The relationship between bank efficiency

and stock returns: evidence

from Asia and Latin America

Christos Ioannidis
1
, Philip Molyneux
2
, Fotios Pasiouras
1*


1
School of Management, University of Bath, UK
2
Bangor Business School, Bangor University, UK

University of Bath
School of Management, Working Paper Series
2008.10






















This working paper is produced for discussion purposes only. The papers are expected to be
published in due course, in revised form and should not be quoted without the authors
permission.

*
Copyright: The Authors, November 2008. Author for correspondence, Tel: +44 (0) 1225 384297; Emails:
C.Ioannidis@bath.ac.uk , p.molyneux@bangor.ac.uk , f.pasiouras@bath.ac.uk
2
University of Bath School of Management
Working Paper Series

School of Management
Claverton Down
Bath
BA2 7AY
United Kingdom
Tel: +44 1225 826742
Fax: +44 1225 826473
http://www.bath.ac.uk/management/research/papers.htm

2008
2008.01 Ana Lozano-Vivas
& Fotios Pasiouras
The impact of non-traditional activities on the
estimation of bank efficiency: international
evidence
2008.02 G.C. Parry, M.
James-Moore, A.P.
Graves and O.
Altinok
Legal aspects of electronic signatures
2008.03 Glenn Parry,
Andrew Graves &
Mike James-Moore
Lean New Product Introduction: a UK
Aerospace Perspective
2008.04 G. C. Parry, A. J.
Towler & A. Graves
Travel Policy: a case study to deliver cost
savings to MOD business air travel
2008.05 Glenn Parry A theoretical approach to construction project
progress drawing on complexity and
metaphysics
2008.06 Manthos D. Delis,
Philip Molyneux &
Fotios Pasiouras
Regulations and productivity growth in banking
2008.07

Richard John
Fairchild


The Airbus-Boeing Launch Aid Dispute-
a Game-theoretic Analysis.

2008.08 Philip Cooper,
Laurence
Etherington, Stuart
Bell, Andrew
Farmer & Julian
Williams

Socio-Economic Scenarios of European
Development and Integrated Management of the
Marine Environment

3

2008.09

Maria-Eleni K.
Agoraki , Manthos
D. Delis &Fotios
Pasiouras



Regulations, competition and bank risk-taking in
transition countries


2008.10

Christos Ioannidis,
Philip Molyneux &
Fotios Pasiouras


The relationship between bank efficiency
and stock returns: evidence
from Asia and Latin America

































4





The relationship between bank efficiency and stock returns: evidence
from Asia and Latin America


Christos Ioannidis
1
, Philip Molyneux
2
, Fotios Pasiouras
1*


1
School of Management, University of Bath, UK
2
Bangor Business School, Bangor University, UK

Abstract
This paper examines the relationship between bank efficiency change and stock price
returns. We first estimate the cost and profit efficiency of a sample of Asian and Latin
American listed banks over the period 2000-2006 while controlling for cross-country
differences such as regulations and the macroeconomic environment. We then regress
the annual efficiency changes on stock returns. The results indicate a positive and
robust relationship between profit efficiency changes and stock returns. However, we
find no evidence that cost efficiency changes are reflected in stock returns. We also
find that profit efficiency better explains bank stock returns compared to traditional
accounting profits measures (ROE). Overall, we conclude that profit efficiency
measures include useful information for shareholders wishing to explain bank stock
returns.

Keywords: Asia, Banking, Efficiency, Latin America, Stock returns





*
Copyright: The Authors, November 2008. Author for correspondence, Tel: +44 (0) 1225 384297;
Emails: C.Ioannidis@bath.ac.uk , p.molyneux@bangor.ac.uk , f.pasiouras@bath.ac.uk
5
1. Introduction
Over the last forty years, the relationship between stock returns and publicly available
information has attracted considerable attention in the accounting and finance
literature. Starting with the seminal work of Ball and Brown (1968) these studies find
that earnings reflect some of the information in stock prices, however, this constitutes
only a small proportion of price movements (Kothari, 2001; Chen and Zhang, 2007).
The present study examines the relationship between efficiency change and
stock returns in 19 Asian and Latin American banking sectors. The motivation for our
study is twofold. First, as Chen and Zhang (2007) highlight, the majority of the
existing studies on accounting information and stock returns focus on earnings which
are applicable only under special economic settings and fail to consider the role of
balance sheet data (Patel, 1989). It is therefore not surprising that recent research has
shifted towards the use of additional data such as accruals (e.g. Sloan, 1996; DeFond
and Park, 2001), revenues (e.g. Jegadeesh and Linvat, 2006), economic value added
(Biddle et al., 1997) and efficiency (Alam and Sickles, 1998), to understand how they
affect stock prices and returns
1
. Kothari (2001) points out that, overall, the results
from such studies indicate that performance measures that have evolved voluntarily in
an unregulated environment are more likely to be incrementally informative than
those mandated by regulation. The efficiency measures used in the present study
fulfill the aforementioned criteria and have several advantages over traditional
accounting ratios as performance measures, and have also been shown in the past to
better explain stock returns
2
.

1
Sloan (1996), and DeFond and Park (2001) examine the price impact and profitability of trading
strategies based on total accruals and discretionary accruals and reveal that financial statement
information beyond earnings has significant value implications. Jegadeesh and Linvat (2006) show that
stock price reactions to earnings announcement data is significantly related to contemporaneous as well
as past revenue surprises. Alam and Sickles (1998) examine the U.S. airline industry and report a
significant positive relationship between stock market returns and changes in technical efficiency. In
contrast, Biddle et al. (1997) examine whether economic value added (EVA) performance measures
correlates more highly with stock returns and prices than historical cost accounting earnings and find
that earnings generally outperform EVA.
2
Berger and Humphrey (1997) and Bauer et al. (1998) emphasise that efficient frontier approaches
seem to be superior compared to the use of traditional financial ratios. Thanassoulis et al. (1996) point
out that the advantage of efficiency frontier techniques is that they take into account simultaneously all
inputs and all outputs of a firm, in contrast to ratios where one input (e.g. total assets) is related to one
output (e.g. profits) each time. In a similar manner, Berger and Humphrey (1997) argue that frontier
approaches offer an overall objective numerical score and ranking, an efficiency proxy to comply with
the economic optimization mechanism. Beccalli et al. (2006) find that a model that includes efficiency
estimates obtained through data envelopment analysis explains a much higher variability in stock prices
than a model developed with traditional accounting ratios.
6
Second, Cooper et al. (2003) and Beccalli et al. (2006) point out that the
literature on accounting information and stock returns typically excludes banking
institutions due to their high leverage and other distinguishing characteristics of the
industry (e.g. regulations). In an attempt to close this gap, studies from the banking
literature have recently investigated the relationship between bank efficiency, and
stock returns
3
. However, despite the substantial number of studies on bank efficiency,
this specific strand of the literature remains rather limited with only a handful of
country-specific studies covering Australia (Kirkwood and Nahm, 2006), Greece
(Pasiouras et al., 2008a), Malaysia (Sufian and Majid, 2006), Spain (Adenso-Diaz and
Gascon, 1997), Singapore (Chu and Lim, 1998; Sufian and Majid, 2007), and the US
(Eisnbeis et al., 1999). Furthermore, in a cross-country setting, Beccalli et al. (2006)
provide evidence from the five principal banking sectors (i.e. France, Germany, Italy,
Spain, UK), Liadaki and Gaganis (2008) investigate the EU-15, while Fernandez et al.
(2002) examine fifteen countries from the European economic area as well as US,
Canada, and Japan. Generally, these studies (that typically focus on developed
banking systems) indicate that efficiency measures derived from various frontier
estimation procedures are related to bank stock price performance.
The aim of this paper is to extend the aforementioned literature by drawing on
a sample across 19 developed and developing Asian and Latin American countries,
the majority of which have not been examined in the past. As Myring (2006) points
out, differences in the environment such as the quality of accounting standards (Ali
and Hwang, 2000), the relative importance of a countrys equity market to the
economy, macro corporate governance mechanisms (Ball et al., 2000) and the
availability of earnigns forecast may impact the performance-returns relation.
Therefore, we evaluate the bank returns efficiency relationship by estimating a
common frontier while accounting for environmental differences across countries. As
such, we avoid the limitations of using a small sample, a drawback that is common to
the three earlier studies that provide country-specific evidence from emerging
markets
4
. Another important aspect of our study is that we examine both cost and

3
In addition to the bank efficiency-stock return studies, Cooper et al. (2003) examine the predictability
in the cross-section of bank stock returns using information contained in individual variables such as
income from derivative usage, previous loan commitments, interest raw swap activity, loan-loss
reserve, earnings and leverage.
4
Chu and Lim (1998) and Sufian and Majid (2007) examine 6 Singaporean banks over 1992-1996, and
1993-2003 respectively. Sufian and Majid (2006) examine 9 Malaysian banks over 2002-2003.
7
profit efficiency in contrast to most of the previous studies that focus on the
relationship between technical and/or cost efficiency and stock returns
5,6
. Profit
efficiency is a wider concept as it combines both costs and revenues in the
measurement of efficiency and as Maudos et al. (2002) argue it provides a more
important source of information than the partial view offered by analyzing cost
efficiency. Furthermore, from a shareholders perspective, we would expect
shareholders to be more sensitive to the profits of a bank rather than its costs, because
the dividends that they receive depend on the banks earning. Thus, profit efficiency
changes may be reflected better in stock returns, compared to other measures such as
cost and technical efficiency changes.
The rest of the paper is structured as follows. Section 2 presents the data and
methodology. Section 3 discusses the empirical results and section 4 concludes the
study.

2. Data and Methodology
2.1. Data
Our starting point consisted of the population of commercial banks and bank holding
companies that are listed on the stock exchanges of Asia and Latin America, and
appear in the Bankscope database
7
. After excluding banks due to: (i) missing or zero
values for inputs/outputs, and (ii) missing values in the case of the country-specific
control variables, we obtained a sample of 260 banks operating in 19 countries
between 2000 and 2006. The dataset is unbalanced and consists of 1,629 yearly
observations. Table 1 presents the distribution of the sample by year and country.

Obviously, both the efficiency estimates and the second stage regressions could be influenced by the
small number of observations.
5
Technical efficiency (TE) indicates whether a bank uses the minimum quantity of inputs to produce
given quantity of outputs. Allocative efficiency (AE) refers to the ability of a bank to use the optimum
mix of inputs given their respective prices. Cost efficiency, which is the product of TE and AE, shows
the ability of a bank to provide services without wasting resources as a result of technical or allocative
efficiency.
6
Chu and Lim (1998) in Singapore, Sufian and Majid (2006) in Malaysia, and Pasiouras et al. (2008a)
in Greece estimate profit-oriented measures of efficiency by defining expenses as inputs and profits as
outcomes. However, these studies do not use information on input and/or output prices which are
required for the estimation of cost and profit efficiency (Coelli et al., 2005). Thus, one can relatively
easily argue that these studies focus on technical efficiency from a different perspective rather than
profit efficiency. One study that actually examines profit efficiency is the one of Kirkwood and Nahm
(2006) in Australia. Finally, Liadaki and Gaganis (2008) examine the relationship between cost and
profit efficiency and stock returns in the EU-15.
7
Information on whether banks were listed or not on a stock exchange was also obtained by
Bankscope.
8
[Insert Table 1 Around Here]

We collected information from various sources. Bank-specific data were obtained
from Bankscope database of Bureau van Dijk and were converted to US dollars. As in
Altunbas et al. (2001) and Lozano-Vivas and Pasiouras (2008) among others, we
express the data in real terms using country GDP deflators. Information on bank
regulations and supervision was obtained by the World Bank (WB) database
developed by Barth et al. (2001) and updated by Barth et al. (2006, 2007)
8
. Data for
concentration were collected from the updated version of the WB database on
financial development and structure (Beck et al., 2006b). Data for the macroeconomic
conditions and financial development indicators were obtained from the Global
Market Information Database (GMID). The International Monetary Fund (IMF) list
served as the basis for classifying countries into developed and developing.

2.2. Methodology
2.2.1. Efficiency estimates
We use the Battese and Coelli (1995) model that allows the estimation of efficiency in
a single stage, while controlling for cross-country differences. In its general form, the
cost model can be written as follows:

t i t i t i t i t i
v u p q C C
, , , , ,
) ; , ( ln + + = , ; ,..., 2 , 1 N i = T t ,..., 2 , 1 = (1)

where:
t i
C
,
is the total cost of bank i at time t;
t i
q
,
is a vector of outputs;
t i
p
,
denotes a
vector of values of input prices associated with a suitable functional form; is a
vector of unknown scalar parameters to be estimated; s v
t i,
are random errors,

8
This WB database is available for only three points in time. Version I was released in 2001 and has
information for 117 countries (Barth et al., 2001b). For most of the countries, information corresponds
to 1999, while for others information is either from 1998 or 2000. Version II describes the regulatory
environment at the end of 2002 in 152 countries (Barth et al., 2006). Version III describes the situation
in 142 countries in 2005/06 (Barth et al., 2007). Consequently, we had to work under the assumption
that the scores of our regulatory variables remain constant within short windows of time. More
precisely, we used information from Version I for bank observations from the period 1999-2000, from
Version II for bank observations from the period 2001-2003, and from Version III for bank
observations from 2004-2006. Other studies that have used this database across a number of years have
obviously worked under a similar assumption (e.g. Demirguc-Kunt and Detragiache, 2002; Demirguck-
Kunt et al., 2004; Fernandez and Gonzalez, 2005; Beck et al., 2006c; Pasiouras et al., 2008b; Lozano-
Vivas and Pasiouras, 2008).
9
assumed to be i.i.d. and have ) , 0 (
2
v
N ; s u
t i,
are the non-negative inefficiency effects
in the model which are assumed to be independently (but not identically) distributed,
such that
t i
u
,
is obtained by truncation (at zero) of the ) , (
2
, u t i
m N distribution where
the mean is defined by:

t i t i
z m
, ,
= (2)

where
t i
z
,
is a ) 1 ( xM vector of observable explanatory variables that influence the
inefficiency of bank i at time t; and is an ) 1 (Mx vector of coefficients to be
estimated (which would generally be expected to include an intercept parameter). The
parameters of equations (1) and (2) are estimated in one-step using maximum
likelihood
9
.
The specification of the profit frontier model is the same as that of the cost
frontier (equation (1)) with profit before tax (PBT) replacing total costs as the
dependent variable. However, the sign of the inefficiency term now becomes negative
(-u
it
). Thus, as in most previous studies, we estimate an alternative profit frontier,
which ignores output prices
10
. Furthermore, since a number of banks in the sample
exhibit negative profits (i.e. losses), the dependent variable in the profit model is
transformed to ( ) ( ) 1 ln
min
+ + PBT PBT , where
min
) (PBT is the minimum absolute
value of PBT over all banks in the sample.
For the selection of the inputs and outputs, we follow the intermediation
approach. We use three outputs namely loans (Q1), other earning assets (Q2), and
non-interest income (Q3), and two input prices that account for the cost of borrowed
funds (W1), and the cost of non-financial inputs (W2)
11
. A time trend (T=1 for 2000,

9
See Battese and Coelli (1995) and Coelli et al. (2005), for further details.
10
Berger and Mester (1997) argue that alternative profit efficiency may provide useful information and
be preferred when one or more of the following conditions are applicable: (a) there are substantial
unmeasured differences in the quality of banking services; (b) outputs are not completely variable; (c)
output markets are not perfectly competitive; (d) output prices are not accurately measured. Based on
these arguments, Kasman and Yildirim (2006) point out that in international comparisons with a
diverse group of countries and competition levels it seems more appropriate to estimate an alternative
rather than a standard profit function. Furthermore, DeYoung and Hasan (1998) point out that output
quantities tend to vary across banks to a greater extent than output prices, thus explaining a larger
portion of the variation in profits in regression analysis.
11
Non-interest income is used as an output to account for the fact that a large proportion of total income
is generated by off-balance-sheet and other non-traditional activities. The cost of borrowed funds is
calculated as the ratio of interest expenses to total deposits. The cost of non-financial inputs is
calculated as non-interest expenses to total assets. Ideally, we would include three input prices, one for
labour (e.g. personnel expenses to total), one for borrowed funds (interest expenses to deposits) and
10
T=2 for 2001,, T=7 for 2006) is included in the function to account for changes in
technology over time. As in Lensink et al. (2008) the trend is included with both T
and T
2
terms. Following Berger and Mester (1997) among others, we specify equity as
a fixed input to control for differences in bank capitalization. We impose linear
homogeneity restrictions by normalizing the dependent variables and input prices by
the second input price W2
.
Using the multi-product translog specification gives our
empirical cost frontier model as follows
12
:


( ) ( ) ( ) ( ) ( ) ( )
t i t i
v u
T EQ T
W
W
T Q T Q T Q T T
W
W
E Q E Q E Q E EQ
EQ
W
W
Q
W
W
Q
W
W
Q
W
W
Q Q Q Q Q Q Q Q
Q
W
W
Q Q Q
W
TC
, ,
27 26 25 24 23
2
22 21
20 19 18 17
2
16
15 14 13 12
2
11
2
10 9
2
8 7 6
2
5 4 3 2 1 0
) ln(
2
1
ln ) 3 ln( ) 2 ln( ) 1 ln(
2
1
ln ln 3 ln ) ln( 2 ln ) ln( 1 ln ) ln( ln
2
1
) ln(
2
1
ln ) 3 ln(
2
1
ln ) 2 ln(
2
1
ln ) 1 ln(
2
1
ln
2
1
)) 3 (ln(
2
1
) 3 ln( ) 2 ln( )) 2 (ln(
2
1
) 3 ln( ) 1 ln( ) 2 ln( ) 1 ln(
)) 1 (ln(
2
1
2
1
ln ) 3 ln( ) 2 ln( ) 1 ln(
2
ln
+ +
+

+ + + + + +

+ + + +
+ +

+
+ + + + +
+

+ + + + =





(3)

To control for cross-country differences and bank-specific risk we define
it
m in
Equation (2) as:

JAPAN DEVEL CLAIMS GDPGR INF
CONC ACTRS MDISCIP OFFPR CAPITRQ LLR m
it
11 10 9 8 7
6 5 4 3 2 1 0


+ + + + +
+ + + + + + =
(4)

Where LLR is calculated as loan loss reserves to gross loans and controls for bank-
risk. CAPITRQ, OFFPR, MDISCIP and RESTR are variables that control for the main

one for physical capital (non-interest expenses other than personnel expenses to fixed assets) as in most
previous studies. However, due to missing values for more than 500 observations in the case of
personnel expenses, we restricted our analysis to the two input prices discussed above. Our approach is
similar to the one of Hasan and Marton (2003), Bonin et al. (2005a,b), Fries and Taci (2005),
Staikouras et al. (2008), Berger et al. (2009).
12
For brevity of space, we present only the cost function here. As mentioned before, for the estimation
of profit efficiency, we replace total costs by profit before taxes, and change the sign of the inefficiency
term (-u
it
).
11
regulatory conditions in the various banking sectors
13
. CAPITRQ is a measure of
capital requirements that accounts for both initial and overall capital stringency
14
.
OFFPR is a measure of the power of the supervisory agencies indicating the extent to
which they can take specific actions against bank management and directors,
shareholders, and bank auditors. MDISCIP is an indicator of market discipline and
shows the degree to which banks are forced to disclose accurate information to the
public and whether there are incentives to increase market discipline. RESTR is a
proxy for the level of restrictions on banks activities. It is determined by considering
whether securities, insurance, real estate activities, and ownership of non-financial
firms are unrestricted, permitted, restricted, or prohibited. CONC is the concentration
in the banking sector, as measured by the proportion of total assets held by the three
largest banks in the country. INF is the annual rate of inflation and GDPGR is the real
GDP growth, both capturing macroeconomic conditions. CLAIMS measures the
activity in the banking sector and it is calculated by dividing bank claims to the
private sector with GDP. DEVEL is as a dummy variable that takes the value of one
for developed countries and zero for developing countries. Finally, JAPAN is as a
dummy variable that takes the value of one for Japan and zero for other countries
15
.
The individual bank (in)efficiency scores are calculated from the estimated
frontiers as CE
kt
= exp(u
i
) and PEF
kt
= exp(-u
i
), the former taking a value between one

13
Recent studies that have used these variables in the efficiency and productivity literature include
Pasiouras (2008), Pasiouras et al. (2008b), Delis et al. (2008), and Lozano-Vivas and Pasiouras (2008).
14
For the construction of CAPITRQ, OFFPR, and MDISCIP, we use the summation of the 0/1
quantified answers as in Gonzalez and Fernandez (2005), Barth et al. (2001b, 2004b, 2007), Pasiouras
et al. (2006, 2008b), Pasiouras (2008), Fonseca and Gonzalez (2008), Lozano-Vivas and Pasiouras
(2008), Delis et al. (2008). An alternative would be to use the principal component as in Beck et al.
(2006a). Barth et al. (2004a) have followed both approaches. They mention that on the one hand the
drawback of using the summation for the construction of the index is that it assigns equal weight to
each of the questions whereas on the other hand the disadvantage of the first principal component is
that it is less transparent how a change in the response to a question changes the index. While they only
report the empirical reports using the principal component indexes, they mention that we have
confirmed all this papers conclusions using both methods (p. 218), implying that there are no
differences in the results. Further information on the calculation of these variables is available in the
Appendix.
15
We include this dummy variable in the analysis in an attempt to capture any distinguishing
characteristics of the Japanese banking sector and account somehow for the large number of Japanese
banks in our sample. For instance, Japan is the worlds second-biggest economy and a highly advanced
developed country with a large financial market. It is also being considered as the largest bank-based
economy (Liu and Tone, 2008) and more than 100 Japanese banks are constantly being listed in the
1,000 largest world banks accounting for 10% of the Top 1000 Tier 1 capital and total assets in 2007
(The Banker, 2004, 2007). However, at the same time, Japans banking industry was one of the most
distressed in the region in recent years and has been subject to significant restructuring. After several
years of poor performance, Japanese banks recorded profits in 2004, however their average return of
capital (5.2% in 2004 for the 113 banks included in the world top 1,000) was well below the Asian
(12.1%) and Latin American (23.9%) corresponding figures (The Banker, 2004).
12
and infinity and the latter between zero and one. In both cases, scores closer to 1
indicate higher efficiency. To make our results comparable, we calculate the index of
cost efficiency as follows: CEF
kt
= 1/ CE
kt
. Hence, both cost and profit efficiency
scores take values between 0 and 1 with values closer to 1 indicating a higher level of
efficiency.

2.2.2. Efficiency change and stock returns
To test whether cost and profit efficiency changes are incorporated into stock
valuation and they subsequently result in higher returns for the banks shareholders,
we undertake the estimation of the simple linear model:

( ) ( )

+ + + =
J
j
K
k
t i t i k t i j t i
h prf d cf d m r
, , , 0 ,
12
t i i t i
h
, ,
+ = (5)


Where
,
12
i t
r m denotes the annual returns of bank (i) over the time period
16
(t).
Changes in cost efficiency per bank over the same period are given by
,
( )
i t
d cf ( d is
the first difference operator), and profit efficiency changes are shown as
,
( )
i t
d prf .
The stochastic component
t i
h
,
contains the unobserved bank specific effect
( )

, 0 ~ IID
i
that is assumed to be time invariant and the idiosyncratic
disturbance ( )

, 0 ~
,
IID
t i
.
The role of the bank-specific stochastic component in the error structure
cannot be determined a-priori; it will be established depending on the method of
estimation. Allowing for unknown correlation between this component and the
regressor requires the estimation of such parameter; to obtain consistent estimates of
the parameter vector ( , )
j k
, this is normally referred as fixed effects estimation.
Alternatively the assumption of zero correlation between the firm-specific unobserved
element and the regressor reduces the number of parameters to be estimated thus

16
We use a 12-months window that covers the same period as the fiscal year. As in Chu and Lim
(1998) we use stock prices from the first and the last day of the window that we examine, and calculate
the returns as [(P
t
-P
t-1
)/P
t-1
]. Stock prices have been adjusted based on the stock split/dividend ratio and
as other bank-level data are expressed in real terms using GDP deflators.

13
increasing the efficiency of the estimated coefficients; in this case the appropriate
method is what is known as random effects.
By and large, inference in this context requires robust estimators of the
variance matrix as the usual least squares estimators rely heavily on the very strong
assumptions of time invariance and independence of the conditional variances of both
error components and zero conditional co-variances. To establish the appropriate
estimation method the test statistic proposed by Hausman (1978) is used. Under the
null hypothesis both fixed and random effects estimators are consistent with the
random effect being the efficient choice. Under the alternative the fixed effects is
inefficient but it remains consistent whilst the random effects estimator becomes
inconsistent. Rejection of the null hypothesis advises against the use of the random
effects estimator.
If improvements in cost and profit efficiency are reflected in stock returns, we
expect that there will be a positive association between these changes and the
dependent variable. In addition, to establish whether the same variables carry
information that cannot be fully reflected in other published accounting data, we
incorporate in the model another variable that indicates financial performance, namely
the change in banks return on equity (ROE). By augmenting the previous model:
Under the null hypothesis that ROE incorporates all the relevant information and
therefore efficiency improvements do not convey independent information it is
expected that:
( ) ( )

+ + + + =
J
j
K
k
L
l
t i t i k t i k t i j t i
h roe d prf d cf d m r
, , , , 0 ,
) ( 12 (6)
0 ,
j k
j k = =

3. Results
3.1. Efficiency scores
Table 2 presents the cost and profit efficiency estimates by year and geographical
region. It is evident that there are marked differences in their evolution and range and
in addition between the groups of Asian banks on the one hand and Latin American in
the other.

14
[Insert Table 2 Around Here]

By and large, the measures of cost efficiency are far more predictable in all
cases as measured by the coefficient of variation (s.d/mean). This measure of
volatility does not exceed 10% in any case and shows remarkable stability over time.
In addition, the steady mean figures, in the region of 92% with similar median figures
(95%) indicate a near symmetric distribution. Both Asian and Latin American banks
exhibit very similar distributions as both the differences between the first and second
moments are not significantly different from zero, over the whole period of the
sample. From our sample, it appears that all the banks are performing very near the
limit of maximum cost efficiency implying that local managers are mindful of
expenses when allocating resources to the production of the banks different outputs.
Thus, the average bank in the sample should reduce its costs by only 7.24% to match
the best practice bank. The similarity between the means and standard deviations are
indicative of a common production technology that is present in the banking sector in
the region under study. The adoption of such technology may limit managerial
discretion in choosing a somewhat idiosyncratic combination of resources reflecting
individual preferences. The transmission of technology across countries for the
making of similar products is a well established consequence of globalisation and
from this, preliminary, assembled evidence it appears that this process is not limited
to manufacturing but it is also present in the production of financial products and
services.
Turning to the profit efficiency the average figure is equal to 0.7025 meaning
that the average bank in sample should improve its profits by 29.75% to match the
best practise bank. A correlation analysis of the cost and profit efficiency scores,
confirms the results of previous studies that these scores do not move in parallel as
one could expect
17
. One explanation is that the profitability of the bank depends both
upon the costs that are incurred in the production of the services and products and the
yield of the assets and liabilities that they manage. The management of assets and
liabilities is probably the most demanding task that the managing team is facing. Their

17
Our finding is consistent with Berger and Mester (1997), Rogers (1998), Pasiouras et al., (2008b). In
our case, the Pearsons coefficient is as low as 0.096. As in Rogers (1998), we also examine the
relationship between the rankings of the banks, rather than the efficiency scores. In this case, the
Spearmans coefficient is equal to 0.306, indicating that there are important differences in the ranking
of banks between these two measures of efficiency.
15
actions are limited by domestic regulatory practices and other institutional factors. It
is in this metric that the quality of managerial teams is distinguished and their
relative performance is judged by the shareholders whose judgement will be reflected
on the value of equity. In our sample, we observe significant differences between
banks from the two geographical blocks. The Asian banks exhibit profit efficiency at
least twice the level exhibited by Latin American banks. The mean efficiency score
for Asian banks is 0.75 and 0.35 for the Latin America banks. In addition to such
discrepancies at the mean, there is significant difference in the coefficient of variation.
Unlike the performance of cost efficiency where there is no significant difference
between the moments of the two distributions, in this case there is a marked increase
in the coefficient of variation in both distributions. Regarding profit efficiency, the
relevant magnitudes are at least twice as large compared to the cost efficiency
averaging 24% and 43% for Asian and Latin American banks respectively. Such
diversity of performance between the geographical blocks and between the banks may
be informative predictors of volatile series such as bank stock returns and so we
expect their inclusion will add significant value to the explanation of bank stock
return variation.

3.2. Regression results
Panel A in Table 3 presents the second stage regression results of the model discussed
in section 2. The exclusion restrictions 0
k l
= = were not rejected in either fixed or
random effects model the p-values of the test statistics being 0.11 and 0.12
respectively. The exclusion restriction regarding the contribution of the variable
denoting improvements in profit efficiency was decidedly rejected in both cases with
p-value equal to 0.0025.

[Insert Table 3 Around Here]

As our sample contains extreme return observations and these may exercise undue
influence on the estimated coefficients we reformulate the model by transforming the
dependent variable into binary values, assuming the value of 1 if
,
12 0
i t
r m > and zero
otherwise. The resulting logistic panel regression is therefore free form all scale
16
factors of the dependent variable and allows for robustness in the reported results. In
this case, we are examining whether changes in efficiency categorise the bank into
one belonging to a set of banks experiencing positive stock returns independently of
their size. The results of the logistic regression are shown in Panel B. As in the
previous specification, we established that profit efficiency improvements are
incorporated into stock returns and their information content makes a modest but
independent contribution that is not captured by changes of ROE.
To conclude, our results show that profit efficiency changes are reflected in
stock returns, although this is not the case for cost efficiency changes. These results
are consistent with the ones of Liadaki and Gaganis (2008) for the EU-15 banking
sector. One potential explanation is that rational shareholders are supposed to be
interested in their eventual wealth, which is the result of dividend payments and
capital gains
18
(Board and Day, 1989). Consequently, because dividends will be paid
on the basis of profits, stock returns are more sensitive to profits efficiency rather than
cost efficiency. Furthermore, while cost efficiency offers an indication as for the
capability of managers, it will not necessarily result in improvements in profits, as
these are subject to revenue efficiency as well. This is particularly important because
it is the capability in generating profits rather than solely managing costs that allows
companies to implement their strategies and grow.
As for our observation that profit efficiency appears to be more important than
traditional indicators of profitability (i.e. ROE) this can be potentially attributed to
quality of earnings and the persistency of earnings explanations. As Chan et al.
(2006) point out, there have been growing concerns about the quality of earnings, or
the extent to which reported earnings reflect operating fundamentals. Furthermore,
Nichols and Wahlen (2004) demonstrate that stock returns react more strongly to
changes in profits that are likely to recur than to changes likely to be transitory. As a
positive ) ( prf d indicates that the bank is capable of operating efficiently in terms of
generating profits there is an increased likelihood that it will continue to generate
earnings in the future. In addition, efficiency is an indicator of quality that may allow
banks to improve their profits, at least relative to competitors, even under adverse

18
Obviously, not all investors intend to keep the stocks in the long-term and benefit from dividend
payments. However, this group of investors will also have an interest on the stream of expected future
dividends since the stock price should reflect the present value of future dividends. Thus, positive
changes in the expectations about the dividends will result in positive stock price changes, allowing
them to earn profits on sale (Board and Day, 1989).
17
environmental circumstances. In other words, because profit efficiency changes take
into account input and output considerations simultaneously via economic
optimization mechanisms (we would argue) that they provide more information about
the quality and the persistency of earnings than changes in ROE. Furthermore,
Destefanis and Sena (2007) mentions that ratios such as ROE under-represent the
firms value because of the investment myopia problem, while this is not the case for
efficiency scores. Destefanis and Sena (2007) also note that if managers engage in
myopic behaviour, long-term investment should be expected to decrease resulting in
lower efficiency. Additionally, due to the separation between management and
ownership, managers may have incentives to invest in projects granting power and
prestige, but not resulting in an improvement in productivity (Shleifer and Vishny,
1997). Such behaviour is likely to be instantly reflected in a reduction in efficiency,
justifying the interest of shareholders in such indicators of performance (Destefanis
and Sena, 2007).


4. Conclusions
The relation between stock returns and publicly available information has traditionally
attracted the attention of researchers in accounting and finance. While the majority of
the literature focuses on earnings, some recent studies examine other firm attributes
such as accruals, revenue surprises, economic value added, and efficiency. Motivated
by the limited research in banking, the present study examines the relationship
between efficiency change and stock returns in 19 Asian and Latin American banking
sectors.
We first use the stochastic frontier analysis to obtain estimates on the cost and
profit efficiency of banks during 2000-2006, while accounting for environmental
differences. Then, we regress annual efficiency changes on annual stock returns. The
results indicate a positive and robust relationship between profit efficiency changes
and stock returns. However, we find no evidence that cost efficiency changes are
reflected in stock returns. Furthermore, we observe that the change in the return on
equity does not provide incremental information.
There are a number of potential explanations for these findings. First,
shareholders are interested in profits rather than costs due to the relationship of the
former with dividends that influences both the future dividend payments and
18
subsequent movements in stock prices. Second, it is likely that profit efficiency
measures are indicators of the quality of earnings and the persistency of earnings
while traditional profitability ratios are not. Finally, efficiency measures may be able
to provide information that is not biased by the investment myopia problem or agency
problems.

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24
Table 1 - Sample composition by year and country
2000 2001 2002 2003 2004 2005 2006 Total
Argentina 4 4 4 5 5 5 5 32
Brazil 6 6 6 7 7 7 7 46
Chile 4 4 4 4 4 4 4 28
China 10 10 10 10 10 10 10 70
Colombia 2 2 2 2 2 2 2 14
Hong Kong 9 10 10 10 10 10 9 68
India 4 24 21 23 25 22 25 144
Indonesia 19 20 20 21 21 21 18 140
Japan 84 88 91 92 92 95 95 637
Kazakhstan 2 2 2 2 2 2 2 14
Korea 4 7 9 9 9 11 11 60
Malaysia 8 8 11 10 11 13 9 70
Mexico 2 3 2 2 2 2 2 15
Pakistan 4 4 4 4 4 4 4 28
Peru 5 5 5 5 5 5 5 35
Philippines 11 11 11 11 9 9 9 71
Singapore 4 4 3 4 4 3 3 25
Thailand 13 13 13 13 13 13 13 91
Venezuela 5 6 6 6 6 6 6 41
Total 200 231 234 240 241 244 239 1,629

25
Table 2- Descriptive statistics of Cost and Profit efficiency estimates

Panel A: Cost efficiency 2000 2001 2002 2003 2004 2005 2006 2000-06
Latin America
Average 0.9054 0.9144 0.9125 0.9162 0.9255 0.9203 0.9082 0.9148
St.dev 0.0721 0.0540 0.0508 0.0509 0.0386 0.0399 0.0536 0.0517
Median 0.9327 0.9354 0.9209 0.9305 0.9334 0.9327 0.9286 0.9305
Min. 0.6482 0.7562 0.7698 0.7402 0.7975 0.8329 0.7416 0.6482
Max. 0.9774 0.9798 0.9763 0.9692 0.9732 0.9742 0.9684 0.9798
Coefficient of Variation 0.0796 0.0591 0.0556 0.0555 0.0417 0.0434 0.0591 0.0565
No. obs 28 30 29 31 31 31 31 211
Asia
Average 0.9349 0.9203 0.9253 0.9290 0.9359 0.9360 0.9255 0.9295
St.dev 0.0866 0.0894 0.0801 0.0744 0.0641 0.0435 0.0792 0.0749
Median 0.9543 0.9541 0.9517 0.9526 0.9525 0.9542 0.9541 0.9534
Min. 0.1163 0.0949 0.1419 0.2023 0.1941 0.7161 0.0804 0.0804
Max. 1.0000 1.0000 1.0000 1.0000 1.0000 0.9881 0.9837 1.0000
Coefficient of Variation 0.0926 0.0972 0.0865 0.0801 0.0685 0.0465 0.0855 0.0806
No. obs 172 201 205 209 210 213 208 1418
Total
Average 0.9307 0.9195 0.9237 0.9273 0.9345 0.9340 0.9233 0.9276
St.dev 0.0852 0.0856 0.0771 0.0719 0.0615 0.0433 0.0765 0.0725
Median 0.9522 0.9527 0.9506 0.9512 0.9505 0.9515 0.9522 0.9514
Min. 0.1163 0.0949 0.1419 0.2023 0.1941 0.7161 0.0804 0.0804
Max. 1.0000 1.0000 1.0000 1.0000 1.0000 0.9881 0.9837 1.0000
Coefficient of Variation 0.0915 0.0931 0.0834 0.0775 0.0658 0.0464 0.0828 0.0781
No. obs 200 231 234 240 241 244 239 1629
Panel B: Profit efficiency 2000 2001 2002 2003 2004 2005 2006 2000-06
Latin America
Average 0.2921 0.2979 0.3255 0.3720 0.4305 0.4259 0.4796 0.3768
St.dev 0.1038 0.1026 0.1235 0.1591 0.1785 0.1565 0.1943 0.1628
Median 0.2889 0.2854 0.3019 0.3417 0.4075 0.4388 0.4764 0.3429
Min. 0.0975 0.1352 0.1193 0.1330 0.1488 0.1461 0.1477 0.0975
Max. 0.5408 0.5055 0.5966 0.7263 0.7437 0.7348 0.8884 0.8884
Coefficient of Variation 0.3553 0.3444 0.3794 0.4279 0.4148 0.3674 0.4052 0.4320
No. obs 28 30 29 31 31 31 31 211
Asia
Average 0.7397 0.7356 0.7472 0.7512 0.7484 0.7585 0.7737 0.7510
St.dev 0.2017 0.1946 0.1932 0.1824 0.1864 0.1720 0.1682 0.1853
Median 0.8445 0.8222 0.8347 0.8149 0.8164 0.8320 0.8507 0.8302
Min. 0.0924 0.1260 0.0000 0.1151 0.0417 0.1900 0.2040 0.0000
Max. 0.9614 0.9608 0.9823 0.9734 0.9709 0.9705 0.9658 0.9823
Coefficient of Variation 0.2727 0.2646 0.2585 0.2429 0.2490 0.2267 0.2174 0.2467
No. obs 172 201 205 209 210 213 208 1418
Total
Average 0.6770 0.6788 0.6950 0.7022 0.7075 0.7163 0.7355 0.7025
St.dev 0.2463 0.2367 0.2321 0.2200 0.2135 0.2028 0.1979 0.2216
Median 0.7365 0.7430 0.7601 0.7669 0.7731 0.7718 0.8228 0.7702
Min. 0.0924 0.1260 0.0000 0.1151 0.0417 0.1461 0.1477 0.0000
Max. 0.9614 0.9608 0.9823 0.9734 0.9709 0.9705 0.9658 0.9823
Coefficient of Variation 0.3638 0.3487 0.3340 0.3133 0.3018 0.2832 0.2690 0.3154
No. obs 200 231 234 240 241 244 239 1629

26
Table 3 Regression results

Panel A: Linear Regression (Dependent Variable = Bank stock return over twelve months,
,
12
i t
r m )
Fixed Effects Random Effects Random Effects Fixed Effects
d(cf) 0.00359 (0.997) 0.643 (1.07) - -
d(prf) 0.35 (3.03) 0.354 (3.22) 0.2269 (3.03) 0.219 (2.64)
d(roe) -0.559 (1.93) -0.472 (1.88) - -
R-sqr 0.0135 0.0145 0.0072 0.008
Panel B: Logistic Regression (Dependent Variable: dpos =1 if Bank stock return over twelve
months :
,
12
i t
r m >0, 0 otherwise)
Fixed Effects Random Effects Random Effects Fixed Effects
d(cf) 0.023 (0.74) 0.037 (1.63) - -
d(prf) 0.009 (1.98) 0.010 (2.69) 0.00842 (2.32) 0.00845 (2.04)
d(roe) -0.007 (0.02) -0.008 (1.10) -
Notes: d(cf) = cost efficiency change, d(prf) = profit efficiency change; d(roe) = roe change; t-
statistics are in parentheses.
27
Appendix - Information on regulatory variables
Variable Category Description
CAPITRQ Capital
requirements
This variable is determined by adding 1 if the answer is yes to questions 1-6 and 0 otherwise, while the opposite occurs in the case of
questions 7 and 8 (i.e. yes=0, no =1). (1) Is the minimum required capital asset ratio risk-weighted in line with Basle guidelines? (2) Does
the ratio vary with market risk? (3-5) Before minimum capital adequacy is determined, which of the following are deducted from the book
value of capital: (a) market value of loan losses not realized in accounting books? (b) unrealized losses in securities portfolios? (c)
unrealized foreign exchange losses? (6) Are the sources of funds to be used as capital verified by the regulatory/supervisory authorities?
(7) Can the initial or subsequent injections of capital be done with assets other than cash or government securities? (8) Can initial
disbursement of capital be done with borrowed funds?
MDISCIP Market
discipline
This variable is determined by adding 1 if the answer is yes to questions 1-7 and 0 otherwise, while the opposite occurs in the case of
questions 8 and 9 (i.e. yes=0, no =1). (1) Is subordinated debt allowable (or required) as part of capital? (2) Are financial institutions
required to produce consolidated accounts covering all bank and any non-bank financial subsidiaries? (3) Are off-balance sheet items
disclosed to public? (4) Must banks disclose their risk management procedures to public? (5) Are directors legally liable for
erroneous/misleading information? (6) Do regulations require credit ratings for commercial banks? Is there a compulsory external audit by
a certified/licensed auditor? (8) Does accrued, though unpaid interest/principal enter the income statement while loan is non-performing?
(9) Is there an explicit deposit insurance protection system?
OFFPR Official
disciplinary
power
This variable is determined by adding 1 if the answer is yes and 0 otherwise, for each one of the following fourteen questions: (1) Does
the supervisory agency have the right to meet with external auditors to discuss their report without the approval of the bank? (2) Are
auditors required by law to communicate directly to the supervisory agency any presumed involvement of bank directors or senior
managers in illicit activities, fraud, or insider abuse? (3) Can supervisors take legal action against external auditors for negligence? (4)
Can the supervisory authorities force a bank to change its internal organizational structure? (5) Are off-balance sheet items disclosed to
supervisors? (6) Can the supervisory agency order the bank's directors or management to constitute provisions to cover actual or potential
losses? (7) Can the supervisory agency suspend directors decision to distribute dividends? (8) Can the supervisory agency suspend
directors decision to distribute bonuses? (9) Can the supervisory agency suspend directors decision to distribute management fees? (10)
Can the supervisory agency supersede bank shareholder rights and declare bank insolvent? (11) Does banking law allow supervisory
agency or any other government agency (other than court) to suspend some or all ownership rights of a problem bank? (12) Regarding
bank restructuring and reorganization, can the supervisory agency or any other government agency (other than court) supersede
shareholder rights? (13) Regarding bank restructuring & reorganization, can supervisory agency or any other government agency (other
than court) remove and replace management? (14) Regarding bank restructuring & reorganization, can supervisory agency or any other
government agency (other than court) remove and replace directors?
RESTR Restrictions on
banks activities
The score for this variable is determined on the basis of the level of regulatory restrictiveness for bank participation in: (1) securities
activities (2) insurance activities (3) real estate activities (4) bank ownership of non-financial firms. These activities can be unrestricted,
permitted, restricted or prohibited that are assigned the values of 1, 2, 3 or 4 respectively. We use an overall index by calculating the
average value over the four categories.
Note: The individual questions and answers were obtained from the World Bank database developed by Barth et al. (2001b, 2006, 2007)
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