X-efficiency is a non-allocative form of efficiency first introduced by Harvey Leibenstein in 1966. The degree of X-efficiency is measured by the deviation of a firm’s costs of production from the technologically minimum costs of production. X-efficiency theory predicts that firms will produce closer to their cost function when they face pressure to do so. In this paper we review studies of X-efficiency among Chinese banks. These studies include the effect of ownership form, for example, state-owned banks versus privately-owned banks, on costs of production. China’s entrance into the WTO, the effect of a bank issuing an IPO and the effect of bank size are other topics of empirical studies reviewed in this paper. In addition some studies on Hong Kong banks before 1997 are included.
In 1966, the year Leibenstein first wrote about X-Efficiency (XE) theory [
Allocative efficiency means that Price (P) is equal to Marginal Cost (MC), and the marginal products per dollar spent on all inputs are equal with each other (MPl/Pl = MPk/Pk = ···MPn/Pn). If either or both of these did not hold, then allocative inefficiency existed. No one took issue with this form of inefficiency, which represented a market failure caused by market power of one or more firms. However, allocative efficiency theory neglects the possibility of intra-firm inefficiencies that firms are not cost minimizers. This internal inefficiency is what Leibenstein defined as X-Inefficiency (XIE). XE theory does not focus on prices and outputs, but on costs. More than a few economists took exception to the possibility of this type of inefficiency. If it exists then it calls into question whether people are rational or economic men. An economic man would minimize the firm’s costs, but a “XIE man” does not. Since 1967 over 200 empirical studies on XE theory have been conducted. These studies have used data from all over the world and the empirical results are largely consistent with each other and with XE theory. The last “wave” of studies has been on banking. The results reported here are consistent with the results of studies in the banking industry from all over the world.
Empirical estimates of the size of allocative inefficiency—price and output deviations from the socially rate of output (SORQ) where P = MC—reveal that for the entire US economy allocative inefficiency is less than one percent of the GDP. Some estimates have it between 0.001 and 0.0001 of GDP. For a $16 trillion GDP this is equal to between $16,000,000,000 and $1,600,000,000. Each year Americans spend $18,000,000,000 on specialty coffee, and $7,000,000,000 on potato chips. Allocative inefficiency is, to use a line from the Godfather, “small potatoes”. It is, for all intents and purposes, insignificant. Robert Mundell (1999), winner of the Nobel Prize in Economics thus lamented that if inefficiency is insignificant then so are economists (Mundell, 1962) [
Leibenstein presents several reasons for the X-istence of XIE. First, the human personality contains two parts, a superego and an id. The superego wants to work hard, improve themselves, do things correctly, find solutions to problems using rational decision making processes. The id wants to be free of effort. The id wants to be free of effort employing lazy decision rules and employs lazy decision rules, only moderate work effort, both of which raise costs above the technological necessary minimum. Second, managers are only rarely the owners, creating an “agency problem”. Third, workers have discretion about levels of work effort. Additionally, numbers two and three above are compounded when firms have monopoly power giving employees an environment in which they can pursue their own interests rather than the firm’s interests. Monopoly power thus triggers non-cost minimizing behavior. We may thus expect government regulation of firms, for example, public utilities, to trigger X-inefficiency.
China is a perfect example for testing XE theory. They had a communist government and a communist economy. Under Mao the profit motive, western technology and economic aid from the West were downplayed, even made illegal. Entrepreneurs were considered bourgeoise criminals. However, beginning in 1979 the Chinese Communist Party began to roll back many of Mao’s programs and expressed the benefits of the profit motive, market prices, and entrepreneurs. How did these changes affect the efficiency of Chinese economic organizations, specifically banking? This paper will review studies of Chinese banks and XE.
Chinese banking reforms may be said to begin in 1979 (Fu & Hefferman, 2009) [
1993 saw the “Decision on Financial System Reform”, during which time state banks were allowed to compete along-side other banking institutions, in an effort to introduce competition. The PBC was in charge of monetary policy, but the China Banking Regulatory Commission (BRC, 2003) took over the regulatory function formerly in the hands of the PBC. The BRC allows foreign institutions to own as much as 25% of a Chinese financial institution.
Three state-owned Policy Banks (PB) were created in 1994 to make loans formerly done by the SOCBs. In 1999 China created four Asset Management Companies (AMC), one for each of the Big Four state-owned commercial banks. Formed as a way to compensate the Big Four for their service to the nation, the AMCs were created to take over the Big Four’s NPLs. In 1999 about 1.5 trillion RMB in NPLs were taken over, an amount equal to about 20% of China’s GDP.
Eleven joint stock-owned banks were created in 2005. It is important that the primary stockholders of these “private enterprise” banks were the State-Owned Enterprises (SOEs). There were 111 city commercial banks owned by local public and private institutions, three rural commercial banks, and 35,544 rural credit coops. By 2004 there were about 204 foreign bank subsidiaries. In the Commercial Bank Law in 1995, Chapter I General Provisions, Article 1 states the desire for modern financial system, protecting the legal rights of banking participants, strengthening the internal structure and performance of commercial banks, while promoting the socialist market economy.
In 1998 the government ended credit quotas. Beginning in 1998 banks could adjust interest rates within a “modest” amount to take risk into account. Capital injections reduced Non-Performing Loans (NPLs) which helped several banks in their successful IPOs on Shanghai and Hong Kong Stock Exchanges. In October 2005 the China Construction Bank initiated an IPO, China’s banking sector’s first IPO. The IPO was listed on the Hong Kong stock exchange. This was the first time that Chinese stock was listed in an overseas stock exchange. The various reforms have had positive effects. For example, among the largest state-owned banks the NPL ratio which was about 30% in 1999 dropped to 10.5% in 2005 and then to 6.7% in 2007, and 2.8% in 2008. Bank profits, measured as either ROA or ROE increased. From 2002 to 2006 ROE and ROA increased about three times, reaching levels of about 11% and 0.5%, respectively. In 2001 China joined the WTO and had five years to open up their banking sector to international competition. Opening the economy to foreign interests was essential for China’s membership in the WTO. Foreign banks were required to have unrestricted access to the Chinese financial sector. By 2007-2009 Chinese banks were the largest commercial banks in the world. The recession of 2007-2009 had intense effects on the world’s financial sector. On the one hand, financial giants such as Citigroup, and the Royal Bank of Scotland saw their stock prices fall by more than 95%. On the other hand, China’s three large state-owned commercial banks became the world’s three largest commercial banks.
Hong Kong was a Special Administrative Region of the People’s Republic of China from 1898 until 1997. Hong Kong has maintained its status as one of the world’s preeminent hubs of economic and financial activity. The laissez-faire attitudes toward banking and commercial activity among Hong Kong banks are well known. Hong Kong is home to the 5th largest stock market in the world, and is home to more than 150 licensed banks. However, banks were also protected from competition, at least until the deregulation of interest rates in 1994. In addition, many medium-sized banks are privately owned and controlled by the founding family. These banks did not respond to market incentive as would a publically listed bank. Overall, economic policy changes in the years since the East Asian financial crisis, as well as the entrance into the World Trade organization by China (2001) and Hong Kong (1995), have been significant.
First, several articles about the effects of ownership form. Fu and Hefferman (2007) [
Given the existence of asymmetric information, agency theory predicts that managers will act in their own interests rather than in the interests of the owner-principals. Fu and Hefferman state that this will be the case in both state-owned, and privately-owned firms. However, XE theory predicts that state-owned banks will suffer more from this problem. Fu and Hefferman state that agency problems may offset any positive effects of banking reforms. As predicted by XE theory, the privately-owned joint-stock banks were about 20% more X-efficient than the state-owned commercial banks.
Yao, Jiang, Feng, and Willenbockel (2007) [
Jiang, Yao, and Zhang (2009) [
Fu and Hefferman (2009) [
García-Herrero, Gavilá, and Santabárbara (2009) [
Matthews, and Zhang (2010) [
Two articles about the effect of China entering the WTO. Yao, Han, Feng (2008) [
Rezvanian, Ariss, and Mehdian (2011) [
Next are three articles on “general effects of financial considerations” on XE. Wu, Chen, and Lin (2009) [
Luo and Yao (2010) [
Hefferman and Fu (2010) [
Two articles about Hong Kong. Fung, and Cheng (2010) [
Kwan (2006) [
XE theory predicts that firms perform closer to potential when they face more “pressure”. The results of the research presented here verify the predictions. Private-owned banks are more X-efficient than state-owned banks. Deregulation, which increases competition (pressure), increases XE. China’s entry into the WTO increased competition from foreign banks and increased XE. When banks issue an IPO, they become subject to market pressures, and XE increases. Empirical evidence on XE covers firms in many industries in every continent of the world and the studies exceed 200. The evidences from all 200+ studies are very consistent with each other and support XE theory [