Efficiency in Banking: Theory, Practice, and Evidence
Joseph P. Hughes
Loretta J. Mester
Federal Reserve Bank of Philadelphia
The Wharton School, University of Pennsylvania
Prepared for the Oxford Handbook of Banking
Abstract. Great strides have been made in the theory of bank technology in terms of explaining
banks’ comparative advantage in producing informationally intensive assets and financial
services and in diversifying or offsetting a variety of risks. Great strides have also been made in
explaining sub-par managerial performance in terms of agency theory and in applying these
theories to analyze the particular environment of banking. In recent years, the empirical
modeling of bank technology and the measurement of bank performance have begun to
incorporate these theoretical developments and yield interesting insights that reflect the unique
nature and role of banking in modern economies. This chapter gives an overview of two general
empirical approaches to measuring bank performance and discusses some of the applications of
these approaches found in the literature.
Keywords: Bank, efficiency, risk, cost, profit, agency costs, X-inefficiency
Mester at Research Department, Federal Reserve Bank of Philadelphia, Ten Independence Mall,
Philadelphia, PA 19106-1574; phone: 215-574-3807; fax: 215-574-4303; email:
Hughes at Department of Economics, Rutgers University, New Brunswick, NJ 08901-1248;
phone: 732- 932-7517; fax: 732-932-7416; email: firstname.lastname@example.org.
The views expressed here are those of the authors and do not necessarily reflect those of the
Federal Reserve Bank of Philadelphia or of the Federal Reserve System. This paper is available
free of charge at www.philadelphiafed.org/econ/wps/.
What do commercial banks do? What are the key components of banking technology?
What determines whether banks operate efficiently? The lit