International Journal of Economics and Financial

Issues
ISSN: 2146-4138

available at http: www.econjournals.com

International Journal of Economics and Financial Issues, 2023, 13(4), 73-83.

Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier

Approach

Khondokar Jilhajj*

Department of Banking and Insurance, University of Dhaka, Bangladesh. *Email: jilhajj56@gmail.com

Received: 16 March 2023 Accepted: 23 June 2023 DOI: https://doi.org/10.32479/ijefi.14420

ABSTRACT
This paper examines the profit efficiency of the banks in Bangladesh using the stochastic frontier approach. The paper is prepared based on the
secondary data only and the sample contains data from 25 banks including state owned banks and private conventional banks in Bangladesh from the
year 2011-2020. Translog function has been employed to construct the profit function and Battese and Coelli, 1995 (BC95) model has been used to
determine the profit efficiency. The efficiency performance reveals that, on average, banks in Bangladesh are 80.73% profit efficient. Dutch-Bangla
Bank Limited (DBBL) is the most profit efficient banks with a score of 92.56% in 2020. While Dhaka Bank is the least profit efficient banks with a
score of 15.42%. Banks belong to the 3rd generation and 2nd generation are the most profit efficient. Besides, none of the inefficiency determinant is
statistically significant to explain variation in the profit inefficiency as the dataset is small and only limited to Bangladeshi banks. Moreover, diagnostic
tests such as Normality test, M3T statistics test and Likelihood Ratio (LR) test have been performed to confirm the existence of inefficiency. This
paper shall provide important insight of state owned banks and private conventional banks in Bangladesh to the managements, regulators and other
concerned parties.
Keywords: Profit Efficiency, Stochastic Frontier Approach, Generation Wise Banks, Intermediation Approach, Inefficiency, COVID-19
JEL Classifications: C33, G21, N25

1. INTRODUCTION imperative to measure the efficiency of commercial banks in

Bangladesh to produce necessary policy options for regulators,
A sound and competitive financial system is capable of improving managers of banks and public by using sophisticated approach.
a country’s financial stability and economic growth as it makes Considering this situation, bank efficiency is one of the best
the sector more enduring to both internal and external shocks. The indicators of sound banking system and it is often examined using
financial sector of Bangladesh is highly dominated by banking a parametric approach named stochastic frontier analysis (SFA)
industry and this industry has experienced significant progress and non- parametric method known as data envelopment analysis
recently in terms of number of banks, growth in assets and (DEA). There are numerous studies which conduct the bank
deposits, number of branches and account holders. In Bangladesh, efficiency such as Baten and Kamil (2010) employed SFA model
there are 61 scheduled banks and these banks have a total of to measure profit efficiency of banks in Bangladesh. Raju (2017)
BDT 20,429.300 billion of assets and a total of BDT 15,181.400 assessed the cost and profit efficiency of state-owned, conventional
billion of deposits (Source: CEIC Data), 10937 branches (Source: and Islamic banks in Bangladesh using both accounting ratios and
CEIC Data) and 13.24 crore bank account holders (Uddin, 2020). SFA method. Cost and profit efficiency of national commercial
Despite such progress, industry experts express that banking banks and private banks in Bangladesh are examined by Baten
industry of Bangladesh is at severe risk due to overcapacity, et al. (2015). These studies have found various problems in the
supervision gaps and market indiscipline. Therefore, it has become banking industry which are liable for increasing profit inefficiency

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 Jilhajj: Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier Approach

such as growing amount of NPLs, high interest rate spread, high foreign banks have the most profit efficiency (68.8%) along with
amount of operational costs etc. Therefore, this paper may help private banks. From the result of maximum likelihood estimates,
give policy recommendation to eliminate such problems associated capital and material have been found statistically significant while
with bank profit efficiency. For my analysis, 3 input prices, 3 labor and time have been found statistically insignificant. Moreover,
outputs, 2 controls variables and 9 determinants of inefficiency it is observed that time, total assets and Herfindahl-Hirschman index
have been taken to see their impact on profit efficiency. There have significant negative impact on bank profits.
are many studies regarding profit efficiency have been conducted
in developed and developing countries but very few studies on Hadhek et al. (2018) estimated the profit efficiency of 37 Islamic
this issue are conducted on the banks in Bangladesh. Given this, banks from 15 countries during 2005-2014 using the SFA
the present study would examine and compare the performance approach. The empirical analysis shows that, on average, the profit
of state-owned banks and private conventional banks from the efficiency level is 25.7%. Bank size, GDP per capita and demand
perspective of profit efficiency based on stochastic frontier density have been found statistically significant to have negative
approach (SFA) over the period of 2011 to 2020. impact on profit efficiency whereas profitability ratio (EBP) is
found to be positive and statistically significant.
The rest of the paper is structured as follows: Section 2 reviews
the previous studies on this topic; section 3 presents the details of Hendrawan and Nasution (2018) conducted a study to assess the
the data and methods revealing the sample collection technique, profit efficiency of 21 Indonesian banks on the IDX from the years
selected variables and mathematical model; section 4 shows the 2008 to 2017 by employing the SFA model. The research shows
results of the analysis; finally, section 5 concludes the results of that maximum efficiency score is 0.69 and the efficiency score
the paper. of the banking sector in the capital market of Indonesia is 0.43
and therefore, banking system in the capital market of Indonesia
2. LITERATURE REVIEW is thought to be inefficient. From the analysis, it is concluded
that Bank Rakyat Indonesia is the most efficient bank. The study
Pasiouras et al. (2009) presented the international evidence on the presents that total loans, securities, price of labor and inflation
effect of banking regulations and restrictions on bank activities on have significant impact on the profits of banks.
the banks’ cost and profit efficiency using the stochastic frontier
analysis. The sample covering the period of 2000-2004 consists of a Delis et al. (2009) performed the analysis of cost and profit
panel dataset of 2853 observations from 74 countries’ 615 publicly efficiency of the Greek Banking system from 1993 to 2005
listed commercial banks. The results suggest that higher official based on SFA model. The results indicate the lower score of
supervisory power and disclosures and incentive requirements of cost efficiency than the profit efficiency but the difference has
market discipline influence cost and profit efficiency positively. been found quite significant between levels of cost and profit
Stricter capital requirements positively affect the cost efficiency efficiency. Compared to smaller banks, larger banks have been
but it has negative influence on profit efficiency. On the other found less profit efficient. Furthermore, state owned banks have
hand, the paper finds opposite result in terms of restrictions on emerged to be less profit efficient. Moreover, the paper also made
bank activities, having a negative impact on cost efficiency and comparison between the parametric (SFA) and non-parametric
positive impact on profit efficiency. The overall efficiency score (DEA) approaches. The results of the DEA method indicate higher
has been found 0.8789 and 0.7679 for cost and profit efficiency average inefficiency compared to the SFA approach.
respectively.
Pasiouras et al. (2007) investigated the impact of regulatory,
Lu et al. (2019) applied parametric SFA approach to examine the supervision and environmental factors on bank efficiency by
cost and profit efficiency of banks in New Zealand from 2002 to employing the stochastic frontier analysis and Tobit regression.
2011. The results indicate that banks from foreign countries are A panel dataset of 3086 observations from 677 publicly listed
more cost and profit efficient than domestic banks. The paper also commercial banks in 88 countries during 2000-2004 have been
shows that locally incorporated subsidiaries of foreign banks are used. From the analysis, it is evident that restrictions on the banking
more efficient than foreign banks operating as branch banks. The activities affect profit efficiency. The results also report that profit
study indicates due to an increase in banking market concentration efficiency is improved by the capital adequacy and the impact of
level, large banks usually gain more in terms of profit efficiency. government ownership of banks is significant. Bank size has been
Bank size has been found positively associate with cost and found to be statistically significant to influence profit efficiency
profit efficiency. Moreover, the study shows significant impact positively. It is reported that stock market capitalization improves
of equity capital ratio, asset quality, interest rate, inflation and profit efficiency but this efficiency is reduced by higher inflation.
unemployment conditions on both cost and profit efficiency. Moreover, profit efficiency has been influenced by GDP growth.
Lastly, property rights protection is negatively influencing profit.
Baten and Kamil (2010) examined the changes in profit efficiency in
accordance with the nationalized commercial banks, Islamic banks, Rusmita and Putri (2020) examined the level of cost and profit
Foreign banks and Private banks during the period 2000-2007 efficiency of the listed Islamic banks in Indonesia using the SFA
by employing stochastic frontier technique. The analysis shows method. Dataset is formed based on cross-section and panel data
that Banks in Bangladesh, on average, are year wise 66.4% profit obtained from 7 banks from 2015 to 2019. The analysis reports
efficient while it is 63.9% under group wise. It has been found that that the average profit efficiency score is 55.35%.

74 International Journal of Economics and Financial Issues | Vol 13 • Issue 4 • 2023

 Jilhajj: Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier Approach

Ariff and Luc (2008) performed the cost and profit efficiency of Douglas cost and profit models. The average profit efficiency is
28 Chinese commercial banks from 1995 to 2004 by employing recorded 91.1% and Eastern Bank was found to be the most profit
Tobit regression. The findings show that overall profit efficiency efficient whereas Janata Bank is ranked in the last.
level is 50.50%. On average, national and city based joint-stock
banks have appeared to be more cost and profit efficient than Belousova et al. (2018) examined how the profit efficiency of
state-owned banks. On the other hand, medium-sized banks have Russian banks affected by the type of ownership during the period
been found to be significantly more efficient. 2004 to 2015 by combining the stochastic frontier analysis with
intermediary approach. The findings show that foreign owned banks
Tahir et al. (2010) performed the relative efficiency level of are most profit efficient than state-owned banks and domestic private
Malaysian domestic and foreign commercial during 2000-2006 banks. During the economically stable periods of 1st quarter of 2004
by employing accounting-based ratio and stochastic frontier to the 2nd quarter of 2008 and 2014 to 2015, foreign banks enjoyed
approach. Based on accounting ratios, domestic banks have the higher profit efficiency than other domestic banks in Russia.
higher interest margin and operating costs than foreign banks However, during the financial turmoil periods, state-owned banks
while foreign banks enjoy slightly higher profit ratios relative to were more profit efficient than any other banks due to state support.
domestic banks. According to the results of SFA method, domestic
banks have proved to be more cost efficient but less profit efficient Raju (2017) used the basic accounting ratios and stochastic cost
compared to the foreign banks. Overall, profit efficiency scores are and profit approaches to assess the cost and profit efficiency of
63.8% for domestic banks and 76.9% for foreign banks. state owned, conventional and Islamic banks in Bangladesh during
2011-2015. Based on accounting ratios, conventional commercial
Mghaieth and Khanchel (2015) used the SFA approach to banks are more cost and profit efficient than other two types of
investigate the cost and profit efficiency’s determinants of Islamic banks. As per the result of stochastic profit frontier, conventional
banks before, during and after the financial crisis of 2008. The banks have the higher alternative profit efficiency than Islamic
sample consists of 62 Islamic banks of 16 countries covering the banks and state-owned banks.
regions of MENA and South East Asia from 2004 to 2010. Results
of the panel data show that banks have average profit efficiency of Hassan et al. (2009) measured and compared the cost and profit
82.47%. According to the regression results, Islamic banks which efficiency using the SFA approach where the sample data consists
are having high profitability ratio and equities are the most profit of 37 conventional banks and 43 Islamic banks from 21 OIC
efficient. The research reports that bank size, capital adequacy countries. The overall result of the efficiency report that average
ratio, ROAA and operational cost have significant impact on bank is better in profit generation than utilizing the resources.
profit efficiency. Also over the years, profit efficiency is more stable than the level
of cost efficiency but in terms of overall sample, cost and profit
Srairi (2010) used a stochastic frontier model to investigate the efficiency of conventional versus Islamic banks do not have
cost and alternative profit efficiency of the Gulf banking industry. significant difference. Large conventional banks have the highest
The sample consists of an unbalanced panel data of 71 commercial profit efficiency whereas lowest profit efficiency have been scored
banks for the period of 1999-2007. The paper reports that profit by the small conventional banks and African conventional banks.
efficiency is increased by financial depth, capital ratio, degree of
monetization and concentration and GDP per capita. The results Isik and Hassan (2002) examined the impact of corporate control,
reveal that banks in Gulf region are more profit efficient than bank size, ownership and governance on the cost and alternative
cost efficient as profit efficiency score is 71% higher than cost profit efficiency of banks in Turkey by employing the stochastic
efficiency score (56%). frontier approach. The results reveal that average profit efficiency
is 84% and the Turkish banking industry’s oligopolistic nature has
Akhigbe and McNulty (2003) researched the profit efficiency of contributed less than optimal competition in the deposit and loan
USA’s small banks for the sample period of 1990 to 1996. The markets. The results also show that Turkish banks do not require
result reveals that small banks are more profit efficient compared greater cost efficiency to have high profit efficiency and the cost
to the large banks for the sample period. From the analysis of inefficient banks can operate in the imperfect market.
single frontier approach, it has been reported that, 69.67% profit
efficiency is enjoyed by small banks in metropolitan statistical Vivas (1997) examined the profit efficiency of Spanish savings banks
areas (MSAs) where banks in non-MSAs have a score of 78.62%. based on thick frontier approach over the period of 1986 to 1991. The
Regression analysis shows that profit efficiency increases due to result reveals that the most and least profitable savings banks have
the increase of bank size. Lastly expense-preference (EP), structure 40% average difference in estimated profits and the difference has
performance (SP) and lender-borrower relationship development arises due to the scale, input prices, output mix, branching intensity
play significant role in explaining the profit efficiency of US small and profit inefficiency. The result also suggests that standard profit
commercial banks. function is not appropriate for the banks in Spain.

Baten et al. (2015) employed stochastic frontier analysis to Wahyuni and Pujiharto (2016) measured the profit efficiency over
estimate the cost and profit efficiency of national commercial banks the period of 2010 to 2014. The results show that overall, there
and private banks in Bangladesh from 2001 to 2010. The analysis is a profit efficiency in the Shariah banks in Indonesia which is
shows that Translog cost and profit models are preferable to Cobb- <1. Both Shariah banks and Shariah business units incur profit

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 Jilhajj: Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier Approach

inefficiency. At the time of global financial crisis of 2008-2009, (2011-2020). The sample of banks consists of 4 state-owned banks
the profit efficiency declined for the Shariah banks but Shariah and 21 private conventional banks. The macro-level data have
business units did not have declining profit efficiency. The result been collected from the World Bank open data.
also indicates that profit efficiency is positively affected by
bank size but capital adequacy do not have any impact on profit 3.2. Model Design and Specification
efficiency. This paper examines the profit efficiency of banks in Bangladesh
and determines the factors that affect the banks’ profit inefficiency
Hassan (2005) employed a panel data to investigate the efficiency using the Stochastic Frontier Approach (SFA). The SFA was first
of the Islamic banking industry of the world over the period of developed by Meeusen and Van Den Broeck (1997) and Aigner
1995 to 2001 by employing both SFA and DEA methods. From et al. (1977). The SFA model deploys a procedure to estimate the
the findings, under SFA method, on average, 84% profit efficiency efficiency score of banks in relation to the best practice frontier
has been achieved. 74% of allocative efficiency is generated while or in other word, the best practice banks in terms of profit. The
technical efficiency score is about 84%. The results also show that SFA method captures the both random error and inefficiency
ROA and ROE are highly correlated with the efficiency measures. components. Among various SFA model available for bank
The results also indicate that increase in productivity growth in efficiency studies, model created by Battese and Coelli (1995)
Islamic banks is due to the changes in technology not change in (BC95, hereafter) has been chosen for two key reasons. Firstly,
technical efficiency. Lastly it has been found that higher efficiency panel data model is allowed by BC95 to capture inefficiency impact
has been associated with greater profitability. on stochastic frontiers. This suits panel data set developed in this
paper and allows to estimate the time verifying efficiency at bank-
Semih and Philippatos (2007) examined the cost and profit level. Secondly, the estimations of the parameters of stochastic
efficiency and found that inefficiencies in management in the frontier model and the inefficiency model in a one-step approach
CEE banking market are significant enough. They conducted simultaneously are permitted by the BC95 model unlike the Aigner
the research based on the stochastic frontier approach (SFA) et al. (1997)’s standard two-step stochastic frontier model.
and the distribution-free approach. The average cost regarding
efficiency levels is significant enough with the efficiency level of The profit model in its general format is as follows:
72% and 77% by the prospects towards DFA and SFA. Also in
the profit efficiency level, it is considered as the relatively lower lnTPit  TP  yit , pit ,    vit  (uit )  (1)
cost-efficient. SFA describes that almost one-third of banks are in
inefficiencies and DFA describes almost one-third of inefficiencies. Where,
They also found that foreign banks are more cost-efficient. On TP = Total profit at time t of the bank i
the other hand, they are less profit efficient compared with the yit = Vector of outputs
domestic private banks and state-owned banks. pit = Vector of input prices
β = Vector of unknown scalar parameters to be estimated
Now based on the results of different papers studied above, it has vit = Random error term follows the standard normal distribution
been found that bank efficiency in terms of profit efficiency has or N (0, σv2) distribution.
only been investigated for the overall banks in the sector. Other (–uit) = Inefficiency terms for profit function follows a half
categories such as generation wise profit efficiency and profit normal distribution or N (mit, σu2) distribution where mean, mit
efficiency level during COVID-19 have not been conducted in is explained as:
Bangladesh. So there is an absent of complete picture of profit mit   0  zit   wit  (2)
efficiency. Therefore, to deliver a complete scenario, generation
wise bank profit efficiency and profit efficiency level during Here, zit is the vector of observable explanatory variables,
global catastrophic event such as COVID-19 pandemic have been represented as exogenous variables which affect the inefficiency
incorporated in this paper. of bank i at time t. δ is defined as the vector of parameters to be
estimated and wit. is the error term.
3. DATA AND METHODS
The parameters of equation (1) and (2) are calculated in one stage
Profit efficiency of banks is measured in terms of the efficient regression model using the Maximum Likelihood Estimation
profit frontier that is the best practice bank. Profit efficiency is method. The efficiency scores of each bank are estimated from
defined as the maximum profit to the actual profit. The Translog the estimated frontiers as PEFit = exp (–uit) having the range of
profit functions developed by Christensen et al. (1973) has value between 0 and 1.
been employed in this paper which includes both inefficiency
component and random component. 3.3. Construction of the Variables
To define input prices and outputs, the intermediation approach
3.1. Sample Selection Procedure has been adopted to examine the profit efficiency of the sample
Preparing this paper requires a panel data set constructed from banks (e.g. Berger and Mester, 1997; Delis et al., 2009; Isik
secondary sources including Profit and Loss Statement and and Hassan, 2002; Srairi, 2010). The intermediation approach
Balance Sheet of the sample banks. The sample covers bank level considers banks as financial intermediaries between savers and
data for the 25 scheduled banks in Bangladesh for the past 10 years investors. Loans and other assets are regarded as the outputs of

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 Jilhajj: Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier Approach

banks while deposits and other liabilities are taken as the inputs source of financing and neglecting it could result in bias
under the intermediation process. inefficiency score.
b) Time trend: Year dummy as a time trend variable is included
Measurement of profit efficiency needs data on total profit, input in the model to capture the technological changes over time
prices and outputs. The dependent variable is total profit (TP) (Pasiouras et al., 2009).
where the profit after tax is taken as the TP. Under this paper, c) Market concentration ratio: The market concentration ratio
banks are viewed as multi-product firms which generate three refers to the likelihood of competition between the banks
outputs by employing three input prices. Finally, to capture the and also in the market as a whole. The ratio is constructed by
impact of inefficiency components on profit functions, various dividing the total assets of the three largest state-owned banks
environmental, bank specific and macroeconomic variables have named Sonali bank, Rupali bank and Janata bank with the total
been included in the model as independent variables. assets of industry. This variable is added in the inefficiency
function to see how the profit frontier as well as the relative
3.3.1. Input prices and outputs profit efficiency of the sample banks get influenced by the
Input prices are measured as flows of expenditures divided by the asset market concentration. Considerable market power is
corresponding quantity. Cost of labor (p1) is calculated as ratio granted to large banks when a concentrated market exists
of personnel expense such as salaries and allowances to the total because it provides them with a power to charge higher price
assets; cost of borrowed funds (p2) measured as interest expense for their products and services and generate higher revenues.
divided by total deposits and lastly cost of physical capital (p3) Result of Lu et al. (2019) suggests that large banks are more
defined as the operating expenses minus salaries and allowances profit efficient than cost efficient when there is a rise of market
which is then divided by total fixed assets. concentration as it has significant negative impact on profit
inefficiency. Srairi (2010) found significant positive influence
The outputs include loans (y1) calculated using gross loans and of concentration ratio on profit efficiency.
advances; Other earnings assets (y2) which comprise total assets d) Bank size: The effect of bank size on profit efficiency has been
minus loans and advances minus fixed assets and finally, off examined in several papers where bank size is measured as
balance sheet items (y3). All three output vectors are in million the natural logarithm of total asset consistent with the studies
taka and they are deflated using GDP deflator. of Hadhek (2018), Hassan (2005) and Srairi (2010). Banks
will operate more efficiently and generate more profit due to
3.3.2. Other variables affecting profit and inefficiency the increase in bank size or economies of scale. It is expected
Besides input prices and outputs, there are control variables that that bank size and profit efficiency are positively associated
have impact on the profit function such as equity and time trend. as large banks have always been in forefront in terms of
Moreover, there are other variables which may belong to the technological innovation, broad range of customer services,
inefficiency function or they may belong to the frontier. Therefore, higher market share and economies of scale. When bank size
to determine the effect of inefficiency on profit function various increases, cost and profit efficiencies fall systematically (Isik
explanatory variables such as market concentration ratio (MC), and Hassan 2002). According to Hassan (2005) and Srairi
bank size (SIZE), credit risk (CRDRISK), profitability ratio (ROA), (2010), there exists a positive relationship between profit
financial intermediation ratio (FIR), operational cost (CIR), efficiency and bank size. Bank size has significant positive
economic growth (GDPGR), interest rate (INT) and inflation rate impact on profit efficiency (Lu et al., 2019).
(INF) have been included into the model. The summary of the e) Credit risk: To incorporate the impact of credit risk on the
each variable is presented in Table 1. profit efficiency, Non-Performing Loans (NPL) to total loans
has been taken as a proxy for credit risk (Fries and Tacy, 2005).
3.3.3. Rationale of the explanatory variables It is expected that the coefficient of credit risk variable (NPL/
a) Equity: Equity capital can be defined as the managerial risk total loans) has negative impact on profit efficiency as higher
preferences of banks as it has impact on the allocation of NPLs lower the profit efficiency. Banks having poor credit
banks’ asset portfolios and forms an alternative sources of risk management are not efficient in their operation (Isik and
funds to deposits. Equity capital varies across banks but Hassan 2002). Semih and Philippatos (2007) suggests that
common elements included in the equity capital are paid- efficient banks are effective in assessing credit risk.
up capital, retained earnings, gains from revaluation and f) Profitability ratio: Return on assets (ROA) is taken as a proxy
reserves. Equity has been used in the model to control the for profitability ratio where it is calculated by dividing the
differences in risk preferences (Pasiouras et al., 2009). Delis net income with total assets of bank. Higher ROA indicates
et al. (2009) includes equity in order to capture insolvency higher ability of banks and better performance. According to
risk, capitalization and various risk preferences across banks. Mghaieth and Khanchel (2015), profit efficiency and ROA are
Equity is included into the profit efficiency function for few positively correlated. While Semih and Philippatos (2007) did
reasons. Firstly, it captures managerial risk preference in not find any relation between bank efficiency and ROA. Ariff
terms of maximization and minimization problems. Risk and Luc (2008) suggests that banks which are more profitable
averse managers might be interested in holding equity capital are more efficient even though the study did not find significant
than that of debt capital which is liable of cost minimization. relationship between profit efficiency and profitability.
Secondly, lower level of default risk is associated with higher g) Financial intermediation ratio: The financial intermediation
level of equity. Finally, equity financing is the most expensive ratio refers to the degree of intermediation through which

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Table 1: Summary of the variables

Variable Notation Measure
Dependent variables
Total profit TP Profit after tax
Input prices
Cost of labor P1 Personnel expenses (salaries and allowances) divided by Total assets
Cost of borrowed funds P2 Interest expenses divided by Total deposits
Cost of physical capital P3 (Operating expenditure ‑ salaries and allowances) divided by Total fixed assets
Outputs
Loans Y1 Gross loans and advances
Other earnings assets Y2 Total assets ‑ loans and advances ‑ fixed assets
Off balance sheet items Y3 Total off balance sheet items
Control variables
Equity EQ Total equity
Time trend t Year
Determinants of inefficiency
Environmental variable
Market concentration ratio MC Total assets of three major state owned banks (Sonali Bank, Rupali Bank and Janata Bank)
divided by Total assets of the banking industry.
Bank specific variables
Bank size SIZE Natural logarithm of total assets
Credit risk CRDRISK Non‑Performing Loans (NPL) divided by Total loans
Profitability ratio ROA Net income divided by Total assets
Financial intermediation ratio FIR Total loans divided by Total deposits
Operational cost CIR Operating expense divided by operating income
Macroeconomic variables
Economic growth GDPGR GDP Growth Rate
Interest rate INT Interest rate spread (lending interest rate ‑ deposit interest rate)
Inflation rate INF CPI index
Source: Author’s self ‑ contribution

deposits are converted into loans by banks. This ratio is finds significant negative impact of real GDP growth on profit
measured by taking total loans to total deposits (Srairi, 2010). inefficiency.
This ratio is included in the profit function in order to capture j) Interest rate: To capture the impact of interest rate on profit
the differences in banking sectors in terms of their ability to inefficiency, interest rate spread is taken as a proxy. Interest
transform deposits into loans. Profit efficiency is expected to rate spread is the difference between the lending interest rate
have positive association with financial intermediation ratio. and deposit interest rate. Interest rate spread will be positive
Intermediation ratio is positively significant to influence profit when lending rates are increased but it is expected to have
efficiency as per the result of Srairi (2010). negative impact on the asset quality of the borrowers who
h) Operational cost: Impact of operational cost on profit efficiency then find lending expensive and as a result, their ability to
is calculated by taking cost to income ratio as a proxy. The cost repay the loans get reduced. However, it is also expected
to income ratio is calculated as operating expense divided by that higher spread will positively affect the bank earnings
operating income. A smaller cost to income ratio indicates that and consequently its profit efficiency. Fries and Taci (2005)
the bank is more efficient in conducting its business related reports a positive association between bank inefficiency and
activities and it also means that the performance of bank will
interest rates. This suggests that higher interest rate will cause
also rise. A cost to income ratio that is <1 indicates that it is
the interest expense to rise which adversely affects the credit
a healthy bank. Ariff and Luc (2008) found cost to income
risk management of banks. Lu et al. (2019) finds positive
has significant negative impact on profit efficiency suggesting
influence of interest rate on profit inefficiency.
efficient banks can control costs better and seek opportunities
to enhance revenues. In contrast, Mghaieth and Khanchel k) Inflation rate: Impact of inflation rate on the profit efficiency
(2015) finds a positive and statistically significant relation of banks mostly depends on whether it is anticipated or
between operational costs and profit efficiency. unanticipated. Banks which can anticipate inflation timely
i) Economic growth: GDP growth rate has been taken as a proxy are able to adjust rate of interest properly. Therefore, they are
for economic growth which is a determinants of inefficiency able to generate high profit by imposing high interest rates
for profit function. It is expected that banks operating in on loans. But if inflation is unanticipated, lower profits and
expanding markets enjoy higher level of profit efficiency. losses are generated by banks as they fail to adjust inflation
Also banks will benefit via good credit repayment by debtors rate timely. According to Pasiouras et al. (2009), inflation rate
due to higher economic growth. Moreover, when favorable has a strong and positive influence on the profit inefficiency
economic condition is achieved, borrowers will be efficient of banks. As per Lu et al. (2019) inflation rate has significant
to service their debts. As a result, banks will enjoy their negative impact on profit inefficiency suggesting banks
expected efficiency. It is expected that GDP growth rate has are able to anticipate inflation rate and adjust interest rates
positive impact on profit efficiency. Pasiouras et al. (2009) properly to have higher profits.

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After discussing about the rationale of the explanatory variables 4.1. Year Wise Average Profit Efficiency Scores
(except equity and time variables), the following hypotheses have Table 2 summarizes the average profit efficiency scores of sample
been developed to check whether they have significant impact on banks in Bangladesh during the period of 2011-2020, estimated by
profit inefficiency. the stochastic frontier approach with a translog profit function. It is
H1: Market concentration ratio has negative impact on profit observed that banks in Bangladesh, on average, are 80.73% profit
inefficiency efficient in terms of making profit oriented services compared to
H2: Bank size has negative impact on profit inefficiency the best performing bank during the sample periods. Based on the
H3: Credit risk has positive impact on profit inefficiency result obtained, it can be concluded that around one-fifth of the
H4: Profitability ratio has negative impact on profit inefficiency profits of banks got vanished due to the existence of inefficiency over
H5: Financial intermediation ratio has negative impact on profit the sample period. Differently put, the banks in Bangladesh could
inefficiency improve their profits by 19.27% to match the performance of the best
H6: Operational costs has positive impact on profit inefficiency practice bank in the industry. From the investigation, highest profit
H7: Economic Growth has negative impact on profit inefficiency efficiency score is obtained in 2011 (0.8921) while the lowest score
H8: Interest rate has positive impact on profit inefficiency is experienced in 2020. One possible reason is due to the impact of
H9: Inflation rate either has positive or negative impact on profit COVID-19 outbreak, banks could not perform efficiently and in this
inefficiency. process, had to give up most of their incomes from profit oriented
services. It can be seen that over the sample period, profit efficiency
Now using three input prices, three outputs and equity and time of banks fluctuated a lot and had become more profit inefficient as
variables, specification of the stochastic profit frontier model based the efficiency scores have decreased from 0.8921 in 2011 to 0.6896
on BC95 is as follows: during 2020.The causes behind the decreasing nature of profit
efficiency in recent times could be the increased expenses to stay
1 relevant in intense competition imposed by other banks, increasing
ln TP   0  1ln( p1 )   2 ln( p2 )   3ln( p3 )   4 (ln  p1 ) 2
2 trend of loan loss provision and impact of Covid-19.
1 1
 5 (ln( p2 )) 2   6 (ln( p3 )) 2   7 ln  p1  ln( p2 ) 4.2. Five Top and Worst Performing Profit Efficient
2 2
 8 ln  p1  ln( p3 )   9 ln  p2  ln( p3 )  1ln( y1 )   2 ln( y2 ) Banks Over the Years
Tables 3 and 4 report the five top and worst performing banks in
1 1 1 terms of profit efficiency. It is observed that not only the private
  3ln( y3 )   4 (ln( y1 )) 2   5 (ln  y2 ) 2   6 (ln  y3 ) 2
2 2 2 conventional banks but also some state-owned banks have been the
  7 ln( y1 )ln( y2 )  8ln( y1 )ln( y3 )   9 ln( y2 )ln( y3 ) best performing profit efficient banks in the most recent year. The
 1ln( p1 )ln( y1 )   2 ln( p1 )ln( y2 )   3ln( p1 )ln( y3 ) five top performing efficient banks during 2020 are Dutch Bangla
bank Ltd - DBBL (with 92.56%), Trust bank (92.56%), Sonali
 4 ln( p2 )ln( y1 )   5ln( p2 )ln( y2 )   6 ln( p2 )ln( y3 )
bank (91.62%), Eastern bank Ltd- EBL (86.97%) and Janata bank
 7 ln( p3 )ln( y1 )   8ln( p3 )ln( y2 )   9 ln( p3 )ln( y3 ) (86.70%). Possible reasons could be that among the top five, private
1 1 banks might have learnt the advantages of technical supports to
 d1lnequity  d 2 (lnequity) 2  1t   2 t 2  vit  (uit )
2 2 reduce their costs and they have the advantage to learn from the
Where, the following constraints with the symmetry being experience of older state-owned banks. On the other hand, Sonali
δ ij = δ ji is used for linear homogeneity: bank and Janata bank have the advantages of economies of scale,
bigger asset sizes and market shares due to being state owned
3 3 3 banks. These advantages certainly had help them reduce their costs,
  j  1,   jh  0,  ij 0 increase their net profit and ultimately, profit efficiency scores.
j j j Moreover, high profit efficiency scores could have been achieved
Lastly, the following equation has been developed to incorporate due to the Corona Virus stimulus package introduced during the
the impact of determinants of inefficiency on profit efficiency. lockdown in 2020. Banks could have used their stimulus package in

mit   0  1MC   2 SIZE   3CRDRISK   4 ROA Table 2: Year wise average profit efficiency scores
 5 FIR   6 CIR   7 GDPGR   8 INT   9 INF  wit Year Profit efficiency
2020 0.6896
2019 0.7845
4. DATA ANALYSIS 2018 0.8152
2017 0.8744
Profit efficiency of banking sector is important and it is either 2016 0.8099
positively or negatively affected by various factors including 2015 0.8406
2014 0.8414
bank size, credit risk, inflation rate etc. The profit efficiency
2013 0.7308
score will determine the best and worst performing banks and 2012 0.7965
the determinants of inefficiency will indicate which variables are 2011 0.8921
causing problems for banks in terms of profit inefficiency. The Overall 0.8073
results obtained by using BC95 model are presented as follows- Source: Author’s self ‑ contribution based on the output from STATA 12.0

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 Jilhajj: Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier Approach

Table 3: Five top performing profit efficient banks over the years
Year Ranking of the five top performing profit efficient banks
1 2 3 4 5
2020 DBBL Trust Bank Sonali Bank EBL Janata Bank
(0.9256186) (0.9255877) (0.9162208) (0.8696852) (0.8669621)
2019 Trust Bank Bank Asia Sonali Bank EBL AB Bank
(0.947899) (0.927484) (0.9162208) (0.8696852) (0.8966012)
2018 Southeast Bank Sonali Bank NCC Bank Dhaka Bank Bank Asia
(0.9302983) (0.9288629) (0.927290) (0.9195475) (0.9113004)
2017 Southeast Bank EBL Rupali Bank National Bank Premier Bank
(0.956076) (0.9399673) (0.9391907) (0.9373465) (0.9331146)
2016 Dhaka Bank Southeast Bank National Bank BRAC Bank NCC Bank
(0.9515038) (0.9509907) (0.9492931) (0.9387072) (0.9385935)
2015 Southeast Bank Agrani Bank Uttara Bank IFIC BRAC Bank
(0.9454165) (0.927393) (0.9254281) (0.9211793) (0.9207833)
2014 Agrani Bank Southeast Bank One Bank NCC Bank Bank Asia
(0.9431147) (0.9353799) (0.9259363) (0.9240212) (0.9222421)
2013 Bank Asia Pubali Bank MTB Agrani Bank EBL
(0.9177309) (0.9047738) (0.9040965) (0.9002042) (0.8991213)
2012 Agrani Bank Jamuna Bank BRAC Bank NCC Bank Uttara Bank
(0.947138) (0.9406456) (0.9286896) (0.9278697) (0.922664)
2011 Agrani Bank NCC Bank One Bank Dhaka Bank National Bank
(0.9640146) (0.9602143) (0.9531149) (0.9527599) (0.9470545)
Source: Author’s self ‑ contribution based on the output from STATA 12.0

Table 4: Five worst performing profit efficient banks over the years
Year Ranking of the five worst performing profit efficient banks
5 4 3 2 1
2020 UCB One Bank IFIC Bank Rupali Bank Dhaka Bank
(0.6673615) (0.4721902) (0.4474975) (0.2369423) (0.1541769)
2019 Janata Bank UCB One Bank Rupali Bank Dhaka Bank
(0.6857982) (0.6673615) (0.6068312) (0.2731613) (0.1666363)
2018 UCB Bank IFIC Bank Rupali Bank City Bank AB Bank
(0.7303395) (0.6629859) (0.5996562) (0.5759244) (0.4281285)
2017 The City Bank Prime Bank Uttara Bank Sonali Bank AB Bank
(0.7930609) (0.7885529) (0.6851936) (0.6803663) (0.6631232)
2016 Mercantile Bank AB Bank Uttara Bank Sonali Bank Rupali Bank
(0.7557) (0.6225609) (0.5901052) (0.5674859) (0.1684959)
2015 Mercantile Bank Premier Bank Prime Bank Rupali Bank AB Bank
(0.7949) (0.685237) (0.6810503) (0.6175005) (0.5843963)
2014 IFIC Bank Premier Bank National Bank Prime Bank Rupali Bank
(0.7276263) (0.6934751) (0.6857381) (0.6777935) (0.653385)
2013 Rupali Bank Southeast Bank Trust Bank National Bank Sonali Bank
(0.5650604) (0.5151089) (0.5140083 (0.2777018) (0.249344)
2012 National Bank Prime Bank AB Bank Trust Bank Southeast Bank
(0.7009696) (0.6914206) (0.6314697) (0.479579) (0.4715256)
2011 Uttara Bank Trust Bank Prime Bank Southeast Bank AB Bank
(0.8692065) (0.8404573) (0.7950043) (0.7514055) (0.7148845)
Source: Author’s self ‑ contribution based on the output from STATA 12.0

providing more loans to large borrowers and this might have helped their profits generated from revenue making services. The possible
increase their interest income which ultimately influenced the profit explanation is that they maintained their costs using various
efficiency scores. Trust bank, which is managed by the Bangladesh technological advantages which they introduced during COVID-19
Army’s highest position holders who had clear idea about the period but to maintain that technical supports, they might have to
situation of the country during COVID-19 might have handled the compromise their profit efficiency. Besides, Rupali bank appears
bank’s profit efficiently and obtained higher profit efficiency score. most of the times in the category of the lowest profit efficiency
score. One important reason is that Rupali bank has the lowest
On the contrary, top five worst performing profit efficient banks in amount of profit after tax compared to other state-owned banks.
2020 are Dhaka bank (with 15.42%), Rupali bank (with 23.69%),
IFIC bank (with 44.75%), One bank (with 47.22%) and United 4.3. Profit Efficiency between State Owned Banks and
Commerce bank –UCB (with 66.74%). Dhaka Bank obtained the Private Conventional Banks
1st highest profit inefficiency position. It has a profit inefficiency Table 5 incorporates the profit efficiency between state owned
level of almost 85% which means on average, they have lost 85% of banks and private conventional banks. It has been observed that

80 International Journal of Economics and Financial Issues | Vol 13 • Issue 4 • 2023

 Jilhajj: Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier Approach

private conventional banks are more profit efficient than state except during the period of COVID -19 for obvious reasons. One
owned banks. State owned banks have the advantages in the explanation is the learning effect where new banks observe the
areas of economies of scale, asset size, market share and public experience of the older banks and implement in their operation.
confidence. These factors might be helpful in reducing the costs Another fact is that these banks belong to the category of private
of the banks but not helpful in increasing the profit. Private conventional banks who are efficient in terms of technological
conventional banks, on the other hand, are quick in adapting the innovation in banking products and customer services which
learning effect from the state owned banks and they have vast in turn, help increase their profit efficiency. Banks having the
research and development team responsible for introducing new attributes of bigger assets size and economies of scale fall under
technology in financial services and wider customer oriented first generation banks. They might be more cost efficient than
services resulting higher profit efficiency. Therefore, it can be profit efficient.
concluded that profit efficiency is likely to be driven by revenues
rather than costs (Pasiouras et al., 2009). But profit efficiency of 4.5. Five Top and Worst Performing Profit Efficient
both categories of banks have been in fluctuated situation over Banks during COVID-19
the periods. Table 7 presents the five top and worst performing profit efficient
banks during COVID-19. During the COVID-19 pandemic,
4.4. Generation Wise Five Top Performing Profit profit efficiency scores of five top performing banks were quite
Efficient Banks in Recent Years satisfactory. As banking activities were operated from home,
Table 6 indicates the profit efficiency scores of the five top banks were able to reduce their operating expenses and increase
performing banks based on the generation of banks. It is observed net profits. Finally, in terms of best and worst performing banks
that most profit efficient banks are from 3rd and 2nd generation banks during that period, Dutch Bangla bank Ltd (DBBL) followed by
Trust bank were the most profit efficient banks while Dhaka bank
Table 5: Profit efficiency between state owned banks and followed by Rupali bank were the worst performing profit efficient
private conventional banks banks respectively.
Years Profit efficiency of Profit efficiency of private
state owned banks conventional banks
4.6. Diagnostic Test for Profit Function
2020 0.6550 0.6973 In Table 8, to confirm the existence of inefficiency term in the
2019 0.6459 0.8123 dataset, skewness tests of OLS residuals have been conducted. Two
2018 0.8032 0.8177 pre-estimation tests called Normality test and M3T statistics test
2017 0.8641 0.8763 have been performed. For both of these tests, null hypothesis (H0)
2016 0.6043 0.8490 states no skewness or there is no inefficiency term in the dataset and
2015 0.8002 0.8482
2014 0.8155 0.8464 alternative hypothesis (H1) states presence of skewness. The result
2013 0.6461 0.7470 under the normality test shows a positively skewed residual with
2012 0.8808 0.7797 a skewness value of 43.65 and it is statistically significant since
2011 0.9325 0.8840 the P=0.0000. In case of M3T test, it is expected that the residuals
Source: Author’s self ‑ contribution based on the output from STATA 12.0 will be skewed negatively for profit function. Now, H0 under M3T

Table 6: Generation wise five top performing profit efficient banks in recent years
2020 Ranking of the five top performing profit efficient banks
1 2 3 4 5
1st generation Sonali Bank Janata Bank AB Bank Uttara Bank National Bank
(0.9162) (0.8670) (0.8354) (0.7967) (0.7802)
2nd generation DBBL EBL Southeast Bank NCC Bank Prime Bank
(0.9256) (0.8697) (0.8626) (0.8103) (0.7414)
3rd generation Trust Bank Mercantile Bank Jamuna Bank BRAC Bank Premier Bank
(0.9256) (0.7391) (0.7343) (0.7303) (0.7143)
2019 1 2 3 4 5
1st generation AB Bank Sonali Bank Uttara Bank Pubali Bank National Bank
(0.8966) (0.8712) (0.8710) (0.8582) (0.8130)
2nd generation DBBL NCC Bank Southeast Bank EBL Prime Bank
(0.9264) (0.9069) (0.8799) (0.8704) (0.8277)
3rd generation Trust Bank Bank Asia Jamuna Bank Premier Bank Mercantile Bank
(0.9479) (0.9275) (0.8963) (0.8853) (0.8744)
2018 1 2 3 4 5
1st generation Sonali Bank Janata Bank National Bank Pubali Bank Agrani Bank
(0.9289) (0.8711) (0.8528) (0.8461) (0.8134)
2nd generation Southeast Bank NCC Bank Dhaka Bank EBL DBBL
(0.9303) (0.9273) (0.9196) (0.9093) (0.7994)
3rd generation Bank Asia Premier Bank MTB Trust Bank Mercantile Bank
(0.9113) (0.9073) (0.9060) (0.8812) (0.8746)
Source: Author’s self ‑ contribution based on the output from STATA 12.0

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 Jilhajj: Profit Efficiency of Bangladeshi Banks: A Stochastic Frontier Approach

Table 7: Five top and worst performing profit efficient banks during COVID‑19
Five top and worst performing profit efficient banks during COVID‑19 (year 2020)
Top five
DBBL (0.9256186) Trust Bank (0.9255877) Sonali Bank (0.9162208) EBL (0.8696852) Janata Bank (0.8669621)
Worst five
Dhaka Bank (0.1541769) Rupali Bank (0.2369423) IFIC Bank (0.4474975) One Bank (0.4721902) UCB (0.6673615)
Source: Author’s self ‑ contribution based on the output from STATA 12.0

Table 8: Diagnostic test for profit function

Test for Test Hypotheses Statistic Critical value Decision
Presence Pre estimation
of the Normality Test H0: No Skewness 43.65 Reject the H0
inefficiency (P=0.0000)
term M3T test H0: No Skewness −6.2471 −1.96 at a 5% Reject the H0
significance level
Post Estimation
Likelihood H0:  0  1   2   3   4   5   6   7   8   9    0 28.5066 8.574 at a 10% Reject the H0
ratio (LR) test significance level
Source: Author’s self ‑ contribution based on the output from STATA 12.0

Table 9: Determinants of profit inefficiency statistically insignificant. Still, the result of each bank’s profit
Z variable Coefficient Std. error Z P efficiency score is reasonable as it is acceptable if no significant
MC 1139443 4208306 0.27 0.787 result is found under the X-efficiency study when the study
SIZE −100057 465488.2 −0.21 0.830 contains small dataset and here the sample dataset contains only
CRDRISK 357358.8 1739238 0.21 0.837 the 25 banks of Bangladesh from 2011 to 2020.
ROA 5395535 25000000 0.22 0.829
FIR 206681.8 877868.5 0.24 0.814
CIR −4508.98 18218.76 −0.25 0.805 5. CONCLUSION
GDPGR 1177.172 2172.962 0.54 0.588
INT −3395.43 6200.797 −0.55 0.584 This paper investigates the profit efficiency of the state owned
INF −18156.9 77105.68 −0.24 0.814
Constant 742194.9 3788914 0.20 0.845
banks and private conventional banks of Bangladesh by employing
the stochastic frontier approach from 2011 to 2020.The sample
Source: Author’s self ‑ contribution based on the output from STATA 12.0
consists of 25 banks and panel data have been used for profit
efficiency. Intermediation approach has been adopted to define the
statistics test for profit function is rejected as −6.2471 is less than
input prices and outputs of the model while Translog function is
−1.96 at a 5% significance level. Therefore, it is confirmed that
employed to develop SFA profit function. Moreover, various control
inefficiency is present in profit frontier. variables and inefficiency determinants have been used to make the
model more reliable. From the results, following issues have been
Moreover, a post estimation test has also been conducted named observed. The overall profit efficiency score is 80.73%. In 2020,
Likelihood Ratio (LR) test. It compares the log-likelihood values DBBL followed by Trust bank were the most profit efficient banks.
of the OLS and SFA estimation. Here, H0 means parameters of z In contrast, Dhaka bank was the least profit efficient banks during
variables along with the γ are jointly equal to zero whereas H1 2020. Most profit efficient banks are from 3rd and 2nd generation
states they are not equal to zero. Under profit frontier, LR statistics banks. During COVID-19, again DBBL followed by Trust bank
is 28.5066 which is greater than critical value at 10% significance were the most profit efficient banks. Lastly, none of the determinants
level. Therefore, H 0 of no skewness is rejected and the of inefficiency has been found statistically significant. This paper
appropriateness of SFA model for profit function is confirmed. has some limitations such as 4th generation banks, foreign banks and
Islami Shariah based banks have been excluded from the study and
4.7. Determinants of Profit Inefficiency to conduct study based on bank efficiency such as profit efficiency,
Table 9 shows the determinants which have effect on the profit large dataset is required. Therefore, for future study, these excluded
inefficiency. Under profit inefficiency term, the expected signs banks could be added to get a robust conclusion. This study also
between profit inefficiency and bank size, credit risk and inflation suggests that banks in Bangladesh have the opportunity and scope
rate have been consistent with the previous studies. For example, to advance further in terms of profit efficiency.
according to Isik and Hassan (2002), higher level of credit risk will
help increase the profit inefficiency. Here, Credit risk and profit
inefficiency are positively associated which means if Credit risk
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