The Quarterly Review of Economics and Finance 50 (2010) 424435

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The Quarterly Review of Economics and Finance

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Estimating banking cost efciency with the consideration of cost management

Chung-Hua Shena, Ting-Hsuan Chenb,

a Department of Finance, National Taiwan University, Taiwan, ROCb Department of Money and Banking, National Chengchi University, No. 64, Sec. 2, ZhiNan Rd., Wenshan Dis

a r t i c l

Article history:Received 1 OcReceived in reAccepted 3 AuAvailable onlin

JEL classicatioC23, G21

Keywords:BankCost efciencyEconomic provCost managem

st efcy; thanageiasedm esteconth aciwan, offe

nive

1. Introduction

Bank corecent yearmetric issuKao, 2006;Kasman, 20loans (Berg1996),2 and

Howevedramaticallestimated ebanking indcost efcienin 1999, wh

Correspon1 For examp

based on thebad loans dueet al. (2000) inusing the Fourcondence int

2 For exampsideration of ninvestigate theZago (2005) esproblem loans

while Kaohsiung Commercial Bank ranked 13th in overall rank-ing. However, nearly 30% of the loans of each of the two banks

1062-9769/$ doi:10.1016/j.st efciency has received signicant attention in thes. Various studies have focused on topics like econo-es (Altunbas, Liu, Molyneux, & Seth, 2000; Huang &Pastor, 2002),1 international comparisons (Carvallo &05), risk of cost functions through non-performinger & DeYoung, 1997; Dongili & Zago, 2005; Mester,mixed-cost functions (Shen, 2005a,b).r, while studies of bank cost efciency are abundant,y contrasting results have been observed when thefciency of each bank is released. By employing theustry in Taiwan as an example, Li (2002) estimatedcy based on the panel data of 43 commercial bankserein Taitung Commercial Bank was the most efcient

ding author. Tel.: +886 2939 3091.le, Pastor (2002) proposed a new three-stage sequential analysisDEA model and decomposed total bad loans into two components:to bad management and due to theoretical environment. Altunbasvestigated the impact of risk and quality factors on banks cost byier-exible cost function. Huang and Kao (2006) estimated the jointerval for technical efciencies by means of multiple comparisons.le, Mester (1996) used the stochastic frontier approach with the con-on-performing loan. Berger and DeYoung (1997) were the rst torelationship betweenbank efciency andproblem loans. Dongili andtimated Italian banks technical efciency with the consideration of.

were non-performing for that year. The two banks would later beplaced in receivership by the Taiwanese government. Incidentally,these counter-intuitive results are not sporadic cases, as they areoften cited in Taiwan bank efciency literature. As data on esti-mated individual bank efciency from other countries are rarelyavailable,3 wecanonly guess the existenceof these conicts. Extantstudies on bank efciencies seldom investigate the reasons for theoccurrences of the inconsistencies.4

The aim of this study is to resolve the counter-intuitive resultsfrom theperspective of earningsmanagement. Ahmed, Takeda, andThomas (1999), Laeven and Majnoni (2003), Cavallo and Majnoni(2001), Kanagaretnam, Lobo, and Yang (2004), and Shen and Chih(2005) to name a few, report their common observations in theearningsmanagement of banks. These studies claim that the provi-sion for loan loss (PLL) is by far the largest andmost important bankaccrual. Banks can accelerate recognition of accounting earnings

3 Past studies rarely report the efciency of individual bank. Hence, it is dif-cult for us to offer more examples to justify the conicting results. Earlier studiestypically report the efciency of one type of banks, for example, the efciency ofstate-owned banks vs. private banks.

4 For example, the exceptions include Pastor (1999) and Altunbas et al. (2000).The former used provision for loan loss as a risk factor to measure cost efciency inSpain. The latter used provision for loan loss as the output quality proxy to evaluateX-inefciency.

see front matter 2010 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.qref.2010.08.002e i n f o

tober 2009vised form 12 July 2010gust 2010e 7 August 2010

n:

ision for loan lossent

a b s t r a c t

This study re-investigates the bank costrand is related to bank cost efcienndings reported in bank earnings mcost (accounting cost) may be the bmay thus yield incorrect inferences froaccounting cost,which is referred to asone that is free of cost management. Boefciency of 29 commercial banks in Tawith the application of economic costaccounting cost.

2010 The Board of Trustees of the Utrict, Taipei City 11605, Taiwan, ROC

ciency by a combination of two strands of literature. The rste other is related to earnings management. Employing thement literature, this study argues that bank observed totalestimator of the true total cost. Using the biased total costimating bank cost efciency.We propose amethod tomodifyomic cost, to be consistentwith the economic theory; that is,counting and economic costs are then adopted to analyze thebanking industry. Our results show that estimated efciency,rs results that are more reasonable results than those of the

rsity of Illinois. Published by Elsevier B.V. All rights reserved.

C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435 425

through current accruals by delaying the recognition of expensesand vice versa. By identifying selectively the timing of PLL recogni-tion, banks can control reported earnings by storing value in goodyears and leasing it in lean years. In other words, the timing of PLLrecognition becomes the choice of bankmanagers, who focusmoreon current earnings and are often more reluctant to recognize PLL.This principPLL deviateof mangers

Bank tocost (operamentioned(hereafter,total cost iaccountingnomic costtotal cost issmoothen oveyed a nuconcluded tand capital.Rezvanian aBerger, Has(Table 1).

Our studrst strandearnings mcost, we remanagemewhich suggmanagemeas denedaccountingargue thatlosses and(hereafter,We then usPLL or Acost. In thising on the r

Our studthis is the managemefound in accif it is ignorof cost manto other coushowing thcost is recal

Next, waffect the don the retritotal costs hinuence oNeverthelesretrieve ecohence, futu

Finally, obanks havebanks in littheir loan lo

5 See Koch a

lower than what is suggested economically. This counter-intuitiveresult is solved in this study.

It is important to note that our study is different from thosethat consider non-performing loans (NPL) in bank cost efciencyliterature. Berger and DeYoung (1997), Hughes and Mester (2008),among other scholars, have discussed the advantages and weak-

of NPL in bank cost functions in order to control loan quality.er, the concept of NPL is different from PLL. NPL is likely todefective output of loans, while PLL is somewhat similar toes subtracted from revenues.paper proceeds as follows. In addition to the rst section,t section discusses cost management. Section 3 shows howulate. Sectcal re

t ma

accraffecestime itst, bah cure veranao min acogniare

Hasagnizencuvoidingse., ast, PLWhrkett thaarketurn. Fial Rell loaorderovisly rond tpleded fr9688

d, bacandnterpro

he acnaryr ando totagers.First Fwritedequadollaral-agent problem fuels PLL manipulation, making thes from economic theory, but on the arbitrary decision.tal cost typically contains interest cost, non-interestting expense/overhead cost), and PLL.5 Thus, the afore-accrual features of PLL cause the observed total costaccounting cost or A TC) to uctuate. Furthermore,s also likely to be manipulated by managers, makingcost differ from theoretical total cost (hereafter, eco- or E TC), as suggested by economic theory. Thus,shifted between current and future periods either tout income or to avoid loss. Wall and Koch (2000) sur-mber of papers on bank loan losses accounting andhat banksused loan loss accounting tomanage earningsPast studies using total cost, such as by Jordan (1998),nd Mehdian (2002), Carvallo and Kasman (2005), andan, and Zhou (2009), have not discussed this issue

y is a combination of the two strands of literature. Theis related to bank cost efciency; the other is related toanagement. As the accrual features of PLL affect totalfer to it as cost management. The concept of costnt is borrowed from earnings management literature,ests that banks using PLL actively to engage in earningsnt could distort accounting cost in relation to cost (i.e.,in economic theory). We propose a method to modifycost; that is, one that is free of cost management. WePLL should be the sum of two components (expectedaccumulated PLL) in each period. This theoretical PLLeconomic PLL or E PLL) is free of cost management.e E PLL to replace reported PLL (hereafter, accountingPLL) in order to yield consistent values for economicstudy, we re-investigate bank cost efciency by focus-esulting consistency in Taiwan.y contributes to the literature in three aspects. First,rst paper incorporating the concept of cost (earnings)nt into bank cost efciency. As bank costmanagement isounting studies, cost efcient estimationmaybebiaseded. Though we use Taiwan bank to illustrate the impactagement on cost efciency estimation, the applicationntries is immediate. Our results conrm this further byat cost efcient rankings could change when the totalculated in view of the cost management effect.e not only emphasize that earnings management canenition of cost; we also provide a systematic methodeval of true total cost. Our approach shows that bankave been volatile for Taiwanese banks because of the

f the Asian Crisis in 1997 and the bailout plans in 2002.s, because this method is rst in literature to attemptnomic cost, the method itself is still in its infancy;

re studies are needed.ur study resolves the gap why some of the distressedbeen classied as among the relatively top-rankederature. Generally, distressed banks under-provisionss in order to make the total cost appear substantially

nd MacDonald (2002, p. 109).

nessesHowevbe theexpens

Thethe nexto calcmodelempiri

2. Cos

Thethat itciencymanag

Firsthrougand vicbank morder tRules othe recas theyows (is recobetweeor to ain earncost (i.

Nexpolicy.cial marequescial mdowntFinanc5% of aPLL incient psuddening toquadruincreasto $40,

Thirprise sthese ediately

6 In tdiscretioBouvatieatically tby mana

7 Thehave tocapital a

8 Oureconomic cost. Section 4 introduces a cost efciencyion 5 provides the data sources. Section 6 reports thesults, while Section 7 presents the conclusion.

nagement

ual nature of PLL allows banks tomanage total cost suchts its earnings, resulting in covertly biased cost ef-ation.6 There are three possibilities wherein bank can

cost.nks can accelerate recognition of accounting earningsrent accruals by delaying the recognition of expenses,sa. For example, when earnings are expected to be low,gers have more likely delay the recognition of PLL intigate the adverse effects of other factors on earnings.crual accounting under which banks operate requiretion of revenue (i.e., as it is earned) and expenses (i.e.,incurred), regardless of the timing of the actual cashn andWall, 2003). Moreover, the loss of writing off NPLd for up to 5 years. Thus, total cost could be shiftedrrentand futureperiodswither to smoothenout incomeloss. Simply put, banks that actively use PLL to engagemanagement can distort accounting cost in relation todened in economic theory).L is affected substantially by government regulationen NPL is high and threatens the stability of nan-s, governments from many developing countries mayt banks either write off NPL or inject funds into nan-s to help the banking sector overcome the economicor example, Taiwanese authorities announced the Firstform in 2001 by asking banks to write off NPL down tons in 2 years.7 Thus, banks had to hold actively theser to off-charge the huge accumulated NPL, as insuf-ions were common in Taiwan before 2001. Total costse that year owing to the rising PLL. It is not surpris-hat the total cost of the First Commercial Bank almostin 2001 because of PLL increases. Its accounting costomNewTaiwanDollar ($NT) 12,259million in 2002:Q1million in 2002:Q2.nk total costs have been affected by a number of enter-als, mainly because total cost contains PLL. As soon asprise scandals were recognized, lending banks imme-vided considerable loan loss reserves to write off the

ademic eld of accounting, PLL is often decomposed into non-and discretionary PLL (Beaver and Engel, 1996; Ahmed et al., 1999;Lepetit, 2008). Unlike non-discretionary PLL, which relates system-l loans and non-performing loans, discretionary PLL is manipulated

inancial Reform is also referred to as the 258 principles, since banksoff the nonperformance loans down to 5% and have to increase thecy ratio up to 8% in 2 years.unit refers to the New Taiwan Dollars throughout the paper.

426 C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435

Table 1Denition of costs.

Paper Cost denition Summary

1. Total cost (interest cost +non-interestcost +provision for loan loss)

Jordan (1998) Total cost

Rezvanian

Carvallo a

Berger et a

2 Non-intereBerger and

Kwan (200

Bos and Sc

Valverde,

Podpiera a

3. Interest coAltunbas e

Bonin, Hasan

Fries and Ta

potential loTaiwanese cbillion borrdefault in 2day, but oveestablishedbroke out,excessivelylic knowledcost becam

3. An appr

Our coscost (E TC)

9 Mega BankBank should inand Mehdian (2002) Total cost

nd Kasman (2005) Total cost

l. (2009) Total cost

st costDeYoung (1997) Non-interest expense (operating

expense)

3) Total operating costhmiedel (2007) Total operating cost

Humphrey, and Paso (2007) Operating cost = laborexpense +physical expense +materialexpense

nd Weill (2008) Total operating cost

sts and non-interest costst al. (2000) Operating cost and nancial cost

, and Wachtel (2005) Interest costs and non-interest costs

ci (2005) Interest expenses and operatingexpenses

sses, thereby increasing total cost. For example, theompany, Rebar, which embezzled approximately $100owed from banks, announced that it was in a state of006. This type of embezzlement does not takeplace in ar years of operations. However, lending banks have notthe necessary PLL. When the news of these scandalsPLL rose immediately,9 causing total cost to decreaselow, even before the scandals became matters of pub-ge; once the scandals were nally publicized, and totale excessively high.

oach to calculate economic cost

t function is estimated based on the economic totaland not the accounting total cost (A TC). The relation

should increase $6 billion PLL and investment losses, and Chinesecrease $40 billion PLL and sale losses of NPL.

between th

E TC = A TC

E PLL = EL1

where E TCloan loss, Aprovision fo

Eq. (1) sif accountinaccountingeconomic cwritten as

E TC = CBP

where CBPTEq. (2) s

adjusted acexpected lo(2005a). ThThis paper measures bank efciency to achieve a betterunderstanding of the crisis in New England banksbetween 1989 and 1992.This paper uses a parametric and nonparametricapproach to examine cost structure and productionperformance in Singapore.A stochastic frontier model with country-specicenvironmental variables was estimated for 481 banksfrom 16 Latin American countries.This paper helps predict the effect of nancial reformthat partially privatizing and taking on minorityforeign ownership of three of its dominant Big Fourstate-owned banks by analyzing the efciency ofChinese banks over 19942003.

This paper addresses a little examined intersectionbetween the problem loan literature and the bankefciency literature.After controlling for loan quality, liquidity,capitalization, and output mix, per unit bank operatingcosts are found to vary signicantly across Asiancountries and over time.

This paper attempts to estimate comparable efciencyscores for European banks operating in the SingleMarket in the EU.Looking at large banks across 10 countries, they nd nocountry seems to have a strong efciency advantage. Itseems likely that state efforts to promote nationalchampions through favorable mergers which expandscale and market share may determine the outcome.This paper addresses the question of the causalitybetween non-performing loans and cost efciency inorder to examine whether either of these factors is thedeep determinant of bank failures.

This paper investigates the impact of risk and qualityfactors on banks cost to evaluate scale andX-inefciencies, as well as technical change for asample of Japanese commercial banks between 1993and 1996.They illustrate SFA to investigate the effects ofownership on bank efciency for eleven transitioncountries.This paper based on the stochastic frontier approach(SFA) use a single-step procedure to examine the costefciency in 15 East European countries.

ese two total costs is shown in Eq. (1) become

A PLL + E PLL, (1)

+ EL2, (2)

is economic total cost, E PLL is economic provision forTC is accounting total cost, and A PLL is accountingr loan loss.uggests that economic cost is equal to accounting costg PLL is equal to economic PLL. However, becausePLL is often not equal to economic PLL in reality, thus,ost is not equal to accounting cost. Eq. (1) can be further

T + E PLL,

=A TCA PLL, and is the cost before provision and tax.uggests that E PLL is affected by expected losses andcumulated PLL in each period, which are referred toss 1 (EL1) and expected loss 2 (EL2), respectively Sheney are described as follows.

C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435 427

3.1. EL1

The expected losses are determined by the current non-performing loan (Current NPL). However, reported NPL is the stockconcept, we need to transform it into a ow concept, which isreferred to as current non-performing loans or economic non-performing

EL1 = k1 where the C

Current NP

where NPLand Recoveof bad loansand k1 is th

Eq. (3) srent NPL. Tcategories,substandar(100%). Theloss that shone categoridentied ithe concepgories belonon-performnon-performgenerated ohave data osimply a keach periodnumbers. F

Eq. (4) fuThough thibanks do noand this scethis potenti

If Curren

Current NP

If Curren

Current NP

where Min(new non-pfor a bank.rent NPL, wnegative Cuof the Curre

3.2. EL2

PLL is alstermedas recient to coas the ratioratio is low

10 This criterIn this study, w

coverage ratio be at least 40%, but that banks experimentwithotherpercentages in pursuit of robust checking. Once the consistent PLLis obtained, the resulting total costs are generated.

The relation between RLL and PLL is:

RLLt = RLLt1 + PLLt .

s, the accumulated PLL should cover a large percentage ofhere we dene the coverage ratio as RLL/NPL and recom-hat

ge raRLLt

k2 is, wee cu

t1 +ge is

0.4

e weng th

t ef

ntierank can, 2eter ach (Sludelly senonusePereim

nd tg frproatle odomuminrrorian a

=

+

+

use they, 19ever

tilizedmethoand htranslto scae canloans. The EL1 is dened as follows.

current NPLt , (3)

urrent NPL is dened as follows.

Lt = NPLt NPLt1 + Write offt + Recoveryt+ Sell offt , (4)

is the non-performing loan, Write off is net charge-off,ry is recovery of the written off loan. Sell off is the sale, including such sales to asset-management companies,e percentage of Current NPL.uggests that expected loss is the percentage of Cur-o illustrate this, loans are typically classied into vewhich are normal loans (0%), loans for observation (2%),d loans (10%), doubtful loans (50%), and loan lossesnumbers in parentheses denote the percentage of loanould be provisioned for that category. PLL for the rsty is referred to as general PLL where the bank has notmpairment. Also, the loan loss in the rst category ist of forward looking. By contrast, the last four cate-ng to specic PLL where the bank will not recover theing loans in full. Also, the specic PLL is based on theing loans that have already occurred, and thus, PLL is

n the concept of backward looking. Because we do notf these ve classications, we assume that the PLL ispercentage of newly created non-performing loans in, where k is the weighted average number of the aboveor simplicity, we assume k1=40%.10

nctions simply to transform the stock NPL to ow NPL.s equation is simply based on an accounting identity,t disclose the amounts of sales of bad assets in detail,nario may yield a negative Current NPL. To overcomeal problem, we modify our Eq. (4) slightly ast NPLt 0 (general condition)Lt = NPLt NPLt1 + Write offt + RECOVERYt , (5)t NPLt k2,

another percentage. Assuming that current PLL is equalargue that the past-accumulated PLL in conjunctionrrent PLL should cover the k2 percentage of NPL. ThatEL1> k2NPLt. Thus, additional loss from insufcient

NPLt (RLLt1 + EL1t). (6)

obtain EL1 and EL2, we can calculate economic PLL byem together.

ciency model

approach is the most often used approach to esti-ost efciency (Mester, 1996; Pastor, 1999; Rezvanian &002). Frontier approach comprises parametric and non-pproach, where the former include stochastic frontierFA) and distribution-free approach (DFA) and the lat-data envelopment analysis (DEA). Parametric approachparates out the effects of inefciency and randomerror,parametric approach does not. Themethods have beend in the literature; see Vennet (2002) and Maudos,z, and Quesada (2002) to name a few.portant factors, that is, the distribution of the errorhe choice of functional form, must be determined inontier approaches. Regarding the former, we adoptch11 which is relatively distribution free in the sensef shape is imposed on the distributions of inefciencyerror. Namely, DFA eschews arbitrary distributionsg that inefciencies are stable over time while ran-tends to average out. Regarding the latter, followingnd Mehdian (2002), we use translog function12

i +Mm

am ln Ym,it +Nn

bn ln Wn,it

12

Mm

Nn

amn ln Yn,it ln Ym,it

12

Mm

Nn

bmn ln Wn,it ln Wm,it

e DFA cannot estimate cost frontier every quarter (see Berger &91), we also use SFA to estimate individual quarterly cost func-, the two methods may generate different results. For example, Weilldata on European banking and reached different results by usingds. Because the results yielded by DFA are more consistent with ourypotheses, we draw our conclusions based on the DFA approach.og has an advantage over earlier functional forms in that it allowsle to change with output or input proportions so that the estimatedtake on the familiar U-shape.

428 C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435

Table 2Denition of variables.

Variable Denition Operational denition

1. Variables used for recovering economic PLLA TC Accounting total costNPL Non-performing loansPLL Provision for loan lossRLL Reserve for loan lossWrite off Net charge-offRecovery Recovery of the written off of the loanSell off Sale of bad loansTotal loan

2. VariablesE TCW1W2W3

Y1Y2Y3

Q

Note: 1. A PLL: re

EL1 = k1 CuEL2 = 0.4 N

Current NPL is e rese

+

where substhe mth outotal cost, pcost.13 Follby fund priwhereas thamounts (Yseasonal duand zero oth

For the d

ln Cit = ln= ln

where errothecomposfrom the eferror). No d

To calcuuals from Ethat cost dian estimatewhile thoseaverage ouln ui into a n

EFF = exp(l

13 Some studDietsch and Loproxy of envir(2003), Bergerever, because ebecause our stdo not conside

minds wimumy useefce wies

3

=1

l

is g. If Sf SE iTotal loanused for cost efciency model

Economic total costFund priceWage rateFixed capital price

InvestmentsLoansFee revenues

Seasonal dummy

accounting provision for loan loss. 2. E TC is equal to A TCA PLL+EL1+EL2, whe

rrent NPLPLt (RLLt1 + EL1t ).

the ow non-performing loan, NPL is the stock non-performing loan and RLL is th

Mm

Nn

abmn ln Wn,it ln Ym,it +4

q=1cqQq + it, (7)

cripts n is the nth inputs (n=1, 2, 3) and m denotestputs (m=1, 2, 3), i is ith bank (i=1, . . ., 29), TC is theroxies by either accounting total cost or economic totalowing Shen (2005b), three input prices are denotedce (W1), wage rate (W2), and xed capital price (W3),e three outputs are investment amounts (Y1), loans2) and fee revenues (Y3), and Qq (q=1, 2, 3 and 4) aremmies that take on the value of one for the qth seasonerwise. See Table 2 for detailed denitions of variables.istribution-free approach, we transform Eq. (7) into

(W ,Y ) + ln

whereresponof minactuallgreater

Onceconom

SE =m

If SEof scalescale. Iit it it

(Wit, Yit) + ln ui + ln vit ,(8)

r term ln it specied here as ln it = lnui + lnit, that is,ite error ln it includesboth inefciency lnui (deviationscient frontier) and random error ln vit (measurementistributional assumptions are imposed on ui or vit .late X-efciency (hereafter, EFF), we average the resid-q. (8) for each bank over years. The key assumption isfferences owing to average residual ln ui for each bank,of lnui, is relatively stable and should persist over time,owing to randomerror (ln vit) is ephemeral and shouldt over time Berger and Hannan (1998). We transformormalized measure of efciency,

n umin ln ui), (9)

ies also consider equity capital in the cost function. For example,zano-Vivas (2000) used the ratio of equity capital to total assets asonmental variable to measure regulatory condition. See also Kwanand Meter (1997), and Patti and Hardy (2005) to name a few. How-quity capital changes slowly and its price is difcult to measure, andudy is to illustrate the inuence of uctuate PLL on cost efciency, wer it.

5. Data sou

All variaa private da33 Taiwan cbecause theCathay Banidated. Thethe startingthat most ointernation

6. Empiric

6.1. Basic stloan loss (E

Table 3 pprovision aover the sawherein thlowed by CTaitung BusInterest cost +non-interest cost +A PLLNon-performing loans + loan subject to observationSame as left columnSame as left columnSame as left columnSame as left columnSame as left columnTotal bills purchased, discounted and loans

A TCA PLL+EL1+EL2Interest expense/(borrowings +deposits)Salary expense/employees(E TC interest expense salary expense)/(xedassets-accumulated depreciation)Short-term investment + long-term investmentTotal bills purchased, discounted and loansService fees + foreign exchange gain + securitybrokerage revenue+ commission revenues

rve for loan loss. 3. Source: Taiwan Economic Journal database.

indicates the minimum for all i. This approach cor-ith the conventional notion of efciency as the ratio

resources needed for production to the resourcesd, and ranges over (0,1], with higher values indicatingiency.e obtain the estimated coefcients, the scale of(SE) is obtained as follows.

ln Cn Ym

= am +3

n=1amn ln Yn +

3k=1

abmn ln Wn. (10)

reater than one, the technology exhibits diseconomiesE is less than one, the technology exhibits economies ofs equal to one, the there are constant returns to scale.rces

bles are taken from the Taiwan Economic Journal (TEJ),ta vending company. Although the database containsommercial banks, our sample is comprised of only 29remaining four banks (e.g., General Bank, DahAn Bank,

k, and Fubon Bank) have either been merged or consol-sample period is 2001:Q2 to 2006:Q4. Please note thatperiod of 2001:Q2 is determined because it is the datef the banks in databank start to have the data of theal denition for non-performing loans.

al result

atistics and recovery of the economic provision forPLL)

resents the average statistics of A TC, A PLL, cost beforend tax (CBPT), EL1, EL2, E PLL, and E TC for each bankmple period. The rst column corresponds to A TC,e highest value represents China Trust Bank, and fol-hang-Hwa Bank and First Bank. The lowest A TC is foriness Bank.

C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435 429

Table 3Recover the economic PLL (each bank). Measure: million New Taiwan Dollars.

Bank (A) A TC (B) A PLL (C) CBPT= (A) (B) (D) EL1 (E) EL2 (F) E PLL =(D) + (E) (G) E TC= (C) + (F)Chang-Hwa 17,382 271 17,653 548 29,994 30,542 48,195First 17,196 93 17,289 679 15,736 16,415 33,703Hua-Nan 16,198 109 16,089 727 14,910 15,637 31,726International Commercial Bank of China 11,591 135 11,456 466 4333 4799 16,255HsinChu 5004 192 4813 235 4016 4251 9064Interna. Bank of Taipei 4330 12 4318 137 3755 3892 8210Kings Town 1848 23 1825 84 4008 4092 5917Taitung Business 1421 37 1384 137 3725 3863 5247Taichung 3505 17 3488 61 9251 9312 12,800China Trust 21,196 582 20,614 1561 4167 5727 26,341Chiao Tung 5691 4 5695 756 5528 6284 11,979Cathay 11,913 514 11,398 1483 4040 5523 16,922Taipei Fubon 10,014 55 9958 786 4191 4977 14,935Chinese 4326 88 4413 225 7624 7849 12,262Taiwan Business 12,186 37 12,223 671 24,090 24,761 36,984Kaohsiung 1874 8 1882 52 1350 1402 3284Cosmos 6081 298 5782 939 3820 4760 10,542Union 5190 26 5164 306 2986 3292 8456SinoPac 5755 189 5566 379 1473 1852 7418E. Sun 5249 31 5279 406 1051 1457 6736Fu-Hwa 3252 280 2971 198 3519 3716 6687Tai-Shin 14,718 352 14,365 1115 1853 2968 17,333Far-Eastern 4158 72 4086 376 2346 2722 6808Ta Chong 4531 95 4436 229 4375 4604 9040En-Tie 3704 173 3531 283 4464 4747 8279Bo-Wa 3097 60 3037 406 12,430 12,836 15,873Jih-Sun 4830 71 4758 401 4822 5223 9981Bank of Overseas Chinese 3891 74 3964 213 8292 8504 12,469Taiwan Cooperative Bank 17,154 680 17,834 1644 21,269 22,913 40,747

Note: 1. A TC: accounting total cost. A PLL: accounting provision for loan loss. 2. CBPT, which is the cost before provision and tax, is equal to (A TCA PLL). 3. E PLL: economicprovision for l Lt1 +

CBPT isand EL2, boPLL provideE PLL (A PLprovisionedexample, th$15,637 miwe see that

lastesentBanest

eir eaingly

Table 4Recover the ec

Quarter

2001:Q32001:Q42002:Q12002:Q22002:Q32002:Q42003:Q12003:Q22003:Q32003:Q42004:Q12004:Q22004:Q32004:Q42005:Q12005:Q22005:Q32005:Q42006:Q12006:Q22006:Q32006:Q4

Note: see noteof EL1 and EL2PLL) parts. E Toan loss, which is equal to EL1+EL2. EL1= k1Current NPLt , EL2 =0.4NPLt (RL

dened as A TC minus A PLL. E PLL is the sum of EL1th of which are calculated based on the recovery of thed earlier. Clearly, A PLL is overwhelmingly smaller thanL

430 C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435

Table 5Descriptive statistics.

Variable Mean SD Min Max

A TC (million) 7710 7434 6536 70,312E TC (million) 15,481 15,946 2076 136,363Fund price 0.03 0.36 0.01 0.71Wage rate (ten thousand) 18.5 8.6 4.6 47.6Fixed capital price 0.45 1.01 0.01 8.18Investments (million) 358,502 298,106 30,126 1,713,910Loans (million) 89,809 105,234 312 434,747Fee revenues (million) 907 1247 37 8220

Note: Mean, SD,Min andMax denote the average, the standard deviation,minimumand; A TC is accounting total cost. E TC is economic total cost. Three prices of inputsare fund price, wage rate, and xed capital price. Three outputs comprise invest-ments, loans, and fee revenues. The detail denition of input price and outputs arein Table 2.

Table 4 presents further the summation of each variable acrossbanks for each quarter. The highest A TC is in 2005:Q4. Note thatCBPT, which is the total cost before provisions and taxes, shouldbe smaller than the A TC. However, we nd that CBPT is greaterthan A TC in 2002:Q1, as A PLL is negative. Meanwhile, the nega-tiveA PLL for thatquarter is aneffect of bankprovisions that are lessin the rst three quarters than in the fourth quarter, which is com-monlyemployed tomanipulate earnings; Liu (1999) referred to thisas evidence of earningsmanipulation. Once our consistentmeasureon PLL is adopted, the E PLL become positive ($14,332 million) in2002:Q1, whereas it decrease to $9522 million in 2002:Q4.

Fig. 2. accounting PLL (accounting cost) vs. economic PLL (economic cost).

Table 5 presents the mean, standard deviations, and the min-imum and maximum values of A TC, E TC, fund price, wage rate,xed capital price, investments, loans, and fee incomes. The meanand the standard deviation of A TC are $7710 and $7434 million,respectively, whereas they are $15,481 and $15,946 million forE TC, respectively. The mean and standard deviation of A TC areonly half of E TC; hence, banks minimize their accounting cost andFig. 1. accounting cost (solid line) vs. economic cost (dash line).

C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435 431

Table 6Translog function.

A TC E TC A TC E TC

Constant lnP1 lnP3 0.001 0.001(0.063) (0.124)

lnY1 lnP2 lnP3 0.023 0.009(0.477) (0.300)

lnY2 lnY1 lnP1 0.016 0.150**

lnY3 lnY1

lnP1 lnY1

lnP2 lnY2

lnP3 lnY2

(lnY1)2 lnY2

(lnY2)2 lnY3

(lnY3)2 lnY3

(lnP1)2 lnY3

(lnP2)2 Q1

(lnP3)2 Q3

lnY1 lnY2 Q4

lnY1 lnY3

lnY2 lnY3

lnP1 lnP2

Note: 1. The m

ln TCit = i +

where TCit is tthree outputsare t-value.

its variationcapital are 3

Fig. 1 ploshow that mthanA TC (dterns in Figmove closeble reason f2002, there(see footnogroup, A TCtern of Taipgroup, theChang-Hwa

Fig. 2 coE PLL (E TCE TC is alsothat of A TCresults, trueunderstatin

6.2. Cost ef

Table 6E TC as the580.873** 338.917**(4.460) (4.828)59.126** 27.789**(5.015) (4.259)10.423** 4.891**(3.590) (2.672)5.606* 0.660(1.699) (0.328)0.630 2.328**(0.426) (2.472)11.448** 2.767(3.312) (1.251)2.013* 0.561(1.913) (0.839)2.846** 1.143**(4.649) (3.203)0.461** 0.238**(2.973) (2.436)0.189 0.103(1.425) (1.246)0.013 0.031**(0.588) (2.191)0.172 0.222(0.449) (0.909)0.002 0.030**(0.084) (2.504)0.199 0.014(0.860) (0.094)0.344* 0.111

(1.719) (0.890)0.264** 0.034(2.856) (0.583)0.076 0.049(1.125) (1.147)

odel is estimated by the following equation.

M

m

am ln Ym,it +Nn

bn ln Wn,it +12

Mm

Nn

amn ln Yn,it ln Ym,it +12

Mm

Nn

bmn ln Wn

he total cost, proxies by either total accounting cost or economic total cost. Three input p(Y) are investment, loans, and fee revenues. Qq is a seasonal dummy. 2. **and* represent

s. The mean values of the price of funds, wages, and%, $185,000, and 45%, respectively.ts the graphs of A TC and E TC for each bank. The plotsost banks have higher E TC (denoted by dashed lines)enotedby solid lines).Wecanclassify the total costpat-. 1 into three groups. In the rst group, A TC and E TCr over time; an example for this is First Bank. One possi-or this phenomenon is government requests. Beginningis sufcient PLL after Taiwans First Financial Reform

te 7). First Bank has sufcient provisions. In the secondand E TC move up and down proportionally; the pat-ei Fubon Bank reects this phenomenon. In the thirddifference between A TC and E TC increase over time;Bank is a good example of this group.mpares the graph of A PLL (A TC) with the graph of) in terms of averages. E PLL is higher than A PLL, andhigher than A TC. The uctuation of E TC is larger thanbecause of the uctuation of PLL. Based on the abovecosts should increasewith accurate PLL, indicating thatg PLL undeniably causes misestimated in total costs.

ciency

presents the estimated results using A TC anddependent variables in our translog function. The

random-effstatistics.14

The coewith some mchange fromchanges froAlso, the siginsignicanboth their ebank resistpose.

The coefwhen varyicients arerespectivelyboth of theused as a de

Once wenomic scale

14 Hausmanesis of randomsquare 2

(30)is

random effect(0.176) (2.579)lnP2 0.705** 0.023

(3.032) (0.152)lnP3 0.155** 0.047

(2.376) (1.134)lnP1 0.041 0.062**

(0.846) (2.023)lnP2 0.140 0.003

(1.132) (0.04)lnP3 0.112** 0.001

(3.409) (0.050)lnP1 0.017 0.013

(0.595) (0.695)lnP2 0.166* 0.115*

(1.688) (1.819)lnP3 0.029 0.032

(0.812) (1.435)0.162 0.003(1.193) (0.028)0.142 0.047(1.052) (0.135)0.002 0.107*(0.050) (1.745),it ln Wm,it +Mm

Nn

abmn ln Wn,it ln Ym,it +4

q=1

cqQq + it ,

rices (W) are denoted by fund price, wage rate, and capital price. Therespectively signicant at 5% and 10%level. Numbers in parentheses

ect model is used because of insignicant Hausman

fcients of A TC and E TC are largely the same, butinor differences. For example, the coefcients of lnY3positive to negative, whereas those of lnY1 lnP3

m negative to positive, though they are insignicant.nicant coefcients of (lnP3)2 whenusing E TCbecomet when using A TC. While coefcients change slightly,ffects on X-efciency and the resulting rankings of eacheasy direct evaluation. Eq. (9) is employed for this pur-

cients of seasonal dummies are considerably differentng total costs are used as dependent variables. The coef-0.162 and 0.003 for A TC and E TC in the rst quarter,. The coefcients for the fourth quarter are negative forspecications, but this is only signicant when E TC ispendent variable.obtain the estimated coefcients, we judge the eco-of each bank. In Table 7, banks are divided into ve

(1978) suggests using the Chi square test to examine the null hypoth-effects vs. the alternative of the xed-effects panel model. The Chifound to be 5.927, which does not undermine the null hypothesis ofs given that the critical value is 43.773.

432 C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435

Table 7Economic scale.

Total assets (thousand) A TC E TC Bank group

Less 200,000 0.148 0.081 Kings Town Bank, Taitung Business Bank, Taichung Bank, ChineseBank, Kaohsiung Bank, Cosmos Bank, Union Bank, Fuh-Wa Bank,Far-Eastern Bank, Ta-Chong Bank, En-Tie Bank, Bo-Wa Bank, Jih-SunBank, and Bank of Overseas Chinese

200,000400,000 0.629 0.222 HsinChu Bank, International Bank of Taipei, Taipei Fubon Bank,SinoPac Bank, E. Sun Bank, and Tai-Shin Bank

400,000600,000 0.295 0.896 International Commercial Bank of China, China Trust Bank, Chiao TungBank, and Cathay Bank

600,000800,000 1.569 0.625 Taiwan Business Bank800,0001,000,000 0.931 0.212 Chang-Hwa Bank, First Bank, Hua-Nan Bank, and Taiwan Cooperative

Bank

Note: 1. A TC is accounting total cost. E TC is economic total cost. 2. Bank Group lists banks name of eac

groups based on total assets. When A TC is used as the dependentvariable, around two-thirds of the economic scale of the banksare lower than 1, suggesting economies of scale. Diseconomiesof scale start to appear in the fourth group, suggesting that costincreases faster than production in this group. For example, thescale economies of Chang-HwaBank comprised of 1.23 in 2003:Q4;the asset size is around $400600 million. When E TC is used thedependent variable, all the scale economies of the banks are lowerthan 1, indither their acurrent asse

Fig. 3 prA TC as thetical axes reResults sugscale, and th

Fig. 4 is sdent variabdependentrange of dibanks woulvision for lo

Table 8 prankings chare used. Firsiderably, aefcient baable, Bo-Wbank, becom

Fig. 4. Economic scaleeconomic cost.

Bankwas classied as a distressed bank andwas taken overan through Resolution Trust Corporation (RTC)15 in Augustecause of the banks worsening net worth and substantial13%. Consequently, the results of the least efcient yield bye consistentwithour intuition, indicating that E TC isprefer-er A TC. The same argument applies to Taitung Businesshich was also taken over by RTC in 2006. Its rank droppedventh to eighthwhen the twomeasureswereused. The rankof Overseas Chinese, whose non-performing ratio reachedand average non-performing ratio at 9.41%, also saw majors, dropping from its rst-place ranking in efciency (i.e., byTC) to the 27th standing (i.e., by using E TC). The rankingg-Hwa Bank exhibits the most drastic change, falling fromto 26th, the drop of which is also consistent with intuition.nsistency reects the banks non-performing ratio, previ-t 4.85%; its average ratio is 4.32%, which is higher than thecating potential economies of scale by expanding fur-ssets. Thus, the optimal size might have exceeded thet size of all banks.esents the plot of the economic scale obtained usingdependent variable, wherein the horizontal and ver-present xed assets and economic scale, respectively.gest that most banks are in the stage of economies ofat a fewbanks are in the stage of diseconomies of scale.imilarwith Fig. 3, but obtained using E TC as the depen-le. Results are also similar to those wherein A TC is thevariable, but the number of banks falling within theseconomies of scale is smaller. In other words, mostd enjoy economies of scale after adjusting for the pro-an loss.resents the estimated X-efciency of the 29 banks. Theange dramatically when different total cost measuresst, some top-ranked banks drop in their standings con-nd since then have been identied as among the leastnks. For example, by using A TC as the dependent vari-a Bank, which previously is the second most efciente the least efcient bank (rank 29) when E TC is used.

Bo-Waby Taiw2007 bNPL ofE TCarable ovBank, wfromseof Bank10.96%changeusing Aof ChanfourthThis coously aFig. 3. Economic scaleaccounting cost.

average of 2

15 The RTC isbanks whose nBo-Wa Banksbanks non-peand then sold16 The Taiwaitory receiptsbankwasnot sreceipts (GDRFinancial Holdbecoming theh group based on total assets..78%, in 2004.16

a government company that was established to take over distressedet worth is negative or whose capital-adequacy ratio is less than 2%.assets reached a negative level of NT$24.7 billion in 2007, and therforming ratio hit a high of 13%. It was taken over by the RTC in 2007to Development Bank Singapore (DBS) through an auction.n government decided to sell Chang-Hwa Bank through global depos-at the end of 2004. However, because the bidding price was low, theold. After the failed attempt to sell the bank throughglobal depository), the government auctioned it on the market in June 2005. Taishining Company purchased 22.5% of the banks special equity shares,largest shareholder of the bank.

C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435 433

Table 8X-Efciency and rank (A TC and E TC).

A TC E TC

Value Rank Value Rank

Chiao Tung 0.97683 5 1.00000 1Cathay 0.94199 29 0.98591 2Kings Town 0.96948 9 0.97601 3Far-Eastern 0.96815 14 0.97421 4Fu-Hwa 0.97350 6 0.97390 5E. Sun 0.96574 20 0.97375 6SinoPac 0.96328 23 0.97276 7Taitung Business 0.97308 7 0.96903 8Ta Chong 0.96808 15 0.96851 9Interna. Bank of Taipei 0.96652 18 0.96755 10Kaohsiung 0.96881 10 0.96733 11Tai-Shin 0.96880 11 0.96732 12Taiwan Cooperative Bank 0.96879 12 0.96731 13Union 0.96878 13 0.96730 14Cosmos 0.96442 21 0.96688 15Taiwan Business 0.99073 3 0.96663 16Hua-Nan 0.95723 27 0.96609 17En-Tie 0.96746 17 0.96600 18Taipei Fubon 0.97255 8 0.96583 19International Commercial Bank of China (ICBC) 0.96605 19 0.96574 20Taichung 0.96790 16 0.96573 21Hsinchu 0.95810 26 0.96567 22Jih-Sun 0.96385 22 0.96554 23First 0.96315 24 0.96411 24China Trust 0.95454 28 0.96404 25Chang-Hwa 0.97755 4 0.96360 26Bank of Overseas Chinese 1.00000 1 0.95816 27Chinese 0.96178 25 0.94822 28Bo-Wa 0.99756 2 0.93953 29

Note: 1. A TC is accounting total cost. E TC is economic total cost. 2. The spearman correlation coefcient (Rs) of two efcient measures is 0.0601.

Table 9X-Efciency and rank (operating cost).

A TC E TC Operatingexpense

Value Rank Value Rank Value Rank

Chiao Tung 0.97683 5 1.00000 1 1.00000 1Cathay 0.94199 29 0.98591 2 0.92990 23Kings Town 0.96948 9 0.97601 3 0.93413 13Far-Eastern 0.96815 14 0.97421 4 0.93947 4Fu-Hwa 0.97350 6 0.97390 5 0.93564 8E. Sun 0.96574 20 0.97375 6 0.93511 10SinoPac 0.96328 23 0.97276 7 0.93067 21Taitung Business 0.97308 7 0.96903 8 0.92549 26Ta Chong 0.96808 15 0.96851 9 0.93197 18Interna. Bank of Taipei 0.96652 18 0.96755 10 0.93297 16Kaohsiung 0.96881 10 0.96733 11 0.93832 5Tai-Shin 0.96880 11 0.96732 12 0.93303 14Taiwan Cooperative Bank 0.96879 12 0.96731 13 0.94580 2Union 0.96878 13 0.96730 14 0.93303 15Cosmos 0.96442 21 0.96688 15 0.92187 29Taiwan Business 0.99073 3 0.96663 16 0.94326 3Hua-Nan 0.95723 27 0.96609 17 0.92874 25En-Tie 0.96746 17 0.96600 18 0.93493 11Taipei Fubon 0.97255 8 0.96583 19 0.93102 20International Commercial Bank of China (ICBC) 0.96605 19 0.96574 20 0.93130 19Taichung 0.96790 16 0.96573 21 0.92970 24Hsinchu 0.95810 26 0.96567 22 0.93524 9Jih-Sun 0.96385 22 0.96554 23 0.93283 17First 0.96315 24 0.96411 24 0.92246 28China Trust 0.95454 28 0.96404 25 0.92348 27Chang-Hwa 0.97755 4 0.96360 26 0.93644 7Bank of Overseas Chinese 1.00000 1 0.95816 27 0.93767 6Chinese 0.96178 25 0.94822 28 0.93450 12Bo-Wa 0.99756 2 0.93953 29 0.93001 22

434 C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435

Table 10X-Efciency and rank (outlier).

E TC Delete outlier

Chiao TungCathayKings TownFar-EasternFu-HwaE. SunSinoPacTaitung BusiTa ChongInterna. BanKaohsiungTai-ShinTaiwan CoopUnionCosmosTaiwan BusiHua-NanEn-TieTaipei FubonInternationaTaichungHsinchuJih-SunFirstChina TrustChang-HwaBank of OverChineseBo-Wa

In contraas the mosranked as thdent variabused. Cathaterms of proto solve its N(credit and$13,879 mithe lower eresent inefbad loans. Ocrisis. E. Susame set of

Third, thFirst Bank mdependent

Our empdent variab

6.3. Robust

We consoperation e(1991) suggbeen showIn particulamanagemenalso we estthe dependrelation coebut is onlyusing E TC aexpenses.

t, wercen, ousimefValue

1.000000.980670.971490.955420.949100.947840.94781

ness 0.947800.94736

k of Taipei 0.943940.942620.94164

erative Bank 0.940570.939960.93327

ness 0.925890.925710.917730.91175

l Commercial Bank of China (ICBC) 0.911500.898060.896741.000000.980670.971490.95542

seas Chinese 0.949100.947840.94781

st, some of the least efcient banks can now be viewedt efcient banks. For example, Cathay Bank, whicheworst bank (rank 29)when A TC serves as the depen-le, becomes the secondmost efcient bankwhenE TC isy Bank constantly exhibits outstanding performance int. However, in late 2005, it acquired PLL of $9 millionPL problem acquired from Taiwans double-card crisis

Nexone pedeletedremainof bankcash cards). This provision led its earnings to fall fromllion in 2004 to $2852 million in 2005. Nevertheless,arnings resulting from the huge provisions do not rep-ciency for that specic year, but a decision to removether banks also suffered substantial losses during this

n Banks rank fell from the top 20 to rank 6 due to thefactors. The bank charged off $7600million in late 2002.e rankingsof somebanks remain the same. Forexample,aintains its ranking as twenty-four, regardless of the

variable measures used.irical studies demonstrate that usingE TCas thedepen-le provides for a more reasonable result.

testing

ider two robust testing in this subsection. First, we usexpenses as the cost measure. Berger and Humphreyested that operating expense (non-interest cost) haven to comprise the bulk of cost inefciency at banks.r, the operating cost may be less inuenced by costt even though it is only part of the total cost. Thus,

imate the X-efciency by using operating expenses asent variable. In Table 9, our results show that the cor-fcient between operating expense and E TC is 0.57,0.34 between operation expense and A TC. The resultsre actually more consistent with those using operating

7. Conclus

This stuestimator oprovision fsure for toeconomic tage earningmaking theular, banksPLL. Our Ecost.

Both A TWe have exwith intuitithat have btive net woprot, as obinefciencyreceivershipwell as yiedevelopme

Our resuthat banksbecause thesis in 2002,double-carductuated sRank Value Rank

1 1.00000 12 0.99523 23 0.98897 34 0.98680 55 0.98649 66 0.98728 47 0.98519 78 0.98157 119 0.98225 8

10 0.98066 2011 0.98157 1212 0.98157 1313 0.98157 1414 0.98157 1015 0.98129 1616 0.98091 1717 0.98165 918 0.98148 1519 0.97336 2720 0.97788 2521 0.98077 1822 0.97978 2123 0.98069 1924 0.97977 2225 0.97852 2426 0.97872 2327 0.97467 2628 0.96798 2829 0.96667 29

winzorize observations that fall in the top and bottomtile of all variables (Table 10). When the outliers arer results change little, that is, the efciency rankingsilar to previous results even though the absolute valuesciency scores increase.ion

dy suggests that A TC is identied often as the biasedf true total cost, primarily because banks manipulateor loan loss. In this paper, we propose a new mea-tal cost, which is designed to act consistently withheory. This new total cost argues that banks man-s by highlighting revenues while concealing losses,conventional measure of A TC misleading. In partic-report higher accounting earnings by providing lessTC overcomes these weaknesses to reect true total

C and E TC are used to calculate bank cost efciency.amined which of the estimated efciency is consistenton. We have dened our intuition as follows: Bankseen taken over by the government due to their nega-rth, high non-performing loans, or substantial negativeserved over years of operations, should display strong. Otherwise, banks that exhibit high efciency but yieldof government are contradicts economic theory, as

lds wrong predictions from the perspective of banknt.lts also show that E TC is higher than A TC, suggestingtypically under-provision their loan loss. In addition,Taiwan banking industry suffered the enterprise cri-the second wave of nancial reforms in 2004, and thecrisis in November 2005, the total cost should haveignicantly as a result of the uctuation of PLL. Our

C.-H. Shen, T.-H. Chen / The Quarterly Review of Economics and Finance 50 (2010) 424435 435

results demonstrate that the uctuation of E TC is larger than thatof A TC, another scenario consistent with our intuition.

Our results show that estimated efciency, with the applicationof new total cost, offers results that aremore reasonable. For exam-ple, the distressed banks that were taken over by RTC are rankedclose to the top when A TC is used, but ranked close to the bottomwhen E TC is employed. Similar conditions apply to banks withvery high non-performing loans. Overall, our proposed measure isa simple method, not only in terms of adjusting earnings manage-ment, but also in calculating total cost and the resulting efciencymeasure.

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Estimating banking cost efficiency with the consideration of cost managementIntroductionCost managementAn approach to calculate economic costEL1EL2

Cost efficiency modelData sourcesEmpirical resultBasic statistics and recovery of the economic provision for loan loss (E_PLL)Cost efficiencyRobust testing

ConclusionReferences