Efficiency and risk in Japanese banking

This paper investigates the impact of risk and quality factors on banks' co st by using the stochastic cost frontier methodology to evaluate scale and X-inefficiencies, as well as technical change for a sample of Japanese comm ercial banks between 1993 and 1996, Loan-loss provisions are included in th e cost frontier model to control for output quality, with a financial capit al and a liquidity ratio included to control risk. Following the approach s uggested in Mester (1996) we show that if risk and quality factors are not taken into account optimal bank size tends to be overstated. That is, optim al bank size is considerably smaller when risk and quality factors are take n into account when modelling the cost characteristics of Japanese banks. W e also find that the level of financial capital has the biggest influence o n the scale efficiency estimates. X-inefficiency estimates, in contrast, ap pear less sensitive to risk and quality factors. Our results also suggest t hat scale inefficiencies dominate X-inefficiencies. These are important fin dings because they contrast with the results of previous studies on Japanes e banking. In particular, the results indicate an alternative policy prescr iption, namely, that the largest banks should shrink to benefit from scale advantages. It also seems that financial capital has the largest influence on optimal bank size. (C) 2000 Elsevier Science B.V. All rights reserved. J EL classification: G21; D21; G23.