Efficiencies of Pakistani Banking Sector: A Comparative Study

International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 46 (2010)

© EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/finance.htm
Efficiencies of Pakistani Banking Sector: A Comparative Study
Ramiz ur Rehman
Assistant Professor, Lahore Business School, The University of Lahore
E-mail; ramiz_rehman@hotmail.com
Tel: +92-4235321456-60; Fax: +92-4235321760
Awais Raoof
Associate Professor, Lahore Business School, The University of Lahore
E-mail; awais_raoof@hotmail.com
Tel: +92-4235321456-60; Fax: +92-4235321760
Abstract
This paper investigates a comparison between public, private and foreign banks
efficiencies. In Pakistan, financial sector had gone through a phenomenon changes over the
past fifteen years. Banking sector particularly grew very rapidly and investor enjoyed very
high return. This study also finds that whether high profitability of the banking sector
shows their high efficiency or not. For this purpose, a sample of forty commercial banks is
taken from the period of 1998-2007. A data envelopment analysis (DEA) is applied to
compute the efficiencies of the respective banks. The results show that the overall
efficiency of the banking sector in the initial year is matched with the world banking
efficiency, but in later years an unsystematic sequence is observed. Initially, foreign and
private sector banks are well ahead of pubic sector in term of technical efficiency, but in
the later part of the analysis public sector banks are the real difference. The main reason of
this change is massive privatization, which is taken place in those years. An aggressive
privatization policy leads the inefficiency of private sector in comparative terms.
1. Introduction
Financial sector plays vital role for the development and progress of country’s economy. Pakistan in
this respect seems to be bit unlucky. Pakistan inherited not very progressive financial sector at the time
of independence. But afterwards, the development in this sector observed to be slow. In Pakistan,
financial sector comprised on regulator, commercial banks, investment intermediaries, development
finance institutions and stock market. In early ages Pakistan has three regulatory authorities, State
Bank of Pakistan, Pakistan Banking Council and Corporate law authorities which used to supervise
financial sector. Corporate Law Authority regulated the equity market, Pakistan Banking Council used
to monitor the performance of nationalized commercial banks and State Bank acted as a central bank.
The banking history of Pakistan is as old as Pakistan itself. At the time of independence,
Pakistan had only one bank named as Habib Bank which was initially started in 1941 in Bombay. State
Bank of Pakistan was established on 1st July 1948 by Pakistan Government. SBP was initially owned
by the government and some private parties but latterly it was declared as an autonomous body. In
1949, the first Pakistan state owned bank was formed name as National Bank of Pakistan. After that
numbers of new financial institutions were established and became the part of financial sector but at
very slow pace.
111 International Research Journal of Finance and Economics - Issue 46 (2010)
Initially, financial sector in Pakistan has been dominated by state owned institution. Especially
in the era of nationalization in 1970, all privately owned institutions were converted into state owned
institutions and a ban was imposed on private ownership. These state owned institutions were fulfilled
the financial need of government, public enterprises and some private big organizations (Khan 1995).
In the continuation of the policy, entire banking sector was nationalized in 1972. National Commercial
Banks were established by merging big commercial banks. These five NCB’s were the main player in
the banking sector in the period of 1972-1990. Almost 92% of the banking assets were captured by
these NCB’s which showed their dominance in the banking sector. One of the main reasons of holding
such a huge level of banking sector assets by these NCB’s was a restriction on private commercial
banks. Private ownership of commercial banks was not allowed during the nationalized period.
Due to the high regulations and more intervention of government authorities, the performance
of banking sector was not up to the satisfactory level. The banking efficiency remained at low resulted
in low growth and decline in savings and investment in the private sector. All these negative outcomes
were the result of less innovation, narrow range of financial products, high tax rates, concentrated
ownership of financial assets, non diversification in consumer and mortgage financing, customer
dissatisfaction and bureaucratic behavior.
In that crucial stage, banking system needs a strong breathing system which was injected in the
form of Banking Sector Reforms in 1991. Many questions were raised at that time, why did we need
financial reforms in banking sector? Why was it so to have healthy and buoyant banks? What was
wrong with Pakistani banking system that such massive reforms had to be undertaken?
The Former Governor of State Bank of Pakistan, Dr Ishrat Hussian had addressed all these
questions very professionally and logically in the later stages of reforms. He said that we need financial
reforms in our banking sector because the banks in Pakistan were owned by the state. So the banks
were catering the need of government organizations, subsidizing the fiscal deficit, serving few
corporate sectors and trade financing. The lending was mainly influenced by the political forces merit
lending was violated. Managers were appointed on political basis and they worked under the influence
of those forces. There was no lending to small and medium enterprises. Even agriculture sector was
totally ignored, no agriculture products were available. The sector which creates most employment and
have major role in the country’s economy was ignored unfortunately. Non performing loans were huge
with little percentage of recovery. Approximately 75% of the loans were waived off on high political
influences. Overstaffing, over branching and unprofitable branches, poor customer services, high
bureaucratic approach and waste of resources lead to inefficiency of banking sector.
Apart from above mentioned, banking sector faced very high tax rate while all other corporate
sector paid only 35% of tax. This high punitive rate along with the burden of stuck loans, inefficiency
of staff was passed on to the customers in the form of high lending and low deposit rates.
Therefore banking industry was not an attractive option for new entrant who could foster
competition and improve efficiency. So it was decided to implement financial reforms in the banking
industry to improve services and efficiency of this sector. As a result, financial reforms were
introduced in different phases.
In first phase starting from 1991, a ban was lifted and ten new private banks were granted
permission to start their operations. These ten banks were started their function in the later half of
1992. After that, three new foreign banks and two provisional banks were also established with in the
period of two years. Not only that, two main nationalized banks were also denationalized in 1993
namely, Muslim Commercial Bank and Allied Bank Limited.
As a result of these financial reforms, Pakistan banking sector moved toward liberalization and
financial sector deregulation. The government of Pakistan now focused on improving the efficiency of
banking sector in Pakistan.
SBP also decided to enhance its role as a strong and professional regulatory authority to
maintain a strong check and balance on privately, publically and foreign owned banks. For that
International Research Journal of Finance and Economics - Issue 46 (2010) 112
purpose, SBP advised all banks to submit their performance report quarterly, set up quarterly recovery
targets and formulate strategies to improve future recovery.
In the second phase of reforms starting from 1997, Banking Council was dissolved and gave
total control to SBP for monitoring and regulations. As a result, SBP introduced two new systems to
monitor and evaluate the performance of each bank which includes CAMELS (capital adequacy, asset
management, management quality, savings, liquidity and sensitivity to market risk system.) and
CAELS (capital adequacy, asset quality, earnings, liquidity and sensitivity). A minimum paid up
capital requirement was also implemented in 2nd phase as 500 million Rupees.
The main objective of these financial reforms was to increase efficiency by introducing such as:
1. Privatization of NCB’s
2. Corporate Governance
3. Capital Structure
4. Improving Asset Quality
5. Liberalization of Foreign Exchange Regime
6. Consumer Financing
7. Mortgage Financing
8. Legal Reforms
9. Prudential Regulation
10. Micro Financing
11. Small and Medium Enterprises Financing
12. Taxation
13. Agriculture Credit
14. Islamic Banking
15. E-Banking
16. Human Resource
17. Credit Rating
18. Supervision and Regulatory Capacity
19. Payments
The result of these reforms showed in early 2000 and within a span of 5 years the industry was
reached to 4 trillion rupees in 2005. The Banking sectors asset’s to GDP ratio grew from 47.2% in
CY00 to 55.6% in CY05 since the growth in banking asset outpaced the nominal GDP. These trends
were sharp contrast to banking asset’s to GDP ratio in later half of 1990. This was achieved due to the
transformation of banking assets from public to private sector. Return on banking asset was grown up
to the level of 2.6% and return on equity was on 25.4%.
According to the latest study conducted by the World Bank, Pakistani banking sector has been
ranked second in performance among the South Asian countries. Not only the profitability of banking
sector was improved but also capital adequacy ratio reached to 11.91% as compared to 10.90% in
1999. Loan infection ratio was also decreased significantly to 2.1% very close to international standard
from 15.3% in 1999. The banks were also operating at the capacity significantly higher than it was in
90’s and the loan deposit ratio was now at 70%.
All these positive indication showed that these financial reforms played significant role in the
banking industry of Pakistan. But it is not completed yet, while transformation of financial sector is
impressive, but it is far from compete.
In this study, we contribute to the literature whether these financial reforms be an evident of
high efficiency in the banking sector of Pakistan along with high profitability and growth. Over a last
decade, as discussed earlier banking sector in Pakistan has passed through phenomenal changes and
achieved remarkable returns. A massive growth was observed during this period. For analysis purpose,
we take a sample of 40 commercial banks over the period of 1998-2007 and use Data Envelopment
Analysis (DEA) to compute the efficiencies of public, private and foreign owned banks over this
period. In this study, we compare the efficiencies of public, private and foreign banks over a decade
and after implementing the statistical test identify the most efficient bank and the ownership.
2. Literature Review
Akhtar (2002) implemented Data Envelopment Analysis (DEA) to compute the banking efficiencies of
Pakistan banking sector. He took a sample of 40 commercial banks in 1998 and computed their
efficiencies. Inputs used in that study was deposits and capital while outputs were investment portfolio
and loan’s and advances. An intermediate approach was used to compute efficiencies.
The result of that study was showed overall efficiency score of Pakistani banks was .80 in 1998.
This score was higher than the result obtained by Mukherjee (2002) for Indian banks and Jemric et al
(2002) for Croatian banks. But this score was less than the world average banking efficiency of 0.86 by
Berger and Humphrey (1997). The results also supported the on going financial reforms and
liberalization of banking sector in Pakistan.
The impact of financial reforms on banking efficiency of state, private and foreign owned banks
in Pakistan was observed by Burki and Niazi (2006). They found first phase of financial reforms was
not very effective. In fact, first phase financial reforms failed to covert cost inefficient bank into
efficient bank in the period of 1993-1996. The reason was obvious, banks were adjusting to new
reforms, increased competition, and strong prudential regulations by the central bank lead the banks to
cost inefficiency. In their study, they took the data of domestic and foreign commercial banks of
Pakistan over the period of (1991-2000). They computed their efficiencies by using Data Envelopment
Analysis. For analysis purpose, they divided their sample into three periods. Pre-reform period (1991-
92), first reform period (1993-96) and second reform period from (1997-2000). They selected inputs
for their analysis as, labor, physical capital, operating cost and financial capital while outputs as, loans,
investments and contra asset account. The result showed that after declining the cost efficiencies in
first phase it was then increased in second phase of reforms. In whole sample period from 1991-2000,
the cost efficiency of state owned bank, private bank and foreign banks was 60%, 75% and 80%
respectively. The main insight of that study was foreign banks identified as most cost efficient banks
than the public and private.
Usman et al (2009) conducted a study on banking efficiency dynamics with financial sector
reforms effect. They took a data set of 20 domestic commercial banks of Pakistan and measure their
efficiency using Data Envelopment Analysis Malmquist Productivity Index of Total Factor
Productivity (TFP) from 1990-2005. Caves et al (1982) initially proposed the idea of Malmquist index
in the parametric frontier framework. The index measures the total factor productivity change between
two data points over time. The idea was further extended by Berg et al (1991) to non parametric
frontier.
For estimation purpose, they took deposits, labor and capital as inputs and loan advances and
investment as outputs. They divided their sample period into three periods, pre-reform period (1991-
1997), first reform period (1998-2001) and second reform period (2002-2005). The data was collected
from State Bank of Pakistan annual issues.
Results showed that in the first phase of reforms technological change decreased by 14.3%
along with total factor productivity by 12.2% but technical efficiency change increased to 2.1%. In 2nd
phase of reforms, total factor productivity, technological change and technical efficiency change was
increased by 17.4%, 14.6% and 2.4% respectively. The results supported the hypothesis that the
financial reforms improved the banking efficiency of Pakistan banking sectors.
Akmal and Saleem (2008) estimated the technical efficiency of the banking sector in Pakistan.
They used a sample of 30 commercial banks including, state, private and foreign owned banks during
the period of 1996-2005. They analyzed the efficiency of banking sector after the introduction of
financial reforms and regulatory structure by SBP. For analysis purpose, they used Two Stage Data
Envelopment Analysis to check the impact of macroeconomic and bank specific factors on banking
efficiency.
First they obtained DEA efficiency scores under constant return to scale and variable return to
scale assumptions. Then at the second stage, efficiencies obtained under variable return to scale
regressed on banking specific factors and macroeconomic factors to find out their respective impact.
For that study, they selected three inputs, operating expense, interest expense and fixed asset, while
three outputs, net loan, liquid asset, and deposit for both constant return to scale and variable return to
scale assumptions.
These efficiency scores then regressed on macroeconomics factor i.e., inflation rate, per capital
income, stock capitalization, real GDP rates and bank specific factors i.e., ownership, net loans,
deposit, fixed capital, bank asset to total asset ratio, loans to total asset ratio, number of branches,
capital adequacy ratio and equity asset ratio. The result showed that almost 12% banks were
technically inefficient under constant return to scale and 9% under variable return to scale assumption.
The results also showed that there was a growth of 5% in total productivity against the massive
technology growth during the last ten years, which was very low as compared to other sectors in the
economy. The results also indicated that the state owned banks were less efficient than the private and
foreign banks. The effect of bank specific factors on the banking efficiency showed that high loan
activity resulted in high technical efficiency where lower fixed assets have positive impact of bank
performance. The results confirmed a positive relation between number of branches and negative
relation between public ownership and banking efficiency.
Bhattacharya et al (1997) estimated 70 Indian commercial banks productive efficiency during
the early stages of liberalization process. They used Data Envelopment Analysis to measure the
efficiency score of these banks. After applying DEA, they used Stochastic Frontier Analysis to
attribute variation in the estimated efficiency scores to three component scores, i.e., random noise,
ownership and temporal component. They concluded in their study that public banks were most
efficient followed by foreign and private owned banks.
Rime and Stiroh (2003) studied the performance of Swiss banks for the period of 1996-1999.
For that study, they used Data Envelopment Analysis Malmquist Index for total factor productivity.
They found in their study that small and medium sized banks achieved economies of scale but larger
banks could not.
Rizivi (2001) conducted a study to analyze the productivity of banking sector in Pakistan
during 1993-1998. He applied Data Envelopment Analysis approach to compute the banking efficiency
scores. He found during the period of first reform the total factor productivity remained stagnant.
However, the domestic banks performed better than the foreign banks during that period.
Kirkwood et al (2003) calculated the cost and profit efficiency for the Australian banks between
(1995-2002). A sample of 10 banks listed on Australian Stock Exchange was taken for analysis. He
applied Data Envelopment Analysis for constructing efficient frontier for those banks. They estimated
efficiency scores by using two models approach. In both models they selected different sets of inputs
and outputs. In model A, they took labor and net fixed assets as inputs and interest bearing assets and
non interest bearing assets as outputs. In model B, they used the same inputs as in model A with
different outputs as profit before tax and abnormal items. For both model they applied Malmquist
Productivity indices so that technological changes might be separated from changes in efficiencies.
After combining the results of both models, it was concluded that the revenue efficiency
declined for regional banks but improved for major banks. Furthermore, major banks improved their
cost and profit efficiency over the period, while regional banks showed reverse trend. An attempt was
made also to relate these efficiency scores with stock returns in the market. The result showed that the
efficiency of the banks was also reflected in their stock returns.
Ozkan Gunay et al (2006) compared the banking efficiency of Turkish banking sector in pre-
crisis and crisis period using the Data Envelopment Analysis. They took the data of private and foreign
banks over the period of (1990-2000). Public banks were not included in the study due to high
influence of political forces in the country. They computed efficiency on two different models. In
model A, input variables were personnel expenses, administrative expenses and interest expenses while
outputs were deposits, loans and security portfolio. In model B, they used the same inputs as in model
A, while interest and non interest income were used as outputs.
The fragility of Turkish banking system has increased over the last decade due to structural
weakness and three crisis periods faced by the Turkish banking system. As a result 25% of the
domestic commercial banks were taken over by Saving Deposit Insurance Funds in the period of 1997-
2001.
These two models were formed to measure the sensitivity of efficiency score on the selection of
inputs and outputs variables. The study reported that the number of efficient banks and mean efficiency
scores of both models have declining trend throughout the analysis period. The results also suggested
that the banks taken over by Saving Deposit Insurance Fund were found to be inefficient during the
pre-crisis and crisis period as compared to non failure domestic banks. It was also observed that the
impact of crisis became more visible when outputs were changed and defined as income.
Qayyum et al (2006) conducted a study on X-efficiency, economies of scale, technological
progress and competition of Pakistani banks. In this study they took a sample of 29 banks over the
period of 1998-2005. They Stochastic Frontier Analysis, a parametric approach to construct a Fourier
flexible cost function with component error. For that purpose, they used three basic inputs, labor,
capital and borrowed funds while took two outputs, loan advances and investments. The input prices
were total admin cost, total interest paid and occupancy cost.
The result showed that the efficiency scores were lowest in 2001 and highest in 2004 for all
groups. Furthermore, the average efficiency score was lower 48% for domestic banks as compared to
foreign owned banks. But the average score for all banks was 54%. The result suggested that domestic
banks operating in Pakistan were relatively less efficient than their foreign counterparts. In domestic
banks big banks achieved high efficiency while small banks were considered to be inefficient. The
scale economies also existed among all group and it suggested that it was lower for big banks but
higher for small banks. Foreign banks economies of scales were higher than the domestic banks.
Results also showed that the market share of big banks was declining over the period but the
average interest rate spread showed fluctuation. It was also observed that the average spread for big
banks was quite high than the small banks. It showed a lack of competition in the banking sector. The
study concluded at this remarks that the mergers should take place between small banks and foreign
banks that could reduce the cost due to the economies of scale and x-efficiency but it was not
recommended that mergers between small and big banks.
Sathye (2001a) used Data Envelopment Analysis to measure the efficiency scores of 29
domestic commercial banks of Australia in 1996. He estimated efficiency scores by taking labor,
physical capital and loan able funds as inputs while loan and demand deposit as outputs. The average
score calculated for Australian banks was 0.58 which was lower than the world average efficiency
score of 0.86 by Berger and Humphrey (1997). In his result, technical efficiency was found to be very
low while allocative efficiency was fairly high by world standards. He also investigated the ownership
issue and separated the sample by ownership. The results showed that domestic banks performed well
as compared to foreign banks. The difference was not statistically significant might be due to small
size.
Chu and Lin (1998) estimated the banking efficiency scores of Singapore banking industry.
They used two models in their study one for profit and other was cost efficiency. They took a sample
of six commercial banks which holds the 70% of market share between (1992-1996). In model one;
they used shareholder funds, operating expense and interest expense as inputs and annual increase in
average asset and total income as output. The model one was specified for cost efficiency. The model
two contained the same inputs while they took profit as output in that model.
The result showed that the cost efficiency score was quite high than the international standard
as 0.95 on average while profit efficiency was low at 0.83.
3. Methodlogy and Variable Construction

In this study we take the sample of commercial banks of Pakistan from the period of (1998-2007). The
study is unique in the way that no study has been conducted on the banking sector efficiency of
Pakistan after the period of (2005). For (1998), a sample of forty commercial banks is selected, in
which twenty banks are foreign owned, ten are privately owned and ten state owned banks. In (1991),
the sample is reduced to thirty eight banks due to stoppage of operations from two foreign based banks.
In this year, eighteen banks are foreign owned, ten privately owned and ten state owned banks. In
(2000), one more foreign bank stopped its operation and sample reduce to thirty seven banks, in which
seventeen are foreign based , ten private owned and ten are state owned banks. In (2001), a sample of
thirty six banks is selected in which eighteen are foreign banks, twelve are privately owned and six are
state owned banks. During (2002), a sample of thirty banks is selected, in which fifteen are foreign
based, twelve are private based and six are state owned banks. In (2003) same sample is used as in
(2002). In (2004), a sample of thirty one banks is selected, in which ten banks are foreign owned,
sixteen are privately owned and five are state owned banks. In (2005), the sample set is remained same
as in (2004). In (2006), a sample of twenty nine banks is selected, in which six are foreign based,
eighteen are privately owned and five are state owned banks. In (2007), a sample of twenty banks is
taken, five are foreign banks, eighteen are private and five are state owned banks.
During the last decade, banking sector has undergone the phenomenal changes. These changes
can be viewed in our sample as well, from the period of (1998-2007), several mergers and acquisitions
have been taken place between foreign and private banks. We start our sample with twenty foreign, ten
private and ten state owned banks in 1998, while at 2007 foreign banks reduced to five, while private
banks increased to eighteen and state owned banks reduced to five banks. So there is no harm in saying
that last decade is an era of privatization
3.1. Data Envelopment Analysis (DEA)

We measure banking efficiency by using DAE approach under constant return to scale. The constant
return to scale is advantageous as it allows for comparison between small and large firms/banks in a
situation where the frequency distribution is skewed due to presence of small and large banks in the
sample. In such a situation the use of variable return to scale raises the possibility that large banks
would appear as efficient in the sample for the simple reason that there are no truly efficient banks
(Berg et al., 1991).
Farrell’s original non-parametric approach where piecewise-linear convex isoquant is
constructed so as no observed point lie left or below it known as mathematical programming technique
for frontier (Worthington, 2000). Later, this methodology was generalized and extended by Charnes et
al. (1978), Färe et al,(1983), Banker et al (1984) and Byrens et al, (1984). This technique now is widely
known as “data envelopment analysis (DEA)”.It is a non-parametric to construct cost and revenue
frontier of banking sector. It based on linear programming technique to measure the relative efficiency
and management performance of firms where multiple inputs and outputs are present which makes the
comparison difficult.
In contrast to econometric method, the DEA does not require any assumption about the
functional form and no need to assume any specific distributional form for the error term. Moreover,
the DEA analysis is flexible and accommodates variable returns to scale (VRS).However a major
disadvantage in this method is its inability to handle noisy data in a satisfactory manner (Worthington,
2000).Data envelopment analysis (DEA) is used in study to analyze the efficiency of the bank in
Pakistan. Both input-oriented (IOM) and output-oriented (OOM) versions of the DEA methodology
have been applied to the data for the sake of efficiency score comparison. The Data Envelopment
Analysis (DEA) approach is based on mathematical programming. It uses the observed values of inputs
and outputs and attempts to find which of the firms in the sample determine an envelopment surface.
Firms lying on the surface are deemed to be efficient and receive a value of unity. Firms that do not fall
the frontier are deemed to be inefficient and capture a value of less than unity. Hence, all deviations
from the estimated frontier represent inefficiency. Banks under the DEA approach are referred to a
decision making unit (DMUs). Data Envelopment Analysis (DEA) is used to estimate output frontier.
Distance functions are estimated under constant return to scale (CRS) and variable return to scale
(VRS) assumptions. The overall bank efficiency can be decomposed into scale efficiency and pure
technical efficiency. However, the frontier obtained through DEA approach is sensitive to extreme
observations and measurement errors (Qayyum and Ahmed, 2006). An output-oriented model implies
that the efficiency is estimated by the output of the firm relative to the best practice level for a given
level of inputs. In order to specify the mathematical formulation of the output oriented, let us assume
we have K decision-making units (DMU) using N inputs to produce M outputs. Inputs are denoted by
xjk (j = 1,……..,n) and the outputs are represented by yik (i=1,…….,m) for each bank k (k=1,…….,K).
The efficiency of DMU can be measured as (Coelli, 1998; Worthington, 1999; Shiu, 2002).
Where yik is the quantity of the ith output (i.e. Loan & Advances and Investment) produced by
the kth DMU firm, xjs is the quantity of jth input (i.e. Deposits, Labor and Capital) used by the sth firm,
and ui and vj are the output and input weights respectively. The DMU maximizes the efficiency ratio,
TEk, subject to
This constraint implies that efficiency measures of a bank cannot exceed one and the input and
output weights are positive. The weights are selected in such a way that the firm maximizes its own
efficiency. To select optimal weights the following mathematical programming (output-oriented) is
specified (Coelli, 1998; Wrothington, 1999; Shiu, 2002)
Input oriented linear programming methods is used in order to obtain the minimize inputs.
Therefore the following mathematical programming model is specified (Banker and Thrall, 1992;
Coelli, 1998; Worthington, 1999; Shiu, 2002; Topuz et al, 2005).
The above model shows CRS if w = 0 and it changed into variable return to scale (VRS) if w is
used unconstrained (Qayyum and Ahmed, 2006).
The data source for this study is Banking Statistics of Pakistan published by State Bank of
Pakistan. This is an annual report, in which financial information is available about all commercial
banks operating in Pakistan. All the data are in term of Pakistani rupees (in Million).
The efficiency of banks can be measured either by using operating approach or intermediation
approach. Under the operating approach, the bank is perceived to be the producer of services for its
account holders and known as the cost/revenue management perspective. The intermediation approach
considers banks as entities, which covert the transfer financial assets between surplus units and deficit
units acting as an intermediary better called a mechanical perspective (Hanif.,2002). This study uses
the intermediation approach as it enables financial institution like bank to be perceived as a
manufacturing unit, converting inputs into outputs.
In this study we take input variable as Deposits (D) and net Capital (K) while the outputs
present the Loans and Advances (L) and Investments (I). The choice of inputs and outputs variable was
influenced by the extent literature on Data Envelopment Analysis application in baking industry, data
availability and theoretical considerations. Deposits are the overall resources available to banks for
carrying on their activities like lending and investment and are one of the main inputs. Net Capital is an
important factor of production for a bank unlike the other business activities. The price of net capital
(P1) is obtained by dividing the profit before tax with the net capital. Cost of serving the deposits is the
interest paid on deposits. Hence, input price for deposits (P2) was derived from total sum of interest
paid on deposits divided by the total value of deposits. The outputs chosen for the study constitute one
of the major activities of banks that channel their funds into investment or lending for profitability
motives.
The sample size of this study is relatively large, to achieve the greater reliability of the analysis
and meaningful results, literature on DEA suggests for a large samples size than the variable to be
examined in DEA inputs and outputs. There is, however, no limitation on applying the DEA technique
as long as the number of subjects is greater than the product of number of the number of inputs and
outputs. Soteriou and Zenios (1998), Nunamaker (1985) suggests that the sample size should be at least
three times larger than the sum of the number of inputs and outputs.
Inputs and outputs construction is as follow in the table 3-1
Table 3-1Inputs
Deposits X1
Net Capital X2
Outputs
Loans and Advances Y1
Investments Y2
Prices of Inputs
Interest Paid to Depositors/Deposit P1
Profit Before Tax/Net Capital P2
After measuring the efficiencies of the banking sector of Pakistan for the period of (1998-
2007), an analysis of variance is applied on yearly basis to find the most efficient banking sector
among public, private and foreign owned banks over last decade. The ANOVA is run through SPSS, a
statistical computer based software.
4. Results and Analysis

The overall efficiency score of Pakistani banks was found to be 0.81 in the year (1998). This is lower
than the world mean efficiency found to be 0.86 by Berger and Humphrey (1997). The technical
efficiency, reflecting the productivity of inputs, of Pakistani banks is found to be little high than the
allocative efficiency in that year. It shows that bank in Pakistan was utilizing their inputs reasonably
well but not at optimal level. The cost efficiency in the year (1998) seems to be very low at 0.73. It
shows the banks are not utilizing their resources properly; in fact they wasted their resources up to the
level of 27%. Moreover, if we compare the performance of private, public and foreign banks, in (1998)
technical efficiency of private bank is 0.89, public banks at 0.85 and foreign banks at 0.86, which
shows private banks have better technical efficiency than their counter parts. In case of cost efficiency,
again private banks lead with score of 0.77 against public and foreign owned banks. See table 4-1.
There is no significant difference in technical, allocative and cost efficiency among public, private and
foreign owned banks. See Table 4-12.
Table 4.1:
1998
All Groups Mean Max Min SD
Technical Efficiency 0.87 1.00 0.63 0.14
Allocative Efficiency 0.83 0.99 0.16 0.27
Cost Efficiency 0.73 0.97 0.11 0.27
Foreign Banks
Private Banks
Public Banks
In (1999), a massive decline in mean efficiency score of Pakistani banking and it falls to the
level of 0.46. The main reason of such a huge decline was highly political instability in the country. All
banks performed very low to their capacity. Technical efficiency of public banks is better than the
private and foreign banks. Cost efficiency is also better for public banks against private and foreign.
See table 4-2. The result of one way ANOVA suggest that the difference mean score of technical,
allocative and cost efficiency of public, private and foreign banks are insignificant. See table 4-12.
Table 4.2:
1999
Foreign Banks
Private Banks
Public Banks
During (2000), overall efficiency score of Pakistan banking sector showed some improvement.
The mean efficiency score in (2000) is 0.76 comparatively low to the world standard but good recovery
as compared to (1999). In this year, again public sector banks achieved a technical efficiency score of
0.90 as compared to private sector bank 0.75 and foreign sector banks 0.86. In cost efficiency, private
banks achieved 0.77, while public sector and foreign banks achieved 0.73 and 0.69 efficiency scores
respectively. See table 4-3. The difference between mean efficiency score of allocative and cost is
insignificant for public, private and foreign. There is a significant difference in mean technical
efficiency score among public, private and foreign owned banks. See table 4-12. The Multiple
comparison tests show that there is a significant difference between mean technical efficiency score of
public and foreign. In fact public banks perform better than the foreign banks in term of technical
efficiency. See table 4-13.
Table 4.3:
2000
Foreign Banks
Private Banks
Public Banks
In (2001), a declining trend was observed in term of overall efficiency score of Pakistani
banking sector. In this year mean efficiency score of Pakistani banking sector was 0.68. Foreign based
banks have technical efficiency score in (2001) is 0.78, public owned banks 0.84 and private owned
banks 0.76. In term of cost efficiency, private banks got a mean cost efficiency score of 0.50, public
banks 0.71 and foreign banks 0.56. See table 4-4. In this year the result of one way ANOVA tells that
the difference between mean efficiency score of technical and cost are insignificant for public, private
and foreign banks while the difference between allocative mean efficiency score is significant among
public, private and foreign owned banks. See Table 4-12. The multiple comparison tests suggest that
the difference between mean allocative efficiency score is significant among public, private and
foreign banks. Public and private banks performed better than foreign banks in term of allocative
efficiency. See Table 4-13
Table 4.4:
2001
Foreign Banks
Private Banks
Public Banks
In (2002), the mean efficiency score of Pakistan banking sector is calculated as 0.80. Though it
is less than the world standard but in the context of (2001), this result shows some recovery in banking
sector efficiency. Technical efficiency of private sector is observed at 0.93, 0.80 for public and 0.80 for
foreign sector banks. In term of cost efficiency, private sector has 0.87 score while 0.64 and 0.69 for
foreign and public sector banks respectively. See table 4-5. The difference between mean efficiency
scores of technical, allocative and cost is insignificant among public, private and foreign banks. See
table 4-12.
Table 4.5:
2002
Foreign Banks
Private Banks
Public Banks
The results showed not much improvement in overall banking sector efficiency in (2003), and
mean efficiency is observed at 0.73. In term of technical efficiency, public sector achieved highest
mean efficiency score 0.94 as compared to private 0.90 and foreign 0.67. Where as private banking
sector achieved mean cost efficiency score of 0.70 against public sector bank 0.68 and foreign banks
0.52. See table 4-6. The difference between mean allocative efficiency score is insignificant among all
ownerships, while there is a significant difference between mean technical and cost efficiency scores of
public, private and foreign banks. See table 4-12. Furthermore, public banks performed better than the
foreign banks in term of technical efficiency while in term of cost efficiency private banks performed
better than foreign banks. See table 4-13.
Table 4.6:
2003
Foreign Banks
Private Banks
Public Banks
In (2004), the mean efficiency score of Pakistani banking sector is 0.62. In this year public
sector banks achieved technical efficiency score of 0.78 as compared to private banks 0.76 and foreign
banks 0.70. While mean score of cost efficiency of all three sectors are 0.44, 0.46 and 0.56 for foreign,
private and public banks. See table 4-7. There is no significant difference between mean technical,
allocative and cost efficiency score of public, private and foreign banks. See table 4-12.
Table 4.7:
2004
Foreign Banks
Private Banks
Public Banks
The mean efficiency score of Pakistani banking sector in (2005) is 0.82. Private banking sector
has 0.93 score of technical efficiency while public and foreign has same score of 0.84. In term of mean
cost efficiency score of private banks are 0.78, public banks 0.71 and foreign banks 0.70.See Table 4-8.
It is also observed that there is no significant difference between mean technical, allocative and cost
efficiency scores of public, private and foreign banks. See table 4-12.
Table 4.8:
2005
Foreign Banks
Private Banks
Public Banks
In (2006), the mean efficiency score of Pakistani banking sector decline to 0.49. Public sector
banks have technical efficiency score of 0.91, private banks 0.79 and foreign banks 0.69. The mean
cost efficiency score of public sector is 0.77, private banking sector 0.23 and foreign banks 0.30. See
table 4-9. The one way ANOVA tells that there is no significant difference between mean allocative
and cost efficiency of public, private and foreign banks while there is a significant difference between
mean technical efficiency scores of all ownership. See table 4-12. It is further observed that public
banks performed better than the foreign banks in term of technical efficiency. See table 4-13.
Table 4.9:
2006
Foreign Banks
Private Banks
Public Banks
In (2007), the Pakistani banking sector efficiency improved a little as compared to (2006), but
still at a very low level of 0.53 in comparison with world standards. The technical efficiency score of
public sector is 0.94, private sector 0.73 and foreign sector 0.45. The mean cost efficiency score of
public and private sectors remain at 0.37 and 0.40 respectively, while foreign banks at 0.32. See table
4-10. There is no significant difference between mean allocative and cost efficiency scores of public,
foreign and private banks while there is a significant difference between mean technical efficiency
score of public, private and foreign banks. See table 4-12. The results also suggest that public banks
performed significantly better than private and foreign banks in term of technical efficiency.
Table 4.10:
2007
Foreign Banks
Private Banks
Public Banks
Table 4.11:
Year wise Comparison of all Banks

categories Efficiencies 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
TE 0.87 0.76 0.80 0.78 0.85 0.82 0.75 0.88 0.79 0.72
Over All AE 0.83 0.35 0.82 0.68 0.82 0.75 0.63 0.83 0.36 0.48
CE 0.73 0.27 0.65 0.57 0.73 0.63 0.47 0.74 0.31 0.38
TE 0.86 0.79 0.73 0.78 0.80 0.67 0.70 0.84 0.69 0.45
Foreign Banks AE 0.80 0.28 0.85 0.66 0.75 0.73 0.63 0.82 0.40 0.50
CE 0.69 0.21 0.61 0.56 0.64 0.52 0.44 0.70 0.30 0.32
TE 0.89 0.75 0.83 0.76 0.93 0.90 0.76 0.93 0.79 0.73
Private Banks AE 0.84 0.39 0.92 0.65 0.91 0.77 0.61 0.84 0.27 0.50
CE 0.77 0.31 0.76 0.50 0.87 0.70 0.46 0.78 0.23 0.40
TE 0.85 0.71 0.90 0.84 0.80 0.94 0.78 0.84 0.91 0.94
Public Banks AE 0.85 0.42 0.68 0.83 0.83 0.71 0.72 0.82 0.78 0.38
CE 0.73 0.33 0.61 0.71 0.69 0.68 0.56 0.71 0.77 0.37
P u bl i c B a nk s
P r i v a t e B a nk s
1
1
0.9
0.9
0.8
0.8
0.7
0.7
TE 0.6 TE
0.6
0.5 AE 0.5 AE
0.4
0.4 CE
CE
0.3 0.3
0.2 0.2
0.1 0.1
0 0
98 99 00 01 02 03 04 05 06 07 98 99 00 01 02 03 04 05 06 07
Ye a r s Y ear s
Table 4.12: Summary of test for same or distinct frontiers by bank ownership
ANOVA
Year Efficiency Measure F Sig.
(1) (2) (3) (4)
TE 0.18 0.83
1998 AE 0.14 0.87
CE 0.30 0.74
TE 0.09 0.92
1999 AE 0.99 0.38
CE 0.90 0.41
TE 3.46 0.04*
2000 AE 2.79 0.08
CE 1.15 0.33
TE 0.01 0.99
2001 AE 9.56 0.00*
CE 2.82 0.07
TE 2.06 0.15
2002 AE 0.39 0.68
CE 1.41 0.26
TE 5.65 0.01*
2003 AE 0.99 0.38
CE 3.90 0.03*
TE 0.41 0.67
2004 AE 0.57 0.57
CE 0.70 0.51
TE 1.23 0.31
2005 AE 2.18 0.13
CE 2.10 0.14
TE 3.52 0.04*
2006 AE 0.57 0.57
CE 0.67 0.52
TE 5.14 0.01*
2007 AE 1.29 0.29
CE 1.74 0.20
P-values are in column 4,* indicate significance at 5% level of significance.
Null hypothesis for ANOVA test is that average efficiencies for three different type pf banks are same
Table 4.13:
Multiple Comparisons
Least Significant Difference(LSD) test
Dependent Mean Difference
Year Bcode(I) Bcode(J) Sig.
Variable (I-J)
Foreign Private -0.09 0.25
2000 TE Public -0.20 0.01
Private Public -0.11 0.20
Foreign Private -0.23 0.02*
2001 AE Public -0.52 0.00*
Private Public -0.29 0.03*
TE Public -0.28 0.01*
2003
CE Public -0.22 0.14
Private Public 0.09 0.53
2006 TE Public -0.47 0.01*
2007 TE Public -0.52 0.00*
Private Public -0.28 0.04*
* The mean difference is significant at the .05 level.
5. Conclusion and Disscusion

This study aims at investing the overall efficiency score of Pakistani banking sector over the period of
(1998-2007). Several studies have already been conducted on banking efficiency of Pakistani banking
sector till the year of (2005).No study has been conducted after the period of (2005) on banking sector
efficiency in Pakistan. We make a comparison between publically owned, privately and foreign owned
banks over the period of (1998-2007). We use Data Envelopment Analysis and compute the efficiency
scores on yearly basis for every bank in the sample set. These efficiencies are further categorized as
technical, allocative and cost efficiency scores.
As Pakistani banking sector has undergone phenomenal changes over the last two decades.
Financial reforms were introduced in early 1990’s and liberalization and privatization were also
became the part of these financial reforms in late 1990’s. All these changes created a healthy and
competitive financial sector in the country. The regulatory authorities also played a vital role in
establishing the financial sector by introducing the prudential regulations and strong monitoring
controls.
These financial reforms also changed the ownership structure of the banking sector. Earlier
banking sector was denominated by public owned banks and have the maximum market share. By
introducing the financial reforms and privatization policy, number of private banks emerged during the
last decade and market share of public banks declined significantly.
The results show an inconsistent performance of banking sector. In (1998), all banks performed
well and their high efficiency score gives an evidence of their good performance. The year may be a
reflection of privatization and liberalization policy on baking sector efficiency. But after this year
performance of banking sector in term of efficiency became inconsistent. In (1999) and (2001) banking
sector efficiency scores were very low as compared to the world standard. The reason was obvious that
in both years Pakistani was suffering with high political and security instability. In comparison with
other banking sector, public banks performed significantly better in term of technology in (2000).
The study also conclude that due to high rate of mergers and acquisitions in banking sector
during (2006) and (2007), the performance of public sector banks become significantly different from
private and foreign banks in term of technical efficiency. The performance of private and foreign banks
is declined due to high rate of mergers and acquisition between private and foreign banks. The number
of private banks is increased significantly during that period, which may cause their performance down
in term of technical and cost efficiencies.
This study also recommends that these mergers and acquisition are not in the favor of banking
efficiencies. The policy of merger and acquisition may be reconsidered at this stage so that the banking
sector will improve their efficiencies in future.
This study owns certain limitations, inputs and outputs used in this study are quantitative, while
qualitative inputs are not considered due to the non-availability, like quality of services provided by the
different banking sectors and level of technological advancement could also have been included in the
analysis.
Overall study provide an insight of banking performance in term of technical, allocative and
cost efficiency over a decade. Even there is a massive growth in banking sector assets; it needs to work
hard to improve its efficiencies score. In the sample period, we indentify that private and public banks
are very close competitors in term of efficiencies score while foreign banks are far behind. In general,
public owned banks have better efficiencies score than its counter part.
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Efficiencies of Pakistani Banking Sector: A Comparative Study

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International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 46 (2010)

Efficiencies of Pakistani Banking Sector: A Comparative Study

3. Methodlogy and Variable Construction

3.1. Data Envelopment Analysis (DEA)

Inputs and outputs construction is as follow in the table 3-1

4. Results and Analysis

Year wise Comparison of all Banks

5. Conclusion and Disscusion

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