Shen et al. (2009). We argue that while the direct approach is theoretically superior it faces very challenging and possibly insurmountable empirical problems.