Measuring Banks Efficiency for the Adoption of Risk Management and Return Optimization

Banks must take various risks, especially credit risks from granting credit, however, they should take action against risks in order to adopt an optimal portfolio between risks and returns. Thus, recent advances in risk management formulas in banking may facilitate credit availability, enabling banks to improve their ability to manage credit risks to extend credit to marginal borrowers in the search for higher returns.In this paper, we study the operating efficiency, and the trade-in point, of the optimal portfolio for banks, balancing between risk and return for 49 banks in Taiwan during 1999-2003. We employed the DEA method to measure operating efficiency and transfer inputs such as assets, capital, and labor expenses into risk dimensions, including credit risk, liquidity risk, and interest rate risk, with loan, discount interest income, and investment income as outputs.Our results show some differences from prior findings. We find that, weighing interest rate risks was more advantageous than liquidity risk, or credit risk, in order to maximize efficiency; in addition, an increase in loan and discount interest income could improve efficiency more than an increase in investment income. We also find that, since most banks have reached the stage of increasing returns to scale, it was beneficial to improve the bank's ability to assume risks in order to increase efficiency. Moreover, in Taiwan, financial deregulation laws have deregulated on banking activities, which may encourage a bank's risk-taking opportunities, especially for the banks established before financial deregulations, who are better than those banks established after financial deregulations