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Analyzing Profit Efficiency Of Banks In India With Undesirable Output– Nerlovian Profit Indicator Approach

Vol 26, No 4; Article by A.R. Jayaraman and M.R. Srinivasan; December 2014

Asset quality is one of the most important indicators of a bank's financial health. For a bank dominated economy such as India, it has important implications for the stability of the overall financial system. Over the years, banking activities have diversified greatly, offering more sophisticated products. Along with this, risks also started increasing and credit risk is the direct fallout of the intermediation process. Non-performing assets, a by-product of loans and advances, have a direct impact on the performance of banks. Hence, for a meaningful performance evaluation of banks, they should be credited for performing assets (desirable outputs) and penalized for non-performing assets (undesirable output). Against this backdrop, this study attempts to analyze the profit efficiency of banks by considering non-performing assets as undesirable output. Construction of profit efficiency measure based on ratio is not feasible when both maximal and observed profit is zero. This is resolved using the Nerlovian profit indicator, which is defined as the difference between maximum and observed profit normalized with value of direction vector.

The objective of this paper is to provide a holistic approach to measure the profit efficiency of banks, factoring desirable/undesirable outputs, using Nerlovian profit indicator approach. Further, profit inefficiency of banks is decomposed into technical and allocation inefficiency. While technical inefficiency indicates suboptimal performance of banks, allocative inefficiency refers to profit losses that arise due to incorrect choice of input-output mix given the relative prices of inputs and outputs. Results reveal that profit inefficiency of banks is primarily due to allocative inefficiency rather than technical inefficiency, which indicates banks need to focus on optimal utilization of input-output mix to enhance the profit efficiency.