Effect Of Financial Sector Reforms On The Efficiency Of Commercial Banks In Pakistan

Banking sector of Pakistan has experienced extensive reforms since 1990. Banking sector was dominated by government ownership since its nationalization in 1974 until the initiation of banking sector reforms in early 1990s. Government of Pakistan decided to undertake banking sector reforms on the advice of International Monetary Fund and World Bank beginning in early 1990s. As part of the banking sector reforms, some state owned banks were privatized and several new private banks were licensed to operate in the banking industry among several other measures. As a result of these steps, banking sector of Pakistan became a competitive one from that of state owned dominated one before 1990. The market share of state owned banks decreased significantly as a consequence of these reforms. The aim of this study is to evaluate the effect of banking sector reforms on the efficiency of commercial banks in Pakistan. Commercial banks are selected for this study owing to the fact commercial banks form a major part of banking sector of Pakistan. I use data envelopment analysis to measure the technical efficiency, cost efficiency, allocative efficiency, revenue efficiency and profit efficiency of commercial banks of Pakistan. Further, I decompose the technical efficiency, cost efficiency, revenue efficiency and profit efficiency into their pure and scale components. The sample covers an unbalanced panel data consisting of 32 years period from 1976 to 2007, a minimum of 13 banks in 1976 and 1977 to a maximum of 40 banks in 1996 and 1997. The intermediation approach is adopted to define the inputs and outputs used to measure the efficiency of commercial banks in Pakistan.The results indicate that average cost efficiency of all the commercial banks in Pakistan over the entire sample period is 0.53. Foreign owned banks are found to be the most efficient as compared with state owned banks and domestic private banks. This is consistent with the previous studies. The average technical efficiency of all the banks over the entire period is 0.86 while the mean allocative efficiency for the entire period is 0.61. It indicates that technical efficiency is higher than allocative efficiency as component of overall cost efficiency. Then I decompose the technical efficiency into pure technical and scale components, I find that both pure technical and scale efficiency contributes equally towards technical efficiency; however the scale efficiency has shown somewhat constant trend over the sample period whereas pure technical efficiency depicted a slight declining trend. State owned banks are found to be the most efficient in terms of pure technical efficiency and least efficient in terms of scale efficiency. It points out that scale economies does exist in the banking sector of Pakistan, the lower level of scale efficiency of state owned banks is due to their large size because small sized banks are found to be the most efficient in terms of scale efficiency while the large sized banks to be the least efficient and most of the large sized banks are state owned. Similarly, breaking the cost efficiency into pure cost and scale parts, I find that scale efficiency contributes more than pure cost efficiency towards overall cost efficiency. Again the state owned banks are found to be most efficient in terms of pure cost efficiency and least efficient in terms of scale efficiency while the small sized banks are found to be the most efficient in terms of scale efficiency and large sized banks to be the least efficient. Next I calculate the revenue efficiency; the average revenue efficiency over the entire period is 0.64 which is higher than average cost efficiency. The revenue efficiency is also decomposed into pure revenue and scale components and scale efficiency is found to be contributing more towards revenue efficiency than pure revenue efficiency. The state owned banks are again found to be the most efficient in terms of pure revenue efficiency while least efficient in terms of scale efficiency. Small sized banks are most efficient in terms of scale efficiency and large sized banks are least efficient. Finally I measured the profit efficiency which is averaged 0.61 for the entire sample period. The scale efficiency contributes more than pure profit efficiency towards overall profit efficiency. State owned banks are again most efficient pure profit efficient and least scale efficient. Small sized banks are most scale efficient and large sized banks are least scale efficient. I conclude that overall foreign owned banks are most efficient except the revenue efficiency. Scale of economies do exist in the banking sector of Pakistan, small sized banks are most scale efficient and large sized banks are least scale efficient. As a whole the banking sector reforms including the privatization of state owned banks did not lead to an increase in efficiency of commercial bank in Pakistan. Only the revenue efficiency showed an increase in post reform period. The unfavorable macroeconomic conditions are hypothesized to be the reason for the negative impact of banking sector reforms on the efficiency of commercial banks in Pakistan.