A Note on Banking Efficiency in Portugal, New vs. Old Banks

Following entry into the European Community in 1986, Portugal transformed rapidly its repressed banking system with deregulation, the opening of borders, the granting of new banking licenses, and privatization. In a more competitive banking system, one would expect a priori an increase in operational efficiency. This paper attempts to quantify the magnitude of efficiency gains over the years 1990 to 1995. Moreover, the paper documents the relative efficiency performance of new domestic banks. Not hampered by a legacy of inefficiency from the past, they could operate nearer the efficiency frontier. The case of Portugal provides unique information on the joint effect of deregulation and the granting of new banking licenses on the change in operational efficiency of a previously repressed banking system. Following entry into the European Community in 1986, Portugal transformed rapidly its repressed banking system with deregulation, the opening of borders, the granting of new banking licenses, and privatization. A priori, one would expect that a more competitive system should lead to operational efficiency gains as banks strive to maintain or increase profitability. The purpose of this paper is first to quantify the impact of deregulation on the efficiency of the Portuguese banking system. Moreover, the case of Portugal is unique in Europe as deregulation was accompanied by the creation of new banks that controlled twenty percent of bank assets in the mid-1990s. Not hampered by a low productivity legacy of the past, these new banks should, in principle, be able to operate nearer the efficiency frontier. A second objective of this paper is to quantify the relative efficiency of new domestic banks as compared to that of older existing banks. The paper belongs to one segment of the bank efficiency literature. According to the international survey of Berger and Humphrey (1997), bank efficiency studies can contribute to government policy, research, and bank management. This paper contributes to government policy with an empirical evaluation of the impact of deregulation and the granting of new banking licenses on the efficiency of a banking system. In Berger and Humphrey’s study, the authors observe that the conventional wisdom that holds that deregulation improves efficiency is not always validated by empirical studies. For instance, the banking efficiency in the US was relatively unchanged by deregulation in the early 1980s (Grabowski, Rangan and Rezvanian (1994) and Elyasiani and Mehdian, 1995), while banks of Norway and Australia experienced improved efficiency after deregulation (Berg, Forsund and Jansen (1992), and Avkiran, 1999). This paper shows that the rapid deregulation in Portugal has been accompanied by a major increase in the efficiency of banks over the period 19901995. Moreover, a limited series of papers in the government policy literature have analyzed the performance of new (de novo) commercial banks in terms of rate of bank failures, portfolio structure, or profitability (for instance, DeYoung and Hasan, 1998). This paper contributes to that literature with a focus on operating efficiency, which to the best knowledge of the authors, has not been studied specifically. It shows that new domestic banks are more efficient than old banks. Although it is only a conjecture, it could well be that it is the combined effect of substantial deregulation and the granting of new banking licenses that have contributed to the improved efficiency of the Portuguese banking system.