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Efficiency, Productivity Growth and Profitability of Korean Banks

Economic Research Institute (82-2-759-5415) 2006.11.14 3192

Efficiency, Productivity Growth and Profitability of Korean Banks

Author :  Kang H. Park and William L. Weber (Southeast Missouri State University, USA)

In this paper we present estimates of efficiency, productivity change and profitability in  Korean banking for the period of 1992-2002 when the Korean banking system experienced financial liberalization, financial crisis and restructuring.  The estimates for efficiency and productivity change of individual banks and the banking industry as a whole are derived from the directional technology distance function.  Our method allows the aggregation of individual bank efficiency and productivity growth to the industry level.  This method also controls for loan losses (non-performing loans) that are an undesirable by-product arising from the production of loans.  These two features of our paper, aggregation of efficiency and productivity measures from the firm to the industry level and the modeling of desirable and undesirable bank outputs, are our unique contribution to the study of the Korean banking system. 
Our findings indicate that in the years before the Asian financial crisis, inefficiency in the Korean banking system increased dramatically.  Although the banking system as a whole became less efficient throughout the period, technical change which can be thought of as shifting the production technology in a welfare enhancing direction was more than enough to offset efficiency declines so that the banking system experienced overall productivity growth.  Weakening financial intermediation of Korean banks might be the result of their efforts to increase productivity growth in the face of efficiency declines.  This paper also identifies the major determinants of profitability in the Korean banking sector.  The results indicate that bank efficiency has a significant effect on bank profitability and support the efficient structure hypothesis.  We also find that the major determinants of bank profitability in Korea changed between pre- and post-Asian financial crisis periods.