Does the Entry Mode of Foreign Banks Matter for Bank ... - EconomiX

C1pln( ) = + ln + ln ln + ln( ) +p2 2 2 2mα0∑βk yk ∑∑βkj yk yj ∑γm3 k= 1 2 k= 1 j= 1 m=1 p31p p p+ γ ln( ) ln( ) + φ ln y ln( ) + ln equity + country + time + ε22 2 2 2m h m∑∑ mh ∑∑ km km= 1 h= 1 p3 p3 k= 1 m=1 p3where C represents total costs, y represents the outputs of the bank and the p variables arethe prices of the inputs. Total costs and input prices are normalized with respect to p 3(price of one of the inputs) to ensure linear homogeneity. The equity variable is includedin the cost function to control for risk preferences. All the variables are in naturallogarithm. Although we choose three relatively homogenous countries for our study,structural conditions in banking and general macroeconomic conditions may still generatedifferences in bank efficiency from country to country. We therefore include bothcountry and time effects in the estimation of the frontier to control for these factors. Forthe sake of simplicity, we do not include the index for bank in the equation.ε is the composed error equal to the sum of the measurement error (v) and the X-inefficiency term (u). Because the inefficiency term is expected to increase costs, the signon u is positive. Consistent maximum likelihood estimation of the above function foreach bank will reveal both the structure of the cost function and the firm-specific X-inefficiency effects. Our definition of inputs and outputs follows the intermediationapproach, whereby banks are seen as accepting deposits from customers and transformingthese into loans to clients and other investments. We therefore include two outputs in thecost function: y 1 =loans and y 2 =investment assets 12 . We would have liked to take intoaccount off-balance-sheet items as a third output. However, due to a large number ofmissing observations of this item (almost one third of the total number of observations),we are unable to do so. We use the prices of labor, physical capital and borrowed fundsas the inputs in the estimation of the cost function. The price of borrowed funds is used tonormalize each variable to ensure linear homogeneity. Following the literature, the priceof labor is the ratio of personnel expenses to total assets, given the unavailability of dataon the number of employees. The price of physical capital is constructed as the ratio of12 This item is denoted as "other earning assets" in BankScope, which are all the earning assets other thanloans.-23-