Technical Change, Costs and Profits in European Banking

This paper examines the impact of technical change on European bank costs and profits between 1992 and 2000. The estimates suggest that technological change reduced the total costs of European banks at an average rate of 3.8% per annum. However, technical change reduced profits by 0.45% annually over the same period. As found in an earlier study by Altunbas et al (1999) pure and non-neutral components of technical change appear to have contributed most to the reduction in total cost and the fall in profits. Large banks and commercial banks are found to experience the smallest cost reductions but the largest profit gains from technical change. Banking systems that experienced the smallest cost reductions seem to have experienced the biggest profit gains. In general, the results indicate that technical change can have a differential effect on bank costs and profits. While technology can reduce costs as well as increase the revenue earning capacity of banks it seems that some banks focus on the former and others the latter. Large cost reductions may feed through into poorer service quality and lower earning capacity and this is presumably why those banks that gained the most on the cost side seem to suffer in terms of profitability. Those banks that appear to have small reductions (or increases) in cost as a result of technical change see to gain most in terms of profits. The results suggest that there may be a clear trade-off between how technology is implemented in terms of whether the focus is primarily on cost reduction or revenue (and therefore profits) growth. To a certain extent, our findings confirm the recent findings on US banking of Berger and Mester (2002) who show that reductions in cost productivity between 1991 and 1997 resulted in increases in profit productivity. They argue that banks increased their cost productivity to improve service quality that was reflected in greater profits. Our results suggest a similar finding in that those banks that had the smallest cost reductions resulting from technical advances had the largest profit improvements.