Managerial Finance

Production efficiency of Chinese banks: a revisit

Xiaotian Tina Zhang Yong Wang
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Production
Production efficiency of efficiency of
Chinese banks: a revisit Chinese banks
Xiaotian Tina Zhang
Finance Department, School of Economics and Business Administration,
Saint Marys College of California, Moraga, California, USA, and
969
Yong Wang Received 20 May 2013
Accounting and Finance Department, College of Business, Revised 28 July 2013
Accepted 29 August 2013
Western New England University, Springfield, Massachusetts, USA

Abstract
Purpose The last decade witnessed the reform of Chinas financial sector, during which Chinese
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commercial banks ownership and operation had been significantly changed in order to improve
efficiency. The purpose of this paper is to investigates whether these banks have improved their
productivity efficiency during their rapid expansion and growth in the post reform era from 2004 to 2011.
Design/methodology/approach Data envelopment analysis is used to investigate the production
efficiency of Chinese commercial banks during 2004-2011. First, the technical efficiency (TE) score is
constructed to evaluate bank productivity. The TE score is disintegrated into pure technical efficiency
(PTE) and scale efficiency (SE) to examine the effects of technical factors and scale economies. Second,
the Malmquist index is constructed to explore the year-by-year productivity. Lastly, regression
analysis examines how bank characteristics and ownership structure affect productivity efficiency.
Findings The Big Four banks are less efficient than other commercial banks, and public banks are
less efficient than private banks. The low efficiency is primarily due to scale inefficiency, rather than
PTE. In addition, ownership structure impacts production efficiency. Specifically, foreign ownership is
related to high efficiency while state ownership is associated with lower productivity.
Research limitations/implications There were small observations of public banks in China.
Thus, a more comprehensive test is impractical to explore whether or not annual changes in ownership
structure improve their production efficiency. With more date, such a test will reveal further
information about the relationship between ownership and productivity.
Originality/value The authors are the first to assess the production efficiency of Chinese
commercial banks after the recent financial reform during which Chinese commercial banks had
undergone significant structural changes. The lower overall productivity of Big Four and public
banks is a result of scale inefficiency, although these banks are better than their peers with respect to
input-output transformation.
Keywords China, Ownership, Efficiency, Banks, Scale economies
Paper type Research paper

1. Introduction
China has experienced rapid economic growth since the economic reform from 1978.
In 2011, China became the worlds second-largest economy. One of the main purposes of
Chinas economic reform is to transform its banking sector from a government-operated
financial system into a market-driven entity. The development of the commercial
banking system has accelerated since the 2000s, supported by the reform of opening up
to foreign investors, reducing state ownership, and listing previously state-owned banks.
As a result, the five largest commercial banks, which had been solely owned by the state,
Managerial Finance
Vol. 40 No. 10, 2014
pp. 969-986
r Emerald Group Publishing Limited
0307-4358
JEL Classifications G21, G28, G32, C52, F23 DOI 10.1108/MF-05-2013-0115
 MF are now traded on stock exchanges, along with many other medium-sized commercial
40,10 banks. Foreign ownership is also present in many commercial banks.
Recently, Chinese banks received extensive media attention because of their
amazing growth. For example, Forbes (2013) reported that the Industrial and
Commercial Bank of China Ltd (ICBC) is the worlds largest public company, with total
assets of $2.8 trillion in 2012. However, the rapid increase in total assets does not
970 obscure potential problems in the Chinese banking system. Financial analysts have
noted that Chinese banks with slow profit growth and fast asset growth may not be
sustainable. In 2013, the Agricultural Bank of China and the Bank of China, two of the
Big Four banks in China, disclosed their slowest profit growth since they went public.
The Wall Street Journal reported that the slow profit growth of these two large banks,
which have significant state ownership, is a result of Chinas economic slowdown and
bank operating inefficiency (Li, 2013).
Prior literature offers empirical evidence supporting the argument that large banks
are associated with low efficiency. For example, Wheelock and Wilson (2001) report
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that large US banks operate inefficiently because they experience decreased returns to
scale. Chinese banks have been documented for not function as efficient financial
intermediaries due to their own weaknesses, such as scale and scope diseconomies, as
well as institutional factors like political intervention (e.g. Berger et al., 2009; Yao et al.,
2007). The Chinese government has stated that the key objective of banking reforms is
to improve bank efficiency. Although the recent reforms have reduced state ownership
in Chinese banks and introduced large banks to the public stock exchanges, it may take
years for their operation and production to show significant improvement. Therefore,
some questions remain unanswered. For instance, has the reform of the ownership
structure improved the operation efficiency of Chinese commercial banks? Do these
banks achieve economies of scale through their rapid expansion? To our knowledge,
there are few empirical studies investigating these questions.
The purpose of this study is to assess the efficiency of Chinese commercial banks
following the economic reforms of the 2000s. We obtain data from Bankscope, China
Securities Market and Accounting Research (CSMAR), annual issues of the Almanac of
Chinas Finance and Banking, and web sites of individual banks. Since the reforms of
bank ownership and bank public listings start in 2005, we choose 2004 to 2011 as our
sample period. Our sample covers 31 Chinese commercial banks excluding policy banks.
Employing data envelopment analysis (DEA), we specify a four-input (labor, fixed assets,
deposits, and non-interest expenses) and four-output (loans, securities, trading activities,
and non-interest income) production model. The production frontiers are then constructed
for each year of the sample period. In turn, production efficiency (TE) scores are estimated
for each commercial bank. To investigate the production efficiency, we decompose the TE
scores into scale efficiency (SE) and pure technical efficiency (PTE). The empirical results
reveal that the Big Four banks have lower production efficiency than the other commercial
banks. Although the Big Four banks obtain higher PTE scores than the other commercial
banks examined, their SE scores are much lower than their peers. Therefore, scale
diseconomy contributes to the overall lower productivity of the Big Four. Similarly, public
banks are producing fewer outputs than private banks given the same level of inputs, and
this disadvantage is not because public banks have poor production management or
input-output transformation (on the contrary, public banks are better than private banks
in this perspective), but because of scale inefficiency.
We also investigate the efficiency change (the changes of total factor productivity
(DTFP) and pure efficiency) derived from the production frontiers of two consecutive
 years. The empirical results indicate that although larger scale does not hinder TFP Production
improvement, it actually makes the bank fall relatively behind its peers. To further efficiency of
explore whether the ownership structure affects production efficiency, we repeat
similar DEA analysis for a subsample of 16 public banks in China. We find that state Chinese banks
ownership is negatively associated with bank productivity efficiency while foreign
ownership is positively related to productivity efficiency.
Our paper contributes to the existing literature in the following ways. First, to the best 971
of our knowledge, this paper is the first one to assess the production efficiency of Chinese
commercial banks during 2004-2011, a time when they experienced structural changes.
This study provides evidence that large commercial banks have gradually increased
efficiency during this period. Second, as a complement to the literature that investigates
banks cost and profit efficiency, we study production efficiency. We find that the lower
overall productivity of the Big Four banks and public banks is a result of scale inefficiency,
although these banks are better than their peers from the perspective of input-output
transformation. Third, we examine the post-reform era of Chinese commercial banks and
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revisit the impacts of ownership on bank efficiency. We find that although state ownership
has been significantly reduced, banks with significant state ownership are less efficient
than banks without such ownership. We also illustrate that foreign ownership is positively
associated with productivity efficiency. Lastly, our findings have significant policy
implications. The empirical results indicate that the rapid asset growth of the large
commercial banks has resulted in scale diseconomies, which support the concern that
rapid asset growth may impede profit growth. A financial sector with considerably
different-sized banks is competitively viable. We also suggest the Chinese government
should continue to facilitate foreign ownership in the banking sector, in addition to
complying with the commitments to the World Trade Organization.
The rest of this paper is organized as follows. Section 2 is the literature review. In
Section 3, the hypotheses are developed. Section 4 describes the DEA methodology and
sample. In Section 5, the empirical results are discussed. Section 6 concludes.

2. Literature review
2.1 Chinese commercial banks: history and reforms
In the late 1970s, China entered into an economic reform period that aimed to create a
competitive, multi-ownership and market-oriented banking system. After joining the
WTO in 2001, China committed to opening its banking markets to outsiders by 2006.
The central government accelerated the banking reform by focussing on optimizing
the bank ownership structure to improve corporate governance. Starting in 2005,
China began publicly listing the Big Four (ABC, BOC, CCB, and ICBC) banks on stock
exchanges. Overall, the banking reforms have diversified the state ownership of the
state-owned banks, as well as fostered the development of Chinese commercial banks
that have different ownership structures[1].

2.2 Bank performance: efficiency

Prior literature focusses on banks efficiency which captures the asset allocation function
and directly demonstrates how efficiently banks transform their inputs into financial
products and services (Hasan et al., 2009). Berger et al. (1993), Berger and Mester (1997),
and Berger and Humphrey (1997) provide comprehensive surveys of the efficiency studies
(cost, profit, and production) in the banking industry. Another benefit of efficiency study
is that the efficiency measure could be used to examine scale and scope efficiency, as
introduced by Berger and Humphrey (1991) and Wheelock and Wilson (2001).
 MF A number of scholars have studies the Chinese bank efficiency from the cost and
40,10 profit perspectives (Chen et al., 2005; Yao et al., 2007; Berger et al., 2009). One potential
issue for the cost and profit efficiency is that the scores are very sensitive to
many exogenous factors, such as market share and the prices of inputs and outputs,
which are beyond the banks control. In this perspective, pure production
efficiency measuring productivity will better suit the need to examine how efficiently
972 a commercial bank operates because it only focusses on operations management, which
is controlled by the banks. Furthermore, production efficiency could be decomposed to
reveal the SE of commercial banks. Our paper is the first to apply production efficiency
and SE to examine the post financial reform era of Chinese commercial banks.
DEA has the advantage in efficiency estimates because it does not require either the
explicit specification of the production function (which is unknown) or output prices
(which could not be accurately defined for the banking industry). Because of the pure
production feature, DEA has been applied in numerous efficiency studies (Casu et al.,
2004). In addition, the Malmquist index derived from the DEA approach enables
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examination on both the cross-sectional and time-series effects of changes in efficiency

and therefore reveals detailed information about production efficiency.

2.3 Impacts of large, non-managerial ownership on performance

The model from Shleifer and Vishny (1986) theoretically demonstrates that large
shareholders can effectively monitor management and reduce free-riding problems in a
dispersed ownership structure. A number of researchers have empirically found
positive impacts of large shareholders on firm performance (e.g. Burkart et al., 1997;
Claessens et al., 2002).
While these studies point out that large non-managerial shareholders have a positive
impact on firm performance, a few others find different results. For instance, Claessens
et al. (2002) disentangle the entrenchment effect of large shareholdings from the incentive
effect, and find evidence of the entrenchment effect in a sample of publicly traded firms in
East Asian economies. Additionally, the impact of large, non-managerial shareholdings
on firm performance is found to be heterogeneous across the world. La Porta et al. (1999)
and Claessens et al. (2002) explore the non-homogeneous relationship between firm
performance and ownership structure across different economies.
Several papers examine the impacts of ownership on bank performance for the
prior reform era of Chinese banks (e.g. Fu and Heffernan, 2008; Berger et al., 2009).
Since the recent reforms in the 2000s, the previously state-owned Big Four banks
have been publicly listed on stock exchanges, and national non-state banks with
a diversified ownership structure play an important role in the financial sector.
Meanwhile, Chinese commercial banks have greater participation from foreign
investors. As a result, the ownership and management structures of Chinese banks
have significantly changed. The impact of large, non-managerial ownership (i.e. state
or foreign) on bank performance needs a re-examination.

3. Hypothesis development: bank efficiency and ownership structure

After the financial reform of 1995, the Big Four banks have significantly reduced their
state ownership. However, The Big Four continue to partially lend to projects in certain
areas as policy banks cannot fulfill the demand due to the lack of a branch network.
The Big Four are still under pressure from both the central and regional authorities to
make loans to their preferred sectors and enterprises (Yao et al., 2007). In addition, the
top managers for the Big Four were appointed by the government after the banks
 public listings. The Big Four are still operated bureaucratically. Shleifer and Vishny Production
(1997) illustrate that bureaucrats in a firm weaken the firms corporate governance. efficiency of
Empirical studies indicate that the Big Four underperform their competitors (Lin and
Zhang, 2009). Thus, we propose H1 on the efficiency of the Big Four: Chinese banks
H1. The Big Four commercial banks are less efficient than other commercial banks
in China.
973
Agency costs in a dispersed ownership structure cause the deviation of a firms optimal
decisions. As a result, public firms have higher inefficiency than private firms. Fama
(1980) proposes that an efficient market can monitor a firms management and then
minimize the agency costs in public firms. He suggests the opposite that public firms
are not less efficient than private firms. Existing literature provides mixed results on
the question of whether or not public status improves bank efficiency. For instance,
Berger and Mester (1997) show that publicly listed banks are more efficient than
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private banks. The results from Berger et al. (2009) demonstrate that private banks are
more efficient in China than their peers from 1994 to 2003.
The Chinese government accelerated the reform of publicly listing Chinese banks
starting in 2005 in order to improve bank efficiency. From 2012, there are 16 large
banks including the Big Four publicly listed in China. In H2, we propose that public
banks in China are more efficient than private banks:
H2. Public commercial banks in China are more efficient than private commercial
banks.
In the Chinese banking system, the large, non-managerial shareholder is the state,
which represents the central government. La Porta et al. (2002) provide empirical
evidence for the political theory. They show that higher government ownership of
banks is associated with slower financial development, as well as lower growth of per
capita income and productivity. Bonin et al. (2005) also find that state ownership is
associated with bank inefficiency in transitional economies.
The majority of studies examining Chinese banks report that the state banks are the
least efficient. For example, employing stochastic frontier analysis, Yao et al. (2007) and
Berger et al. (2009) find that state ownership of banks is associated with low efficiency.
On the other hand, Chen et al. (2005) show that in 1993-2000, both the large state-owned
banks and smaller banks are more efficient than medium-sized banks. Due to a lack of
data, a few studies have investigated whether bank efficiency in China has improved
with the bank reforms of the 2000s.
The recent bank ownership reforms in China have reduced state ownership in
commercial banks. However, banking regulations continue to restrict the types of
financial services they can provide, the amount of credit they can extend, the interest
rates they can charge, and other aspects of bank operations (Annual Report of China
Banking Regulatory Commission, 2010, 2011). As a result, bank inefficiency may not
improve as anticipated. We propose an inverse relationship between state ownership
and bank efficiency in China in H3:
H3. There is an inverse relationship between state ownership and bank efficiency in
China.
Most studies propose that foreign ownership can improve firm performance (e.g. Stulz,
2005). In transitional economies, foreign ownership in banks is usually associated with
 MF higher firm efficiency. Berger et al. (2009) argue that banks with foreign ownership are
40,10 more efficient because foreign owners typically contribute superior managerial skills
and high quality human capital. Bonin et al. (2005) find that foreign-owned banks are
the most efficient compared to both domestic private banks and state-owned banks in
transitional economies.
After joining the WTO in 2001, China opened its banking markets to outsiders to
974 improve bank efficiency (China Banking Regulatory Commission, 2010, 2011). Berger
et al. (2009) find that minority foreign ownership of Chinese banks is associated with
higher profits and cost efficiency. Therefore, in H4 we propose a positive relation
between foreign ownership and bank efficiency in China:

H4. Foreign ownership is positively associated with bank efficiency in Chinese

commercial banks.
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4. Methodology and sample construction

4.1 Methodology
DEA utilizes linear programming to identify the set of best-practice units and therefore
construct the production possibility set. Each production unit is compared to the
production possibility set to generate the TE (Farrell, 1957). Alternatively, an input
distance function D (x i, yi) is defined as the inverse of TE, which measures the ratio
of the inputs of an inefficient unit to the inputs of an efficient unit when they produce
the same outputs.
Fare et al. (1985) show that TE under a constant returns to scale (CRS) specification
can be further decomposed into two components: PTE and SE, where
TE PTE  SE. PTE is derived from the same DEA but under a variable return to
scale (VRS) specification. It reflects the physical efficiency of the input-output
transformation relative to a production frontier unrestricted by the VRS. Consequently,
SE measures the deviation of the production from the optimal CRS condition, which
offers information about the production units scale inefficiency.
To examine the dynamic change of production efficiency from year-to-year,
DEA also generates the Malmquist index of productivity (Malmquist, 1953) as the ratio
of the technical efficiencies derived from two consecutive years. The Malmquist index
with respect to the production possibility set of year t and t 1 (Mt and Mt 1) are
defined by Equations (1) and (2), respectively[2]. Fare et al. (1994) define the Malmquist
index as the geometric mean of Mt and Mt 1 (Equation (3)), which examines the
change in the total factor productivity (DTFP) from a particular year to the next using
the unit itself as a reference. If a production unit experiences productivity growth,
stagnation, or decline over the year, DTFP will attain a value greater than, equal to, or
o1, respectively:

AP t1 yt1 =xt1 Dct xt ; yt

M t xt ; xt1 ; yt ; yt1 1
AP t yt =xt Dct xt1 ; yt1

Dct1 xt ; yt
M t1 xt ; xt1 ; yt ; yt1 2
Dct1 xt1 ; yt1
  1=2
Dct xt ; yt Dct1 xt ; yt Production
M xt ; xt1 ; yt ; yt1 3
Dc x ; y Dc xt1 ; yt1
t t1 t1 t1 efficiency of
Chinese banks
Fare et al. (1994) show that DTFP can further be decomposed into three factors, one of
which measures pure efficiency change (DPEFF):
  975
Dvt xt ; yt
DPEFF 4
Dvt1 xt1 ; yt1

This variable compares the production units distance functions from the production
frontier in year t to its new distance from the frontier in year t 1; therefore, it
demonstrates how the units efficiency (relative to its peers) changes over time. If a unit
falls further behind (catch up with) its peers and becomes less (more) efficient, DPEFF
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will have a value smaller (greater) than one.

4.2 Sample construction

The data are from multiple sources. All the production-related input and output
information, such as data on loans and deposits, are from Bankscope. CSMAR offers
financial statement data and shareholding information for all public companies traded
on Chinese stock markets. We also obtained the annual reports of public banks and
collected the stock-holding data wherever it is not available from CSMAR. Other data
are from issues of the Almanac of Chinas Finance and Banking.
The process of transforming Chinese banks into a shareholding system started in
2004, when the Bank of China and China Construction Bank went public on the stock
exchange. Therefore, our sample period is 2004-2011 due to data availability from
Bankscope. Since small and large banks operate under different corporate structures, the
sample is restricted to larger banks (maximum total assets in eight years 4f100 billion)
in order to maintain homogeneity. This restriction coupled with the requirement of no
missing data in Bankscope left us a primary sample of the 31 largest banks in China,
16 of which are public traded. We use this sample to test production efficiency[3].
To further examine whether the ownership structure of a bank affects its production
efficiency, we obtain the ownership data for the 16 public banks for the 2006-2011 period.
Since only public banks publish detailed ownership data, this subsample will mainly be
used to test the relationship between ownership structure and production efficiency.

4.3 Variable construction

This study adopts the intermediation approach in describing the functionality of
banks. This approach treats banks as intermediaries of financial services, as described
in Hughes and Mester (1993)[4]. Accordingly, four inputs are specified: labor, fixed
assets, deposits, and non-interest expenses excluding expenses on labor. Labor is
measured by the personnel expenses. Fixed assets include premises, other fixed assets,
and capitalized leases. Deposits are measured by total customer deposits. Lastly, other
operating expenses are used to proxy for non-interest expenses. Following Casu et al.
(2004) and Elyasiani and Wang (2012), four outputs are considered:

(1) loans (total loans, net of non-performing loans);

(2) securities (derivatives and other securities);
 MF (3) trading activities (other earning assets); and
40,10 (4) non-interest income (other operating income).

The non-interest income output is used to incorporate banks income from fiduciary
activities, service charges, commissions, and fees.
For each sample year, production frontiers are constructed under both the
976 constant and variable returns to scale specifications (CRS and VRS). The technical
efficiency scores (TEC and TEV) for each bank are calculated relative to the
frontiers; TE scores under CRS measure the overall production efficiency and
TE scores under VRS measure PTE. SE is derived as the ratio of TEC to TEV.
Specifically, a noticeably smaller TEC than TEV in one bank-year reveals the
scale inefficiency of that observation. Lastly, DTFP and pure efficiency change
(DPEFF) are derived based on the production frontiers of two consecutive years.
The former variable reveals information of a banks productivity change relative
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to its own performance of last year, while the latter examines whether a bank has
improved its productivity relative to the entire group of peer banks (production
possibility set).
The 16 banks that are publicly traded on the Shanghai or Shenzhen stock
exchanges are identified using a dummy variable PUBLIC and the Big Four banks are
identified using the dummy variable BIG4. Further, we obtained the top ten
shareholders for each of the public banks from the annual reports on the banks
websites and/or CSMAR data set. Following Berger et al. (2009), we calculate the ratio
of the total number of state shares from the top ten shareholders to total number of
circulating shares and use a dummy variable STATE to identify those bank-year
observations whose ratio is higher than 50 percent. The dummy variable FOREIGN is
whether the ratio of foreign-controlled shares to total circulating shares is higher than
25 percent[5].
Following the literature on the banking industry and production efficiency (Berger,
1995; Berger and Mester, 1997), we include size, capital adequacy, profitability, and
intangible assets as control variables in our regression analysis. Size (SIZE) is the
natural log of the banks total assets. LEVERAGE (the total liability/total assets) is
used to proxy for bank capital. Return on assets is used to measure bank profitability.
The ratio of intangible assets to total assets (INTANGIBLE) is controlled for to
test the effect of banks intangible assets, such as reputation and trademarks, on
their productivity.

4.4 Model specification

We examine the production efficiency of banks in two steps. First, the banks with
specialized operations (Big Four) are compared to other commercial banks in China and
public banks are compared to private banks utilizing TE, PTE, and SE scores to test
which group is more productive and if the difference is due to scale economies or
production function. Since TE, PTE, and SE scores range from zero to one, Tobit
regressions (Equation (5)) are used:

TEPTE; SE a bPUBLICor bBIG4 gContral Variables e 5

Next, we examine whether different groups have different patterns in terms of changes
in efficiency by testing the DTFP and DPEFF obtained from the Malmquist index.
 Since DTFP and DPEFF can take any value, the ordinary least squares (OLS) Production
technique is applied, as described in Equation (6): efficiency of
DTFPor DPEFF a bPUBLICor bBIG4 gContral Variables e 6 Chinese banks
Lastly, using the subsample of 16 public banks, we test whether state and/or foreign
ownership impacts production efficiency. Similar regression techniques are employed 977
as specified in Equation (7):

TE a b1 State b2 Foreign gContral Variables e 7

5. Empirical analysis
5.1 Sample description
Table I provides the summary statistics. The banks in our sample have total assets
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of f10.31 billion-f15.48 trillion, with a mean of f1.45 trillion. As to the production

efficiency under CRS, the sample average TE score is 0.938. The average bank
has a PTE score of 0.979 and a SE score of 0.958. This later number indicates
that the production operation is not at the best scale in terms of improving
production efficiency.
Table II contains the summary statistics for the input/output variables used in the
DEA. Input-oriented DEA is performed for the sample under both CRS and VRS
specifications. For each year from 2004 to 2011, an efficient frontier is constructed and
the efficiency scores (TE) of each bank are derived.

5.2 Group comparison

Table III reports the results of the means comparison tests that examine whether
different types of banks are different in terms of production efficiency. First, the Big

Variable Description Mean Median SD Max. Min.

Bank characteristics
TA Total assets (fbillion) 1,453.14 273.78 2,746.87 15,476.87 10.31
SIZE Natural log of total assets 26.606 26.336 1.695 30.370 23.056
LEVERAGE Total liability/total assets 0.949 0.948 0.026 1.137 0.858
ROA Net income/total assets 0.008 0.008 0.004 0.021 0.004
INTANGIBLE Intangible assets/total assets 0.001 0.001 0.004 0.036 0
Bank efficiency
TE (CRS) Technical efficiency CRS 0.938 0.961 0.072 1 0.688
SE Scale efficiency 0.958 0.989 0.054 1 0.781
PTE Pure technical efficiency 0.979 1 0.049 1 0.753
Notes: This table describes the sample of 31 banks for 2004-2011 (248 bank-year observations). The
variables are defined as follows: TE (CRS) is the technical efficiency score obtained through DEA
analysis based on the constant returns to scale (CRS) specification. TE is decomposed into SE and
PTE, which measure deviation of the banks scale from the optimal CRS condition, and the physical
efficiency of the input-output transformation relative to a frontier unrestricted by return to scale
specification, respectively. TA is the book value of total assets at the end of each year. SIZE is the
natural log of total assets. LEVERAGE is defined as the ratio of total liabilities to total assets. ROA is a
profitability measure defined as the ratio of net income-to-book value of total assets. INTANGIBLE is Table I.
defined as the ratio of intangible assets to book value of total assets Descriptive statistics
 MF Variable Mean Median SD Max. Min.
40,10
Outputs
Loan 737.381 139.538 1,359.775 7,594.019 5.022
Securities 364.293 65.792 762.424 3,966.112 2.299
Trading activities 669.267 125.918 1,325.357 7,495.562 4.725
978 Non-interest income 6.859 0.708 16.607 112.450 5.000
Inputs
Labor 7.355 1.275 13.999 79.721 0.037
Fixed assets 13.446 1.867 26.976 131.815 0.195
Deposits 1,164.720 212.839 2,255.319 12,261.219 7.632
Table II. Non-interest expenses 7.300 1.602 13.156 77.472 0.073
Descriptive statistics of
outputs and inputs of Notes: All variables are measured in billions of f (RMB). The sample includes balanced panel data for
DEA analysis 31 banks for 2004-2011. This study specifies a four outputs-four inputs production model
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Variable BIG4 Others Diff. PUBLIC Others Diff.

Bank characteristics
SIZE 29.592 26.163 3.429*** 27.757 25.379 2.378***
LEVERAGE 0.955 0.949 0.006 0.952 0.948 0.004
ROA 0.009 0.008 0.001* 0.008 0.007 0.001
INTANGIBLE 0.002 0.001 0.001*** 0.001 0.002 0.001***
Bank efficiency
TE (CRS) 0.922 0.940 0.018* 0.919 0.958 0.041***
SE 0.922 0.963 0.041*** 0.938 0.979 0.041***
PTE 1.000 0.976 0.024*** 0.979 0.979 0.000
Notes: This table describes the group means comparison for BIG4 banks versus other banks and
public banks versus private banks for the sample of 31 banks over 2004-2011. As defined in Table I,
SIZE is the natural log of total assets at the end of each year. LEVERAGE is defined as the ratio of total
liabilities to total assets. ROA is a profitability measure defined as the ratio of net income to book value
of total assets. INTANGIBLE is defined as the ratio of intangible assets to book value of total assets.
TE (CRS) is the technical efficiency score obtained through DEA analysis. TE is further decomposed
into SE and PTE, which measure deviation of the banks scale from the optimal CRS condition, and the
physical efficiency of the input-output transformation relative to a frontier unrestricted by return to
Table III. scale specification, respectively. *,**,***Significance of the mean difference test at the 10, 5, and 1
Group means comparison percent, respectively

Four have marginally lower production efficiency (TE) than other banks under CRS
specification (0.922 vs 0.940), indicating they produced fewer outputs using the same
amount of inputs as the peer banks. Second, the Big Four show a significantly higher
PTE (1 vs 0.976) but lower SE (0.922 vs 0.963) than other banks, indicating that their
lower overall productivity is not the result of poor input-output transformation (the Big
Four are actually better than the other banks in this respect) but rather a result of scale
inefficiency (or decreasing return to scale).
The comparison shows that public banks are significantly larger than their private
peers. Public banks also have lower overall productivity (0.919 vs 0.958) than private
banks due to scale inefficiency (0.938 vs 0.979) since public and private banks are at the
same level for PTE.
 In addition, we also perform group comparisons of production efficiency for each Production
year in our sample period. Figure 1 illustrates the Big Four had the highest PTE of efficiency of
every year. However, the Big Four are less efficient than other banks in terms of overall
production efficiency. The different behavior of the TE scores and PTE scores is Chinese banks
primary due to the divergence of SE between the two groups. Figure 2 compares the
overall productivity efficiency of the public and private banks. The public banks had
significantly lower production efficiency in each year. Since the difference in overall 979
production efficiency is much more obvious than the difference in PTE, SE evidently
accounts for the majority of the disparity.
Overall, the results support H1. The Big Four are less efficient than other banks in
productivity primarily because of scale inefficiency. Similar results are attained for the
public banks when compared to private banks, thus H2 is rejected.

5.3 Models explaining TE

We employ the Tobit regression to explore how bank characteristics affect their
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efficiency. We also investigate the efficiency of the Big Four and public banks after
controlling for these factors.
The results in Model A in Table IV show that SIZE is negatively associated with
TE score, indicating that large banks had lower productivity. Large banks also had

0.95

PTE BIG4
PTE Others
0.9 TE BIG4
TE Others

0.85 Figure 1.
Technical efficiency under
CRS and VRS for Big Four
0.8 banks vs others
2004 2005 2006 2007 2008 2009 2010 2011

1.02

0.98

0.96

0.94 PTE Public

PTE Private
0.92 TE Public
TE Private
0.9

0.88 Figure 2.
Technical efficiency under
0.86
CRS and VRS for public
0.84 banks vs private banks
2004 2005 2006 2007 2008 2009 2010 2011
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MF

980
40,10

Table IV.

scale efficiency
Regressions explaining

technical efficiency, and

technical efficiency, pure
Model A B C
Dependent variable TE PTE SE TE PTE SE TE PTE SE

Constant 1.049*** (3.10) 0.812 (1.63) 1.185*** (4.97) 1.239*** (3.49) 1.304** (2.12) 1.274*** (5.09) 0.756** (2.18) 0.465 (0.92) 0.985*** (4.01)
SIZE 0.021*** (4.52) 0.017** (2.38) 0.022*** (6.82) 0.029*** (4.77) 0.001 (0.10) 0.026*** (5.89) 0.008 (1.34) 0.034*** (3.37) 0.014*** (3.13)
LEVERAGE 0.495 (1.42) 0.157 (0.30) 0.398 (1.62) 0.535 (1.51) 0.182 (0.28) 0.414 (1.41) 0.492 (1.43) 0.208 (0.41) 0.396 (1.63)
ROA 0.259 (0.11) 4.865 (1.38) 0.807 (0.47) 0.411 (0.17) 5.047 (1.36) 0.860 (0.50) 0.279 (0.12) 5.558 (1.57) 0.448 (0.26)
INTANGIBLE 1.212 (0.59) 3.225 (1.21) 0.542 (0.36) 1.476 (0.73) 3.717 (1.45) 0.410 (0.27) 1.999 (0.98) 4.279 (1.60) 0.007 (0.01)
BIG4 0.062** (2.14) 2.678*** (3.31) 0.028 (1.35)
PUBLIC 0.059*** (2.89) 0.078*** (2.59) 0.041*** (2.78)
No. of obs. 248 248 248 248 248 248 248 248 248
LR w2 23.80 10.31 47.12 28.37 24.94 48.94 32.13 15.51 54.92

Notes: TEPTE; SE a bPUBLICor bBIG4 gContral Variables e. This table reports the results of Tobit regressions based on the sample of 31
banks for 2004-2011. The dependent variables are technical efficiency (TE), which is technical efficiency score obtained through DEA analysis, pure technical
efficiency (PTE), which is technical efficiency score obtained through same production model but under VRS specification to measure the physical efficiency
of the input-output transformation relative to a frontier unrestricted by return to scale specification, and scale efficiency (SE), which is the ratio of TE to PTE
that measures the deviation of the banks scale from the optimal CRS condition. The independent variables include the following. SIZE is the natural log of
book value of total assets at the end of each year. LEVERAGE is defined as the ratio of total liabilities to total assets. ROA is a profitability measure defined
as the ratio of net income to book value of total assets. INTANGIBLE is defined as the ratio of intangible assets to book value of total assets. BIG4 is
a dummy variable to identify the four special banks. PUBLIC is a dummy variable to separate the publicly traded banks from the private banks.
*,**,***Significance of 10, 5, and 1 percent, respectively
 higher PTE (better technology and/or input-output transformation), although this Production
effect is overwhelmed by the negative effect of scale inefficiency, as indicated by the efficiency of
negative coefficient of SIZE on SE. Therefore, the overall effect of size on TE is
negative. This finding is in line with our discussion about the scale inefficiency of Chinese banks
banks in China, where pursuing bigger size hinders productivity due to diseconomies
of scale.
In Model B in Table IV, SIZE is negatively associated with TE. After controlling for 981
the size effect, the Big Four are more efficient than other banks, as indicated by the
positive coefficient of BIG4. In addition, SIZE has no effect on PTE since the positive
effect in Model A is captured by the dummy variable BIG4, indicating that the Big Four
(instead of just large banks) are the leading banks in the technological perspective of
production. Lastly, large banks are associated with low SE. Overall, the results show
that large bank size reduces productivity due to its negative effect on.
Model C in Table IV tests whether public and private banks are different in all the
efficiency specifications. As for TE, the coefficient of SIZE is not significant since its
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negative effect is captured by PUBLIC. The result is expected because public banks are
much bigger than private banks (Table III). SIZE is positively related to PTE, as in
Model A. In addition, after controlling for the size effect, public banks are far less
efficient than private banks in pure technology (PTE), indicating private banks
possess better production technology and/or input-output transformation. SIZE is
negatively correlated with SE; public banks are worse than private banks even after
controlling for the size effect is controlled for. Therefore, public banks are less efficient
than private banks in both pure technology and scale.
After the effect of bank size is controlled for, the Big Four banks have higher PTE
and therefore they are more productive than other banks even though they suffer scale
inefficiency due to their size. On the other hand, public banks have lower PTE and
lower SE; therefore, they are less efficient than the private banks after we consider the
effect of bank size.

5.4 Productivity and efficiency change

The Malmquist index ( DTFP) measures productivity change over time. We decompose
DTFP to obtain the pure efficiency change factor (DPEFF). Table V reports the OLS
regression. The results explain the efficiency change relative to the production
possibility sets, DPEFF, which measures whether or not a bank has caught up with
the most efficient banks. SIZE is negatively associated with DPEFF, indicating that
banks with larger assets are more likely to be left behind. This result is consistent with
the finding that scale inefficiency hinders banks from improving their production
efficiency. The dummy variables BIG4 and PUBLIC do not have a significant impact on
either DTFP or DPEFF, indicating that banks are similar in production efficiency.

5.5 Ownership structure and production efficiency

Due to the unavailability of ownership data for private banks, we use a subsample of
16 public banks to test how ownership affects production efficiency. Since most public
banks were listed on stock exchanges after 2006, our subsample starts from that year
and ends at 2011, yielding 96 bank-year observations.
We use the Tobit model as described in Equation (7) to examine the effect of state
and foreign ownership on production efficiency. The results in Table VI confirm the
negative association between state ownership and production efficiency since banks
that have a majority of state ownership had significantly lower overall productivity.
 MF Dependent variable DTFP DPEFF
40,10
Constant 0.994*** (3.21) 1.005*** (3.45)
SIZE 0.011 (0.95) 0.006*** (2.98)
LEVERAGE 0.024 (0.75) 0.032 (0.69)
ROA 0.011** (2.05) 0.012** (3.02)
982 INTANGIBLE 1.142** (2.14) 2.011 (1.00)
BIG4 0.012 (0.82)
PUBLIC 0.008(0.74)
No. of obs. 217 217
Adjusted R 2 0.171 0.168
Notes: DTFPor DPEFF a bPUBLICor bBIG4 gContral Variables e. This table reports
the results of OLS regressions based on the sample of 31 banks for 2004-2011. Dependent variables are
change of total factor productivity (DTFP, which measures the banks productivity change from last
year comparing to itself) and pure efficiency change (DPEFF, which measures the banks annual
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productivity change relative to the peer banks). The independent variables include the following. SIZE
is the natural log of book value of total assets at the end of each year. LEVERAGE is defined as the
Table V. ratio of total liabilities to total assets. ROA is a profitability measure defined as the ratio of net income
Regressions explaining to book value of total assets. INTANGIBLE is defined as the ratio of intangible assets to book value of
total factor productivity total assets. BIG4 is a dummy variable to identify the four special functional banks. PUBLIC is a
change and pure efficiency dummy variable to separate the publicly traded banks from the private banks. *,**,***Significance of
change 10, 5, and 1 percent, respectively

Dependent variable TE TE

Constant 0.6584 (1.56) 0.6076 (1.23)

SIZE 0.009*** (2.96) 0.007*** (2.74)
LEVERAGE 0.478 (0.74) 0.538 (0.49)
ROA 0.156 (1.44) 0.167 (1.11)
INTANGIBLE 12.524** (2.01) 13.235** (1.98)
BIG4 0.044** (1.97)
STATE 0.015** (2.01)
FOREIGN 0.034* (1.75)
No. of obs. 96 96
LR w2 24.38 31.25
Notes: TE a b1 State b2 Foreign gContral Variables e. This table reports the results of
Tobit regressions based on the sample of 16 public banks for 2006-2011. The dependent variable
is technical efficiency (TE, which is the technical efficiency score obtained through DEA analysis).
The independent variables include the following. SIZE is the natural log of book value of total assets
at the end of each year. LEVERAGE is defined as the ratio of total liabilities to total assets. ROA
is a profitability measure defined as the ratio of net income to book value of total assets. INTANGIBLE
is defined as the ratio of intangible assets to book value of total assets. BIG4 is a dummy variable
to identify the four special functional banks. STATE is a dummy variable indicating majority
state owned (the ratio of total number of state owned shares in the top ten shareholders to total number
Table VI. of circulating shares is higher than 50 percent). FOREIGN is defined as a dummy variable indicating
Regressions explaining significant foreign ownership (the ratio of foreign controlled shares in the top ten shareholders to
ownerships effect on total circulating shares is higher than 25 percent). *,**,***Significance of 10, 5, and 1 percent,
technical efficiency respectively
 The coefficient of FOREIGN shows the positively association between foreign Production
ownership and productivity. Thus, H3 and H4 are supported. We tried to identify efficiency of
whether the relationship is a result of monitoring or a pre-selecting effect; however, due
to the small sample size, we could not adequately separate the two effects. Chinese banks
5.6 Discussions
We have examined the robustness of our findings. First, we follow Casu et al. (2004) 983
and consider an alternative set of outputs that consist of loans (net loans, net of un-
performing loans), securities (held-to-maturity and available-for-sale), and total non-
interest income given the same set of four inputs. We find that the average TE scores
under this new production specification are slightly lower than those under the original
specification. Berger et al. (1993) explain that when more outputs are specified, more
banks will be relatively efficient because each one is more likely to succeed in some
dimensions when more products are defined. However, the group means comparison
and regressions following Equation (5) yield statistically equivalent results. Therefore,
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our results are robust to production function specification.

Second, for our subsample of public banks, we try to calculate the DTFP and pure
efficiency change (DPEFF) and perform regression analysis of Equation 6. However,
because of losing one year of observations in calculating the efficiency change, we have
only 80 bank-year observations and the statistical analysis was inapplicable due
to small sample size. It would be beneficial to test whether the state and foreign
ownership improves or diminishes production efficiency from year to year with a large
data set.
Lastly, we acknowledge that our ownership structure measurement could be
improved with variables measuring the exact percentage of each type of ownership
to the entire shareholding instead of being restricted to the top ten shareholders.
Due to the small number of public banks, this test is not feasible at this time.

6. Conclusions
Chinese banks have long been criticized for their low production efficiency. Remarkable
reforms were enacted to improve their production efficiency. This study assesses the
production efficiency of Chinese banks after the ownership structure changes in the
2000s. Our sample covers 31 Chinese commercial banks from 2004 to 2011. A four-
input and four-output production model is employed under the DEA framework to
evaluate bank efficiency. The production efficiency score (TEs) as well as its two
components, SE and PTE, are calibrated for each commercial bank to measure
production efficiency.
Prior literature has labeled the Big Four as inefficient before the reforms in the
2000s. Our study reveals that although they are still less efficient than other
commercial banks, their scale diseconomy contribute to the overall low productivity.
We demonstrate that after the size effect is controlled for, the Big Four achieve higher
PTE than other commercial banks, indicating that they are the leaders in TE. After
controlling for size, public banks are found to have lower PTE and SE than their
private peers. The test of efficiency changes further indicates that although larger scale
does not hinder total productivity improvement for a bank, it makes it fall further
behind its peers. We also find that state ownership is inversely related to productivity
efficiency while foreign ownership is positively associated with it.
Our paper is the first study applying production efficiency and SE to examine
Chinese commercial banks in the post-reform era. As a complement to the existing
 MF literature that investigates banks cost and profit efficiency, we focus on the overall
40,10 production efficiency, as well as SE and PTE.
Our study has important policy implications. It raises the concern of the scale
inefficiency of Chinese banks with slow profit growth and fast asset growth. Large
banks in China may shift their strategy away from asset growth. We also suggest the
Chinese government continue to open up the banking sector to foreign ownership and
984 further reduce state ownership of commercial banks.
Notes
1. Refer to Berger et al. (2009) for a complete review of the reforms of Chinese
commercial banks.
2. The subscript c denotes that the distance is measured under the assumption of constant
returns to scale (CRS) technology. AP is the average productivity (the ratio of outputs
to inputs).
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3. Although our sample size is relatively small, these 31 banks represent the majority of loans
(76 percent as of 2011) and total assets (80 percent as of 2011) of all the commercial banks in
China covered in Bankscope.
4. Researchers employ two main approaches to model the production structure of financial
institutions: the intermediation approach and the production approach. The later treat banks
as producers of loans and deposits.
5. The first case to permit foreign holding in Chinese commercial banks occurred in 1996;
subsequently, the regulatory permission for foreign holding progressed very slowly.
As a result, the total percentage holding by foreign shareholders was still low on average as
a result of stringent license granting policies and regulations.

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Corresponding author
Dr Xiaotian Tina Zhang can be contacted at: xz4@stmarys-ca.edu
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