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EPRU
THE NAMIBIAN ECONOMIC POLICY RESEARCH UNITPostal: P. O. Box 40710, Ausspannplatz, Windhoek, Namibia
Street: Cnr Louis Raymond & Grand Webster, Windhoek, Namibia
Tel.: Fax:+264 - 61 - 277500 +264 - 61 - 277501
Email: Web site:[email protected] www.nepru.org.naN
Factors Influencing the Alternative Profit
X- Efficiency of Namibias Banking Sector
September, 2005
Jonathan AdongoChristoph StorkElisa Hasheela
NEPRU Working Paper No. 103
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ii
NEPRU produces:
Books
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Namibia Business Climate Survey
Research Reports
Working Papers
Travel and Meeting Reports
Occasional Papers
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All rights reserved. No part of this publication may be reproduced or transmitted in
any form or by any means, including photocopying, recording and storage in a
retrieval system, without the written permission of the copyright holder except inaccordance with the copyright legislation in force in the Republic of Namibia.
Copyright 2005 by the Namibian Economic Policy Research Unit.
NEPRU Working Paper ISSN 1026-9258
First published in 2005 by the Namibian Economic Policy Research Unit
P.O. Box 40710, Ausspannplatz, Windhoek, Namibia
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iii
Acknowledgements
This study was conducted by Jonathan Adongo and Christoph Stork. The fieldwork
on which this study is based was carried out in Windhoek over the period January to
February, 2005 by Elisa Hasheela. The authors would like to express their gratitude
to the Agricultural Bank of Namibia, Bank Windhoek, First National Bank of Namibia,
Nedbank Namibia and Standard Bank of Namibia for providing access to theirannual reports. In addition, the authors would like to specially thank, without
implicating, Anne-marie Chidzero, Barbara James, Jeffery Fine, Julia Lowell,
Matthew Gamser and Ndiritu Muriithi, for their insightful comments that brought this
paper from its rough initial stages to this final document. Any questions or comments
regarding this working paper should be referred to Jonathan Adongo
Disclaimer
The opinions presented are those of NEPRU and should not be regarded as the
views of any other party.
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Executive Summary
The efficiency of the overall financial sector in allocating credit to investment
opportunities that offer the highest returns is a necessary condition for increased
economic growth. This partly depends on the efficiency of the banking sector, which
can be measured by the average internal efficiencies of its banks.
This study adopted a two-step procedure. The first step involved the measurement
of bank efficiency by adopting the alternative profit X-efficiency concept and
applying a transcendental logarithmic function to a panel dataset of banks in
Namibia that were in continuous existence from 1998 to 2003. It then used the
distribution free approach to estimate the efficiencies of individual banks and the
overall banking sector in Namibia.
The study found that Nedbank Namibia was the most efficient bank in Namibia from
1998 to 2003. It was closely followed by Bank Windhoek, Standard Bank Namibia,
the Agricultural Bank of Namibia and First National Bank of Namibia, respectively.
The low rank of First National Bank of Namibia was attributed to its merger andacquisition (M&A) activity over the sample period. Although Nedbank Namibia also
participated in M&A activity in 2002, through its acquisition of the micro lending arm
of SAAMBOU Bank housed in Finance in Education (Pty.) Ltd., this did not have the
same negative effect as in the case of First National Bank of Namibia because the
newly acquired institution was not incorporated into the banking operations of
Nedbank Namibia but was left as an independent subsidiary regulated by the
Namibia Financial Institutions Supervisory Authority.
The study also found that the mean level of alternative profit X-efficiency in
Namibias banking sector from 1998 to 2003 was 83% suggesting that banks in
Namibia lost approximately 17% of their potential profits between 1998 and 2003due to inefficiency. This finding fares well relative to other studies that had been
conducted internationally as of 1997, where the mean level of potential profits lost
by banking sectors in all studies, regardless of methodology, was 50%. However,
the small, panel dataset for Namibia included banks that were engaged in M&A
activity over the sample period (that ideally should have been excluded). Therefore,
the results of bank efficiency in Namibia can only be conclusive if more robust
findings are obtained in the context of a regional study.
This study extended the methodology to a panel dataset for all financial
intermediaries in Botswana, excluding insurance companies. In addition, a cross-
country panel dataset for Namibia and Botswana was analysed as a pilot initiativefor a future continental study consisting of all financial intermediaries in Africa,
excluding insurance companies.
The study then went on to apply the overall mean efficiency estimates for the
banking sector obtained in the first step by specifying an analysis of covariance
model for a panel dataset of banks in Namibia to identify external factors that
influenced the efficiency in Namibias banking sector from 1998 to 2003.
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v
The study found that merger & acquisition activity, market power, age, risk and
holding company ownership, structure, location and whether or not it is publicly
traded; influenced the alternative profit X-efficiency of Namibias banking sector
between 1998 and 2003.
The findings of this study result in a more robust, empirical tool that will assist
institutions such as NEPRU to monitor the impact of various events, such asregional integration and M&A activity, on bank efficiency. In addition, it will motivate
practitioners to improve efficiency in the banking sector. The findings are also
useful in directing the efforts of regulatory bodies to areas that they can intervene to
improve the effectiveness of the banking sector in Namibia in allocating credit
efficiently, which has positive implications for economic growth.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector vii
vii
Table of Contents
1. INTRODUCTION................................................................................................. 1
2. BACKGROUND................................................................................................... 3
2.1. Importance of X-efficiency........................................................................... 5
2.2. Purpose of an X-Efficiency Measure........................................................... 7
2.3. Alternative Ways to Measure Efficiency ...................................................... 8
2.4. Other Factors ............................................................................................ 12
2.5. Influencing Factors .................................................................................... 14
3. NAMIBIAS BANKING SECTOR ....................................................................... 27
3.1. Regulatory Framework.............................................................................. 27
3.2. Banks in Namibia ...................................................................................... 28
3.3. Market Features ........................................................................................ 29
4. MEASURING ALTERNATIVE PROFIT X-EFFICIENCY................................... 33
4.1. Efficiency Concept..................................................................................... 33
4.2. Efficiency Technique ................................................................................. 38
4.3. Approach................................................................................................... 42
4.4. Functional Form ........................................................................................ 44
4.5. Sample ...................................................................................................... 50
4.6. Data........................................................................................................... 51
4.7. Procedure.................................................................................................. 51
4.8. Results and Discussion ............................................................................. 53
5. IDENTIFYING EXTERNAL INFLUENCING FACTORS .................................... 58
5.1. Sample ...................................................................................................... 58
5.2. Data........................................................................................................... 58
5.3. Model......................................................................................................... 59
5.4. Procedure.................................................................................................. 605.5. Results and Discussion ............................................................................. 62
6. CONCLUSION................................................................................................... 65
7. REFERENCES.................................................................................................. 67
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector ix
ix
List of Acronyms
Alternative Profit X-efficiency
ANCOVA Analysis of Covariance
ATM Automated Teller Machine
BCBS Basel Committee on Banking Supervision
BoN Bank of Namibia
BWP Botswana Pula
CMA Common Monetary Area
DEA Data Envelopment Analysis
DFA Distribution Free Approach
FDH Free Disposable Hull
FFF Fourier-Flexible Function
H-Index Herfindahl-Hirschman IndexHRM Human Resource Management
ICT Information and Communication Technologies
K Capital
L Labour
LIMDEP Limited Dependent Variables
M&A Mergers and Acquisitions
NAD Namibian Dollars
NBFI Non-Bank Financial Institutions
Netputs Fixed Inputs and Outputs
NPL Non-Performing Loans
NSX Namibia Stock Exchange
OLS Ordinary Least Squares
PC Personal Computer
ROA Return on Assets
ROE Return on Equity
ROI Return on Investment
SBSS Small Business Scoring Service
SADC Southern African Development Community
SARB South African Reserve Bank
SFA Stochastic Frontier Approach
SME Small and Medium-Scale Enterprises
SMME Small, Micro and Medium-scale Enterprises
SWA South West Africa
TFA Thick Frontier Approach
USD United States Dollars
xa
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 1
1. INTRODUCTION
The main goal of this study was to identify the external factors that influence the
efficiency of Namibias banking sector. To achieve our goal this study used a two-
step approach (Coelli, Prasada & Battese, 1998). The first-step involved the
modelling of a banks internal activities based on the input-output production
function and then applying frontier analysis to estimate the alternative profit X-
efficiency of Namibias banking industry.1
This first step provided a numerical, objectively determined, efficiency value that
was used to to rank banks in Namibia according to their relative efficiencies, as an
indication of their relative abilities to allocate credit efficiently attributed to how
technology, human resources and process management methods varied across
them (Frei, Harker & Hunter, 1998).
The top ranking bank was defined as the best practice bank i.e. it had the lowest
expected costs and highest expected profits, given the business conditions specified
in the alternative profit X-efficiency function. It reflected the best management efforts
to use technology and respond to market prices and other business conditions
(Berger & Humphrey, 1993). The identification of this bank should motivate
practitioners to adopt practices that improve and discard those that hinder their
efficiencies.
In the second step, the average efficiency estimates for the overall banking sector in
Namibia were regressed on potential external factors that could influence the
banking sectors efficiency in Namibia using ordinary least squares (OLS). Standard
hypothesis testing was used to identify those factors that influenced the efficiency of
Namibias banking sector. This should be useful in directing the efforts of policy
makers and regulators to areas that they can intervene in their attempts to boost the
effectiveness of the banking sector in allocating credit efficiently
A key assumption in this study was that efficiency at the intra-bank level is a key
determinant of efficiency in the allocation of credit to available investment
opportunities that offer the highest return. This conforms to the definition of an
efficient credit opportunity, defined in Luccheti, Papi & Zazzaro (2000). Therefore,
alternative profit X-efficiency served as a proxy for the efficiency in allocating credit
to the highest-return investment opportunities.
This study aims to serve as a foundation for a future, continental, bank efficiencystudy by measuring and applying a robust, objective tool that is relevant to the
banking environment in Africa. To achieve this aim the methodology was replicated
for Botswana and also for a cross-country panel consisting of Namibia and
Botswana as a pilot initiative that is to be extended to additional countries in Africa.
1This is described in an earlier publication (Adongo & Stork, 2005a).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector2
The remainder of this paper is organised as follows Section two provides a
theoretical background to the measurement of X-efficiency and its application.
Section three briefly describes the structure of the Namibian banking sector. Section
four presents the methodology used to measure efficiency in the Namibian banking
sector and the results and associated discussion of an application of the
methodology to the banking sector in Namibia, Botswana and a cross-country panel
of Namibia and Botswana. Section five describes the methodology used to identifyexternal factors that influence efficiency in the Namibian banking sector, the results
and associated discussion of an application of the methodology. Section six
presents the conclusions.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 3
2. BACKGROUND
A positive link between financial intermediation and economic growth is empirically
supported, widely accepted and has been increasingly incorporated as a
determinant in growth studies over the past several decades (Gurley & Shaw, 1955
and Goldsmith, 1969). Empirical studies indicate that this link could occur through
two channels -- factor accumulation and changes in efficiency (Collins, 2002).
Therefore, even though a country has enough savings to generate adequate factor
accumulation (capital accumulation specifically),2 its growth potential can be
hindered if the domestic financial intermediation mechanism fails to allocate these
savings to available investment opportunities efficiently (Stulz, 2001).3 An efficient
financial intermediation mechanism increases the expected returns to investment,
which can promote innovation resulting in further positive implications for economic
growth (Collins, 2002).
Banks, as financial intermediaries, provide various services for depositors and
borrowers. They provide liquidity and safekeeping for savings, which allows
depositors to smooth consumption over time. They also conduct credit analysis,
disburse loans and monitor outstanding credits for borrowers who require more
financing than they can generate from internal sources or from alternative sources of
finance such as financial markets (Berger & Humphrey, 1993). The disbursed loans
are mainly working capital, defined as the credit required in the interval between
actual investment and the sale of output (Livesey, 1993). In addition, to this they
provide payment services and trade finance, leasing and factoring solutions that
finance the inventory and fixed asset needs of borrowers. The efficiency of the
banking sector in providing these services, particularly at the intra-bank level, and
conditions in the external environment; influence the effectiveness of the domesticfinancial intermediation mechanism.
The level of intra-bank efficiency is represented by alternative profit X-efficiency in
this paper. X-efficiency is defined as the general efficiency of a firm judged on
managerial and technological criteria in transforming inputs at minimum costs into
maximum profits. It includes intra-bank economic, intra-bank motivational efficiency -
individual personality and external motivational efficiency - arising from management
incentives and the environment (Leibenstein, 1978).
2A discussion on the availability of labour (the other factor of production) is beyond the scope of this
paper.
3This paper assumes the that perfect markets exist where contracting is costless and the Coase
theorem applies i.e. whenever there is a reallocation of resources that creates value it can beimplemented at no cost (Stulz, 2001).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector4
Banks that exhibit X-inefficiency are either wasting resources (technical inefficiency),
or are using inefficient business processes (allocative inefficiency), or both. This is
caused by employee, management and environmental factors. 4
X-efficiency captures the effects of the adoption of technology relative to the number
of staff and the way this technology is used (Frei, Harker & Hunter, 1998). How
effectively technology is used depends on how employees are introduced to newtechnologies and how these technologies are integrated into the business process.
Another important factor is how well employee contracts are drawn up and policy
and procedures implemented. These factors are determined by a banks
management. They are responsible for selecting the right staff and setting
appropriate incentives aimed at influencing the behaviour of employees.
The effectiveness of management is also affected by its own preferences. Publicly
traded banks may be subject to the principal-agent problem, where managers
pursue objectives that differ from those of stockholders such as empire-building -
defined as the pursuit of inefficient mergers to gain larger scale and presumably
prestige in having large staffs or other perks (Hughes et al 2003).
At the external level, a banks X-efficiency is influenced by the pressure applied by
its operating environment arising from regulation, innovation and competition.
Innovations arising from advances in information and communication technology
(ICT) cause the introduction of new financial products developed by financial
engineers.
Furthermore, the level of competition in a banking industry determines the pressure
on banks to increase efforts to innovate and improve their business processes. In an
oligopolistic banking industry, arising from exits or within-market merger and
acquisition (M&A) activity in the banking industry, there is low pressure to increaseperformance from the environment. This results in quiet life effects that can be
exacerbated by the interdependence among oligopolistic banks, which cooperate
tacitly and imitate each other to some extent. Under these conditions, higher costs
can be passed on to consumers who do not understand the nature of the service
offered or lack alternative sources of finance. Low levels of competition are
associated with lower X-efficiency levels (Berger & Hannan, 1993).
A decade of econometric research has shown that X-efficiency dominates scale and
scope economies (Frei, Harker & Hunter, 1998). In addition to including scale and
scope effects, X-efficiency takes into account the external environment that a bank
operates in.
4X-inefficiency may also arise because inputs are theoretically assumed to have a fixed specification
and yield a fixed performance, which is unrealistic (Leibenstein, 1966).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 5
Box 1: Economies of Scale and Scope
Scale economies refer to how the banks size (scale of operations) is related to its
profit. 5 It focuses on selecting appropriate outputs and reflects technical efficiency,
which is the ability of a bank to produce maximal output from a given set of inputs
over a certain time period.
Scope economies refer to changes in product mix related to cost. It focuses on
selecting the appropriate outputs and reflects allocation efficiency, which is the
ability of a bank to use inputs in optimal proportions, given their respective prices
and the production technology i.e. input-mix efficiency.
The concept of X-efficiency, which takes the output bundle as given, differs from that
of scale and scope efficiency. Scale economies assume that banks are already on
the efficient frontier6, where banks are fully X-efficient and minimise costs for every
scale of output. Analysing banks other than those on the frontier confound scale
effects with differences in X-efficiency (Berger & Humphrey, 1993).
Scope efficiency is concerned with movements along the frontier, while X-efficiency
relates to an outward shift in the frontier (Frantz, 1992). Although, both scope and X-
efficiency presume that inputs will be allocated to the right decision and performance
units, X-efficiency does not presume the decision and performance units involved
will decide and actually use inputs as effectively as possible.
Due to the negligibility of scope economies, X-inefficiencies are usually found to
arise from scale diseconomies, suggesting that it arises due to poor choice of inputs
as a result of poor reaction to the prices faced.
2.1. Importance of X-efficiency
An increase in the X-efficiency of the banking sector has positive implications for
economic growth. The most X-efficient banks should be better at loan targeting than
their counterparts and allocate credit to the most productive uses i.e. those yielding
the highest return.7 By bringing about a change in ownership and composition of a
given amount of savings, they enhance the productivity of the capital stock leading
to higher levels of economic growth (Bhatia & Khatkhate, 1975). This mechanism is
illustrated in a theoretical framework of capital intermediation, attributed to Galbis
(1977).8
5These concepts are described relative to the profits, but they can also be described relative to thecosts or revenues.6
An efficient frontier is defined by the most X-efficient bank in a sample.
7This does not consider opportunities that may be more productive from a social welfare perspective.8
Banks may not be conducting effective loan targeting due to risk aversion as opposed to inefficiency(Adenso-Diaz & Gascn, 1997).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector6
The implication of Galbiss model for small-scale enterprises is that banks that are
X-efficient are able to identify those that have high-return yielding projects and direct
credit to them. This finance injection should enable small-scale enterprises to grow
and move to the medium and large-scale segments of the enterprise spectrum,
where it is easier to obtain additional finance. For small-scale enterprises that are
already operating at optimal capacity and have no growth prospects, the provision of
bank finance will increase their potential to achieve sustainability at existing levels.Furthermore, improved loan targeting by X-efficient banks will lead to lower default
levels on disbursed loans. The reduction in non-performing loans (NPLs), coupled
with higher returns on disbursed loans should increase profits in the banking sector.
X-efficiency is also important for the effectiveness of monetary policy. According to
the Post-Keynesian view, money supply is endogeneous (Moore, 2002). Therefore,
the structure of the banking system and its overall level of efficiency have a direct
effect on monetary variables in the domestic economy.
In this era of post-globalisation where the pace of financial sector liberalisation is
high (and arguably irreversible), increasing integration into the international financialsystem is accompanied by within and cross-country M&As. This is expected to
improve the stability of financial intermediaries because they will be able to fund
themselves from abroad and diversify their risks abroad, which should lead to their
insulation from local shocks. This should result in price reductions, service
expansion and improvements in X-efficiency (Stulz, 2001). Whether, the resulting
liberalisation has positive or negative impacts on a societys welfare depends on the
strength of the banking sector in general (Lowell, Neu & Tong, 1998) and pre-M&A
levels of X-efficiency in the banking industry in particular.
Due to the absence of systematic internal controls in X-inefficient banks,
inappropriate sequencing of stages of financial liberalisation, central decisions thatdo not make any provisions for the wave of reorganisation that ought to take place
at the banks branch level prior to and during liberalisation and the intervention of
other incentives; the positive expectations of liberalisation may not always be
realised (Berger & Humphrey, 1997; Athanassopoulos, Soteriou & Zenios, 1997 and
Frenkel & Menkhoff, 2004).
In some cases, liberalisation has led to rapid branch expansion, excessive asset
growth and reduced X-efficiency. The oversupply of finance (too much money
chasing too few investment opportunities) could result in an increase in NPLs, a run-
up in bank failures and instability in the economy (Berger & Humphrey, 1997). In
other cases, the elimination of loan interest rate ceilings resulting in higher marketrates and increased competition from non-bank financial institutions (NBFIs) can
lead to higher costs of funding, increased demand for funds and a reduction in the
supply of deposits per bank. This can result in poor total factor productivity growth,
which has negative implication for economic growth (Berger & Mester, 1999).
The negative aspects of inappropriate financial liberalisation particularly affect small-
scale enterprises because the intermediated finance that they are eligible for cannot
be provided from abroad, as opposed to medium and large-scale firms that can
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 7
bypass much of the local financial structure (Jun-Koo, Yong-Choel, Park & Stulz,
1995).
Finally, X-efficiency is important if banks are to survive over the long-term. The
competitive landscape has been greatly altered by the innovative financial products
accompanying the proliferation of NBFIs and new financial service distribution
channels enabled by advances in ICT. The competition from existing banks, newentrants, international banks and NBFIs such as leasing companies, grocery chains,
mobile phone companies, furniture companies and automotive giants
(Athanassopoulous, Soteriou & Zenios, 1997 and National Treasury, 2004) requires
banks to compete to maintain and increase their existing market share. This will
require them to choose cost-effective delivery systems and make human resource
changes and appropriate technology investments (Frei, Harker & Hunter, 1998).
Their success in this effort directly depends on their X-efficiency.
2.2. Purpose of an X-Efficiency Measure
Measuring the X-efficiency of banks in Namibia is important for policymakers,practitioners and academic research.
X-efficiency measures are important for better antitrust policy analysis. Antitrust
policy relies heavily on the use of the H-Index, which uses ex ante information to
assess the market power and efficiency effects of M&A deals. This analysis should
control for efficiency. Otherwise, the observed relationship between market power
and prices or profits may not be easily separated from the effects of market power
and efficiency (Akhavein, Berger & Humphrey, 1997).
X-efficiency measures can also improve the predictive accuracy of failure prediction
models, which is useful for regulators such as the Bank of Namibia (BoN), which isNamibias central bank (Barr, Seiford, & Siems, 1994). Various empirical studies
have shown that banks display low efficiency prior to failure and those with relatively
low efficiency levels have a higher probability of failure than their more efficient
counterparts (Berger & Humphrey, 1992a; Cebenoyan, Cooperman, and Register,
1993 and Hermalin and Wallace, 1994).
In addition, X-efficiency measures can motivate a banks management to adopt
best practices that are found among banks on or near the X-efficient frontier.9 It
can also assist managers in adjusting their policies and procedures to avoid worst
practices that are relatively common among banks that are far from the X-efficient
frontier.
Furthermore, when X-efficiency measures are regressed on potential determinants
they may highlight relationships with various internal organisational and external
9A best practice bank is defined as one that has the highest expected profits, given the business
conditions specified in its profit function and reflects the best attempts to use technology andrespond to market prices and other business conditions (Berger & Mester, 1999).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector8
environmental factors that suggest managerial arrangements and environmental
conditions that are associated with X-efficiency (Berger & Humphrey, 1997). This is
important for policy makers to identify potential areas of intervention that can boost
efficiency in a banking sector.
X-efficiency measures can also be of assistance in monitoring the dynamics in the
banking sector in the context of increased regional integration and the impact ofother external events. This is important for the Southern Africa Development
Community in measuring its objective of fostering competition and improving
efficiency in the regional banking sector (SADC, 2003).
X-efficiency measures are also important for monitoring the impact of the regulatory
changes instituted by the Basel II Capital Accord on X-efficiency in the banking
sector. These changes are expected to arise from the different uses of the risk
measurement framework stipulated by the new Accord relative to Basel I
(Saidenburg & Schuermann, 2003).
Also, the information provided by the X-efficiency measures on the relativeefficiencies of banks in the industry will support Pillar 3 on public disclosure in the
Basel II Capital Accord. This pillar depends on the financial market to apply pressure
on banks (Saidenbuurg & Schuermann, 2003). An X-efficiency measure is important
where some banks are not listed on the stock exchange, like in Namibia, or where
there is no active investor community.
Finally, the Basel Committee on Banking Supervision (BCBS), through the
Advanced Measurement Approach, seeks to provide flexibility for banks to use their
own internal measurement approaches subject to meeting rigorous qualitative and
quantitative standards (Saidenburg & Schuermann, 2003). The method used to
measure X-efficiency in this paper supports this effort and will be a first step towardsdetermining areas for which more advanced risk measures can be applied in the
banking industry.10
2.3. Alternative Ways to Measure Efficiency
Besides the use of frontier analysis to measure X-efficiency, various other
approaches to measuring bank efficiency exist.
2.3.1. Banking Productivity per Employee Hour
Some government agencies collect productivity statistics on various sectors,including banks. These statistics view efficiency from the production approach,
which we describe in the methodology section. A typical measure captures banking
productivity per employee hour. However, bank employee labour hours may be an
inaccurate indicator of efficiency because of trends towards outsourcing of back-
10Currently models from the insurance industry are being applied (Saidenbuurg & Schuermann, 2003).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 9
office operations to holding company affiliates and service bureaus. Failure to
account either for the labour used elsewhere in the holding company but effectively
working for the bank or for the cost of this labour and capital could bias government
productivity measures toward a spurious finding of productivity arising from the
change in output per employee labour hour because of the incorporation of total
labour hours worked by employees and non-employees.
2.3.2. Minimum Reserves
Bank regulatory agencies use a comparison of actual reserves (required as well as
excess reserves) held against the regulatory minimums as a legal basis for taking
supervisory action (Demigr-Kurt & Huizinga, 1998). A high ratio of actual reserves
over the regulatory minimum would be an indicator of financial repression and
inefficiency.
2.3.3. Risk Ratings
In addition, the Basel II capital accord advocates the use of risk ratings as an
alternative way to capture bank efficiency. One measure used under this approach
is the value-at-risk, which is defined as the loss to an investment portfolio due to an
adverse market move (Saidenburg & Schuermann, 2003). It is a scalar measure and
may not incorporate all the different aspects of the highly dimensional problem that it
summarises. Risk ratings also capture credit risk, concentration risk, interest rate
risk and business risk (operational risk). Operational risk is defined as the risk of
direct or indirect loss resulting from inadequate or failed internal processes, people
and systems or from external events, thus capturing X-efficiency (Basel Committee
on Banking Supervision, 2001).
2.3.4. Monetary Aggregates
Macroeconomic studies use monetary aggregates to represent efficiency. These
aggregates include the ratio of bank credit granted to the private sector to GDP, as
an explanatory variable in growth regressions (King & Levine, 1993). This assumes
that pure size of the financial system is closely related to quality of financial services
or efficiency, which may not be so. In addition, the level of bank credit may simply
reflect the demand for bank services, which may have nothing to do with the
banking sectors own efficiency. The use of monetary aggregates is only justified if
there is an absence of reliable data on the number and size of deposits and loans
available.
2.3.5. Interest Spreads and Margins
The most common macroeconomic measure of efficiency is the interest spreads. It
is a direct measure of banks mark-up over cost. The justification for using interest
spreads to measure efficiency is because financial intermediation affects the net
return to savings, and the gross return for investment. Interest spreads can either be
ex ante or ex post. The former is the more common one and is calculated from the
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector10
contractual rates charged on loans and rates paid on deposits. They are biased to
the extent that differences in perceived risks are reflected in the ex ante yields.
These differences tend to distort spread comparisons. Ex ante spread data are also
generally put together from a variety of different sources at the aggregate industry
level and are not completely consistent. Ex post spreads, on which this paper
focuses, consist of the difference between banks actual interest revenues and
actual interest expenses. A problem with ex post spreads is that the interest incomeand draw downs from the loan loss provisions materialise in different time periods.
This may lead to inaccuracies in reflecting efficiency differences due to differences
in NPLs and monitoring costs associated with loan quality (Demirg-Kurt &
Huizinga, 1998).
Another common macroeconomic measure of efficiency is the net interest margin. It
is argued that net interest margins mirror the interest spreads. However, they also
reflect a variety of other factors including bank characteristics, macroeconomic
conditions, taxation, deposit insurance regulation, overall financial structure, and
several underlying legal and institutional indicators (Demirg-Kurt & Huizinga,
1998). Therefore, a change in the interest margins may be a result of changes infactors other than efficiency which interest margins cannot account for, because
they only capture scale and scope economies.
2.3.6. Accounting Ratios
Some microeconomic studies use accounting ratios such as return on assets (ROA),
return on investment (ROI) and return on equity (ROE) to represent efficiency
(Ikhide, 2000 and Bedari, 2004). Ikhide (2000) argues that use of total assets, loans
or deposits, like in alternative profit X-efficiency, does not sufficiently capture bank
output, which he defines as the value of services rendered by banks. However, this
definition only applies if the banks provision of financial services is viewed in terms
of the production approach, as opposed to the intermediation approach that is
adopted in this paper.11
Accounting ratios are limited as measures of efficiency. Since they do not control for
output mix or input prices, they do not enable the determination of whether X-
efficiency or scale and scope efficiency are the source of variation in bank
performance (Akhavein, Berger & Humphrey, 1997). Also, ratios that contain assets,
such as ROA, assume that all assets are equally costly to produce and all locations
have equal costs of doing business. In addition, many accounting ratios exclude
interest expenses, which comprise most of total bank costs and often represent
operating expenses incurred elsewhere in the banking system (Berger & Humphrey,
1993).12 Furthermore, changes in accounting ratios may reflect a change in the
numerator or denominator values as opposed to changes in the overall ratio
(Demirg-Kurt & Huizinga, 1998). Finally, accounting ratios do not capture long-
11More on these approaches is presented in the methodology section.
12ROA includes interest expenses as part of operating expenses
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 11
term performance, and aggregate many aspects of performance such as operations,
marketing and financing (Sathye, 2001).
2.3.7. Frontier Analysis
Microeconomic studies apply frontier analysis, which captures the deviation between
actual and desired performance. They measure efficiency relative to an objectivefunction for output (product) maximisation and profit maximisation.13 The bank is
viewed as a black box, where the production function is a simple relationship
between inputs and outputs (Farrell, 1957) and the issue facing banks is to
maximise profits while reducing costs. This is done by selecting:
The levels of inputs: physical capital (K), labour (L) and technology, which
depends on the next three choices (Frei, Harker & Hunter, 1998);
The input transformation function;
The production function for the organisation;
The mix of outputs that will maximise profits.
The bank that is best at executing these four choices within its environment will be
the most X-efficient.
2.3.7.1. Market-based Approaches
Some microeconomic studies use a market-based approach. This measures
efficiency in terms of the percentage of expected profit being earned for a given
level of risk relative to a best practice bank on a risk-expected return, efficiency
frontier (Hughes, Lang, Moon & Pagano, 1997). A bank with too little profit for the
amount of risk it is taking is deemed inefficient. Banks that achieve efficient
allocations maximise the market value of their assets and are more profitable.14 The
measure was applied to a sample of publicly traded bank holding companies and
evidence showed that banks signal better asset quality through their capitalisation.
The use of the market-based efficiency measure assumes the existence of at least a
semi-strong, efficient financial market. This market provides the best measure of
estimating whether firms are creating value for shareholders or not because most of
the information is incorporated into prices (Brealey & Myers, 1991). Under this
financial market structure the relative efficiencies of banks will be reflected in market
prices, directly through lower costs or higher output or indirectly, through higher
customer satisfaction and higher prices that translate into better stock performance
(Adenso-Diaz & Gascn, 1997). Since all banks in Namibia are not listed on the
13These three concepts are not independent. Duality theory can be used to derive the cost function
from the production function, and cost is a component of profit.
14Note that profit maximisation will differ from value maximisation to the extent that banks are not risk-
neutral (Berger & Mester, 1999).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector12
Namibia Stock Exchange (NSX), the use of this measure was not pursued in this
paper.
Hughes, Lang, Moon & Pagano (1997) argue that profit X-efficiency may be
inadequate because it does not take into account sub-optimal choices of risk and
quality that affect prices. When uncertainty exists, the objective of profit
maximisation fails to account for the riskiness of the production plan and the rate ofinterest at which the stream of profits is discounted (Modigliani and Miller, 1958). In
addition, profit X-efficiency does not reflect all relevant expected future cash flows
and expected costs of financial distress but focuses on current prices and quantities
of inputs and outputs.
The choice of measure that one uses to measure efficiency is important because
each one will give different results if used to investigate the relationships with other
economic variables. The alternative profit X-efficiency measure, which this paper
adopts, is attributed to Farrell (1957). It models the banks activities using the
production function and measures how close a banks profit is to what a best
practice banks profit would be for producing the same output bundle under similarconditions. The best practice bank defines the frontier that represents the best
practice observed in the industry and not the theoretical maximum profit possible,
which is not easily observable.
Besides the economic approaches used to measure efficiency summarised above,
many banks have their own internal benchmarking procedures that are mostly used
at the branch level. These consist of relatively simple comparisons or rankings of
offices according to a set of performance measures, which include the stock of
accounts serviced or the values within various accounts. These efforts lack a
powerful and comprehensive optimising methodology similar to the frontier analysis
approach used in this paper (Berger & Humphrey, 1997).
2.4. Other Factors
Bank efficiency is not the only factor that is necessary to create an effective financial
intermediation mechanism that allocates credit efficiently. A stable macro
environment, with minimal business cycle fluctuations is also important. Namibia has
a relatively stable macro environment and the regulatory framework for its financial
sector is determined by the CMA.
This stable macro environment needs to be supported by appropriate infrastructure
and facilities. Although, Namibia ranks quite highly in the usage of ICT compared toother countries in Sub-Saharan Africa the high cost of these services creates a
barrier the hinders potential gains that could result from improved financial service
provision by an efficient banking sector (Stork, 2005).
Despite effective provision of finance by X-efficient banks, gaps in the financial
intermediary system will hinder its potential to contribute to economic growth.
Currently, there is no formal financial mechanism that provides transformation
lending or managerial support geared to growth for small-scale enterprises in
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 13
Namibia. This function cannot be effectively undertaken by banks (which in Namibia
are not engaged in universal banking). Alternative institutions such as private sector,
venture capital firms that are specifically suited to perform this function are needed.
Banks lending policies determine their efficiency in credit allocation. Inappropriate
lending policies result in cheap credit being provided to medium and large-scale
firms, regardless of the value of their returns on investment (ROI), at the expense ofhigher yielding opportunities provided by small-scale enterprises (Obwona &
Mugume, 2001). Such lending policies result in low productivity investment no
matter how efficiently they are implemented.
The design of financing interventions also determines the effectiveness of the
financial intermediation mechanism in allocating credit efficiently. Inappropriately
designed financial provision strategies will not produced the desired results
regardless of how efficiently they are implemented. This is exhibited by the
continued complaints of inadequate finance reported in the results of surveys
targeted at small-scale enterprises (Grossman, Mwatotele, Stork & Tobias, 2005). In
Namibia the design of an effective financing mechanism that targets the poorest ofthe poor could be improved (Investment Development Consultancy & Development
Strategies, 2001).
The existence of M&A deals in the banking industry may affect the effectiveness of
the financial intermediation mechanism in allocating credit efficiently. Merging banks
tend to shift their portfolios into higher risk, higher expected-return investments to
take advantage of diversification gains from the mergers. These are typically high-
yielding loans. Therefore, M&A in the banking industry could increase the
effectiveness of the financial intermediation mechanism.15
Also, regulation determines a banks choice of investment portfolios, which hasimplications on its efficiency in credit allocation. The design of regulation depends
on different goals and objective functions of different constituencies including the
trade-off between customer protection and increased access to credit; the desire for
both simplicity - emphasis on rules, and flexibility - emphasis on supervision; and the
need to allow for market forces to provide a powerful monitoring and correction
mechanism (Saidenburg & Schuermann, 2003).
Besides corporate income tax, which represents direct taxation, banks are subject to
indirect taxation through reserve requirements, which are usually remunerated at
less-than-market rates. As opposed to corporate income tax that can be targeted at
pure profit, making it relatively non-distorting, the reserve tax is proportional to thevolume of deposit taking and is therefore a distorting tax (Demigr-Kurt & Huizinga,
15This positive effect can be outweighed by the negative effects arising from an increase in marketpower.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector14
1998).16 This distortion affects the banks efficiency in credit allocation, which has
negative implications on economic growth.
The existence of an explicit deposit insurance scheme may also affect the
effectiveness of the financial intermediation mechanism. Therefore, if deposit
insurance is chosen to mitigate information asymmetry inherent in banking, its
design matters in determining banking stability and efficiency. The fall in depositrates that accompanies explicit deposit insurance makes the operation of small
banks feasible, which provides a valuable source of alternative finance for small-
scale enterprises. However, deposit insurance creates a subsidy that could be
exploited by taking additional risks, which would reduce the quality of the loan
portfolio. This lowers net interest margins and profits, which could create a barrier
for competition by discouraging new entry, after a point (Demigr-Kurt & Huizinga,
1998).17
2.5. Influencing Factors
The firms that banks lend to are the small and medium-scale enterprises (SMEs)and large-scale enterprises. Some of these enterprises are profitable but cash poor.
They are rapidly expanding with fast sales growth, positive profit margins but lack
marketable fixed assets or accounts receivables that are needed to reduce the
lending risk. Others are growing rapidly towards liquidity. Although, they are
successful and stable enough so that the risk to outside lenders is reduced, they still
need outside cash to sustain their growth (Sahlman, 1990).
The official definition of SME in Namibia, depicted in Table 1 below, is based on
number of employees, annual turnover and capital employed. A firm is categorised
as an SME if it meets at least two of the three criteria. Dahl (2002) argues that the
official definition may not be appropriate for Namibia where the average SME size isapproximately 3 (2.2) employees and the annual turnover and capital employed
appear to fit few Namibian enterprises with between 1and 9 employees.
As described in earlier paragraphs, a banks lending practices has an impact on thelevel of funds these SMEs and large enterprises can raise and how these firms aremanaged (Stulz, 2001). These practices depend on internal factors, which thebanks management can control or external factors, beyond its control.
16 The effect of these direct and indirect taxes on interest margins and profits work in opposite
directions, especially in developing countries.
17Although, Namibia has no deposit insurance it sets its interest rate 20 basis points below that of the
CMA. This has the same effect if an explicit deposit insurance scheme existed and may explain someof the variation in profits that is currently attributed to market power.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 15
Table 1: Definition of Small Business by Ministry of Trade and Industry in
Namibia
SectorNumber ofEmployees
Annual turnover Capital employed
Manufacturing Less than 10 NAD 1,000,000 NAD 500,000
All other businesses Less than 5 NAD 250,000 NAD 100,000
Source: Ministry of Trade & Industry (2000)
2.5.1. Internal Factors
This section describes factors under a bank managements control that influencealternative profit X-efficiency and can be an area of focus to increase theeffectiveness of the financial intermediation mechanism in allocating creditefficiently.
2.5.1.1. Information Systems
The way a bank structures it processes has important implications on alternative
profit X-efficiency. Processes increase the banks ability to compete, satisfy their
customers and complete transactions accurately and address other sets of business
problems (Frei, Harker & Hunter, 1998 and KPMG, 2004c). These processes need
to be aligned with the overall goals of the organization.
Process alignment in banks is a management task. In recognition of this, banks
invest in the existing group of managers through management development
programs where they learn how to integrate varied pieces together to form a
coherent, formidable structure. Banks also hire managers from manufacturing
enterprises to drive the process alignment of technology, human resource
management (HRM) and strategy.
Rather than focusing on one process, bank managers need to improve a set of
processes i.e. rather than focusing on one best practice they have to look at the
overall set of practices as they interact with each other. This is because there is no
one set of management practices, capital investments and strategies that lead to
success. Rather, it appears that the alignment of technology, capital investments
and human resources with appropriate delivery processes appears to be a more
appropriate strategy to increasing alternative profit X-efficiency in the banking
industry.
2.5.1.2. Information and Communications Technology
The level of adoption and application of ICT may also affect the level of alternative
profit X-efficiency in the banking sector. ICT is used by a banks management and
staff to transform raw inputs into useful inputs. It adds value by creating new
sources of information in an organization, rather than simply automating existing
processes (Zuboff, 1985). It is viewed within a bank at two main levels. Firstly there
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector16
is overall investment in ICT. The banking sector in Namibia is continuously
undertaking technology infrastructure projects, platform automation and information
and transaction process upgrading. These are aimed at integrating the traditional
front-office and back office systems to reduce costs by enabling the operation of
smaller bank branches with fewer but more highly qualified staff.
Secondly, there is the ICT functionality deployed in the production and servicedelivery processes, which focuses on its ability to perform certain functions within
the organization. The purchase of a computer in itself adds nothing to the productive
capability of an organization. It is only after this computer has been integrated into
the production technology of the firm that it adds value (the same is true of labour
and other capital inputs) (Frei, Harker & Hunter, 1998). The selection of ICT projects
and their management are crucial factors in transforming the investment in ICT into
effective ICT aimed at generating higher profit.
2.5.1.3. Human Resource Management
Human resource management (HRM) processes provide a high-level frameworkand guiding principles, while HRM policies bring this framework down to an
operational level. At increasingly specific levels below HRM processes and policy
lies the implementation of particular HRM practices.
HRM practices create value by attracting and retaining employees, reinforcing
employee behaviors and developing employee skills through compensation, hiring
and selection, staffing, training, work organization and employee involvement. They
affect both managerial and non-managerial employees and affect alternative profit
X-efficiency to the extent that both groups play important roles in engaging or
supporting profit generating activities in banks (Frei, Harker & Hunter, 1998).
Solid empirical evidence shows that HRM contributes to organizational performance
and implies that efficiencies in banking may be increased by effective management
of human resources (Frei, Harker & Hunter, 1998).
2.5.1.4. Service Delivery Channels
Another factor influencing alternative profit X-efficiency is the cost of and revenue
generated by the channel used to provide financial services. Banks use branches,
automated teller machines (ATMs), the personal computer (PC), fixed-line
telephones and most recently cellular phones (cell phones) to provide financial
services to their clients. The increase in service delivery channels are the result of
pressures from a globalised financial services industry, opportunities provided by
advances in ICT and innovations in financial engineering. The management of
process consistency within and across these service channels is important because
of the interactions between them.
2.5.1.4.1. Branches
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 17
Branches are the tradition delivery channel used by banks for financial service
provision. However, due to their fixed location their outreach is limited to the local
clientele in their immediate surroundings. For most branch employees time spent
with customers focuses on simple, transaction-oriented activities and basic servicing
of accounts rather than on activities that are likely to lead to sales opportunities
(Frei, Harker & Hunter, 1998)
The pace of innovation in financial engineering and advances in ICT has brought
their traditional role into question. The future of branches does not lie in their
elimination in favour of new service delivery channels but in transforming them into
sales as opposed to service centres (Athanassopoulos, Soteriou & Zenios, 1997).
This will involve designing processes to supplement or improve employee-customer
interaction that will allow bank employees to increase their cross-selling efforts, in
addition to assessing and meeting customers needs.
2.5.1.4.2. Automated Teller Machines
Technological advances have assisted banks in reducing the cost of branchnetworks and allowed them to expand faster into new areas. This has mainly been
through setting up ATMs instead of adding more costly physical branch offices
(Berger & Mester, 1997). Mini-ATMs and mobile agencies have further reduced the
cost incurred by setting up fixed ATM centers that are usually found outside bank
branches.
The ATM channel provides an opportunity for banks to channel routine transactions
towards this interface and introduce customers in new markets to different ways of
interacting with banks. In addition, it is a useful channel through which SMEs can
use debit cards to access approved credit lines for their businesses.
2.5.1.4.3. Fixed-Line Telephones
Banks also take advantage of the fixed-line telephone as a service delivery channel.
This occurs mainly through the provision of call center services to handle routine
questions and service transactions day and night. The use of this channel involves
the routing of all calls to a call center. This strategy could be used to free up branch
employees to pursue more sales opportunities.
Shifting the call centre from a pure service channel to a sales and service channel
enables it to shift from a cost centre to a profit centre. In other banks this has been
handled through the use of technology to give call centre representatives a completepicture of each calling customers financial portfolio, position and potential. This
should enhance their sales efforts by enabling them to suggest an optimal fit
between customers and services, and to refer the customers to areas in the bank
with particular expertise in a product as it becomes necessary (Frei, Harker &
Hunter, 1998). This channel can also be used to approve loans without actually
meeting the loan applicant through the use of credit scoring models discussed later
on in this section.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector20
The move of the capital allocation decision to the banks headquarters or holding
company makes no difference to capital budgeting decisions and investment activity
because whether a bank varies leverage to business units on the basis of risk or
varies the cost of capital with the risk of each individual project makes no difference.
In addition, it frees managers to focus their attention on risk that they can influence
i.e. business risk (James, 1996).
Box 2: Risk Categories
- Credit risk refers to the risk of loss due to borrower default or failure to
pay on a contractual obligation. It arises in lending to marginal, small-
scale enterprises.
- Business risk refers to the uncertainty of the revenues and expenses
associated with activities such as loan origination, servicing and data
processing. It depends on X-efficiency.
- Market risk refers to the risk of loss due to changes in the market price of
a publicly traded banks assets and obligations such as foreign exchangerisk, interest-rate risk and options risk on mortgages and deposits. The
banks treasury unit is responsible for hedging against market risk.
- Country risk refers to the risk of loss on cross-border and sovereign
exposures due to governmental actions such as the suspension of hard
currency payments, radical devaluation of the currency and
nationalization of assets held as investments. This arises from
government action (James, 1996).
To the extent that riskier divisions face a higher capital charge, business unit
managers may be tempted to understate the risk of their division. This behaviour
can be mitigated by evaluating the realized outcomes of a position (net of hedgable
risk) relative to management forecasts, as part of the performance evaluation
system of senior management (James, 1996).
2.5.1.5.1. Credit Scoring
The implementation of risk-based capital allocation will hinder the effectiveness of
the financial intermediation mechanism in lending to high-return destination. This is
because these lending opportunities are associated with higher credit and business
risk (See Box 2 above), which lead to a lower-quality loan portfolio. Business units
that seek out high-risk, high return opportunities contribute to a greater volatility of
the banks overall market value, resulting in higher costs of raising external funds
and a reduction in its competitiveness in the wholesale market. Due to these factors
such business units will face a higher capital charge than those that lend to less
risky, lower return destinations.
However, banks have begun to downstream their service offerings towards the
marginal, small-enterprise sector (Harper & Arora, 2005). This pool of clientele is
typically informationally opaque, request for loans that are small in size and lack
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector22
account was likely to generate, identification of applicants who may be candidates
for other services and targeting of prospective customers.
Box 3: Types of Credit-Scoring Systems
- A generic model that predicts the likelihood of a business loan applicant
paying in a severely delinquent manner based upon a sample of
businesses from across all industry segments, utilizing a wide range of
commercial information.
- An industry-specific model that predicts the probability of delinquent
payment based upon a sample of firms within a given industry.
- A model that predicts the likelihood of business owner payment
performance based on the owners payment behaviour.
- A scoring model developed from a sample of businesses that most
resemble the banks actual borrowers (Rowland, 1995).
The implication of the adoption of SBSS by banks in Namibia is that it could reduce
the credit and business risk of SME branches and make them less of a liability when
assessed using risk management methods. Another implication is that small
business owners who have been scrupulous about paying off personal debts are
more likely to get a new loan than those with a troubled credit history, even if their
enterprises have impressive balance sheets.
The adoption of SBSS requires banks that are down streaming into the marginal,
small-scale enterprise sector to view the issue of collateral from a different
perspective.20 By not relying so much on financial statements for small enterprise
lending, which tend to be unsophisticated or may understate income for tax reasons,
SBSS is more effective than the original credit scoring models for small business
lending. By enabling banks to evaluate business loan applications based on the
owners personal and business finances, which is important where entrepreneurs
keep debt in the business and cash in their personal account, SBSS allows a bank
that is willing to make large personal loans to self-employed people not to give the
same clients a hard time when they apply for business loans by taking the owner
and the business as the same entity. This inclusion of personal profiles in loan
assessment is relevant to Namibia where a small businesses future is closely tied to
the owner's creditworthiness (Grossman, Mwatotele, Stork & Tobias, 2005).
The ability of SBSS models to improve collection activity depends on the information
base on which they rely. The personal information used is usually obtained from one
or more consumer credit bureaus and may be combined with data from business
credit bureaus and basic business-specific data collected by the bank. Currently the
20The use of SBSS conflicts with the limited liability rule in the case of default where the applicant
enterprise is a corporation.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 23
existence of domestic, independent credit rating agencies that could provide this
information in Namibia is limited. However, Compuscan, an off-the-shelf SBCS is
used by microlenders in South Africa, Namibia and Botswana.21
To create a database from which a SBSS can be developed, banks should collectdata on all previous (approved and rejected) and current loan applicants andexisting customers. This pool of data will allow the creation of a SBSS that willautomate the loan assessment process and reduce the time loan officers spendevaluating referrals, which are not a revenue generating activity and do notcontribute to improvements in alternative profit X-efficiency and efficient creditallocation.
2.5.2. External Factors
This section describes external factors that affect alternative profit X-efficiency that
are beyond the control of bank managers. An empirical analysis to determine which
of these influences bank efficiency has important implications for public policy and
academic research.
2.5.2.1. Bank Size
According to microeconomic theory on scale economies, bank size is negatively
related to alternative profit X-efficiency because bigger banks suffer from scale
diseconomies due the difficulties of managing a larger entity. However, no
consistent picture emerges from empirical studies that have investigated the
relationship between bank size and profit efficiency (Mester, 1993 and 1996).
2.5.2.2. Organisational Form and Governance
Organisational form and governance is influenced by bank M&A activity, ownershipform and structure as well as financial market influence.
2.5.2.2.1. Mergers and Acquisitions
M&A theory postulates a positive relationship between mergers and alternative profit
X-efficiency. There are three main competing hypotheses as to why this relationship
exists.
First, the efficient structure hypothesis argues that the positive relationship exists
because relatively more efficient banks with Iower costs of production, superior
management and production technologies, compete more aggressively for and gain
market share leading to higher profits, which is reflected in higher alternative profit
X-efficiency.
Second, the relative market power hypothesis argues that the positive relationship
exists because banks with well-differentiated products are able to exercise market
21See www.compuscan.co.za for more information.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector24
power in pricing these products resulting in their capture of market share (Berger &
Humphrey, 1997). Ikhide (2000) points out that banks offer basically the same
facilities, thus this competition is mainly non-price in form through advertising,
quality improvement, product packaging and services, as opposed to underpricing.
Finally, the market power hypothesis (also known as the structure-conduct-
performance hypothesis) argues that the positive relationship may be due to banksin concentrated markets, where there are limited alternative sources of financial
services, exercising market power to charge prices that deviate widely from their
equilibrium levels and are unfavourable to consumers (lower deposit rates, higher
loan rates), which results in high profits, which is reflected in higher alternative profit
x-efficiency.
On the contrary, an opposing negative influence of M&A activity on bank efficiency
can arise because M&A is correlated with bank size which is postulated to be
negatively related to bank efficiency.
2.5.2.2.2. Holding Company Features
Theory postulates that ownership by a holding company is positively associated with
bank efficiency due to the discipline it imposes on banks. Weak evidence exists that
banks in holding companies are more efficient than independent banks (Mester,
1996). This finding is based on the efficient structure hypothesis that postulates that
more efficient banks may tend to acquire other banks and the holding company is
the vehicle that allows them to do that (Berger & Mester, 1997).
However, a multi-layered, holding company should be negatively associated with
bank efficiency because banks with complicated organisational forms or internal
management structures could be less efficient. The negative relationship betweenbank efficiency and multi-layered holding companies should be more pronounced if
the holding company is located outside of a country because banks are more
difficult to control and the ultimate bank owners suffers from information asymmetry
disadvantages compared to those whose holding companies are located in a
country. Empirical studies show that the more complex structure of multi-layered
holding companies does not seem to harm bank efficiency.
Finally, theory postulates that a publicly traded holding company should be
positively associated with bank efficiency because outside shareholders can exert
pressure on bank management.
2.5.2.3. Other Bank Characteristics
The age of bank and the risks that it takes are also postulated to be related to
alternative profit X-efficiency.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 25
2.5.2.3.1. Age
According to the learning by doing hypothesis theory postulates that age should be
positively related to bank efficiency since bank production improves over time
(Mester, 1996).
2.5.2.3.2. Risk
Theory postulates that risk is positively related to bank efficiency because a risk-
loving bank will issue more loans, which are more highly valued than securities. In
addition, due to higher market power existing in loan markets compared to other
product markets in which banks operate the relative market power hypothesis
postulates that the potential for higher profits due to adverse pricing by more
powerful banks is increased.
2.5.2.4. Market Characteristics
The characteristics of the market in which a bank operates influence bank efficiency.
Based on the quiet life hypothesis, competition is expected to be negatively related
to profit efficiency because banks in less competitive markets can charge higher
prices for their services but might feel less pressure to keep costs down. There is
limited evidence that banks operating more concentrated markets are less efficient,
supporting the quiet life theory that inefficiency has been sustainable in banking
because competition has not been robust (Berger & Hannan, 1996).
2.5.2.5. Regulation
The identity of the banks primary regulator helps to account for the regulatory
regime that banks face arising from the charter. Publicly owned banks are regulated
by independent statutes while commercial banks are regulated by the BoN. The
differences in the nature of regulation may influence bank efficiency. However,
empirical studies show that only weak relationships exist between regulator identity
and bank efficiency.
Besides explicit regulation by the BoN, commercial bank depositors also imposeimplicit regulation on a bank. The information asymmetry that exists between banksand their depositors concerning the risk of a banks assets arising from fixedpayments to depositors, as opposed to equity payments, which vary with financialsuccess, creates an incentive for banks to substitute riskier assets to seek a greaterpayoff. However, the higher expected payoff is unlikely to increase the value ofequity more than it decreases the value of debt, resulting in a fall in the market value
of the bank to the detriment of depositors. Whenever, such asset substitution issuspected depositors have an incentive to withdraw their savings.
Since banks are highly leveraged with relatively short-term liabilities, typically in theform of deposits and relatively illiquid assets - usually loans to firms or households,this withdrawal can lead to a liquidity crunch, which could lead to bank failure or arun on banks causing economic instability. The threat of withdrawal when riskshifting is suspected reduces a banks incentive to engage in asset substitution,which transfers value from debt holders and improves the value of bank assets(Hughes, Lang, Moon & Pagano, 1997).
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector26
In addition, to explicit bank regulation and the implicit regulation arising from thethreat of depositor withdrawal, bank deposits are also protected by depositinsurance. This insurance is designed to overcome the asymmetry of information inthe banking system (Diamond and Dybvig, 1983). This eliminates the need fordepositors to fear asset substitution. With the establishment of deposit insurance,depositors no longer have an incentive to monitor banks since their deposits areguaranteed up to a certain limit (Saidenburg & Schuermann, 2003). These benefits
do not accrue to Namibia because it has no explicit deposit insurance scheme.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector 27
3. NAMIBIAS BANKING SECTOR
3.1. Regulatory Framework
Banks in Namibia fall under the jurisdiction of the Common Monetary Area (CMA).Under this framework monetary policy in Namibia is determined by the South African
Reserve Bank (SARB), which is South Africas Central Bank. To mitigate potentially
adverse effects of shocks due to loss of monetary policy control, governors from
each Central Bank in the CMA meet on a quarterly basis at a Governors Forum to
exchange views about recent economic developments in their respective countries.
This forum takes place shortly before the meeting of the quarterly, Monetary Policy
Committee at the SARB, which incorporates the views expressed by the Governors
in the formulation of monetary policy for the CMA.
In addition, under the CMA, Namibia does not have the freedom to alter its
exchange rate at will but has ceded this responsibility to South Africa through apegged exchange rate. This arrangement implies a loss in autonomy of exchange
rate and exchange control policies, which exposes Namibia to asymmetric
macroeconomic shocks (Jenkins & Thomas, 1996).
Domestically, the primary regulator for commercial banks is the BoN. It was formed
in 1990 following Namibias independence and inherited its legal framework from the
Banks Act 23 of 1965, for the banking industry, and Building Societies Act of 1986,
for building societies. In 1998, these were replaced by the Banking Institutions Act 2
of 1998. This Act represents a legal framework encapsulating internationally
adopted banking standards and supervisory practices that are based on the Core
Principles for Effective Banking Supervision recommended by the Basel Committeeon Banking Supervision (BCBS). Provisions of the Act include the implementation of
prudential requirements, regulations and guidelines and a bank risk reporting
system. The provisions are reviewed regularly in order to conform to local and
international developments arising from recommendations by the Basel Committee.
The BoNs main role is to promote monetary and financial stability in the interest of
the nations sustainable economic growth and development. Despite its lack of direct
control over monetary policy instruments, it still influences monetary policy in
Namibia by focusing on ensuring stability and efficiency in the banking industry. This
function is based on Post-Keynesian principles, described in the earlier section.
The publicly-owned banks in Namibia are regulated by independent statutes
enacted by Acts of Parliament. The Agricultural Bank of Namibia (Agribank) is
regulated by Agribank Act No. 5 of 2003 (Agribank, 2003). The Namibia Post Office
Savings Bank (NamPost) is regulated under the Post and Telecomm Act. No. 19 of
1992.
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Factors Influencing the Alternative Profit X- Efficiency of Namibias Banking Sector28
3.2. Banks in Namibia
Currently the privately-owned banks in Namibia include Bank Windhoek, Standard
Bank Namibia, First National Bank Namibia and Nedbank Namibia. The publicly-
owned institutions include Agribank, NamPost and the Development Bank of
Namibia. Although, NamPost is a depository institution it does not lend to borrowers
either in the private or public sector. The features of banks in Namibia aresummarised in Table 2 below.
Table 2: Summary of Banks in Namibia from 1998 to 2003
Bank StandardBank
Namibia
AgriculturalBank ofNamibia
BankWindhoek
NedbankNamibia
FirstNational
BankNamibia
DevelopmentBank ofNamibia
Establishment date inNamibia
1915 1922 1948 1973 1990 2002
Regulator Bank ofNamibia
Government Bank ofNamibia
Bank ofNamibia
Bank ofNamibia
Government
Average Branches(1998-2003)
21 6 22 n/a 27 -
Average ServiceCentres (1998-2003)
17 0 12 n/a 11 -
Average AutomatedTeller Machines(1998-2003)
67 0 44 n/a 77 -
Average MobileAgencies (1998-2003)
n/a 0 n/a n/a 6 -
Average Mini-ATM(1998-2003)
n/a- 0 n/a n/a 99 -
Internet Banking Yes No Yes Yes Yes No
Insurance Subsidiaries Yes No Yes No Yes No
Holding CompanyOwnership
Yes No Yes Yes Yes No
Holding CompanyLocation
SouthAfrica
- Namibia SouthAfrica
Namibia -
Multi-Structure HoldingCompany
No No No No Yes No
Publicly Traded HoldingCompany
Yes No No Yes Yes No
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Merger or AcquisitionParticipation
No No No Yes Yes No
Note: n/a means that data was not available in the banks annual reports
The privately owned banks can be categorised as domestically or foreign owned.
DeYoung and Nolle (1996) define a bank as foreign-owned if at least 25 percent ofits shares are owned by foreign residents or institutions for at least 10 years while
Demigr-Kurt and Huizinga (1998) define a bank as foreign-owned if 50 percent or
more of its shares are owned by foreign residents or institution. Based on the latter
definition, all privately owned banks in Namibia, except Bank Windhoek, are foreign-
owned by South African-based owners. This implies that Namibias banking sector is
subject to a dual regulatory arrangement arising from legislation passed by the
SARB (Ikhide, 2000). This has an effect on the BoNs role of ensuring stability and
efficiency in the banking industry and influencing monetary policy through the Post
Keynesian channel.
3.3. Market Features
The banking sector in most developing countries is oligopolistic features. This is
defined as a market structure in which a few banks dominate the industry (Griffiths &
Wall, 1996). A less formal definition of oligopoly is a where two banks alone hold
more than 75 percent of the market share, the remaining 25 percent of which is
shared by less than ten banks (Athanassopoulos, Soteriou & Zenios, 1997).
Empirical evidence indicates that the input (deposit) markets banking sector in
Namibia is oligopolistic (Adongo & Stork, 2005).
We use the Herfindahl-Hirschman index (H-Index) to assess the market structure of
the output (loan) market for banks in Namibia. It is a microeconomic measure of theconcentration of market power in an industry.
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23682364
2400
2467
2439
2453
2300
2320
2340
2360
2380
2400
2420
2440
2460
2480
1998 1999 2000 2001 2002 2003
Year
IndexScore
Figure 1: Herfindahl-Hirschman Index Scores for the Output Market Structure
of Namibias Banking Sector from 1998 to 2003
The H-Index scores range from zero, for a perfectly competitive industry, to 10,000
(1002), for a pure monopoly. Therefore, the higher the indexs score the less
competitive the market. According to the interpretation of the United States
Department of Justice and Federal Trade Commission, who developed the index,
any score above 1,800 represents a highly concentrated industry that indicates the
presence of oligopoly. Therefore, Figure 1 above illustrates that the output marketstructure of Namibias banking sector is oligopolistic.
After a period of no growth between 1998 and 1999, the size of the banking sector
in Namibia, measured in terms of total assets, had incre