INFORMATION TECHNOLOGY AND PRODUCTIVITY

CHANGES IN THE BANKING INDUSTRY

di
Luca Casolaro* e Giorgio Gobbi**

Abstract

This paper analyzes the effects of investment in information technologies (IT) in

the financial sector using micro-data from a panel of 600 Italian banks over the period
1989-2000. Stochastic cost and profit functions are estimated allowing for individual
banks displacements from the best practice frontier and for non-neutral technological
change. The results show that both cost and profit frontier shifts are strongly correlated
with IT capital accumulation. Banks adopting IT capital intensive techniques are also
more efficient. On the whole, over the past decade IT capital deepening contribution to
total factor productivity growth of the Italian banking industry can be estimated in a
range between 1.3% and 1.8% per year.

JEL classification: D24, G21, O33.

Keywords: banking, productivity, efficiency, information technology.

(*) Banca dItalia, Filiale di Livorno, Piazza del Municipio 47, 57123 Livorno Italy.
E-mail address: luca.casolaro@bancaditalia.it.
(**) Banca dItalia, Economic Research Department, Via Nazionale 91, 00184 Rome
Italy. E-mail address: giorgio.gobbi@bancaditalia.it.

Electronic copy of this paper is available at: http://ssrn.com/abstract=478323

1. Introduction1
This paper examines the effects of investment in information processing,
telecommunications, and related technologies (IT) on productivity growth in the
banking industry. Several reasons make this sector a particularly interesting case for
testing the impact of IT capital deepening. First, financial services account for between
5 and 10 % of GDP in most industrialized countries. Banks contribute to a large
proportion of financial-related output and play an important role in key activities for the
functioning of the economy, such as the allocation of capital and the provision of
liquidity, payment and safekeeping services. Efficiency improvements in the production
and delivery of these services can bring widespread welfare effects.2 Second, the
acquisition and the treatment of information is a central activity in banking and the
impact of innovations in IT is likely to be larger than in other industries. Finally, the
stability of the banking system is a primary policy objective. Innovations affecting
production costs and profit opportunities can have major consequences on the industry
structure altering banks incentives to take risks and need to be monitored by regulators.
Although banking is among the most IT-intensive industries and among those that
started earlier to rely massively on computers for their operations, the large bulk of
applied literature on bank technology includes very few studies on this topic, mainly
1

We acknowledge the helpful suggestions of Allen N. Berger, Luigi Guiso, Salvatore Rossi,
Stefano Siviero, two anonymous referees and the participants at the seminars held at the Bank of Italy and
the Federal Reserve Board. We are also indebted with Tim Coelli who kindly made available the
econometric software FRONTIER 4.1, used in part of the estimations. Ginette Eramo and Roberto Felici
provided outstanding research assistance. All the remaining errors are ours. The views expressed in this
paper do not necessarily represent those of the Bank of Italy.
2

The following straight calculation provides a quantitative insight of how large these effects could be:
If a typical economy has a capital output ratio of 3:1, it follows that an increase in the efficiency with
which capital is allocated of 2 percent or roughly 20 basis points has a social benefit equivalent to that of
6 percent of GNP in forgone consumption. (Summers (2000), pp 2-3).

Electronic copy of this paper is available at: http://ssrn.com/abstract=478323

because of the paucity of appropriate quantitative information. We overcome this hurdle

using a panel of more than 600 Italian banks over the period 1989-2000, which includes
information on both investment and expenses related to computers and software. To our
knowledge, no prior study on the banking industry has measured directly the impact of
IT diffusion on such a comprehensive basis.
Using stochastic cost and profit frontier techniques we are able to estimate the
relationship between total factor productivity (TFP) changes and the use of IT. We find
a positive correlation between IT capital intensity with both frontier shifts and
efficiency scores. We interpret our results as strongly supporting the hypothesis that the
diffusion of digital technologies fosters TFP growth. The economic magnitude of the
effect is also relevant: IT investment has allowed banks to reduce costs by 1.3% a year
and increase short run profits by 2.0%.
We also show that a large number of other factors influence TFP, some of them
reinforcing the IT drift, others curbing it. Most of these factors reflect restructuring and
changes in regulation over the sample period that affected the banking industry in Italy,
as well in numerous other countries. As a consequence, in the absence of detailed data,
inferences about the impact on bank costs or profits of any single factor should be taken
prudently.
The paper is organized as follows. Section 2 selectively reviews the literature
related to our paper. Section 3 highlights the key developments of the Italian banking
industry over the sample period. Section 4 lays out the methodology for the empirical
analysis and Section 5 presents the data. In section 6 we display our empirical results
and Section 7 briefly concludes.

2. Related literature

Over the past 20 years firms responded to the fall in the quality-adjusted price of
computers and related technologies by substituting IT capital for others production
factors. Computers share with other landmark technological innovations the feature of
being a multipurpose technology, which can be adopted into virtually every economic
activity. Historically, technological advances that falls in this class were followed by
major total factor productivity pushes although the empirical evidence varies greatly
across time periods, countries, and measurement strategies.
Studies on TFP growth in the U.S. conducted during the 1980s and the early
1990s generally found that the use of computers had a negligible impact on productivity
(Roach (1987); Berndt and Morrison (1997)). Later research found evidence of a
significant contribution of IT capital to the recent productivity growth in the US (e.g.
Jorgenson and Stiroh (2000); Oliner and Sichel (2000); Jorgenson (2001)) albeit more
skeptical scholars argued that productivity gains were largely owed to cyclical factors
(Gordon (1999)).
Most of these studies are based on aggregate industry data and their conclusions
are likely to underestimate the effect of IT on productivity for two reasons. First, the use
of computers is often associated with large changes in the quality of output that are
difficult to measure accurately (Boskin et al. (1997)), especially when aggregating
broad ranges of products and services. Second, the use of digital technologies is likely
to require time to adjust workplace organization and employees skills, and industry
data can average out large cross-firm variability due to different stages in IT adoption.
As a consequence, recent research has shifted to micro-data trying to uncover the

transformation that digital technologies induce on firm organization and workplace

activities.3
Bresnahan et al. (2002) find a positive correlation between the accumulation of IT
capital, innovation in workplace organization and the use of more highly skilled
workers. Brynjolfsson and Hitt (2003) estimated a production function for a panel of
600 large US firms, finding that the contribution of IT investments to output growth
significantly exceeds its factor share, implying a positive effect of computers on
productivity growth in the long-run. The results also suggest that IT capital deepening is
associated with far-reaching organizational changes within the firm.
The policy relevance of IT investment has spurred international organizations to
collect data and to sponsor research programs. OECD (2004) gathers a set of empirical
papers that offers a comprehensive overview of the impacts of IT on economic
performance in advanced countries. The nine studies based on micro-data show
significant impacts of digital technologies on firm-level performance. In most cases
there is also evidence that IT investment is associated with more rapid TFP growth and
that this effect differs across industries. Firms in the financial sector are among those
that have benefited more from the new technologies.
To our knowledge, there are only two academic papers that directly investigate the
effects of IT in the banking industry, and both of them use data from case studies4.
Parsons et al. (1993) estimate a cost function using data from a large Canadian bank
over the period 1974-1987 and find a weak but significant correlation between

3
4

Pilat (2004) reviews most of the relevant literature in this field.

By contrast, the issue is widely debated within the industry. Olazabal (2002) claims that many of the
post-1995 IT investments were aimed at rising revenue-increase activities that have yet to be repaid,
leading to a decline in banking productivity due to excess capacity.

productivity growth and the use of computers. Autor et al. (2002) examine the
introduction of automatic image processing of checks in one of the top 20 U.S. banks.
They argue that this single technological innovation led to complex organizational
changes and distinct effects on different departments of the bank. Computers turn out as
substitute for low skilled works in standardized tasks, but complementary to computerskilled labor.
Leaving out of consideration technological innovations, there is a large body of
bank studies that investigate productivity growth by evaluating changes over time both
in the best practice frontier and in the average industry efficiency levels (Berger
(2003)). A common finding of these studies is that in the last quarter of a century the
banking industry experienced small, if not negative, TFP growth, owing to the
overlapping of a wide range of shocks.
Deregulation seems to have had prolonged depressing effects on productivity
growth in several countries. Using data from large samples of US banks, Berger and
Humphrey (1991), Bauer et al. (1993), Humprey and Pulley (1997) and Wheelock and
Wilson (1999) find that the deregulation of deposit rates was followed by negative
productivity growth rates for most of the 1980s. Fiercer competition among banks and
from non depositary institutions forced organizational changes, such as the opening of
more branches that, at least in the short run, raised average costs. This pattern has been
partially reversed only in the late 1990s when US banks were able the ripe the gains
from the higher quality services (Stiroh (2000), Berger and Mester (2003)).
Berg et al. (1992), argue that in the late 1970s deregulation in the Norwegian
banking sector was followed by a prolonged period of excess capacity, absorbed only in
the 1980s. Grifell-Tatje and Lovell (1996) find that deregulation induced a sharp decline
in the productivity of the top performer Spanish saving banks in the late 1980s.
5

Kumbhakar et al. (2001) using a larger sample and a longer time horizon panel show
that the decline is mostly attributable to an increase in the average industry inefficiency
level. Gobbi (1996) also finds a decline in productivity for a sample of large Italian
banks in the aftermath of the regulatory reforms of the early 1990s. Casu et al. (2003)
in a comparative study of European banks during the 1990s find a recovery in
productivity growth brought about mainly by shifts in the best practice frontier whereas
there does not appear to have been catch-up by non-best-practice institutions.
A second source of shocks is the wave of mergers and acquisitions, which in the
past 20 years reshaped the financial systems in most countries. Rebounds on efficiency
and productivity growth vary according to country and time-period, but a general
finding is that the final effects tend to materialize after several years from the deals
(Amel et al. (2004)) owing the long time required by post merger restructuring. This
implies that in the past two decades the performance of a sizeable fraction of the
banking industry has been influenced by the adjustment to larger and more complex
business organizations.
Finally, the pattern of business specialization in the banking industry has changed
dramatically. Revenues accruing from non-interest income have been on the rise
everywhere and there is some evidence that this has brought about an increase in
operational efficiency (Rogers (1998); Vander Vennet (2002)).
The Italian banking industry is a highly representative case for documenting the
effects of IT capital accumulation in business environment shaped by deep internal
restructuring and several concurrent external shocks. The following section briefly
describes the basic facts.

3. The Italian banking industry in the 1990s

Our sample period starts in 1989, when IT technologies had already been adopted
by the vast majority of banks, and extends up to year 2000, covering a further wave of
IT capital deepening. In the first half of the 1990s the IT-related expenses of Italian
banks accounted for about 9 % of total operating costs, peaking above 13 % in 1999
with the introduction of the single currency and the Y2K (Table 1). Annual investment
in hardware increased by six times, after adjusting for hedonic price changes, that on
software by three times (Table 2). In 2001 the total real value of hardware, software and
EDP specific plants per employee was almost six times higher than in 1989.
Over the sample period the Italian banking industry experienced a variety of
shocks ranging from severe macroeconomic fluctuations to sweeping changes in
regulation and ample demand shifts. A new banking law was passed in 1993 which
abolished a wide range of regulatory restrictions, barriers to entry and market
segmentations. It also paved the ground for the privatization of virtually all banks under
public control.
The prolonged slow down of GDP growth winding up in the 1994 recession
depressed the demand financial services and led to widespread excess capacity across
the industry. Rigidity in staff costs and massive provisions for loan losses brought down
net return on equity from 10% to 1% between 1990 and 1995, while the cost-income
ratio increased by almost seven percentage points.
Post deregulation heightened competition and low profit margins triggered off a
wave of mergers and acquisitions swept through the industry involving some 400
mergers and 500 deals in which the control of one banks changed hands.
7

Performance subsequently recovered along with a decrease in the burden of staff

costs and bad loans and with a strong increase in revenues from fees and commissions.
Measures of productivity growth in our data sample are likely to reflect the
compounded effects of all these shocks. Our empirical strategy consists in testing the
existence of a link between the usage of IT and changes in bank efficiency and
productivity in an indirect way.

4. Modeling strategy
4.1 IT investment and TFP growth
Following a well established methodology, we decompose productivity growth
into changes in the best practice and change in efficiency. Our approach is very close in
spirit to that of Berger and Mester (2003).
The best practice reflects the production choices of the best performing firms in
the industry. It identifies a frontier, but not necessarily the technological frontier
because of other factors such as (de)regulation or macroeconomic shocks, that may
prevent even the best existing bank from adopting the fully efficient technology.
Nonetheless, as long as technical progress shifts the efficient technological frontier it
should also shifts the best practice frontier. This is the first link between IT capita
deepening and TFP growth.
The second link between IT investment and TFP growth is the change in average
industry efficiency. For each bank an (in)efficiency score can be defined in terms of its
distance, expressed in a proper metric, from the best practice frontier. Idiosyncratic
shocks, poor management, and late adoption of new technologies concur to determine
an ongoing average level of inefficiency within a given industry. A well-documented
8

stylized fact is that the pattern usage of new technologies over time typically follows an
S-curve (Geroski (2000)). Firms lagging behind are likely to be less efficient just
because they use obsolete production plans. As long as the diffusion of a new
technology gains momentum we should observe the closing up of the efficiency gap.
Firms that move over time from lower to higher efficiency levels add to industry TFP
growth.
To account for the two channels linking IT and TFP growth, we apply the
stochastic frontier methodology developed by Battese and Coelli (1993), which allows
us to estimate simultaneously both a time variant best practice and the pattern of
industry inefficiency.

4.2 The empirical model

Our analysis builds on the specification of dual functions in place of the standard
primal production function owing to the multiple nature of the bank output and to the
measurement problems associated with services provided through the activities of
lending and fund-raising (Hanckock (1991)). The details are discussed in the Appendix.
First we estimate a stochastic translog cost function with a time polynomial
included as a production factor to allow for non-neutral technological progress.

M M
M
N
N M
1 N N
C = 0 + yn yn + pm pm + yn yl yn yl + pm pk pm pk + yn pm yn pm
2 n=1 l =1
m=1 k =1
m=1
n =1
n=1 m=1
N

n =1

m=1

(1)

+ tyn yn t + tpm pmt + t1t + t 2t 2 + 1GNPt + 2 rt + vit + uit

where the yns are the N outputs and the pms are the prices of the M inputs. These
variables are in logs and standardized by subtracting the sample means. Standard
symmetry and linear homogeneity conditions are imposed. Bank and time subscripts i
9

and t are omitted for simplicity. We include the growth rate of the real GNP (GNPt) and
the real official discount rate (rt) in order to extract the business cycle effect from the
time polynomial. The cost inefficiency term uit measures how close the costs of bank i
at time t are to those of a bank on the efficient frontier, producing the same output. The
term vit stands for the usual white noise error terms.
The best practice frontier estimated through a cost function focuses on the input
side of bank production and may overlook important dimensions of banks decision
making. Berger and Mester (1997) argue that the use of a profit frontier can be more
appropriate than that of a cost frontier because it accounts for both output and input
suboptimal banks decisions. However, in standard profit analysis output prices are
taken as exogenous, considering profit inefficiency as a sub-optimal choice with respect
to input-output relative prices. This is not an accurate representation of the banking
industry because a large share of revenues originates from bilateral contracting in which
banks have some bargaining power. We therefore adopt an alternative formulation of
the profit function, introduced by Humphrey and Pulley (1997), in which output prices
are flexible while output levels are taken as given, like in the cost function. Errors in the
choice of outputs do not affect the efficiency vector, while errors in setting output
prices do.5 The estimated efficiency levels in this case measure how close a bank is to
its maximum profit given an input-output quantity mix. The price to be paid for this
gain is the assumption that profits are maximized conditional on output levels, which is
also a very demanding hypothesis. Nonetheless, we estimate an alternative profit
5

The standard profit function presents the drawback that is not defined for constant or increasing
return to scale technologies. In that case the appropriate model is the short-run profit function in which
some production factors are constrained to be operated at a fixed level. These and other technical
difficulties of the standard dual frontier have made the alternative profit function an increasingly popular

10

function model as a consistency check for the cost function findings because previous
research shows that the results may vary substantially according to which dual model is
specified and estimated.
The translog alternative profit frontier is specified as:
M M
1 N N
N M
= 0 + yn yn + pm pm + yn yl yn yl + pmpk pm pk + yn pm yn pm
2 n=1 l =1
m=1 k =1
m=1
n=1
n=1 m=1
M

+ tyn ynt + tpm pmt + t1t + t 2t +1GNPt +2rt + vit +uit

(2)

n=1

m=1

where the variable uit measures inefficiency in terms of forfeited profits.

In both cost and profit analysis the inefficiency term is modeled as follows:
J

vit = 0 + j z itj + t t + wit

(3)

j =1

where 0 is a constant term, zit are individual time-varying covariates, t is a linear time
trend to account for time patterns of inefficiency, and wit a white noise stochastic
disturbance . We estimate equation (1) and equation (2) jointly with equation (3) using
maximum likelihood techniques that produce asymptotically consistent and efficient
estimates.
Among the covariates zj we include a measure of IT capital, because the pace at
which different banks have invested in the new technologies can be very different. On
the one hand, the speed of adoption of IT can be hampered by lack of information on
how to implement them or by the need for workforce skills that are obtainable only
through learning-by-doing processes (following the epidemic models of technology
model in applied banking research (see, among others, Altunbas et al. (2001) Clark and Siems (2002),
Vander Vennet (2002), Berger and Mester (2003)).

11

diffusion). On the other hand, different firms may want to adopt the new technology at
different times because of idiosyncratic adjustment costs. A difference in the adoption
rate of new technologies across banks is likely to be reflected in the distribution of
efficiency levels.

)
Let k be the estimated coefficient of IT capital obtained from equation (3). If its
sign is negative (positive) a raise in IT capital reduces (increases) the extra cots or
forfeited profits due to inefficiency. For each period t, we compute the average
contribution of IT to industry inefficiency as follows:

)
INEFF_ITt = (100*i k ITit)/Ht
where Ht is the number of existing banks at period t. INEFF_ITt

(4)

is a measure,

expressed in percentage points, of the average cost reduction or of the profit increase
due to the impact of IT on industry inefficiency. The first difference INEFF_ITt is the
annual change in average inefficiency induced by IT capital accumulation. Averaging
over the time the INEFF_ITts we obtain a measure of the average yearly TFP change
due to the effect of IT capital accumulation on industry efficiency.
As a last step we investigate the correlation between IT capital accumulation and
shifts in the cost and profit frontiers for banks over time. The idea behind this exercise
is that frontier shifts are driven by the introduction of new best practices along with the
increase of IT capital.6

Salter in his seminal empirical investigation on productivity and technical change observed that
gross investment is the vehicle of new techniques, and the rate of such investment determines how
rapidly new techniques are brought into general use and are effective in raising productivity. (Salter
(1966), p. 17).

12

We first compute the time derivative of the frontier function for each bank in each
year, which is given by:

FSit =

M
N
f
= t1 + 2 t 2t + yti yi + pt j p j
t
j =1
i =1

(5)

where the f stands for the cost or the profit function. For each bank i the time derivative
is computed taking the projection on the frontier of its input-output mix. The frontier
shifts represents the variation in total cost or profit for a given level of outputs and
inputs owing to TFP changes.7
As in the case of idiosyncratic inefficiency changes, frontier shifts reflect the
sum of a variety of shocks affecting the industry, among them the effects of technical
progress. More importantly, these shocks are likely to hit each bank with different
intensity and this is reflected on the frontier, which is estimated using information on all
the production units in the sample.
To filter the effect of IT on frontier shifts, we estimate the panel of banks frontier
shifts for each year with a fixed effects regression of the kind:
J

FSit = j w jit + i + t + it

(6)

j =1

where the wjs are time-varying bank specific variables, the is are bank fixed effects,
the ts are time dummies and it the white noise disturbance error. This procedure is
very close to the approach proposed by Brynjolfsson and Hitt (2003). As in the case of
the inefficiency estimates among the wj variables we include a measure of IT capital. In

For a thorough discussion of the technical and economic meaning of these derivative in the case of
the cost function we refer to Hunter and Timme (1986).

13

a similar way we obtain an estimate of the average contribution of IT to the frontier

shift in each period as:

)
FS_ITt =(100*i k ITit)/Ht

(7)

)
where k is the estimated coefficient of IT capital obtained from equation (6) and, as
before H the number of banks indexed by i. The time mean of FS_ITt is our measure of
the average yearly TFP change due to the frontier shifts induced by IT capital
accumulation.

5. Data

5.1 Sample

In our empirical analysis we employ data referring to an unbalanced panel of 618

Italian banks over the period 1989-2000. We use information from the Supervisory
Returns Database of the Bank of Italy, which includes detailed information on balance
sheet and profit and losses accounts disclosed by banks complying to prudential
regulation requirements. Data on IT expenses, investment in software and hardware,
outsourcing and the number of employees working in the computing centers are
collected yearly.
The panel has three sources of attrition. The first one is due to the demography of
the industry: some banks go out of businesses and others are established. This is
accommodated using unbalanced panel estimation techniques. The second one owes to
banks that disappear because of mergers. We adjust for that by computing pro-forma
balance sheets and profit and loss accounts. Possible productivity shifts of the banks
involved in M&A deals are accounted for by introducing the share of the target banks

14

into the joint assets of the target and the acquiring banks among the explicative
variables of both the inefficiencies and the frontier-shifts equations. Acquisitions that
maintain the charter of the target bank within a banking group are controlled for by
means of dummy variables.
The third source of attrition is the change in the information requested to the
banks for supervisory purposes. Up to 1994 the very small-sized banks were exempted
from filing in the data on IT investment. Subsequently, the more extensive information
requirement was enforced gradually in order to minimize the compliance costs of these
banks. This affects about 170 banks in our sample, although the number of those that
for which this information becomes available increases over time.
Finally we exclude from the sample the branches of foreign banks because their
balance sheets and profit and loss accounts are strongly affected by the strict
relationships they entertain with their parent companies.
In our sample there is a great variance across banks owing to size, business focus
and organizational complexity. In principle, banks of different size could have access to
different production set and this could distort the estimates of the parameters of the
frontier functions. Thus we divide the sample banks into three groups according to their
average total assets during the sample period. The first group includes the smallest two
thirds of the sample and contains almost exclusively cooperative banks: we call it small
banks. In the second group, our medium-sized banks, we include banks between the top
33 and the top 10% of total asset distribution, while the large banks are those in the top
10% of the distribution.

15

5.2 Outputs and inputs

The appropriate representation of the bank production operations and, in

particular, the definition of bank output is a long-standing and controversial issue. In
this paper we follow what has come to be known as the value added approach, in which
all the activities which produce value added are considered outputs of the bank. We
classify services produced and supplied by banks into two broad areas.
The first group includes services for which banks charge direct fees such as
payment execution, safekeeping, brokerage, and asset management. Although this type
output is usually overlooked in previous research, they represent a major source of
revenues for the banking industry.8 These outputs are likely to be standardized and in
principle it would be possible to have appropriate physical measures for them, such as
the number of transactions. However, data are collected in a rather aggregate form, and
owing to quality heterogeneity they are at best only proxies for output levels. Moreover,
banks supply a large number of different services which can hardly be accommodated
in an econometric model. We have therefore combined the information on three broad
categories of services in a single composite output using their shares in total fees and
commission income as weights. Specifically, we have the turnover of current accounts
as a proxy for payment services, the total amount of deposited securities as a proxy for
both safekeeping and asset management, and loan guarantees as a proxy for off-balance
intermediation activity.

Rogers (1998) and Clark and Siems (2002) are instances of the few exceptions. Both these papers find
that bank efficiency scores are affected by the off-balance-sheet activities which are one of the sources of
fees and commissions bank revenue.

16

The second group of services consists of traditional intermediation activity:

raising and lending funds. According to the theoretical micro-foundations of financial
intermediation, banks produce financial contracts taking advantage of economies of
scale in transaction technologies as well as in screening and monitoring activities. The
revenue from intermediation services is given by the spread between the interest paid
on financial liabilities and the interest charged on assets. Since this kind of activity
tends to be customer-specific, there is no clear-cut distinction between prices and
quantities. Intermediation services are to a large extent not standardized and it is hard to
find compelling physical measures. In the applied literature they are usually assumed to
be proportional to the face value of assets and liabilities, meaning that a 100 loan
corresponds to two times the amount of services produced with a 50 loan. The
outstanding amounts of loans to and deposits from the non-bank sector are assumed to
be the main carriers of these kinds of services. The exclusion of other items, such as
interbank accounts and securities, can be motivated on the ground that they contribute
little to the value added once their user costs are properly taken into account (Hancock
(1991) and Fixler (1993)). The idea behind the value added approach is to identify bank
output as the repackaging of assets and liabilities not traded in organized markets. For
instance, interests received from and capital gains accrued on a portfolio of securities
add to bank revenues, but not to bank output, because there is no value added originated
by the fact that that portfolio is held by a bank instead of a private investor. On the
contrary banks repackage the funds raised from depositor in a format that make them
loanable to the borrowers adds to both revenues and output. The depositors benefit from
the insurance against liquidity shocks and a large number of borrowers would not be in

17

a position to raise funds directly on the capital market. Under this perspective interbank
loans are very close to securities and are treated in the same way.9
We consider separately short-term loans, those with original maturity up to 18
months, and medium- and long-term loans on the grounds that they are likely to differ
in terms of the amount of resources they require for their origination, screening and
monitoring. In Italy, most of the short-term loans consist of non-collateralized
commercial and industrial lending and medium and long-term loans mainly include
mortgaged lending.
On the input side we have considered labor and two types of physical capital
services: IT capital and other premises and equipment. For operating expenses other
staff and capital expenditure, since we do not have enough information to separate
prices from quantities, we assume that they enter into the production in fixed proportion
with other inputs. The IT price is calculated as a usage cost, given by the ratio between
IT expenses and the value of IT capital stock. As a proxy for the price of labor we use
the average wage, while the price of the other type of physical capital is constructed as
the ratio of the capital expenses divided by its book value. We also include estimates of
the value of leases consistently with the definition of the expenses on the left hand side.
Total operating expenses are the left-hand side variable in the frontier estimation.
Price homogeneity of the cost function has been imposed by normalizing both costs and
input prices by the price of labor. Outputs and inputs have been deflated by the
consumer price index in order to avoid the estimated coefficients of the time variable

An anonymous referee pointed out that this treatment of interbank transactions may underrate the
connection between IT investment and the creation of an electronic screen based market for interbank
deposits (loans) in 1990. However, since over the sample period only medium and large Italian banks
traded funds on the screen based market, the sample splits according to different banks size classes
capture most of the innovation spurring effects of these transactions.

18

being affected by inflation. In the profit function the dependent variable is the value of
total revenue before taxes.

5.3 IT capital

The IT capital stock at the micro level has been computed by applying the
permanent inventory method to the real investment in hardware, software and premises
for computing equipment. The value of banks investment has been deflated using
hedonic price indexes of software and hardware developed by the Bureau of Economic
Analysis (BEA) and adjusted for the variation in the ITL/USD exchange rate.10 The
U.S. deflator is the only one available for each group of products; its application to
Italian data may be justified by the high share of imported IT equipment and the
existence of a global market for these products. Capital stock is obtained as the sum of
past investment flows, weighted by the relative efficiency in production of different
vintages. We assume the depreciation rate is constant in time but different across goods.
Following Seskin (1999) and Jorgenson and Stiroh (2000) software is assumed to
depreciate at a yearly rate of 44%, hardware and dedicated premises by 32 %yearly.

5.4 Explanatory variables of inefficiency levels and frontier shifts

On the right-hand side of the inefficiency and the frontier-shift regressions we

include several explanatory variables to control for environmental and bank individual
characteristics. To investigate the impact of IT capital accumulation on productivity we
introduce the variable IT_CAP, representing the amount of IT capital stock per

10

Data have been downloaded from the web site www.bea.org.

19

employees; in a more detailed analysis we split this variable in two, representing

software and hardware capital stock (respectively SOFT_CAP and HARD_CAP). The
variable IT_STAFF represents staff costs for IT personnel divided by total staff costs;
the variable OUTSOURCE is given by the fraction of IT expenses coming from
outsourcing of computing services.
The development of alternative distributive channels for bank products is
measured by the variable REMOTE, defined as the number of remote customers
standardized by the total number of current accounts, and the variable ATM_BR, given
by the number of automatic teller machines (ATM) divided by the number of branches.
We the ratio of income from services to gross income, SERVICE as a measure of
impact of banking activities. REDUNDANCE represents the fraction of staff made
redundant by banks through major restructuring programs and should proxy for the
absorption of excess capacity.
There is a widespread presumption that the impact of IT on productivity varies
according to business focus. Banks active in wholesale (i.e. securities trading) or in
markets for highly standardized financial products (i.e. consumer credit) rely largely
standardized information flows and a large fraction of their operations is screen-based
or involve automatic data processing. On the other side, bank activities like small
business lending are based on the acquisition and the processing of soft information,
which in turn require the physical proximity of the decision unit to costumers (Berger
et al. (2005)). Size is usually taken as a proxy for bank specialization under this respect:
large banks are taken on the hard information and small banks are assumed to work
mainly with soft information. Although this appears a reasonable classification, it is not
completely appropriated for our sample: in the Italian banking industry several large
banks compete with small banks in supplying finance to small business, and small
20

institutions specialize in standardized products. We therefore try to capture the effects

of business specialization regarding information processing through the variables
SMALL, which stands for the fraction of loans to small and medium-sized firms,
MANAGERS, defined as the ratio of managers costs to total staff costs, and
STAFF_BR, given by the average number of employees per branch.
The variable CAP_ASS, defined as the ratio of capital and reserves to total assets,
controls for the degree of capitalization of the bank, the variable M&A measures the
increase in assets obtained with mergers. We also include the variable AGE, given by
the expression:

AGE = 1 1

year foundyear

where foundyear is the year of foundation of the bank and year is the current date. In
this way, differences in the age of the banks are more important for relatively younger
banks. The dummies NW (northwestern regions), NE (northeastern regions), SOUTH
(southern regions), ISL (Sicily and Sardinia, the two main islands) account for
geographical differences, while the dummies GROUP1 and GROUP2 have value one if
the bank is part of a large group (the top 25% of the groups total assets distribution) or
of a medium or small group (the last 75%) respectively. Summary statistics of the
variables used in the empirical analysis are reported in table 3.

6. Results

6.1 Frontier estimates and catching-up effects

Table 3 summarizes the descriptive statistics of the variable used in the

regressions and table 4 shows the estimated coefficients of the traslog cost and profit

21

functions. The pattern of signs and the magnitude of the coefficients are remarkably
consistent both with the prediction of the theory and with those of similar studies. The
average inefficiency levels estimated from the cost and the profit frontiers are displayed
in figure 1 and 2, respectively. Cost inefficiency averages at 9.2% and profit
inefficiency at 8.1%, with large differences across size classes. These values are far
lower than those found in the vast majority of other studies both on Italy (Resti (1997))
and on other countries (Berger and Humphrey (1997)). We interpret this result as a
consequence of accounting for IT capital as an input and of nontraditional activities as
an output. This is consistent with the findings of Rogers (1998): Models that ignore
nontraditional outputs are likely to underestimate bank efficiency.
Robustness checks, not reported for the sake of brevity, show that average
inefficiency levels remain comparatively small also if the status of deposits is changed
from output to input and considering different time windows.11
The time pattern of inefficiency levels is the same for all bank classes, displaying
an increasing inefficiency over the decade, although small banks are always more
efficient than the other groups. This can be attributed to the different magnitude of the
shocks and the different speed at which banks responded to them.
The parameters of the inefficiency equations, jointly estimated with the translog
cost and profit functions, are reported in table 4. The effect of IT capital stock on
inefficiency is negative and statistically significant in both equations. This result
confirms that the most IT-capitalized are more likely to be closer to the efficient cost
and profit frontiers. Specifically, for the median bank, an increase of one standard

11

In particular we have estimated the model separately for the periods 1989-1995 and 1996-2000. The
entire set of results is qualitatively unchanged, albeit reducing the variability along the time dimension
inflates somewhat the standard errors.

22

deviation in the level of IT capital per employee will generate a 3.7% cut in costs and a
7.5% profit boost due to decreased inefficiency. The average contribution of IT capital
to TFP growth via the catching up effect estimated from the cost function is as large as
0.5% per year. The magnitude of the same contribution estimated through the
alternative profit function is higher and amount to 1.1%. One possible explanation of
the difference between the estimates obtained from the two frontier models is that banks
that have invested more in the new technologies have also improved the quality of the
services they supply and this is reflected on higher prices and short run profits, as
stressed by Berger and Mester (2004). If the production of higher quality services
requires also higher cost, it is then plausible the productivity gains measured in terms of
short-run profit efficiency are higher than those measured in terms of cost efficiency.
This explanation based on an improvement of the quality of services is supported
by the estimated coefficients of other variables in the inefficiency regression.
SERVICE, which represents the fraction of earnings coming nontraditional activities, is
negatively correlated with the degree of efficiency. REMOTE, an indicator of
innovation in the delivery channels of banking services, has a negative and statically
significant effect only on inefficiency measured through the alternative profit function.
On the contrary, banks with a larger number of ATM per branch display greater
inefficiency. The interpretation is that, in the majority of cases, the staff downsizing
required by large-scale automation of some basic activities takes time or it is not fully
adjusted, leading to some excess capacity. The existence of frictions in the adjustment
of labor, which is supported by the estimated negative correlation between inefficiency
and the fraction of staff made redundant, is a consequence of major restructuring plans
(REDUNDANCE).

23

Among the other factors affecting inefficiency, the ratio of capital to total assets
(CAP_ASS) has a sizeable impact, although the causality link is ambiguous. Large
capital ratios may follow from excess capacity or may be due to agency problems as
long as more efficient banks can signal their quality through a high leverage as in
Berger and Bonaccorsi di Patti (2006).
Mergers and acquisitions are negatively correlated with inefficiency. Since we use
pro-forma data, this result simply means that banks which buy other banks have aboveaverage efficiency scores, a well-established result in the M&A literature (Amel et al.
2002). The dummy variables identifying the partnership in a large (GROUP1) or small
(GROUP2) banking group have estimated coefficients with positive signs in the cost
function and negative signs in the profit regression. Most of these banks have been
acquired by a bank holding company during the sample period. Target banks were
usually poorly performing, and restructuring within the banking group has initially
focused on the revenue side and only later gradually extended to the cost side (Focarelli
et al. (2002)).
The AGE variable is negatively correlated with inefficiency: this may be due to
the time needed by the de novo banks to reach their optimal level of capacity utilization.
Finally, the geographical dummies show that banks with headquarters in the richest
regions of the country (NE and NW) are closer to the efficient frontier than banks
located elsewhere.

6.2 Frontier shift regressions

Tables 5 and 6 report the results of the panel data estimation of cost and profit
frontier shifts. A negative sign for a coefficient in Table 5 implies an inward shift of the
industry best practice cost function, while a positive sign of a coefficient in Table 6

24

implies an outward shift of the industry best practice alternative profit function. The
first three columns report the results of different specifications of the IT variables for
the entire sample. In the last three columns we check for differences owing to bank size.
In columns A, D, E and F, IT capital deepening is measured simply by total IT
capital per employee. The results are consistent with the hypothesis that computers and
related technologies lead to sizeable increases in productivity, here measured by frontier
shifts. The coefficient of the IT capital variable is different from zero at high
significance levels, and the sign is negative for the cost frontier regression and positive
for the profit frontier one. The result holds true across all bank size classes (columns D,
E, and F) and the two the type of frontier.
On average the shifts in best practice due to IT capital accumulation can be
quantified in a reduction of costs of 0.8% per year and in an increase of short run profits
of 0.7%.
In column B we have split IT capital into two broad categories: hardware and
software. The coefficient of the HARD_CAP variable is negative in the cost function
and positive in the profit function and statistically significant, indicating a favorable
effect of computers on productivity. The coefficients of SOFT_CAP are estimated less
precisely and have an opposite pattern of signs. A possible explanation is that software
capital stock is poorly measured because hedonic prices do not account properly for
quality improvements (Jorgenson and Stiroh (2000)).
In columns C we introduce a variable aiming to capture the impact of IT on labor
organization: the fraction of salary expenses devoted to IT staff. This variable is
available only for a sub-sample of banks, about half of the total number. The sign of its
the coefficient is positive in the cost frontier shift regression and negative in the profit
frontier one. Within-firm production of IT services is detrimental to TFP growth. This

25

finding is confirmed by the productivity enhancing effects of the variable

OUTSOURCE, which measures the amount of IT-related expenses for outsourced
activities. The result is consistent with theories of the firm boundaries, which predict
that firms allocate to external suppliers activities for which they do not have
comparative advantages (Heshmati (2003)).
Among the other regressors, SERVICE has the same economic effect as in the
inefficiency regressions: shifting from traditional to nontraditional banking activities
shift also the best practice frontier. The same holds, at least partially, for the dummies
that identify membership of a banking (GROUP1 and GROUP2). On the other hand,
the influence on TFP growth of other variables, like CAP_ASS, ATM_BR, and
REDUNDANCE is of opposite sign when measured by frontier shifts and by changes in
the level of industry inefficiency. This can be interpreted in terms of equilibrium and
out of equilibrium effects. For instance, introducing network of cash dispensers (ATMs)
boosts productivity only after that the activities branch staff have been reorganized and
the idle capacity has been cut. Before a new optimal allocation of resources within the
bank it is likely to observe a deterioration of performance. This pattern is fully
consistent with our estimates.
The number of staff per branch (STAFF_BR), the share of managers salaries in
total salaries (MANAGERS) and that of small business loans in total loans (SMALL)
are negatively correlated with TFP growth. All these three variables capture the
information specialization of banks and show that the route to innovation has been less
straightforward for those institutions which rely more on soft information..

7. Conclusions

26

Several studies have emphasized the role of technological innovation as a primary

source of structural changes within the financial industry. However, empirical evidence
on the effects of technical progress in increasing TFP and abating unit costs is still
scarce. This paper contributes in building up evidence by investigating the effect of
information technologies on the Italian banking industry over the period 1989-2000. We
have estimated stochastic cost and profit functions allowing for individual banks
displacements from the efficient frontier and non-neutral technological change. Data on
IT capital stock for individual banks enabled us to distinguish between movements
along the We found that both cost and profit frontier shifts are strongly correlated with
IT capital accumulation. Banks adopting IT capital intensive techniques are also closer
in average to the best practice of the banking industry, implying ceteris paribus a higher
level of efficiency. We interpret this last result as evidence of a catching-up effect
consistent with the usual pattern of diffusion of the new technologies.
Compounding the estimates from the inefficiency regressions with those coming
to the analysis of frontiers, the TFP growth associated with IT investment is of 1.3 % if
estimated from the cost function and 1.8 % if estimated from the profit function. These
figures appear quite large if compared with the estimated TFP growth for the banking
industry of other studies. But comparisons should be made with homogenous figures
restricted to IT contribution, referring to the financial sector as well to other industries,
which are not available. Nonetheless, our results fall in line with those obtained by
other studies based on micro-data: they support the hypothesis that computers are a
general purpose technology which contribute to output growth not only through the
process of capital deepening, but also because of the changes it induces in workplace
organization reflected in higher TFP growth. Skeptical views about the existence and

27

the magnitude of productivity gains brought by digital technologies in the financial

sector are unwarranted.

28

Appendix: Stochastic frontiers and inefficiency

Considering a generic cost (profit) frontier function, we estimate the following

system:
Fit =

f [Yit , Pit , t ] + u it + v it

u it = z it + wit

(A1)

(A2)

where Fit stand for the costs (profits) of bank i in period t, Yit is an n-dimensional
vector of output quantities (prices), and Pit is the m-dimensional vector of the m input
prices. The residual of equation (A1) is a composite term formed by a standard white
noise residual vit plus an asymmetric distribution term uit, accounting for inefficiency. In
equation (A2) the uit term is specified as a stochastic process with mean dependent from
a vector of covariates zit, and a random component wit defined as the truncation of an
2
independent normal distribution with mean zero and variance U , such that uit is a

non-negative truncation of the normal distribution N(zit, 2U) 12.

This general specification partially mitigates the usual problems the stochastic
frontier methodology related with the ad hoc assumptions imposed to the inefficiency
distribution (Battese and Coelli (1995)).13 The model allows also inefficiency levels to
vary over time without imposing the same ordering of firms in terms of efficiency for

12

The usual procedure in the past literature was first to estimate the stochastic frontier and predict
inefficiency under the assumption of identical distributions, then to estimate an inefficiency equation
using the predicted uit term, in contradiction with the prior distributional assumption (see Khumbhakar,
Ghosh and McGukin,(1991)).
The assumption that the uit are independent distributed i and t, made to simplify the model, is a
restriction because it does not account for heteroskedasticity or for possible correlation structures among
the residuals. In our estimates, however, we control for robustness to different inefficiency estimation
methods.
13

29

each period, as in Battese and Coelli (1993).14 In our setting a bank i can be relatively
more efficient than bank j in year t and become less efficient in year t+1.
The ui term can be identified, following Jondrow et al. (1982), conditional on the
estimated residual ei = vi + ui. Battese and Coelli (1988) prove that the best predictor of
cost inefficiency for firm i is the expression eui, for which the following expression
holds (Battese and Coelli (1993)):

[(1 ) z it ei ] a [e + 2 / 2 ]
ui
e i a
E e | ei = a

[(1 ) z it ei ]
a

(3)

where a is equal to the square root of the expression (1-)(2U +2V), is the density
function of a standard normal random variable = 2U/(2U+2V), 2U and 2V being
respectively the estimated variance of the inefficiency term uit and of the white noise vit.
The parameter estimated in the regression represents the fraction of total
variance around the frontier due to inefficiency. A value of equal to zero means that
the distance to the frontier is entirely due to noise, while a value equal to one indicates
that the entire deviation is due to inefficiency. The expectation of inefficiency uit
conditional to the whole residual eit measures the ratio between the costs (profits) of a
generic firm i and those of the most efficient firm i*, which is on the frontier with an
inefficiency level equal to zero (eui* = 1).

14

The relation zit + wit > zit + wit for i i does not imply zit + wit > zit + wit for t t .

30

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35

Table 1

ITALIAN BANKS OUTALY RELATED TO IT

Year

IT expenses as a
percentage of
Gross
Operating
income
costs

Composition of IT expenses (percentages)

Hardware

Software

Staff

Outsourcing

Others

Total

1989

5.6

9.0

26.1

9.9

32.2

13.9

17.9

100.0

1990

5.8

9.4

27.2

10.8

30.3

14.4

17.3

100.0

1991

6.1

9.5

27.1

10.7

29.8

14.8

17.7

100.0

1992

6.0

9.2

24.4

12.4

28.9

14.9

19.5

100.0

1993

5.5

9.1

23.4

13.2

26.5

16.4

20.5

100.0

1994

6.6

9.8

22.0

13.4

26.8

17.7

20.0

100.0

1995

6.7

9.9

19.2

13.6

25.1

22.3

19.8

100.0

1996

6.4

9.6

16.6

15.2

21.7

25.3

21.2

100.0

1997

6.4

9.4

16.9

16.7

21.2

25.6

19.7

100.0

1998

7.4

12.2

21.3

20.7

16.5

17.8

23.7

100.0

1999

7.6

12.8

19.7

19.7

15.0

26.6

19.0

100.0

2000

7.6

13.5

14.9

18.3

12.4

38.7

15.8

100.0

2001
8.0
14.5
Sources: Bank Supervisory Reports.

15.6

20.8

10.4

34.1

19.2

100.0

36

Table 2
ITALIAN BANKS IT INVESTMENT AND CAPITAL STOCK*
(1989=100)
Nominal IT investments

Year

Hardware

Software

Real IT investments

Hardware

Software

Real IT Capital
Total

Per
employee

1989

100

100

100

100

100

100

1990

101

126

135

154

129

125

1991

114

149

154

166

155

148

1992

112

179

158

188

176

167

1993

98

191

133

164

179

168

1994

101

222

164

205

193

182

1995

96

295

185

270

215

202

1996

97

268

258

264

254

243

1997

99

337

302

302

300

292

1998

123

430

523

405

421

414

1999

91

370

430

300

458

455

2000

105

393

535

289

522

514

2001

107

453

656

312

612

599

Sources: Bank Supervisory Reports, ISTAT and BEA.

37

Table 3
DESCRIPTIVE STATISTICS
Symbol

Description

Obs.

Mean

Min

Max

St.dev

COST

Log of total cost (divided by the price of labor)

5231

5.077

1.676

10.696

2.006

PROF

Log of gross profit (divided by the price of labor)

5231

8.2889

2.480

10.279

.316

Y1

Log of short-term loans

5231

4.341

-5.276

10.902

1.932

Y2

Log of long-term loans

5231

4.000

-1.440

10.952

1.744

Y3

Log of services weighted commission income.

5231

5.167

-2.624

10.786

1.611

Y4

Log of deposits

5231

-0.181

-5.291

7.151

2.107

P1

Log of IT capital price (divided by the labor price)

5231

2.069

0.253

3.744

0.620

P2

Log of branches price (divided by the labor price)

5231

-0.137

-1.266

1.833

0.530

CAP_ASS

Capital divided by total assets

5231

0.093

0.017

0.396

0.034

AGE

5231

0.842

0.000

0.875

0.082

SERVICE

1 1 bank age
Net services value revenue divided by gross income

5231

0.060

-0.983

0.556

0.060

SMALL

Value of small loans (under 5 billion lire) over total loans

5231

0.675

0.023

1.000

0.197

GROUP1

Part of a big group (top 25 % of the groups total asset

distribution)

5231

0.059

0.000

1.000

0.236

GROUP2

Part of a medium or small group (last 75 % of the groups

total asset distribution)

5231

0.088

0.000

1.000

0.283

MERACQ

Relative increase in total assets of the bank due to M&A

5231

0.011

0.000

1.536

0.066

STAFF_BR

Number of employees divided by number of branches

5231

11.200

2.000

242.00

10.057

MANAGERS

Wages paid to managers divided by total wages.

5213

36.189

0.520

331.46

26.645

REDUNDANCE Number of redundant employees divided by total staff

5231

0.001

0.000

0.519

0.012

IT_CAP

Stock of real IT capital per employee (billion lire)

5231

0.056

0.001

0.482

0.044

HARD_CAP

Stock of real hardware capital per employee (billion lire)

5231

0.051

0.000

0.467

0.042

SOFT_CAP

Stock of real software capital per employee (billion lire)

5231

0.004

0.000

0.060

0.004

OUTSOURCE

Share of IT expenses due to outsourcing of services

5100

.3689

0.000

1.000

.2996

IT_STAFF

Wages paid to IT personnel divided by total wages

3031

0.055

0.000

1.000

0.070

REMOTE

Number of phone and electronic banking accounts of

households divided by total number of current accounts.

5231

0.018

0.000

1.000

0.091

ATM_BR

Number of ATM divided by number of branches.

5231

0.526

0.000

20.00

0.750

NW

Headquarters in the North-West

5231

0.201

0.000

1.000

0.401

NE

Headquarters in the North-Est

5231

0.408

0.000

1.000

0.492

CE

Headquarters in the Centre

5231

0.211

0.000

1.000

0.408

SOUTH

Headquarters in the South or islands

5231

0.180

0.000

1.000

0.384

Sources: Bank Supervisory Reports. All financial variables are measured in ITL million and are adjusted for
inflation. Statistics refer to the panel of 618 banks for the period 1989-2000 with the exception of internet banking
accounts, available from 1995.

38

Table 4
COST AND PROFIT FRONTIERS
The dependent variables are the total operating expenses and the total revenue before taxes, both normalized by the
price of labor. The independent output variables are the amount of short term loans (Y1) medium and long term loans
(Y2), a composed measure of bank services (Y3) and the amount of deposits (Y4). The input variables are the
estimated price of IT (P1) and of the other physical capital (P2), both normalized by the price of labor. The
parameters 1 and the 2 refer to growth rate of Italian GNP and to the Italian real interest rate level. All variables,
except the interest rate, are in log and are computed as differences from the sample mean.
Variables
CONST

Y1
Y2
Y3
Y4
P1
P2
T1
Y12
Y22
Y32
Y42
P12
P22
PT2
Y1Y2
Y1Y3
Y1Y4
Y1P1

COST FRONTIER

-0.8337
0.0648
0.3547
0.0211
0.1574
0.0127
0.0780
0.0167
0.3765
0.0226
0.0550
0.0155
0.1069
0.0190
0.1462
0.0093
0.0039
0.0030
0.0323
0.0019
-0.0050
0.0042
0.0379
0.0035
0.0073
0.0053
-0.0228
0.0083
-0.0097
0.0005
-0.0303
0.0036
0.0231
0.0078
-0.0144
0.0076
0.0171
0.0112

***
***
***
***
***
***
***
***

***

***

***
***
***
***
*
*

PROFIT FRONTIER

0.7211
0.0420
0.0182
0.0109
0.0286
0.0086
0.0448
0.0112
-0.0965
0.0149
0.0027
0.0104
0.1227
0.0128
-0.1473
0.0060
0.0079
0.0021
0.0059
0.0013
0.0019
0.0028
0.0033
0.0023
0.0014
0.0034
-0.0443
0.0056
0.0069
0.0003
-0.0003
0.0025
-0.0222
0.0049
0.0155
0.0046
0.0189
0.0075

Variables

***

Y1P2

Y1T

***

Y2Y3

***

Y2Y4

***

Y2P1
Y2P2

***

Y2T

***

Y3Y4

***

Y3P1

***

Y3P2
Y3T
Y4P1
Y4P2

***

Y4P2

***

P1P2
P1T

***

P2T

***

**

COST FRONTIER

-0.0843
0.0147
-0.0243
0.0028
-0.0304
0.0044
-0.0334
0.0045
0.0000
0.0075
0.0599
0.0102
0.0032
0.0018
0.0172
0.0081
-0.0240
0.0082
0.0637
0.0107
0.0154
0.0023
0.0082
0.0098
-0.0365
0.0170
0.0057
0.0029
-0.0104
0.0099
-0.0046
0.0021
-0.0129
0.0026
0.0213
0.0029
0.0348
0.0039

***
***
***
***

***
*
**
***
***
***

**
**

**
***
***
***

PROFIT FRONTIER

-0.0175
0.0098
0.0006
0.0018
0.0118
0.0027
0.0022
0.0027
-0.0090
0.0050
0.0538
0.0071
-0.0008
0.0012
0.0135
0.0054
-0.0101
0.0055
-0.0071
0.0072
-0.0023
0.0015
-0.0148
0.0068
-0.0093
0.0116
0.0108
0.0019
0.0051
0.0066
-0.0001
0.0014
-0.0059
0.0017
-0.0092
0.0020
-0.0159
0.0026

***

*
***

**
*

**

***

***
***
***

Observations = 5231
Cross-sections = 618
Time periods = 12
Note: Statistically different from zero, respectively, at: *** 99%, **95% and *90% significance level.

39

Table 5
COST AND PROFIT INEFFICIENCY CORRELATES
Variables
CONSTANT
TREND
IT_CAP
SERVICE
REMOTE
ATM_BR
REDUNDANCE
CAP_ASS
MERACQ
GROUP1
GROUP2
AGE
NW
NE
CE

COST INEFFICIENCY

0.2126
0.0568
0.0117
0.0038
-0.9100
0.1939
-1.5195
0.2018
-0.0294
0.0551
0.0192
0.0078
-0.0148
0.2841
0.0139
0.1510
-0.0293
0.0721
0.0661
0.0210
0.1665
0.0288
-0.0095
0.0569
-0.3572
0.0609
-0.4983
0.0943
-0.2293
0.0384
0.0521
0.0039
0.4419
0.0511

***
***
***
***

***

***
***

***
***
***
***
***

PROFIT INEFFICIENCY

0.8587
0.0651
0.0352
0.0068
-1.7889
0.3683
-1.2455
0.0482
-0.0592
0.0347
0.0417
0.0077
-0.8690
0.2184
3.9501
0.4436
-0.2367
0.0422
-0.7449
0.0961
-0.6888
0.0877
-0.6347
0.0266
-0.3838
0.0212
-0.0438
0.0228
-0.0156
0.0266
0.0669
0.0086
0.8320
0.0282

***
***
***
***
*
***
***
***
***
***
***
***
***
*

***
***

Observations = 5231
Cross-sections = 618
Time periods = 12
The dependent variables are respectively the cost and the profit inefficiencies jointly
estimated from the translog specification of Table 4. A complete description of the
independent variables is given in Table 3.
Note: Statistically different from zero, respectively, at: *** 99%, **95% and *90% significance level.

40

Table 6
COST FUNCTION SHIFTS
Variables
CONSTANT
IT_CAP

(A)

(B)

(C)

(D)

(E)

(F)

FULL
SAMPLE

FULL
SAMPLE

FULL
SAMPLE

LARGE
BANKS

MEDIUMSIZED BANKS

SMALL
BANKS

0.1296***
0.0119
-0.1597***
0.0131

0.1297***
0.0119

0.0826***
0.0129
-0.1412***
0.0198

0.0399
0.0281
-0.1022**
0.0501

0.0746***
0.0163
-0.0747***
0.0216

0.2700***
0.0211
-0.1953***
0.0163

0.0851***
0.0173
-0.0220***
0.0041
-0.0368***
0.0012
-0.0014
0.0080
-0.7348***
0.0300
0.0949***
0.0089
-0.1980***
0.0149
0.0024***
0.0002
0.0592
0.0619
0.0001***
0.0000
0.0159*
0.0084
-0.0251***
0.0027
-0.0174***
0.0027
-0.0607***
0.0124

-0.0345***
0.0105
-0.0355***
0.0030
0.0092
0.0332
-0.2278**
0.0973
0.0789***
0.0259
-0.1207***
0.0303
0.0022***
0.0002
-0.0934
0.1041
0.0000
0.0001
-0.0289
0.0429
-0.0324***
0.0114
-0.0151***
0.0053
-0.0363
0.0272

-0.0252***
0.0042
-0.0385***
0.0016
-0.0172***
0.0062
-0.6437***
0.0440
0.0672***
0.0124
-0.2288***
0.0176
0.0028***
0.0003
-0.1494
0.1109
0.0000
0.0000
0.0096
0.0129
-0.0241***
0.0025
-0.0205***
0.0029
-0.0140
0.0156

-0.0018
0.0029
-0.0326***
0.0011
0.0265***
0.0099
-0.7691***
0.0318
0.0706***
0.0074
-0.2819***
0.0185
0.0025***
0.0002
0.1383**
0.0552
0.0004***
0.0000
0.0216***
0.0074
-0.0263
0.0244
--

-0.1753***
0.0142
0.2759*
0.1486

HARDW_CAP
SOFTW_CAP
IT_STAFF
OUTSOURCING
ATM_BR
REMOTE
CAP_ASS
SMALL
SERVICE
STAFF_DEN
REDUNDANCE
MANAGERS
MERACQ
GROUP2
GROUP1
AGE

-0.0109
0.0024
-0.0362***
0.0009
-0.0007
0.0058
-0.7754***
0.0250
0.0761***
0.0063
-0.2267***
0.0117
0.0023***
0.0001
0.0838*
0.0446
0.0002***
0.0000
0.0133**
0.0066
-0.0231***
0.0026
-0.0162***
0.0026
-0.0957***
0.0125

-0.0098***
0.0024
-0.0364***
0.0009
0.0002
0.0058
-0.7739***
0.0250
0.0744***
0.0063
-0.2229***
0.0118
0.0023***
0.0001
0.0777*
0.0446
0.0002***
0.0000
0.0134**
0.0066
-0.0234***
0.0026
-0.0167***
0.0026
-0.0966***
0.0125

-0.2764***
0.0239

Observations
5082
5082
2921
435
1318
3329
Banks
612
612
396
49
146
417
R-squared (within)
0.756
0.757
0.787
0.698
0.836
0.760
R-squared (between)
0.001
0.001
0.014
0.049
0.329
0.016
R-squared (overall)
0.440
0.439
0.451
0.405
0.688
0.375
The dependent variable is the time derivative of the cost function estimated in Table 4. A complete description of the independent
variables is given in Table 3. The full sample regression refers to the sample employed for estimations in Tables 4 and 5, reduced
by the missing values in the OUTSOURCING and the IT_STAFF variables. The Large banks sample refers to the top 10 % of banks in
total asset distribution, the Medium-sized banks sample include banks from the 33 to the 10 % and the Small banks the last 66 %
of banks. For the estimated coefficients, a positive sign implies an increasing effect on costs and a correspondent decreasing
effect on productivity.
Note: Statistically different from zero, respectively, at: *** 99%, **95% and *90% significance level.

41

Table 7
PROFIT FUNCTION SHIFTS
Variables
CONSTANT
IT_CAP

(A)

(B)

(C)

(D)

(E)

(F)

FULL
SAMPLE

FULL
SAMPLE

FULL
SAMPLE

LARGE
BANKS

MEDIUMSIZED
BANKS

SMALL
BANKS

-0.1376***
0.0086
0.1351***
0.0094

-0.1379***
0.0086

-0.0940***
0.0092
0.1362 ***
0.0141

-0.0507**
0.0203
0.1271***
0.0363

-0.0825***
0.0119
0.0699***
0.0158

-0.2575***
0.0150
0.1545***
0.0116

-0.0705 ***
0.0124
0.0205 ***
0.0029
0.0262 ***
0.0008
0.0067
0.0057
0.5461 ***
0.0214
-0.0634 ***
0.0064
0.2019 ***
0.0107
-0.0021 ***
0.0001
-0.0222
0.0442
-0.0002 ***
0.0000
-0.0018
0.0060
0.0195 ***
0.0019
0.0160 ***
0.0019
0.0393 ***
0.0089

0.0258***
0.0076
0.0278***
0.0022
0.0255
0.0240
0.2003***
0.0705
-0.0480**
0.0188
0.1234***
0.0220
-0.0018***
0.0002
0.0888
0.0754
-0.0002***
0.0001
0.0264
0.0311
0.0259***
0.0083
0.0157***
0.0038
0.0197
0.0197

0.0222***
0.0031
0.0287***
0.0011
0.0134***
0.0046
0.4855***
0.0322
-0.0440***
0.0091
0.2293***
0.0129
-0.0022***
0.0002
0.1299*
0.0812
-0.0001***
0.0000
-0.0025
0.0094
0.0194***
0.0018
0.0178***
0.0021
0.0074
0.0114

0.0060***
0.0021
0.0221***
0.0008
-0.0238***
0.0070
0.5625***
0.0225
-0.0473***
0.0052
0.2899***
0.0131
-0.0023***
0.0002
-0.1162***
0.0391
-0.0005***
0.0000
-0.0081
0.0052
0.0409***
0.0173
--

0.1419***
0.0102
-0.0706
0.1071

HARDW_CAP
SOFTW_CAP
IT_STAFF
OUTSOURCING
ATM_BR
REMOTE
CAP_ASS
SMALL
SERVICE
STAFF_DEN
REDUNDANCE
MANAGERS
MERACQ
GROUP2
GROUP1
AGE

0.0124***
0.0017
0.0258***
0.0006
0.0001
0.0042
0.5722***
0.0180
-0.0518***
0.0045
0.2333***
0.0084
-0.0020***
0.0001
-0.0579*
0.0321
-0.0003***
0.0000
-0.0026
0.0048
0.0190***
0.0019
0.0152***
0.0019
0.0694***
0.0090

0.0118***
0.0017
0.0259***
0.0006
-0.0003
0.0042
0.5721***
0.0180
-0.0509***
0.0045
0.2317***
0.0085
-0.0020***
0.0001
-0.0549*
0.0321
-0.0003***
0.0000
-0.0026
0.0048
0.0192***
0.0019
0.0155***
0.0019
0.0700***
0.0090

0.2134***
0.0169

Observations
5082
5082
2921
435
1318
3329
Banks
612
612
396
49
146
417
R-squared (within)
0.801
0.801
0.833
0.785
0.871
0.800
R-squared (between)
0.046
0.044
0.152
0.067
0.307
0.033
R-squared (overall)
0.493
0.490
0.551
0.484
0.706
0.433
The dependent variable is the time derivative of the profit function estimated in Table 4. A complete description of the
independent variables is given in Table 3. The full sample regression refers to the sample employed for estimations in
Tables 4 and 5, reduced by the missing values in the OUTSOURCING and the IT_STAFF variables. The Large banks sample
refers to the top 10 % of banks in total asset distribution, the Medium-sized banks sample include banks from the 33 to
the 10 % and the Small banks the last 66 % of banks. For the estimated coefficients, a positive sign implies an increasing
effect on profits and a correspondent increasing effect on productivity.
Note: Statistically different from zero, respectively, at: *** 99%, **95% and *90% significance level.

42

Figure 1
INEFFICIENCY ESTIMATES FOR THE COST FUNCTION MODEL
1 .1 8

1 .1 6

1 .1 4

1 .1 2

1 .1

1 .0 8

1 .0 6

1 .0 4
A ll s a m p le

la r g e b a n k s

m e d iu m b a n k s

s m a ll b a n k s

1 .0 2

1
1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Figure 2
INEFFICIENCY ESTIMATES FOR THE PROFIT FUNCTION MODEL
1 .2 5

1 .2

1 .1 5

1 .1

1 .0 5

1
a ll s a m p le

la r g e b a n k s

m e d iu m b a n k s

s m a ll b a n k s

0 .9 5
1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

43