Examining the relationships between Capital, Risk and

Efficiency in European Banking.

Presented By:Ambu GyawaliAnita K. LuitelAyush Nepal

Barsha ShresthaBidur Koirala

IntroductionIn recent years European banking systems have become

increasingly integrated and liberalized on the road to greater product and service deregulation.

The progressive process of financial integration emphasizes the importance of enhancing competition and leading towards improved efficiency of financial institution.

Regulators have tried to counterbalance various incentives by creating capital adequacy as a prominent role in the entire banking regulatory process.

Due to both regulatory and market pressures European banks have been under pressure to boost their capitalization.

This paper analyses the relationship between capital, risk and efficiency for a large sample of European banks between 1992 and 2000 from 15 European countries.

Bank-specific data were obtained from the Bank-scope database that includes balance sheet and income statement information on European (and other) banks.

Researchers focused on different bank ownership types as non-quoted (and/or private) firms might pursue different objectives than their joint-stock competitors.

Literature ReviewJensen and Meckling (1976), Fama (1980)

Lack of capital market discipline for firms weakens owners’ control over management, making management freer to pursue its own agenda, and thus providing it with fewer incentives to be efficient.

Purroy and Salas, 2000; Berenguer et al., 2003

Mutual banks may have competitive/efficiency advantages even if they show expense preference behavior.

Altunbas et al. (2001)

Public and mutual banks have slight cost and profit efficiency advantages over their private commercial banking counterparts

Hughes and Moon (1995)

It is necessary to recognize explicitly, the concept of efficiency in the empirical models, linking the relationship between bank capital and risk.

Purpose of the StudyThe purpose of the study is to examine the

relationship between capital, risk and efficiency in European banking.

Likewise, the study focuses to investigate the elements of capital, risk and efficiency in the European banking sector.

The study furthermore examines the impact on financial strength of the corporate sector and bank risk taking and capital levels.

Significance of the StudyThe study basically helps apprehend the

relationship between capital, risk and efficiency in European banking.

This study is relevant to examine how the capital, risk and efficiency in European banking can better be improved if attention is given to a number of variables.

MethodologyZellner’s Seemingly Unrelated Regression

(SUR) approach has been used in the research.

This allows for simultaneity between banks’ risk, capital and efficiency.

Further, this also helps controlling important bank and country-specific factors.

For the explanatory variables bank specific and country specific variables has been used.

ModelModel 1: Banking Sector Risk

LLRLij = a + b ETAij + c INEFFij + d NLTAij + e LNTAij + f LAODEPij + g INSBOCj + h

SOLVENCYj + i LAOACj + j LLPOACj + YEARj ………………………………………………(1)

Model 2: Bank Capital Levels ETAij = a + b INEFFij + c NLTAij + d LNTAij + e ROAij + f LAODEPij + g INSBOCj + h SOLVENCYj + i LAOACj + j ROCCj + k COIRCj + l OEPOACj + m LLPOACj + YEARj..……….(2)

Model 3: Determinants of Bank Cost Inefficiency. INEFFij = a + b ETAij + c LLRLij + d NLTAij + e LNTAij + f LAODEPij + g INSBOCj + h SOLVENCYj + i LAOACj + jCOIRCj + k OEPOACj + l LLPOACj + YEARj ………….(3)

Where: Bank-specific variables are:

LLRLij Loan-Loss Reserves for bank i in country j

ETAij Equity to Assets Ratio for bank i in country j

INEFFij Cost Inefficiency for bank i in country j

NLTAij Net Loans to Total Assets for bank i in country j

LNTAij Natural log of Total Assets for bank i in country j

ROAij Return-on-Assets for bank i in country j

LAODEPij Liquid Assets to Customer and Short-term

deposits for bank i in country j

Country-specific variables are:

INSBOCj Interest rate spreads over 3-year government bonds

in country j

SOLVENCYj Current assets to current liabilities for non-financial companies in country j

LAOACj Banking system liquid assets to total assets in country j

ROCCj Banking system return on capital in country j COIRCj

Banking system cost to income ratios in country j

OEPOACj Banking system operating expenses to total assets in country j

LLPOACj Banking system loan-loss provisions to total loans in country j

YEARj Yearly dummy variables for 1992 to 2000

Major Findings

 Variables

 All banks

Commercial

BanksSavingsBanks

CooperativeBanks

Most Efficient

Banks1

Least Efficient

Banks2

ETAij 0.085∗ 0.033∗ 0.091∗ −0.066∗ −0.059∗ 0.053∗

  (0.0045) (0.0078) (0.0089) (0.0117) (0.0093) (0.0093)INEFFij −0.008 −0.04∗ −0.154∗ −0.041∗ −1.559∗ 0.056∗

  (0.0042) (0.0071) (0.0089) (0.0085) (0.0486) (0.0074)NLTAij −0.028∗ −0.019∗ −0.044∗ −0.014∗ −0.037∗ −0.023∗

  (0.0016) (0.0030) (0.0018) (0.0023) (0.0048) (0.0028)LNTAij 0.019 −0.223∗ 0.024 0.083∗ −0.093+ −0.215∗

  (0.0173) (0.0386) (0.0176) (0.0220) (0.0404) (0.0409)LAODEPij 0.005∗ 0.006∗ −0.002 0.018∗ 0.011∗ −0.001

  (0.0012) (0.0020) (0.0014) (0.0021) (0.0024) (0.0023)INSBOCj 0.124∗ −0.017 0.206∗ 0.022 0.906∗ −0.303∗

  (0.0271) (0.0577) (0.0283) (0.0348) (0.0691) (0.0639)SOLVENCYj −0.025∗ −0.012∗ −0.018∗ −0.05∗ −0.006 −0.013∗

  (0.0018) (0.0033) (0.0018) (0.0031) (0.0039) (0.0037)LAOACj 0.052∗ 0.043∗ −0.034∗ 0.057∗ 0.078∗ 0.032∗

  (0.0030) (0.0055) (0.0045) (0.0048) (0.0083) (0.0055)LLPOACj 1.519∗ 1.379∗ 0.708∗ 3.274∗ 1.354∗ 1.959∗

  (0.0763) (0.1478) (0.0713) (0.1326) (0.1713) (0.1863)

 Variables

 All banks

CommercialBanks

SavingsBanks

CooperativeBanks

Most EfficientBanks1

Least Efficient

Banks2

D1992 0.128 0.296 0.248 0.15 −0.854 0.047

  (0.2325) (0.4522) (0.2020) (0.3469) (0.5680) (0.4730)

D1993 −0.288 −0.074 0.291 −0.432 −0.651 −0.469

  (0.2196) (0.4325) (0.1904) (0.3347) (0.5225) (0.4578)

D1994 −0.702∗ −0.558 0.032 −1.165∗ −0.854 −1.225∗

  (0.2205) (0.4394) (0.1904) (0.3377) (0.5202) (0.4682)

D1995 −0.843∗ −0.322 −0.007 −1.647∗ −1.185+ −0.846

  (0.2169) (0.4313) (0.1879) (0.3338) (0.5142) (0.4547)

D1996 −0.597∗ −0.084 0.079 −1.338∗ −0.732 −0.736

  (0.2128) (0.4229) (0.1821) (0.3254) (0.5022) (0.4487)

D1997 −0.324 0.21 0.147 −0.733+ −0.535 −0.269

  (0.2109) (0.4182) (0.1793) (0.3230) (0.4947) (0.4416)

D1998 −0.46+ 0.205 0.145 −1.229∗ −0.321 −0.323

  (0.2097) (0.4181) (0.1778) (0.3204) (0.4919) (0.4391)

D1999 −0.476+ 0.023 −0.094 −1.006∗ −0.272 −0.314

  (0.2099) (0.4224) (0.1766) (0.3191) (0.4891) (0.4447)

CONS 3.786∗ 5.678∗ 8.408∗ 6.313∗ 28.199∗ 3.511∗

  (0.3718) (0.7074) (0.3970) (0.6233) (1.0838) (0.7971)

Observations 20,333 7,108 5,810 7,415 5093 5078

R square 0.1483 0.0555 0.3688 0.3022 0.1778 0.0789

    Commercial Savings Cooperative Most efficient Least efficientVariables All banks banks banks banks banks1 banks2

INEFFij 0.146∗ 0.02 0.085∗ −0.14∗ −2.652∗ 0.17∗

  (0.0062) (0.0104) (0.0113) (0.0072) (0.0658) (0.0107)NLTAij −0.01∗ 0.005 −0.014∗ 0.017∗ −0.012 −0.001

  (0.0023) (0.0044) (0.0022) (0.0019) (0.0068) (0.0041)LNTAij −1.199∗ −1.898∗ −0.531∗ −0.261∗ −1.061∗ −1.588∗

  (0.0247) (0.0521) (0.0205) (0.0188) (0.0555) (0.0559)ROAij 1.133∗ 1.016∗ 1.916∗ 1.594∗ 1.298∗ 0.903∗

  (0.0307) (0.0487) (0.0699) (0.0390) (0.0688) (0.0497)LAODEPij 0.057∗ 0.065∗ −0.011∗ −0.002 0.072∗ 0.037∗

  (0.0017) (0.0029) (0.0017) (0.0019) (0.0033) (0.0033)INSBOCj 0.596∗ 0.453∗ 0.273∗ 0.089∗ 1.517∗ 0.412∗

  (0.0452) (0.0986) (0.0354) (0.0348) (0.1033) (0.1142)SOLVENCYj −0.015∗ 0.007 0.005 −0.007 0.027∗ −0.003

  (0.0028) (0.0051) (0.0024) (0.0035) (0.0061) (0.0056)LAOACj 0.108∗ −0.025 −0.005 0.077∗ 0.095∗ 0

  (0.0075) (0.0164) (0.0066) (0.0086) (0.0167) (0.0185)ROCCj 5.961∗ 5.679∗ 1.813∗ −2.447∗ 8.721∗ 4.436∗

  (0.4355) (0.8052) (0.5513) (0.8152) (1.1215) (0.9699)COIRCj 0.241∗ 0.251∗ 0.017 −0.176∗ 0.291∗ 0.208∗

  (0.0178) (0.0329) (0.0271) (0.0321) (0.0527) (0.0372)OEPOACj 1.091∗ −2.138∗ 3.151∗ 8.196∗ −1.466+ −1.161

  (0.2801) (0.4964) (0.3201) (0.6324) (0.6675) (0.6144)LLPOACj 0.073 −0.574+ 0.712∗ 2.371∗ −0.933∗ 0.071

  (0.1302) (0.2588) (0.0986) (0.1400) (0.2707) (0.3388)

Table 2

D1992 −4.218∗ −2.19∗ −3.676∗ −4.874∗ −4.424∗ −3.161∗

  (0.3505) (0.6847) (0.2495) (0.3362) (0.8127) (0.7128)

D1993 −4.616∗ −2.009∗ −4.112∗ −4.947∗ −4.826∗ −2.543∗

  (0.3289) (0.6527) (0.2323) (0.3136) (0.7450) (0.6843)

D1994 −4.188∗ −1.726∗ −3.803∗ −4.911∗ −3.979∗ −3.006∗

  (0.3277) (0.6584) (0.2292) (0.3024) (0.7381) (0.6939)

D1995 −4.407∗ −1.981∗ −3.624∗ −4.577∗ −4.004∗ −3.357∗

  (0.3231) (0.6481) (0.2265) (0.2915) (0.7321) (0.6752)

Table 2. Contd..

   Commerci

al SavingsCooperati

veMost efficient Least

efficient

Variables All banks banks banks banks banks1 banks2

D1996 −3.852∗ −1.71∗ −2.797∗ −3.561∗ −3.509∗ −2.825∗

  (0.3178) (0.6339) (0.2210) (0.2821) (0.7166) (0.6658)D1997 −3.108∗ −1.466+ −2.243∗ −2.546∗ −2.748∗ −2.604∗

  (0.3154) (0.6217) (0.2198) (0.2828) (0.7108) (0.6512)D1998 −2.52∗ −0.865 −2.235∗ −2.783∗ −2.345∗ −2.277∗

  (0.3099) (0.6150) (0.2161) (0.2759) (0.6952) (0.6411)D1999 −2.309∗ −0.865 −1.639∗ −1.766∗ −1.689+ −2.505∗

  (0.3162) (0.6251) (0.2228) (0.2792) (0.7050) (0.6572)CONS −10.053∗ 2.743 1.708 9.656∗ 27.443∗ 0.292

  (1.4127) (2.7406) (1.9273) (2.0333) (4.0179) (3.0039)Observati

ons 20,333 7,108 5,810 7,415 5093 5078R sq 0.2942 0.3003 0.6149 0.7000 0.4195 0.2512

Table 2. Contd..

Notes:• + significant at 5%; ∗ significant at 1%• Top quartile of cost efficient banks are used as the sample. • Bottom quartile of cost efficient banks are used as the sample.

   Commercia

l Savings CooperativeMost

efficientLeast

efficientVariables All banks banks banks banks banks1 banks2

ETAij 0.176∗ 0.035∗ 0.079∗ −0.356∗ −0.094∗ 0.269∗

  (0.0076) (0.0131) (0.0145) (0.0165) (0.0024) (0.0173)LLRLij 0.022 −0.102∗ −0.309∗ −0.102∗ −0.107∗ 0.197∗

  (0.0119) (0.0204) (0.0189) (0.0160) (0.0036) (0.0268)NLTAij −0.023∗ −0.008 −0.013∗ −0.023∗ 0 −0.028∗

  (0.0026) (0.0050) (0.0027) (0.0031) (0.0013) (0.0053)LNTAij 0.466∗ 0.161+ 0.12∗ 0.318∗ −0.087∗ 0.505∗

  (0.0291) (0.0645) (0.0256) (0.0302) (0.0111) (0.0775)LAODEPij −0.012∗ −0.001 −0.023∗ −0.026∗ 0.003∗ 0.002  (0.0020) (0.0034) (0.0019) (0.0029) (0.0007) (0.0044)INSBOCj 0.436∗ 0.311∗ 0.538∗ 0.494∗ 0.328∗ −0.028  (0.0473) (0.1052) (0.0411) (0.0480) (0.0193) (0.1380)SOLVENCYj −0.004 −0.001 0.003 0.021∗ 0.008∗ −0.018+

  (0.0030) (0.0056) (0.0027) (0.0055) (0.0011) (0.0071)LAOACj 0.233∗ 0.143∗ 0.113∗ 0.206∗ 0 0.116∗

  (0.0075) (0.0156) (0.0074) (0.0138) (0.0031) (0.0196)COIRCj −0.076∗ −0.04+ −0.04∗ −0.04+ −0.004 −0.066∗

  (0.0095) (0.0186) (0.0096) (0.0160) (0.0040) (0.0232)OEPOACj 1.726∗ 0.253 −0.454+ 5.181∗ −0.25∗ 1.805∗

  (0.2213) (0.4197) (0.1989) (0.5467) (0.0810) (0.5730)LLPOACj −1.508∗ −1.276∗ −0.011 0.156 0.048 −1.656∗

  (0.1317) (0.2510) (0.1088) (0.2277) (0.0487) (0.3639)

Table 3

D1992 −1.564∗ −0.745 −0.657+ −5.362∗ −0.467∗ 0.272

  (0.3937) (0.7728) (0.2974) (0.5331) (0.1563) (0.9176)

D1993 −2.105∗ −1.156 −0.803∗ −5.467∗ −0.175 −0.249

  (0.3701) (0.7385) (0.2798) (0.5005) (0.1438) (0.8836)

D1994 −1.21∗ −0.464 −0.597+ −4.908∗ −0.176 1.096

  (0.3702) (0.7500) (0.2771) (0.4810) (0.1428) (0.8979)

D1995 −1.401∗ −0.727 −0.582+ −4.592∗ −0.18 0.665

  (0.3653) (0.7368) (0.2732) (0.4643) (0.1417) (0.8761)

D1996 −1.471∗ −0.619 −0.56+ −4.018∗ −0.091 0.925

  (0.3588) (0.7206) (0.2646) (0.4495) (0.1385) (0.8628)

Table 3. Contd..

    Commercial Savings Cooperative Most efficientLeast

efficientVariables All banks banks banks banks banks1 banks2

D1997 −1.374∗ −0.448 −0.401 −3.669∗ −0.065 0.547  (0.3555) (0.7069) (0.2617) (0.4473) (0.1372) (0.8429)

D1998 −1.521∗ −0.02 −0.507+ −3.566∗ −0.096 0.251  (0.3487) (0.6991) (0.2570) (0.4379) (0.1340) (0.8292)

D1999 −1.008∗ 0.017 −0.004 −3.122∗ −0.072 0.824  (0.3559) (0.7101) (0.2623) (0.4452) (0.1359) (0.8489)

CONS 16.499∗ 22.392∗ 18.883∗ 11.658∗ 17.114∗ 23.815∗

  (0.8079) (1.5508) (0.7966) (1.5612) (0.3064) (1.9492)Observatio

ns 20,333 7,108 5,810 7,415 5093 5078R sq 0.1275 0.0419 0.1310 0.2280 0.1939 0.0403

Table 3. Contd..

Notes:• + significant at 5%; ∗ significant at 1%• Top quartile of cost efficient banks are used as the sample. • Bottom quartile of cost efficient banks are used as the sample.

  Change in risk Change in capital Change in inefficiency  Variables (DLLRij) (DETAij) (DINEFFij)  

DETAij 0.573∗   0.064∗    (0.0063)   (0.0082)  

DINEFFij −0.094 0.047∗      (0.0058) (0.0069) −0.159∗  

DLLRLij          −0.000 (0.010)  

NLTAij 0.002 0.001    (0.0011) (0.0012) (0.0014)  

LNTAij −0.042∗ −0.056∗ 0.192    (0.0116) (0.0137) (0.0151)  

ROAij   0.416∗        (0.0166)  

LAODEPij 0.004∗ 0.008∗ −0.004∗    (0.0008) (0.0009) (0.0010)  

INSBOCj −0.048+ −0.029 0.094∗    (0.0201) (0.0264) (0.0274)  

SOLVENCYj −0.006∗ 0.001 0.005∗    (0.0013) (0.0016) (0.0018)  

LAOACj 0.004 0.002 0.010∗    (0.0020) (0.0042) (0.0043)  

ROCCj   0.092        (0.2741)    

ROCCj   0.092        (0.2741)

−0.006 

COIRCj   0.027      (0.0107) (0.0053)  

OEPOACj   −0.385 0.084      (0.1873) (0.1294)  

Table 4

   Change in risk Change in capital Change in inefficiency

Variables (DLLRij) (DETAij)   (DINEFFij)LLPOACj 0.306∗ 0.096   −0.361∗

      (0.0618) (0.0813)   (0.0862)D1993   0.021 −0.140   −1.269∗

      (0.1510) (0.1810)   (0.1995)D1994   −0.821 −0.261   −0.914∗

      (0.1463) (0.1736)   (0.1914)D1995   −0.137 −0.287   −0.652∗

      (0.1412) (0.1684)   (0.1861)D1996   −0.068 −0.299   −0.952∗

      (0.1378) (0.1644)   (0.1816)D1997   −0.095 −0.365+   −0.828∗

      (0.1366) (0.1631)   (0.1801)D1998   −0.124 −0.127   −0.692∗

      (0.1352) (0.1596)   (0.1761)D1999   −0.199 −0.256   −0.898∗

      (0.1352) (0.1631)   (0.180)CONS   0.646∗ −0.881   0.625

      (0.2462) (0.7993)   (0.469)Observations 17,356 17,356   17,356

R square 0.0142 0.0433   0.0098

Table 4. Contd..

Notes:• + significant at 5%; ∗ significant at 1%• Top quartile of cost efficient banks are used as the sample. • Bottom quartile of cost efficient banks are used as the sample.

ConclusionThis paper analyses the relationship between capital,

risk and efficiency for a large sample of European banks between 1992 and 2000.

Inefficient European banks appear to hold more capital and take on less risk.

Empirical evidence is found showing the positive relationship between risk on the level of capital (and liquidity), possibly indicating regulators’ preference for capital as a means of restricting risk-taking activities.

Unlike the previous literature that focuses on US banking, authors do not find any strong relationship between inefficiency and bank risk-taking.

The financial strength of the corporate sector has a positive influencing reducing bank risk-taking and capital levels.

There are no major differences in the relationships between capital, risk and efficiency for commercial and savings banks although there are for co-operative banks.

In the case of co-operative banks authors do find that capital levels are inversely related to risks and we find that inefficient banks hold lower levels of capital.

Some of these relationships also vary depending on whether banks are among the most or least efficient operators.

The cost inefficiencies have a low co-relation with bank cost income ratios of around 0.1 and therefore are not expected to presented multi-collinearity problems in estimation of the model.