An Analysis of the

Production Function of
Private-Sector Banks in
India
Submitted to Dr. Kaushik Bhattacharya
Indian Institute of Management Lucknow

8/7/2010

By,
Anurag Arora – PGP26006
Hashim S- PGP26015
Jay Prakash Musirana – PGP26018
Ravi Pathak – PGP26039
Ravi Ramani – PGP26040
Sabareesh Venugopal – PGP26046
Soundarya Kedarnath- PGP26057

Section A, Group 3
Contents
Contents.................................................................................................2
ABSTRACT..............................................................................................3
INTRODUCTION.......................................................................................4
Economies of Scale.............................................................................4
Production Function............................................................................5
Cobb-Douglas Production Function.....................................................5
METHODOLOGY......................................................................................6
Regression Models Adopted ...............................................................6
Regression Methodology.....................................................................8
Formation of Cobb-Douglas function for Banks................................8
Regression models tested for Indian Domestic Private Banks (2008-
09 data) ..........................................................................................9
Regression models tested for Foreign Banks in India (2008-09 data)
.......................................................................................................10
DATA ANALYSIS AND INTREPRETATIONS...........................................12
RETURNS ON SCALE BASED ON SEGMENTATION OF BANKING
INDUSTRY..........................................................................................14
Limitations of the methodology adopted.........................................15
Comparison between Foreign and Domestic Private Banks..............16
CONCLUSION........................................................................................16
REFERENCES........................................................................................16
ABSTRACT
This project estimates the Production Function of Private Sector Banks in
India from the year 2004-05 till 2008-09. We worked on a set of 4 input and 4
output variables to arrive at the best two Cobb-Douglas models for the
Production function. Different combinations of input and output variables
were analyzed statistically using multivariate regression on the data of 5
years. The two selected models were then analyzed for comparing Returns to
Scale for different years in the Banking Industry. The study finds the results
to be consistent with the erstwhile economic conditions and the economies of
scale in the banking industry. Furthermore, we segmented the banking
industry into small, medium and large scale banks to analyze the Returns to
Scale for these segments. The results showed that small size banks have the
Returns to Scale lower than the industry figure. The study also highlights the
key differences in the Production Function analysis of Domestic Private Banks
and Foreign Banks in India.
INTRODUCTION
Defining and measuring bank output has long been a difficult and somewhat
contentious issue. This has been made even more challenging by rapid and
massive changes over the past two decades in both the form of organizations
and the range and features of financial instruments offered by banks.
Nowadays, banks engage in a wide range of non-traditional activities such as
underwriting firms’ public offerings of debt and equity securities, standby
letters of credit and a variety of derivatives contracts (e.g. swaps and
options). The main reason for the difficulty in measuring the output is that
much of bank service output is not explicitly priced. Instead the implicit
charges for financial services are bundled with interest flows between banks
and their customers; on net, banks earn a positive spread between interest
rates received and interest rates paid.

In 2010, the share of private sector banks increases to 30 per cent of total
sector assets, from current levels of 18 per cent, while that of foreign banks
increases to over 12 per cent of total assets. The share of the private sector
banks (including through mergers with PSBs) increases to 35 per cent and
that of foreign banks increases to 20 per cent of total sector assets.

ECONOMIES OF SCALE

Economies of scale relates to the cost advantage a business obtains from

expansion. It is a long-run concept and refers to the reduction in unit cost as
the facility size and usage level of other inputs increase. The common
sources are purchasing (bulk buying through long-term contracts),
managerial (increasing the specialization of managers), financial (obtaining
lower-interest charges and having access to a greater range of financial
instruments), marketing (spreading the cost of advertising over a greater
range of output in media markets) and technological (taking advantage of
returns to scale in the production function). Each of these factors reduces the
long run average costs (LRAC) of production by shifting the short-run average
total cost (SRATC) curve down and to the right. Economies of scale are also
derived partially from learning by doing.

If a bank expands its scale of operations and diversifies its activities, it can
reduce average costs and thereby improve spread. Thus, the bank can
exploit economies of scale and scope. While banking researchers generally
agree that economies of scale do exist in the industry at low levels of output,
there is less agreement about whether diseconomies of scale emerge at high
levels of output. Earlier studies found evidence that diseconomies of scale did
occur when total banking assets exceeded roughly $10 billion. However,
these results were discovered when banking companies operating in multiple
states had to maintain separately capitalized, individually chartered bank
subsidiaries in those states.

On the cost side, it is apparent that the cost structure of running a network of
bank branches across multiple states should be more efficient than running a
group of individually capitalized bank subsidiaries. On the revenue side,
research on mega-mergers suggests that merged banks experienced higher
profit efficiency from increased revenues than did a group of individual
banks, because they provided customers with higher value-added products
and services. Moreover, a banking organization of a certain scale may even
earn a "too-big-to-fail" subsidy due to the market's perception of de facto
government backing of a megabank in times of crisis.

PRODUCTION FUNCTION

A production function is a function that specifies the output of a firm, an

industry, or an entire economy for all combinations of inputs. This function is
an assumed technological relationship, based on the current state of
engineering knowledge.

In a general mathematical form, a production function can be expressed as:

Q = f(X1, X2, X3... Xn)
Where: Q = quantity of output
X1, X2, X3... Xn = quantities of factor inputs (such as capital, labor, land or raw
materials).

One formulation of the production function is as a linear function:

Q = a + bX1 + cX2 + dX3 +...
Where a, b, c and d are parameters that are determined empirically.

RETURNS TO SCALE
Returns to Scale refer to changes in output resulting from a proportional
change in all inputs (where all inputs increase by a constant factor). If the
output increases by that same proportional change, then there are constant
returns to scale (CRS). If the output increases by less than that proportional
change, then there are decreasing returns to scale (DRS). If the output
increases by more than that proportional change, there are increasing
returns to scale (IRS). Thus the returns to scale faced by a firm are purely
technologically imposed and are not influenced by economic decisions or by
market conditions.

COBB-DOUGLAS PRODUCTION FUNCTION

The Cobb–Douglas functional form of production functions is widely used to

represent the relationship of an output to inputs. It was proposed by Knut and
Wicksell and tested against statistical evidence by Charles Cobb and Paul
Douglas.
α β
The function is: Y = AL K
Where: Y = total production (the monetary value of all goods produced in a
year)
L = labor input
K = capital input
A = total factor productivity
α and β are the output elasticities of labor and capital, respectively. The
intercept value A is a constant determined by available technology.

Output elasticity measures the responsiveness of the output to a change in

levels of either labor or capital used in production, ceteris paribus. For
example if α = 0.15, a 1% increase in labor would lead to approximately a
0.15% increase in output.
If α + β = 1, the production function has constant returns to scale. That is, if
L and K are each increased by 20%, Y increases by 20%.
If α + β < 1, returns to scale are decreasing.
If α + β > 1, returns to scale are increasing.

METHODOLOGY

REGRESSION MODELS ADOPTED

We employed the Cobb-Douglas Production Function to measure the total

production of banks as the output with different input factors described
below. A bank’s output and input can be presented by many different
variables, as opposed to a manufacturing firm which has fixed output and
input parameters. We analyzed 4 different output variables for our initial
analysis and these were regressed with 4 input variables. These input
variables were carefully selected to take into account the possible inputs for
a bank.
• Selection of Input Variables – We employed a 2-input variable Cobb
Douglas Production Function. A combination of 2 inputs was taken from
the 4 inputs given below.

o No. of Employees – This refers to the number of people hired

by the bank to run its operations. Employees are one of the
inputs on which a bank’s production depends. We expect the
increase in labor to translate into an increase in the output. This
input can be used as the ‘Labor’ variable in the Cobb Douglas
function.

o Capital – The Capital parameter signifies the monetary capital

employed by the bank for carrying out the business. The Capital
parameter consists of the Paid-Up Capital and the General
 Reserves and Surplus available, and the long term loans taken
by the bank. This summed up capital would be used up by the
bank for furthering its business. This input can be used as the
‘Capital’ variable in the Cobb Douglas function.

o Number of offices – Another choice of input is the No. of

offices (Branches) of the Bank. This factor need not be fully
factored in by ‘labor’ input, since as the no. of offices increases,
the reach ability of the bank to its customers increases manifold.
When the no. of employees increases, the service quality of the
bank is affected.

o Capital and Deposits: This input is defined as the summation

of capital (as described above) and the deposits available to the
bank. This term tells us the total lending capacity of the bank,
since we are taking the total cash available to the bank. This
input can be used as the ‘Capital’ variable in the Cobb Douglas
function.

• Selection of Output Variables – We considered the following variables

to be a representative of the production output of a bank

o Advances – This refers to the loans given by the bank to its

customers. The data for ‘Advances’ is sourced from the Balance
Sheets of various banks.

o Deposits – This refers to the deposits made by the bank’s

customers. We consider deposits to be an intermediate output in
the operations of banks. The data for ‘Deposits’ is sourced from
the Balance sheets of various banks.

o Sum of Advances and Deposits (SAD) – Measures the

cumulative sum of Advances and Deposits. This overall measure
is taken since the bank bases its financial position on the
deposits it has and the incomes from loans.

o Interest Income – The Interest Income is another output which

shows the net interest earned by the bank.

• Segregation of Indian Banking Industry – We segregated of the

Indian private banking industry into ‘Indian Domestic private
Banks’ and ‘Foreign banks in India’. The need for this segregation
arises because the scale of operations for a private domestic bank is
much larger than scale of operations of a foreign bank in India. Many of
the foreign banks have just set foot in India and they don’t have a big
presence in the country yet.
REGRESSION METHODOLOGY

The methodology employed in estimating the Production function is multi-

variate linear regression. In order for the linear regression to hold we take the
natural logarithm of the Cobb-Douglas Production function and apply linear
regression.
α β
Let the production function be Y = AL K
Where: Y = total production (the monetary value of all goods produced in a
year)
L = labor input
K = capital input
A = total factor productivity

Taking log on both sides,

Log Y = Log A + α Log L + β Log K

Formation of Cobb-Douglas function for Banks

We have 2 input variables to choose the ‘Labor’ variable from and 2 input
variables to choose the ‘Capital’ variable from. We also have one output
variable to be selected from the 4 output variables defined above. There are
thus 16 combinations of Cobb-Douglas production functions.

We then applied the regression methodology on the 16 combinations by

using the bank data for 2008-09. Our objective was to find those models
which were able to fit the output and input data in a straight line. We
rejected those models which have a ‘p-value’ corresponding to an input
variable greater than 0.05, since that indicates an insignificant relationship.

The models which showed significant results while fitting the input and output
data are listed below in the table along with the corresponding ‘α’ and ‘β’
values. The corresponding p-values for each coefficient are also shown in
parenthesis.

Explanation of statistical terms

• R square: This represents the goodness of fit of a model. The R-
square of the regression is the fraction of the variation in the
dependent variable that is accounted for by the independent variables.
• T-stat: It is the ratio of the coefficient to the standard error.
• P value: It represents the significance level. A ‘p-value’ of 5% or less is
the generally accepted point at which the null hypothesis is rejected. It
says that there is only a 5% chance that these values fitted into the
model by chance.
 Regression models tested for Indian Domestic Private Banks (2008-
09 data)

P- P-value
Case R Square Α β value(α) (β)
α+β
Output: Interest Income
Input 1:Employee 0.982550801 0.554116 0.514068 4.26E-06 6.72E-06 1.068185
Input 2:Capital
Output: Sum of Advances &
Deposits
Input 1:Employee 0.968976113 0.629405 0.421238 2.64E-05 0.001072 1.050643
Input 2:Capital
Output: Advances
Input 1:Employee 0.973508226 0.607138 0.487517 2.55E-05 0.000186 1.094655
Input 2:Capital
Output: Deposits
Input 1:Number of Offices 0.94579181 -0.19342 1.175867 0.187725 9.85E-08 0.982451
Input 2:Employee
Output: Advances
Input 1:No: of Off 0.953850263 -0.30885 1.348553 0.039753 1.03E-08 1.039707
Input 2:Employee
Output: Interest Income
Input 1: Summation of Capital and
0.989561 0.861616 0.185377 5.03E-07 0.118248 1.046993
Deposits
Input 2: Number of employees
Output: Advances
Input 1: Summation of Capital and
0.993051 0.98431 0.091359 2.73E-09 0.321592 1.07567
Deposits
Input 2: Number of employees
Output: Interest Income
Input 1:Number of Offices 0.967523077 0.263061 0.821105 0.001388 2.47E-10 1.084167
Input 2:Capital
Output: Interest Income
Input 1:Number of Offices 0.965092768 -0.38279 1.386763 0.004461 4.74E-10 1.003974
Input 2:Employee
Output: Advances
Input 1:Number of Offices 0.961543406 0.312397 0.807114 0.000829 1.97E-09 1.119511
Input 2:Capital
Output: Deposits
Input 1:Employee 0.961159734 0.368085 0.651488 0.005905 4.76E-05 1.019573
Input 2:Capital
Output: Sum of Advances &
Deposits
Input 1:Number of Offices 0.951395799 -0.24382 1.249514 0.092841 2.65E-08 1.005693
Input 2:Employee
Output: Sum of Advances
&Deposits
Input 1:Number of Offices 0.957389468 0.333219 0.746038 0.000509 8.01E-09 1.079257
Input 2:Capital
Output: Deposits
Input 1:Number of Offices 0.949894537 0.351464 0.699719 0.000514 4.81E-08 1.051183
Input 2:Capital

Regression models tested for Foreign Banks in India (2008-09 data)

P P-value
Case R Square α Β -value(α) (β)
α+β

Output: Interest Income

Input 1:Employee 0.961655 0.34782 0.89997 2.55E-03 9.08E-09 1.2478
Input 2:Capital
Output: Sum of Advances
& Deposits
0.936269 0.49812 0.71244 2.64E-05 0.000826 1.210571
Input 1:Employee
Input 2:Capita
Output: Advances
Input 1:Employee 0.818368 0.48986 0.80667 6.30E-02 0.003882 1.29654
Input 2:Capital
Output: Deposits
Input 1:No: of Off 0.936389 0.63753 0.58157 6.05E-05 1.80E-04 1.219109
Input 2:Employee

Selection of models which fitted best with the input and output data

Out of the models which showed significant results, we selected the two best
models based on R square value, Multiple Regression coefficient, t-stat and p-
values.

The following are the best two models selected:

Model No Input 1 Input 2 Output
1 No. of Employees Capital Interest Income
2 No. of Employees Capital Sum of Advances and Deposits

These selected combinations are then used to determine the returns to scale
for the banking industry by regressing data for all 5 years from 2004-05 till
2008-09. This same process is done separately for both Foreign and Domestic
Private Banks.

Production Output for Indian Domestic Private Banks –

The Production Functions using the two models are plotted. The actual
values, along with their estimated values are plotted alongside to get a feel
of the closeness of regression fit performed. This is important, since the high
R square value may not always be a sufficient condition for a good model.
Production Output for Foreign Banks in India -

Calculation of Returns to Scale

A regression analysis was done on the two best models selected above for
2004-05 till 2008-09. The returns to scale (α+β) is plotted as shown in the
graphs below –

Model 1: We saw that the returns on scale for the banking industry for the
model (Output: Interest Income, Input: Capital and employees) showed a
value greater than 1 in all the 5 years we studied (2004-09)

Model 2: The second model (Output: Sum of Advances and Deposits, Input:
Capital and Employees) also showed a value greater than 1 in all the 5 years
we studied (2004-09)

DATA ANALYSIS AND INTREPRETATIONS

Interest plot in the figure stands for Model 1(Output is Interest Income)
SAD plot in the figure stands for Model 2 (Output is Sum of Advances and
Deposits)

Indian Domestic Banks –

SAD is the sum of advances a bank makes to outside entities and deposits
that it receives from its customers. Interest income is the revenue it
generates on advances minus the money it gives on the deposits. RBI uses
CRR and SLR as tools to tackle inflation and to spur growth in the economy.
An increase in SLR or CRR effectively reduces the amount that a bank can
lend as advance which in turn will reduce its interest income. A decrease in
the base rate to spur growth also has a tendency to reduce the interest
income.

The plot of private banks can be interpreted using the above logic. During
2004 – 2005, the interest rates might be decreasing and hence we are seeing
a dip in the graphs. When there has been sufficient liquidity created in the
market, RBI might have started increasing the interest rates to curb excess
liquidity and bring down inflation. Since the interest rates are high, the banks
might see an increase in their volume of business as well as their income. So,
in a year of low base rate, the net amount generated as interest on the
capital employed decreases and when the base rate increases, the net
interest earned increases on the same amount of capital. The sharp dip in the
SAD and interest income in 2008-09 is consistent with the financial crisis of
2008. The banks did not have enough capital resources to lend and hence the
sharp decline in both SAD and interest income.

The Central Government is one of the most prolific money takers from the
market. Increase in Government borrowings from the market results into an
increase in bond rates. Because of General elections in May 2004, the
government had to halt its social sector schemes, which probably would
result into a decrease in bond rates. This decrease in yield rate perhaps could
be one of the many reasons why interest income for the year 2004-05
decreased for the Indian private banks. The same reasoning doesn’t apply to
foreign banks since they are not much dependent on the Indian government
borrowings. Based on this reasoning, we do not see a dip in the graph of the
foreign banks.

The above graphs are consistent in that they in proportion to the actual base
rates of RBI in the period 2004 to 2009. The central bank overnight rate in
2004 was around 4.5%; it increased in the period during 2007 – 2008 to 6%
and decreased to around 3.25% in 2009.

Foreign Banks in India –

During the first half of the 2000’s, the foreign banks started to establish
themselves and tried to improve their foothold in India, hence (alpha +
beta ) may be less than 1 during the initial phase as captured by the graph.
Since the foreign banks base inputs were low, they could expand their
operations rapidly. Hence we see the slope increasing at a faster rate.
During the worldwide recession, all the banks were hit and we could
see a dip in the graph around 2007 – 2008. Once the economies started
recovering, the parent companies of these foreign subsidiaries might have
hesitated to invest in already volatile developed markets and instead
concentrated on investing in the emerging markets. The Indian foreign banks
thus had larger access to lending capital. Hence we could see an increase in
the returns of scale of foreign banks even when many private Indian banks
saw a decline in the corresponding period.

RETURNS ON SCALE BASED ON SEGMENTATION OF BANKING

INDUSTRY

After the calculation of return on scale for the industry, we investigated the
possibility of finding the returns to scale for small banks, medium sized banks
and large banks. We conjectured that the returns of scale would be less for
small sized banks when compared to the industry average and the large
sized banks.

Criteria for Industry Segmentation

We took a reasonable assumption that the size of the bank depends upon the
capital that a bank has. The criterion is as given below:

Small sized Banks: Capital < 1000 crores

Mid-sized Banks: 1000 crores < Capital < 5000 crores
Large Banks: Capital > 5000 crores.

We also thought of segmenting the banks based on their Market

capitalization (used by BSE, NSE to classify banks). But since market
capitalization is not related to the full capital available with the banks, we
decided to classify banks on the basis of Capital with the assumption made
above

Results of Regression based on segmented banks

We regressed the data on small, medium and large banks on the two best
models described above for the year 2008-09. The regression was done
separately for these 3 categories of banks. But probably because of the lack
of adequate data, the results generated came out to be insignificant (p value
> 0.05) for all models except one model on ‘Small Sized Banks’ mentioned
below.

For Small sized Banks, the following model gave significant results.

Input R Square Alpha Beta

Input 1 2 Output Value (Input 1) (Input 2)
Employ Capita
ee l Interest 0.954543 0.26 0.66

Significance of this result:

The (α+β) value of this model comes out to be 0.92 which is less than the
industry average of 1.06 for the year 2008-09. This result is significant
because it shows that the returns of scale for small sized banks are less than
the industry average. This result is consistent with the widely held belief that
large banks enjoy operating scale advantages over small banks. We expected
the (α+β) value for large sized banks to be greater than the industry average
but could not validate it because the available data could not fit into the
model for large banks. Segmentation of banks resulted into the large bank
category not having enough data for regression and thus could not fit into the
model.

LIMITATIONS OF THE METHODOLOGY ADOPTED

The estimation methodology employed may have some limitations, apart

from those of the Cobb-Douglas production function. Some of them are
elucidated as below -

• There can be several input parameters. The Cobb-Douglas function

restricts us to use only two of them as inputs at a time. Similarly, there
are several parameters which can be considered as the output but the
Cobb-Douglas function restricts us to use only one. In that sense, the
production function thus determined is not comprehensive and is not
an accurate representation of the production function of the industry.
• The assumption ‘Ceteris Paribus’ (i.e. all other things being constant)
is not true in strict sense because other parameters like technology
keep on changing with time.

• We assume that α < 1 and β < 1, so that the firm has decreasing
marginal products of inputs which might not be necessarily true.

• There are extraneous variables which are neither input nor output but
may have an influence on output like the prevailing macroeconomic
conditions.

• We have not considered other production estimation methods like

“Olley/Pakes” and “Levinshon/Pertin” functions to derive the
production function.
• We have not factored any smoothing techniques in the regression
model.
• The monetary figures have been taken on nominal terms which do not
take inflation into account.
• We took data from a sample of 21 banks for our regression analysis.
Although we tried to take the sample from all categories of banks
(Small, Mid-Sized, Large), it is possible that the representation of banks
was not uniform.
COMPARISON BETWEEN FOREIGN AND DOMESTIC PRIVATE BANKS

• Private banks have low Rural and Small city Penetration. This is almost
nil in case of Foreign banks.
• Foreign banks are striving to increase business by technological
advances and use of value added services to win over clients in metros.
Domestic Private Banks are expanding reach in tier-2 and smaller cities.
• Foreign banks have higher growth rate than other banks due to rapid
expansion and M&A activities (increase in buying old and new foreign
banks in recent past) and also due to favorable government and central
bank policies.
• Consolidation is going on everywhere in the sector: example mergers
such as ICICI-BoR, HDFC-CBoP, etc.

CONCLUSION
The project focused on defining production function for Private (domestic and
foreign) Banks in India. We used capital, employees, number of offices and
Summation of Capital and Deposits as inputs whereas Interest Income,
Summation of Advances and Deposits, Advances and Deposits were taken as
outputs. Regression results showed a weak linkage for the input variables
‘No. of offices’ and ‘Summation of Capital and Deposits’ with the four outputs.
Out of the 4 outputs, we found that ‘Summation of Advances and Deposits’
and ‘Interest Income’ represent the production function of banks in the best
way. The project indicates that there are increasing returns of scale for
private banks, especially foreign banks as a trend. This is expected to
continue with the current Macroeconomic Environment and new government
Policy Framework.

Future Scope of Analysis -

• Examination of the production functions of banks in metro and non-
metro/rural areas to check profitability of operations in these areas.
• We can take yearly data instead of Cumulative Data for Loans and
Advances.
• Using some other model of Production function, apart from Cobb-
Douglas.
• Using inputs such as business done per employee or capital employed
per employee.

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