Adongo Stork Hasheela (2005) X Efficiency Namibia

Factors Influencing the Alternative Profit
X- Efficiency of Namibia’s Banking Sector
September, 2005
Jonathan Adongo
Christoph Stork
Elisa Hasheela
NEPRU Working Paper No. 103
THE NAMIBIAN ECONOMIC POLICY RESEARCH UNIT
N EPRU
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NEPRU Working Paper ISSN 1026-9258
First published in 2005 by the Namibian Economic Policy Research Unit

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ii
Acknowledgements
This study was conducted by Jonathan Adongo and Christoph Stork. The fieldwork
on which this study is based was carried out in Windhoek over the period January to
February, 2005 by Elisa Hasheela. The authors would like to express their gratitude
to the Agricultural Bank of Namibia, Bank Windhoek, First National Bank of Namibia,
Nedbank Namibia and Standard Bank of Namibia for providing access to their
annual reports. In addition, the authors would like to specially thank, without
implicating, Anne-marie Chidzero, Barbara James, Jeffery Fine, Julia Lowell,
Matthew Gamser and Ndiritu Muriithi, for their insightful comments that brought this
paper from its rough initial stages to this final document. Any questions or comments
regarding this working paper should be referred to Jonathan Adongo
(jonathana@nepru.org.na)
Disclaimer
The opinions presented are those of NEPRU and should not be regarded as the
views of any other party.
iii
Executive Summary
The efficiency of the overall financial sector in allocating credit to investment

opportunities that offer the highest returns is a necessary condition for increased
economic growth. This partly depends on the efficiency of the banking sector, which
can be measured by the average internal efficiencies of its banks.
This study adopted a two-step procedure. The first step involved the measurement
of bank efficiency by adopting the alternative profit X-efficiency concept and
applying a transcendental logarithmic function to a panel dataset of banks in
Namibia that were in continuous existence from 1998 to 2003. It then used the
distribution free approach to estimate the efficiencies of individual banks and the
overall banking sector in Namibia.
The study found that Nedbank Namibia was the most efficient bank in Namibia from
1998 to 2003. It was closely followed by Bank Windhoek, Standard Bank Namibia,
the Agricultural Bank of Namibia and First National Bank of Namibia, respectively.
The low rank of First National Bank of Namibia was attributed to its merger and
acquisition (M&A) activity over the sample period. Although Nedbank Namibia also
participated in M&A activity in 2002, through its acquisition of the micro lending arm
of SAAMBOU Bank housed in Finance in Education (Pty.) Ltd., this did not have the
same negative effect as in the case of First National Bank of Namibia because the
newly acquired institution was not incorporated into the banking operations of
Nedbank Namibia but was left as an independent subsidiary regulated by the
Namibia Financial Institutions Supervisory Authority.
The study also found that the mean level of alternative profit X-efficiency in
Namibia’s banking sector from 1998 to 2003 was 83% suggesting that banks in
Namibia lost approximately 17% of their potential profits between 1998 and 2003
due to inefficiency. This finding fares well relative to other studies that had been
conducted internationally as of 1997, where the mean level of potential profits lost
by banking sectors in all studies, regardless of methodology, was 50%. However,
the small, panel dataset for Namibia included banks that were engaged in M&A
activity over the sample period (that ideally should have been excluded). Therefore,
the results of bank efficiency in Namibia can only be conclusive if more robust
findings are obtained in the context of a regional study.
This study extended the methodology to a panel dataset for all financial
intermediaries in Botswana, excluding insurance companies. In addition, a cross-
country panel dataset for Namibia and Botswana was analysed as a pilot initiative
for a future continental study consisting of all financial intermediaries in Africa,
excluding insurance companies.
The study then went on to apply the overall mean efficiency estimates for the
banking sector obtained in the first step by specifying an analysis of covariance
model for a panel dataset of banks in Namibia to identify external factors that
influenced the efficiency in Namibia’s banking sector from 1998 to 2003.
iv
The study found that merger & acquisition activity, market power, age, risk and
holding company ownership, structure, location and whether or not it is publicly
traded; influenced the alternative profit X-efficiency of Namibia’s banking sector
between 1998 and 2003.
The findings of this study result in a more robust, empirical tool that will assist
institutions such as NEPRU to monitor the impact of various events, such as
regional integration and M&A activity, on bank efficiency. In addition, it will motivate
practitioners to improve efficiency in the banking sector. The findings are also
useful in directing the efforts of regulatory bodies to areas that they can intervene to
improve the effectiveness of the banking sector in Namibia in allocating credit
efficiently, which has positive implications for economic growth.
v
Factors Influencing the Alternative Profit X- Efficiency of Namibia’s Banking Sector vii
Table of Contents
1. INTRODUCTION ................................................................................................. 1
2. BACKGROUND................................................................................................... 3
2.1. Importance of X-efficiency........................................................................... 5

2.2. Purpose of an X-Efficiency Measure ........................................................... 7
2.3. Alternative Ways to Measure Efficiency ...................................................... 8
2.4. Other Factors ............................................................................................ 12

2.5. Influencing Factors .................................................................................... 14
3. NAMIBIA’S BANKING SECTOR ....................................................................... 27
3.1. Regulatory Framework .............................................................................. 27

3.2. Banks in Namibia ...................................................................................... 28
3.3. Market Features ........................................................................................ 29
4. MEASURING ALTERNATIVE PROFIT X-EFFICIENCY ................................... 33

4.1. Efficiency Concept..................................................................................... 33
4.2. Efficiency Technique ................................................................................. 38
4.3. Approach ................................................................................................... 42
4.4. Functional Form ........................................................................................ 44
4.5. Sample ...................................................................................................... 50
4.6. Data........................................................................................................... 51
4.7. Procedure.................................................................................................. 51
4.8. Results and Discussion ............................................................................. 53
5. IDENTIFYING EXTERNAL INFLUENCING FACTORS .................................... 58
5.1. Sample ...................................................................................................... 58
5.2. Data........................................................................................................... 58
5.3. Model......................................................................................................... 59
5.4. Procedure.................................................................................................. 60
5.5. Results and Discussion ............................................................................. 62
6. CONCLUSION................................................................................................... 65
7. REFERENCES .................................................................................................. 67
vii
List of Tables
Table 1: Definition of Small Business by Ministry of Trade and Industry in

Namibia ....................................................................................................15
Table 2: Summary of Banks in Namibia from 1998 to 2003 .....................................28
Table 3: Ranking of Banks in Namibia according to Alternative Profit X-

efficiency ..................................................................................................53
Table 4: Ranking of Banks in Botswana according to Alternative Profit X-

efficiency ..................................................................................................55
Table 5: Ranking of Banks in Botswana and Namibia based on a Single

Alternative Profit X-efficiency Frontier......................................................57
List of Figures
Figure 1: Herfindahl-Hirschman Index Scores for the Output Market Structure of

Namibia’s Banking Sector from 1998 to 2003..........................................30
Figure 2: Size of Namibia’s Banking Sector from 1998 to 2003 in Real NAD ..........31
Figure 3: Relative Size of Banks in Namibia from 1998 to 2003 ..............................32
Figure 4: Relative Ratios of Business Loans to Total Loans for Banks in

Namibia from 1998 to 2003......................................................................32
List of Boxes
Box 1: Economies of Scale and Scope.......................................................................5
Box 2: Risk Categories .............................................................................................20
Box 3: Types of Credit-Scoring Systems ..................................................................22
viii
Factors Influencing the Alternative Profit X- Efficiency of Namibia’s Banking Sector ix
List of Acronyms
aπ x Alternative Profit X-efficiency
ANCOVA Analysis of Covariance
ATM Automated Teller Machine
BCBS Basel Committee on Banking Supervision
BoN Bank of Namibia
BWP Botswana Pula
CMA Common Monetary Area
DEA Data Envelopment Analysis
DFA Distribution Free Approach
FDH Free Disposable Hull
FFF Fourier-Flexible Function
H-Index Herfindahl-Hirschman Index
HRM Human Resource Management
ICT Information and Communication Technologies
K Capital
L Labour
LIMDEP Limited Dependent Variables
M&A Mergers and Acquisitions
NAD Namibian Dollars
NBFI Non-Bank Financial Institutions
Netputs Fixed Inputs and Outputs
NPL Non-Performing Loans
NSX Namibia Stock Exchange
OLS Ordinary Least Squares
PC Personal Computer
ROA Return on Assets
ROE Return on Equity
ROI Return on Investment
SBSS Small Business Scoring Service
SADC Southern African Development Community
SARB South African Reserve Bank
SFA Stochastic Frontier Approach
SME Small and Medium-Scale Enterprises
SMME Small, Micro and Medium-scale Enterprises
SWA South West Africa
TFA Thick Frontier Approach
USD United States Dollars
ix
Factors Influencing the Alternative Profit X- Efficiency of Namibia’s Banking Sector 1
1. INTRODUCTION
The main goal of this study was to identify the external factors that influence the
efficiency of Namibia’s banking sector. To achieve our goal this study used a two-
step approach (Coelli, Prasada & Battese, 1998). The first-step involved the
modelling of a bank’s internal activities based on the input-output production
function and then applying frontier analysis to estimate the alternative profit X-
efficiency of Namibia’s banking industry.1
This first step provided a numerical, objectively determined, efficiency value that
was used to to rank banks in Namibia according to their relative efficiencies, as an
indication of their relative abilities to allocate credit efficiently attributed to how
technology, human resources and process management methods varied across
them (Frei, Harker & Hunter, 1998).
The top ranking bank was defined as the best practice bank i.e. it had the lowest
expected costs and highest expected profits, given the business conditions specified
in the alternative profit X-efficiency function. It reflected the best management efforts
to use technology and respond to market prices and other business conditions
(Berger & Humphrey, 1993). The identification of this bank should motivate
practitioners to adopt practices that improve and discard those that hinder their
efficiencies.
In the second step, the average efficiency estimates for the overall banking sector in
Namibia were regressed on potential external factors that could influence the
banking sector’s efficiency in Namibia using ordinary least squares (OLS). Standard
hypothesis testing was used to identify those factors that influenced the efficiency of
Namibia’s banking sector. This should be useful in directing the efforts of policy
makers and regulators to areas that they can intervene in their attempts to boost the
effectiveness of the banking sector in allocating credit efficiently
A key assumption in this study was that efficiency at the intra-bank level is a key
determinant of efficiency in the allocation of credit to available investment
opportunities that offer the highest return. This conforms to the definition of an
efficient credit opportunity, defined in Luccheti, Papi & Zazzaro (2000). Therefore,
alternative profit X-efficiency served as a proxy for the efficiency in allocating credit
to the highest-return investment opportunities.
This study aims to serve as a foundation for a future, continental, bank efficiency
study by measuring and applying a robust, objective tool that is relevant to the
banking environment in Africa. To achieve this aim the methodology was replicated
for Botswana and also for a cross-country panel consisting of Namibia and
Botswana as a pilot initiative that is to be extended to additional countries in Africa.
1
This is described in an earlier publication (Adongo & Stork, 2005a).
2 Factors Influencing the Alternative Profit X- Efficiency of Namibia’s Banking Sector
The remainder of this paper is organised as follows Section two provides a

theoretical background to the measurement of X-efficiency and its application.
Section three briefly describes the structure of the Namibian banking sector. Section
four presents the methodology used to measure efficiency in the Namibian banking
sector and the results and associated discussion of an application of the
methodology to the banking sector in Namibia, Botswana and a cross-country panel
of Namibia and Botswana. Section five describes the methodology used to identify
external factors that influence efficiency in the Namibian banking sector, the results
and associated discussion of an application of the methodology. Section six
presents the conclusions.
2. BACKGROUND
A positive link between financial intermediation and economic growth is empirically

supported, widely accepted and has been increasingly incorporated as a
determinant in growth studies over the past several decades (Gurley & Shaw, 1955
and Goldsmith, 1969). Empirical studies indicate that this link could occur through
two channels -- factor accumulation and changes in efficiency (Collins, 2002).
Therefore, even though a country has enough savings to generate adequate factor
accumulation (capital accumulation specifically),2 its growth potential can be
hindered if the domestic financial intermediation mechanism fails to allocate these
savings to available investment opportunities efficiently (Stulz, 2001).3 An efficient
financial intermediation mechanism increases the expected returns to investment,
which can promote innovation resulting in further positive implications for economic
growth (Collins, 2002).
Banks, as financial intermediaries, provide various services for depositors and

borrowers. They provide liquidity and safekeeping for savings, which allows
depositors to smooth consumption over time. They also conduct credit analysis,
disburse loans and monitor outstanding credits for borrowers who require more
financing than they can generate from internal sources or from alternative sources of
finance such as financial markets (Berger & Humphrey, 1993). The disbursed loans
are mainly working capital, defined as the credit required in the interval between
actual investment and the sale of output (Livesey, 1993). In addition, to this they
provide payment services and trade finance, leasing and factoring solutions that
finance the inventory and fixed asset needs of borrowers. The efficiency of the
banking sector in providing these services, particularly at the intra-bank level, and
conditions in the external environment; influence the effectiveness of the domestic
financial intermediation mechanism.
The level of intra-bank efficiency is represented by alternative profit X-efficiency in

this paper. X-efficiency is defined as the general efficiency of a firm judged on
managerial and technological criteria in transforming inputs at minimum costs into
maximum profits. It includes intra-bank economic, intra-bank motivational efficiency -
individual personality and external motivational efficiency - arising from management
incentives and the environment (Leibenstein, 1978).
2
A discussion on the availability of labour (the other factor of production) is beyond the scope of this
paper.
3
This paper assumes the that perfect markets exist where contracting is costless and the Coase
theorem applies i.e. whenever there is a reallocation of resources that creates value it can be
implemented at no cost (Stulz, 2001).
Banks that exhibit X-inefficiency are either wasting resources (technical inefficiency),
or are using inefficient business processes (allocative inefficiency), or both. This is
caused by employee, management and environmental factors. 4
X-efficiency captures the effects of the adoption of technology relative to the number
of staff and the way this technology is used (Frei, Harker & Hunter, 1998). How
effectively technology is used depends on how employees are introduced to new
technologies and how these technologies are integrated into the business process.
Another important factor is how well employee contracts are drawn up and policy
and procedures implemented. These factors are determined by a bank’s
management. They are responsible for selecting the right staff and setting
appropriate incentives aimed at influencing the behaviour of employees.
The effectiveness of management is also affected by its own preferences. Publicly

traded banks may be subject to the principal-agent problem, where managers
pursue objectives that differ from those of stockholders such as empire-building -
defined as the pursuit of inefficient mergers to gain larger scale and presumably
prestige in having large staffs or other ‘perks’ (Hughes et al 2003).
At the external level, a bank’s X-efficiency is influenced by the pressure applied by

its operating environment arising from regulation, innovation and competition.
Innovations arising from advances in information and communication technology
(ICT) cause the introduction of new financial products developed by financial
engineers.
Furthermore, the level of competition in a banking industry determines the pressure

on banks to increase efforts to innovate and improve their business processes. In an
oligopolistic banking industry, arising from exits or within-market merger and
acquisition (M&A) activity in the banking industry, there is low pressure to increase
performance from the environment. This results in quiet life effects that can be
exacerbated by the interdependence among oligopolistic banks, which cooperate
tacitly and imitate each other to some extent. Under these conditions, higher costs
can be passed on to consumers who do not understand the nature of the service
offered or lack alternative sources of finance. Low levels of competition are
associated with lower X-efficiency levels (Berger & Hannan, 1993).
A decade of econometric research has shown that X-efficiency dominates scale and
scope economies (Frei, Harker & Hunter, 1998). In addition to including scale and
scope effects, X-efficiency takes into account the external environment that a bank
operates in.
4
X-inefficiency may also arise because inputs are theoretically assumed to have a fixed specification
and yield a fixed performance, which is unrealistic (Leibenstein, 1966).
Box 1: Economies of Scale and Scope
Scale economies refer to how the bank’s size (scale of operations) is related to its
profit. 5 It focuses on selecting appropriate outputs and reflects technical efficiency,
which is the ability of a bank to produce maximal output from a given set of inputs
over a certain time period.
Scope economies refer to changes in product mix related to cost. It focuses on

selecting the appropriate outputs and reflects allocation efficiency, which is the
ability of a bank to use inputs in optimal proportions, given their respective prices
and the production technology i.e. input-mix efficiency.
The concept of X-efficiency, which takes the output bundle as given, differs from that
of scale and scope efficiency. Scale economies assume that banks are already on
the efficient frontier6, where banks are fully X-efficient and minimise costs for every
scale of output. Analysing banks other than those on the frontier confound scale
effects with differences in X-efficiency (Berger & Humphrey, 1993).
Scope efficiency is concerned with movements along the frontier, while X-efficiency
relates to an outward shift in the frontier (Frantz, 1992). Although, both scope and X-
efficiency presume that inputs will be allocated to the right decision and performance
units, X-efficiency does not presume the decision and performance units involved
will decide and actually use inputs as effectively as possible.
Due to the negligibility of scope economies, X-inefficiencies are usually found to

arise from scale diseconomies, suggesting that it arises due to poor choice of inputs
as a result of poor reaction to the prices faced.
2.1. Importance of X-efficiency
An increase in the X-efficiency of the banking sector has positive implications for
economic growth. The most X-efficient banks should be better at loan targeting than
their counterparts and allocate credit to the most productive uses i.e. those yielding
the highest return.7 By bringing about a change in ownership and composition of a
given amount of savings, they enhance the productivity of the capital stock leading
to higher levels of economic growth (Bhatia & Khatkhate, 1975). This mechanism is
illustrated in a theoretical framework of capital intermediation, attributed to Galbis
(1977).8
5
These concepts are described relative to the profits, but they can also be described relative to the
costs or revenues.
6
An efficient frontier is defined by the most X-efficient bank in a sample.
7
This does not consider opportunities that may be more productive from a social welfare perspective.
8
Banks may not be conducting effective loan targeting due to risk aversion as opposed to inefficiency
(Adenso-Diaz & Gascón, 1997).
The implication of Galbis’s model for small-scale enterprises is that banks that are
X-efficient are able to identify those that have high-return yielding projects and direct
credit to them. This finance injection should enable small-scale enterprises to grow
and move to the medium and large-scale segments of the enterprise spectrum,
where it is easier to obtain additional finance. For small-scale enterprises that are
already operating at optimal capacity and have no growth prospects, the provision of
bank finance will increase their potential to achieve sustainability at existing levels.
Furthermore, improved loan targeting by X-efficient banks will lead to lower default
levels on disbursed loans. The reduction in non-performing loans (NPLs), coupled
with higher returns on disbursed loans should increase profits in the banking sector.
X-efficiency is also important for the effectiveness of monetary policy. According to

the Post-Keynesian view, money supply is endogeneous (Moore, 2002). Therefore,
the structure of the banking system and its overall level of efficiency have a direct
effect on monetary variables in the domestic economy.
In this era of post-globalisation where the pace of financial sector liberalisation is

high (and arguably irreversible), increasing integration into the international financial
system is accompanied by within and cross-country M&As. This is expected to
improve the stability of financial intermediaries because they will be able to fund
themselves from abroad and diversify their risks abroad, which should lead to their
insulation from local shocks. This should result in price reductions, service
expansion and improvements in X-efficiency (Stulz, 2001). Whether, the resulting
liberalisation has positive or negative impacts on a society’s welfare depends on the
strength of the banking sector in general (Lowell, Neu & Tong, 1998) and pre-M&A
levels of X-efficiency in the banking industry in particular.
Due to the absence of systematic internal controls in X-inefficient banks,

inappropriate sequencing of stages of financial liberalisation, central decisions that
do not make any provisions for the wave of reorganisation that ought to take place
at the banks’ branch level prior to and during liberalisation and the intervention of
other incentives; the positive expectations of liberalisation may not always be
realised (Berger & Humphrey, 1997; Athanassopoulos, Soteriou & Zenios, 1997 and
Frenkel & Menkhoff, 2004).
In some cases, liberalisation has led to rapid branch expansion, excessive asset
growth and reduced X-efficiency. The oversupply of finance (too much money
chasing too few investment opportunities) could result in an increase in NPLs, a run-
up in bank failures and instability in the economy (Berger & Humphrey, 1997). In
other cases, the elimination of loan interest rate ceilings resulting in higher market
rates and increased competition from non-bank financial institutions (NBFIs) can
lead to higher costs of funding, increased demand for funds and a reduction in the
supply of deposits per bank. This can result in poor total factor productivity growth,
which has negative implication for economic growth (Berger & Mester, 1999).
The negative aspects of inappropriate financial liberalisation particularly affect small-

scale enterprises because the intermediated finance that they are eligible for cannot
be provided from abroad, as opposed to medium and large-scale firms that can
bypass much of the local financial structure (Jun-Koo, Yong-Choel, Park & Stulz,
1995).
Finally, X-efficiency is important if banks are to survive over the long-term. The
competitive landscape has been greatly altered by the innovative financial products
accompanying the proliferation of NBFIs and new financial service distribution
channels enabled by advances in ICT. The competition from existing banks, new
entrants, international banks and NBFIs such as leasing companies, grocery chains,
mobile phone companies, furniture companies and automotive giants
(Athanassopoulous, Soteriou & Zenios, 1997 and National Treasury, 2004) requires
banks to compete to maintain and increase their existing market share. This will
require them to choose cost-effective delivery systems and make human resource
changes and appropriate technology investments (Frei, Harker & Hunter, 1998).
Their success in this effort directly depends on their X-efficiency.
2.2. Purpose of an X-Efficiency Measure
Measuring the X-efficiency of banks in Namibia is important for policymakers,

practitioners and academic research.
X-efficiency measures are important for better antitrust policy analysis. Antitrust
policy relies heavily on the use of the H-Index, which uses ex ante information to
assess the market power and efficiency effects of M&A deals. This analysis should
control for efficiency. Otherwise, the observed relationship between market power
and prices or profits may not be easily separated from the effects of market power
and efficiency (Akhavein, Berger & Humphrey, 1997).
X-efficiency measures can also improve the predictive accuracy of failure prediction
models, which is useful for regulators such as the Bank of Namibia (BoN), which is
Namibia’s central bank (Barr, Seiford, & Siems, 1994). Various empirical studies
have shown that banks display low efficiency prior to failure and those with relatively
low efficiency levels have a higher probability of failure than their more efficient
counterparts (Berger & Humphrey, 1992a; Cebenoyan, Cooperman, and Register,
1993 and Hermalin and Wallace, 1994).
In addition, X-efficiency measures can motivate a bank’s management to adopt

“best practices” that are found among banks on or near the X-efficient frontier.9 It
can also assist managers in adjusting their policies and procedures to avoid “worst
practices” that are relatively common among banks that are far from the X-efficient
frontier.
Furthermore, when X-efficiency measures are regressed on potential determinants

they may highlight relationships with various internal organisational and external
9
A best practice bank is defined as one that has the highest expected profits, given the business
conditions specified in its profit function and reflects the best attempts to use technology and
respond to market prices and other business conditions (Berger & Mester, 1999).
environmental factors that suggest managerial arrangements and environmental

conditions that are associated with X-efficiency (Berger & Humphrey, 1997). This is
important for policy makers to identify potential areas of intervention that can boost
efficiency in a banking sector.
X-efficiency measures can also be of assistance in monitoring the dynamics in the

banking sector in the context of increased regional integration and the impact of
other external events. This is important for the Southern Africa Development
Community in measuring its objective of fostering competition and improving
efficiency in the regional banking sector (SADC, 2003).
X-efficiency measures are also important for monitoring the impact of the regulatory
changes instituted by the Basel II Capital Accord on X-efficiency in the banking
sector. These changes are expected to arise from the different uses of the risk
measurement framework stipulated by the new Accord relative to Basel I
(Saidenburg & Schuermann, 2003).
Also, the information provided by the X-efficiency measures on the relative

efficiencies of banks in the industry will support Pillar 3 on public disclosure in the
Basel II Capital Accord. This pillar depends on the financial market to apply pressure
on banks (Saidenbuurg & Schuermann, 2003). An X-efficiency measure is important
where some banks are not listed on the stock exchange, like in Namibia, or where
there is no active investor community.
Finally, the Basel Committee on Banking Supervision (BCBS), through the

Advanced Measurement Approach, seeks to provide flexibility for banks to use their
own internal measurement approaches subject to meeting rigorous qualitative and
quantitative standards (Saidenburg & Schuermann, 2003). The method used to
measure X-efficiency in this paper supports this effort and will be a first step towards
determining areas for which more advanced risk measures can be applied in the
banking industry.10
2.3. Alternative Ways to Measure Efficiency
Besides the use of frontier analysis to measure X-efficiency, various other

approaches to measuring bank efficiency exist.
2.3.1. Banking Productivity per Employee Hour
Some government agencies collect productivity statistics on various sectors,

including banks. These statistics view efficiency from the production approach,
which we describe in the methodology section. A typical measure captures banking
productivity per employee hour. However, bank employee labour hours may be an
inaccurate indicator of efficiency because of trends towards outsourcing of back-
10
Currently models from the insurance industry are being applied (Saidenbuurg & Schuermann, 2003).
office operations to holding company affiliates and service bureaus. Failure to

account either for the labour used elsewhere in the holding company but effectively
working for the bank or for the cost of this labour and capital could bias government
productivity measures toward a spurious finding of productivity arising from the
change in output per employee labour hour because of the incorporation of total
labour hours worked by employees and non-employees.
2.3.2. Minimum Reserves
Bank regulatory agencies use a comparison of actual reserves (required as well as

excess reserves) held against the regulatory minimums as a legal basis for taking
supervisory action (Demigürç-Kurt & Huizinga, 1998). A high ratio of actual reserves
over the regulatory minimum would be an indicator of financial repression and
inefficiency.
2.3.3. Risk Ratings
In addition, the Basel II capital accord advocates the use of risk ratings as an
alternative way to capture bank efficiency. One measure used under this approach
is the value-at-risk, which is defined as the loss to an investment portfolio due to an
adverse market move (Saidenburg & Schuermann, 2003). It is a scalar measure and
may not incorporate all the different aspects of the highly dimensional problem that it
summarises. Risk ratings also capture credit risk, concentration risk, interest rate
risk and business risk (operational risk). Operational risk is defined as the risk of
direct or indirect loss resulting from inadequate or failed internal processes, people
and systems or from external events, thus capturing X-efficiency (Basel Committee
on Banking Supervision, 2001).
2.3.4. Monetary Aggregates
Macroeconomic studies use monetary aggregates to represent efficiency. These

aggregates include the ratio of bank credit granted to the private sector to GDP, as
an explanatory variable in growth regressions (King & Levine, 1993). This assumes
that pure size of the financial system is closely related to quality of financial services
or efficiency, which may not be so. In addition, the level of bank credit may simply
reflect the demand for bank services, which may have nothing to do with the
banking sector’s own efficiency. The use of monetary aggregates is only justified if
there is an absence of reliable data on the number and size of deposits and loans
available.
2.3.5. Interest Spreads and Margins
The most common macroeconomic measure of efficiency is the interest spreads. It

is a direct measure of banks’ mark-up over cost. The justification for using interest
spreads to measure efficiency is because financial intermediation affects the net
return to savings, and the gross return for investment. Interest spreads can either be
ex ante or ex post. The former is the more common one and is calculated from the
contractual rates charged on loans and rates paid on deposits. They are biased to
the extent that differences in perceived risks are reflected in the ex ante yields.
These differences tend to distort spread comparisons. Ex ante spread data are also
generally put together from a variety of different sources at the aggregate industry
level and are not completely consistent. Ex post spreads, on which this paper
focuses, consist of the difference between banks’ actual interest revenues and
actual interest expenses. A problem with ex post spreads is that the interest income
and draw downs from the loan loss provisions materialise in different time periods.
This may lead to inaccuracies in reflecting efficiency differences due to differences
in NPLs and monitoring costs associated with loan quality (Demirgüç-Kurt &
Huizinga, 1998).
Another common macroeconomic measure of efficiency is the net interest margin. It

is argued that net interest margins mirror the interest spreads. However, they also
reflect a variety of other factors including bank characteristics, macroeconomic
conditions, taxation, deposit insurance regulation, overall financial structure, and
several underlying legal and institutional indicators (Demirgüç-Kurt & Huizinga,
1998). Therefore, a change in the interest margins may be a result of changes in
factors other than efficiency which interest margins cannot account for, because
they only capture scale and scope economies.
2.3.6. Accounting Ratios
Some microeconomic studies use accounting ratios such as return on assets (ROA),
return on investment (ROI) and return on equity (ROE) to represent efficiency
(Ikhide, 2000 and Bedari, 2004). Ikhide (2000) argues that use of total assets, loans
or deposits, like in alternative profit X-efficiency, does not sufficiently capture bank
output, which he defines as the value of services rendered by banks. However, this
definition only applies if the bank’s provision of financial services is viewed in terms
of the production approach, as opposed to the intermediation approach that is
adopted in this paper.11
Accounting ratios are limited as measures of efficiency. Since they do not control for
output mix or input prices, they do not enable the determination of whether X-
efficiency or scale and scope efficiency are the source of variation in bank
performance (Akhavein, Berger & Humphrey, 1997). Also, ratios that contain assets,
such as ROA, assume that all assets are equally costly to produce and all locations
have equal costs of doing business. In addition, many accounting ratios exclude
interest expenses, which comprise most of total bank costs and often represent
operating expenses incurred elsewhere in the banking system (Berger & Humphrey,
1993).12 Furthermore, changes in accounting ratios may reflect a change in the
numerator or denominator values as opposed to changes in the overall ratio
(Demirgüç-Kurt & Huizinga, 1998). Finally, accounting ratios do not capture long-
11
More on these approaches is presented in the methodology section.
12
ROA includes interest expenses as part of operating expenses
term performance, and aggregate many aspects of performance such as operations,

marketing and financing (Sathye, 2001).
2.3.7. Frontier Analysis
Microeconomic studies apply frontier analysis, which captures the deviation between
actual and desired performance. They measure efficiency relative to an objective
function for output (product) maximisation and profit maximisation.13 The bank is
viewed as a black box, where the production function is a simple relationship
between inputs and outputs (Farrell, 1957) and the issue facing banks is to
maximise profits while reducing costs. This is done by selecting:
• The levels of inputs: physical capital (K), labour (L) and technology, which
depends on the next three choices (Frei, Harker & Hunter, 1998);
• The input transformation function;
• The production function for the organisation;
• The mix of outputs that will maximise profits.
The bank that is best at executing these four choices within its environment will be
the most X-efficient.
2.3.7.1. Market-based Approaches
Some microeconomic studies use a market-based approach. This measures

efficiency in terms of the percentage of expected profit being earned for a given
level of risk relative to a best practice bank on a risk-expected return, efficiency
frontier (Hughes, Lang, Moon & Pagano, 1997). A bank with too little profit for the
amount of risk it is taking is deemed inefficient. Banks that achieve efficient
allocations maximise the market value of their assets and are more profitable.14 The
measure was applied to a sample of publicly traded bank holding companies and
evidence showed that banks signal better asset quality through their capitalisation.
The use of the market-based efficiency measure assumes the existence of at least a
semi-strong, efficient financial market. This market provides the best measure of
estimating whether firms are creating value for shareholders or not because most of
the information is incorporated into prices (Brealey & Myers, 1991). Under this
financial market structure the relative efficiencies of banks will be reflected in market
prices, directly through lower costs or higher output or indirectly, through higher
customer satisfaction and higher prices that translate into better stock performance
(Adenso-Diaz & Gascón, 1997). Since all banks in Namibia are not listed on the
13
These three concepts are not independent. Duality theory can be used to derive the cost function
from the production function, and cost is a component of profit.
14
Note that profit maximisation will differ from value maximisation to the extent that banks are not risk-
neutral (Berger & Mester, 1999).
Namibia Stock Exchange (NSX), the use of this measure was not pursued in this
paper.
Hughes, Lang, Moon & Pagano (1997) argue that profit X-efficiency may be
inadequate because it does not take into account sub-optimal choices of risk and
quality that affect prices. When uncertainty exists, the objective of profit
maximisation fails to account for the riskiness of the production plan and the rate of
interest at which the stream of profits is discounted (Modigliani and Miller, 1958). In
addition, profit X-efficiency does not reflect all relevant expected future cash flows
and expected costs of financial distress but focuses on current prices and quantities
of inputs and outputs.
The choice of measure that one uses to measure efficiency is important because
each one will give different results if used to investigate the relationships with other
economic variables. The alternative profit X-efficiency measure, which this paper
adopts, is attributed to Farrell (1957). It models the bank’s activities using the
production function and measures how close a bank’s profit is to what a best
practice bank’s profit would be for producing the same output bundle under similar
conditions. The best practice bank defines the frontier that represents the best
practice observed in the industry and not the theoretical maximum profit possible,
which is not easily observable.
Besides the economic approaches used to measure efficiency summarised above,

many banks have their own internal benchmarking procedures that are mostly used
at the branch level. These consist of relatively simple comparisons or rankings of
offices according to a set of performance measures, which include the stock of
accounts serviced or the values within various accounts. These efforts lack a
powerful and comprehensive optimising methodology similar to the frontier analysis
approach used in this paper (Berger & Humphrey, 1997).
2.4. Other Factors
Bank efficiency is not the only factor that is necessary to create an effective financial
intermediation mechanism that allocates credit efficiently. A stable macro
environment, with minimal business cycle fluctuations is also important. Namibia has
a relatively stable macro environment and the regulatory framework for its financial
sector is determined by the CMA.
This stable macro environment needs to be supported by appropriate infrastructure

and facilities. Although, Namibia ranks quite highly in the usage of ICT compared to
other countries in Sub-Saharan Africa the high cost of these services creates a
barrier the hinders potential gains that could result from improved financial service
provision by an efficient banking sector (Stork, 2005).
Despite effective provision of finance by X-efficient banks, gaps in the financial

intermediary system will hinder its potential to contribute to economic growth.
Currently, there is no formal financial mechanism that provides transformation
lending or managerial support geared to growth for small-scale enterprises in
Namibia. This function cannot be effectively undertaken by banks (which in Namibia

are not engaged in universal banking). Alternative institutions such as private sector,
venture capital firms that are specifically suited to perform this function are needed.
Banks’ lending policies determine their efficiency in credit allocation. Inappropriate

lending policies result in cheap credit being provided to medium and large-scale
firms, regardless of the value of their returns on investment (ROI), at the expense of
higher yielding opportunities provided by small-scale enterprises (Obwona &
Mugume, 2001). Such lending policies result in low productivity investment no
matter how efficiently they are implemented.
The design of financing interventions also determines the effectiveness of the

financial intermediation mechanism in allocating credit efficiently. Inappropriately
designed financial provision strategies will not produced the desired results
regardless of how efficiently they are implemented. This is exhibited by the
continued complaints of inadequate finance reported in the results of surveys
targeted at small-scale enterprises (Grossman, Mwatotele, Stork & Tobias, 2005). In
Namibia the design of an effective financing mechanism that targets the poorest of
the poor could be improved (Investment Development Consultancy & Development
Strategies, 2001).
The existence of M&A deals in the banking industry may affect the effectiveness of
the financial intermediation mechanism in allocating credit efficiently. Merging banks
tend to shift their portfolios into higher risk, higher expected-return investments to
take advantage of diversification gains from the mergers. These are typically high-
yielding loans. Therefore, M&A in the banking industry could increase the
effectiveness of the financial intermediation mechanism.15
Also, regulation determines a bank’s choice of investment portfolios, which has

implications on its efficiency in credit allocation. The design of regulation depends
on different goals and objective functions of different constituencies including the
trade-off between customer protection and increased access to credit; the desire for
both simplicity - emphasis on rules, and flexibility - emphasis on supervision; and the
need to allow for market forces to provide a powerful monitoring and correction
mechanism (Saidenburg & Schuermann, 2003).
Besides corporate income tax, which represents direct taxation, banks are subject to
indirect taxation through reserve requirements, which are usually remunerated at
less-than-market rates. As opposed to corporate income tax that can be targeted at
pure profit, making it relatively non-distorting, the reserve tax is proportional to the
volume of deposit taking and is therefore a distorting tax (Demigürç-Kurt & Huizinga,
15
This positive effect can be outweighed by the negative effects arising from an increase in market
power.
1998).16 This distortion affects the banks’ efficiency in credit allocation, which has
negative implications on economic growth.
The existence of an explicit deposit insurance scheme may also affect the
effectiveness of the financial intermediation mechanism. Therefore, if deposit
insurance is chosen to mitigate information asymmetry inherent in banking, its
design matters in determining banking stability and efficiency. The fall in deposit
rates that accompanies explicit deposit insurance makes the operation of small
banks feasible, which provides a valuable source of alternative finance for small-
scale enterprises. However, deposit insurance creates a subsidy that could be
exploited by taking additional risks, which would reduce the quality of the loan
portfolio. This lowers net interest margins and profits, which could create a barrier
for competition by discouraging new entry, after a point (Demigürç-Kurt & Huizinga,
1998).17
2.5. Influencing Factors
The firms that banks lend to are the small and medium-scale enterprises (SMEs)
and large-scale enterprises. Some of these enterprises are profitable but cash poor.
They are rapidly expanding with fast sales growth, positive profit margins but lack
marketable fixed assets or accounts receivables that are needed to reduce the
lending risk. Others are growing rapidly towards liquidity. Although, they are
successful and stable enough so that the risk to outside lenders is reduced, they still
need outside cash to sustain their growth (Sahlman, 1990).
The official definition of SME in Namibia, depicted in Table 1 below, is based on

number of employees, annual turnover and capital employed. A firm is categorised
as an SME if it meets at least two of the three criteria. Dahl (2002) argues that the
official definition may not be appropriate for Namibia where the average SME size is
approximately 3 (2.2) employees and the annual turnover and capital employed
appear to fit few Namibian enterprises with between 1and 9 employees.
As described in earlier paragraphs, a bank’s lending practices has an impact on the

level of funds these SMEs and large enterprises can raise and how these firms are
managed (Stulz, 2001). These practices depend on internal factors, which the
bank’s management can control or external factors, beyond its control.
16
The effect of these direct and indirect taxes on interest margins and profits work in opposite
directions, especially in developing countries.
17
Although, Namibia has no deposit insurance it sets its interest rate 20 basis points below that of the
CMA. This has the same effect if an explicit deposit insurance scheme existed and may explain some
of the variation in profits that is currently attributed to market power.
Table 1: Definition of Small Business by Ministry of Trade and Industry in

Namibia
Number of
Sector Annual turnover Capital employed
Employees
Manufacturing Less than 10 NAD 1,000,000 NAD 500,000
All other businesses Less than 5 NAD 250,000 NAD 100,000
Source: Ministry of Trade & Industry (2000)
2.5.1. Internal Factors
This section describes factors under a bank management’s control that influence
alternative profit X-efficiency and can be an area of focus to increase the
effectiveness of the financial intermediation mechanism in allocating credit
efficiently.
2.5.1.1. Information Systems
The way a bank structures it processes has important implications on alternative

profit X-efficiency. Processes increase the bank’s ability to compete, satisfy their
customers and complete transactions accurately and address other sets of business
problems (Frei, Harker & Hunter, 1998 and KPMG, 2004c). These processes need
to be aligned with the overall goals of the organization.
Process alignment in banks is a management task. In recognition of this, banks

invest in the existing group of managers through management development
programs where they learn how to integrate varied pieces together to form a
coherent, formidable structure. Banks also hire managers from manufacturing
enterprises to drive the process alignment of technology, human resource
management (HRM) and strategy.
Rather than focusing on one process, bank managers need to improve a set of
processes i.e. rather than focusing on one best practice they have to look at the
overall set of practices as they interact with each other. This is because there is no
one set of management practices, capital investments and strategies that lead to
success. Rather, it appears that the alignment of technology, capital investments
and human resources with appropriate delivery processes appears to be a more
appropriate strategy to increasing alternative profit X-efficiency in the banking
industry.
2.5.1.2. Information and Communications Technology
The level of adoption and application of ICT may also affect the level of alternative
profit X-efficiency in the banking sector. ICT is used by a bank’s management and
staff to transform “raw” inputs into useful inputs. It adds value by creating new
sources of information in an organization, rather than simply automating existing
processes (Zuboff, 1985). It is viewed within a bank at two main levels. Firstly there
is overall investment in ICT. The banking sector in Namibia is continuously

undertaking technology infrastructure projects, platform automation and information
and transaction process upgrading. These are aimed at integrating the traditional
front-office and back office systems to reduce costs by enabling the operation of
smaller bank branches with fewer but more highly qualified staff.
Secondly, there is the ICT functionality deployed in the production and service
delivery processes, which focuses on its ability to perform certain functions within
the organization. The purchase of a computer in itself adds nothing to the productive
capability of an organization. It is only after this computer has been integrated into
the production technology of the firm that it adds value (the same is true of labour
and other capital inputs) (Frei, Harker & Hunter, 1998). The selection of ICT projects
and their management are crucial factors in transforming the investment in ICT into
effective ICT aimed at generating higher profit.
2.5.1.3. Human Resource Management
Human resource management (HRM) processes provide a high-level framework

and guiding principles, while HRM policies bring this framework down to an
operational level. At increasingly specific levels below HRM processes and policy
lies the implementation of particular HRM practices.
HRM practices create value by attracting and retaining employees, reinforcing

employee behaviors and developing employee skills through compensation, hiring
and selection, staffing, training, work organization and employee involvement. They
affect both managerial and non-managerial employees and affect alternative profit
X-efficiency to the extent that both groups play important roles in engaging or
supporting profit generating activities in banks (Frei, Harker & Hunter, 1998).
Solid empirical evidence shows that HRM contributes to organizational performance

and implies that efficiencies in banking may be increased by effective management
of human resources (Frei, Harker & Hunter, 1998).
2.5.1.4. Service Delivery Channels
Another factor influencing alternative profit X-efficiency is the cost of and revenue
generated by the channel used to provide financial services. Banks use branches,
automated teller machines (ATMs), the personal computer (PC), fixed-line
telephones and most recently cellular phones (cell phones) to provide financial
services to their clients. The increase in service delivery channels are the result of
pressures from a globalised financial services industry, opportunities provided by
advances in ICT and innovations in financial engineering. The management of
process consistency within and across these service channels is important because
of the interactions between them.
2.5.1.4.1. Branches
Branches are the tradition delivery channel used by banks for financial service
provision. However, due to their fixed location their outreach is limited to the local
clientele in their immediate surroundings. For most branch employees time spent
with customers focuses on simple, transaction-oriented activities and basic servicing
of accounts rather than on activities that are likely to lead to sales opportunities
(Frei, Harker & Hunter, 1998)
The pace of innovation in financial engineering and advances in ICT has brought
their traditional role into question. The future of branches does not lie in their
elimination in favour of new service delivery channels but in transforming them into
sales as opposed to service centres (Athanassopoulos, Soteriou & Zenios, 1997).
This will involve designing processes to supplement or improve employee-customer
interaction that will allow bank employees to increase their cross-selling efforts, in
addition to assessing and meeting customers’ needs.
2.5.1.4.2. Automated Teller Machines
Technological advances have assisted banks in reducing the cost of branch

networks and allowed them to expand faster into new areas. This has mainly been
through setting up ATMs instead of adding more costly physical branch offices
(Berger & Mester, 1997). Mini-ATMs and mobile agencies have further reduced the
cost incurred by setting up fixed ATM centers that are usually found outside bank
branches.
The ATM channel provides an opportunity for banks to channel routine transactions
towards this interface and introduce customers in new markets to different ways of
interacting with banks. In addition, it is a useful channel through which SMEs can
use debit cards to access approved credit lines for their businesses.
2.5.1.4.3. Fixed-Line Telephones
Banks also take advantage of the fixed-line telephone as a service delivery channel.
This occurs mainly through the provision of call center services to handle routine
questions and service transactions day and night. The use of this channel involves
the routing of all calls to a call center. This strategy could be used to free up branch
employees to pursue more sales opportunities.
Shifting the call centre from a pure service channel to a sales and service channel
enables it to shift from a cost centre to a profit centre. In other banks this has been
handled through the use of technology to give call centre representatives a complete
picture of each calling customer’s financial portfolio, position and potential. This
should enhance their sales efforts by enabling them to suggest an optimal fit
between customers and services, and to refer the customers to areas in the bank
with particular expertise in a product as it becomes necessary (Frei, Harker &
Hunter, 1998). This channel can also be used to approve loans without actually
meeting the loan applicant through the use of credit scoring models discussed later
on in this section.
To reduce the costs of the call center, banks have applied technological advances to
have more calls handled by automated voice response systems instead of by
people. This decreases the call volume that reaches the call center representatives,
which frees up their time to focus on sales functions. These systems need to be
customer-oriented in design to allow efforts to increase their functionality to have the
desired effect (Frei, Harker & Hunter, 1998).
2.5.1.4.4. Personal Computers
Technological advances have also made it possible to take advantage of the PC as

a service delivery channel. It allows customers to use internet banking to conduct
routine transactions such as electronic fund transfers and on-line payments, which
provides the advantages of cost reductions and customer convenience.
Despite the large up-front costs associated with PC banking, banks do not really
have the option of not providing the PC banking channel at this point due to its
competitive necessity. Therefore, it’s planning and implementation has to be
considered most carefully, down to the precise objectives and detailed descriptions
of how the customer will interact with the channel (Frei, Harker & Hunter, 1998).
The introduction of internet banking through the PC channel has resulted in banks
facing a similar set of service issues that the software industry faces such as how to
deal with hardware related questions about customers’ PCs and modems as well as
issues such as hacking and identity theft. This creates the need to train and retain
technically skilled call center representatives and technical support staff.
2.5.1.4.5. Cellular Phones
The cell phone is a delivery channel that combines the functionality of the PC and
fixed-line telephone in one device. Therefore, it combines the advantages offered
and issues faced by these channels, as described above. The importance of this
channel to the Namibian financial services industry cannot be overstated. Finscope
(2004) estimates that 46% of the Namibian population has cell phones, as opposed
to only 27% having fixed line telephone access. Of the latter, only 1 out of 20 have
access to the internet. Therefore, the embracing of this channel represents a high-
growth area if the objective of banks is to increase market share, profits and access
to financial services for banks in Namibia.
The introduction of a new service delivery channel does not replace previous
channels. Therefore, banks need to integrate these new channels into the existing
methods of interacting with the customer. A wholistic approach to channel
management will allow a bank to take advantage of the increasing volume of
interaction with the customers that a service delivery channel shift creates to
promote the new product options and services that are offered by the new
technology. This requires the management of interactions within and across service
delivery channels to ensure that they complement each other (KPMG, 2004c).
Banks also need to understand how customers interact with the bank through each
service delivery channel. This is useful so that when they migrate a set of customer
transactions from one channel to another, appropriate processes can be designed to
facilitate the switching by these customers from one delivery channel to another.
This will allow existing customers, who may be channel-specific to use their
preferred channel and allow newly acquired customers to use one or all channels to
prevent a channel from suffering unduly when an additional one is introduced. This
is because each service delivery channel has a customer retention value and the
challenge is to cross-sell to the existing customer base, in addition to acquiring the
new customers that a new channel attracts, without losing existing customers (Frei,
Harker & Hunter, 1998).
2.5.1.5. Risk Management
To ensure that banks achieve the objective of customer protection and control for
systemic risk, which refers to the risk that the liquidity crunch problems of a few
institutions spreads to many other institutions that are otherwise solvent and liquid
(Berger & Humphrey, 1997), the Basel II Capital Accord requires banks to better
align their regulatory capital to the underlying risks (Saidenburg & Schuermann,
2003).
Since a bank’s insolvency risk depends on the financial capital available to absorb
portfolio losses, as well as on the portfolio risks themselves, the Basel Capital
Accord places limitations on exposure to sources of vulnerability. If banks
continuously exceed any of these limitations they are subjected to heavy costs in the
form of increased regulatory oversight (remedial covenants) or may even have their
charters revoked.
Bank are required to adhere to a capital requirement that is more closely linked to
each bank’s actual credit risks through the use of risk-based capital allocation
systems that reward low risk. To the extent that banks can lend to less risky
investment opportunities, the potential of loss is reduced, which leads to more stable
profit levels and less variation in alternative profit X-efficiency.
These risk-based capital allocation systems are based on the assumption that
capital market frictions, such as limited public information, costly renegotiations due
to defaults and agency problems between managers and outside investors, exist,
which drive a wedge between the cost of internal and external funds.18 To the extent
that these frictions lead to credit constraints, allocating capital from a central office to
a diverse set of projects based on an ordinal measure of the value of the project,
can increase investment efficiency (James, 1996).19
18
Frictionless capital markets are those with perfect information and without taxes, bankruptcy costs or
conflicts between managers and shareholders.
19
An example of such a system is described in detail in James (1996).
The move of the capital allocation decision to the bank’s headquarters or holding
company makes no difference to capital budgeting decisions and investment activity
because whether a bank varies leverage to business units on the basis of risk or
varies the cost of capital with the risk of each individual project makes no difference.
In addition, it frees managers to focus their attention on risk that they can influence
i.e. business risk (James, 1996).
Box 2: Risk Categories
- Credit risk refers to the risk of loss due to borrower default or failure to
pay on a contractual obligation. It arises in lending to marginal, small-
scale enterprises.
- Business risk refers to the uncertainty of the revenues and expenses

associated with activities such as loan origination, servicing and data
processing. It depends on X-efficiency.
- Market risk refers to the risk of loss due to changes in the market price of
a publicly traded bank’s assets and obligations such as foreign exchange
risk, interest-rate risk and options risk on mortgages and deposits. The
bank’s treasury unit is responsible for hedging against market risk.
- Country risk refers to the risk of loss on cross-border and sovereign

exposures due to governmental actions such as the suspension of hard
currency payments, radical devaluation of the currency and
nationalization of assets held as investments. This arises from
government action (James, 1996).
To the extent that riskier divisions face a higher capital charge, business unit
managers may be tempted to understate the risk of their division. This behaviour
can be mitigated by evaluating the realized outcomes of a position (net of hedgable
risk) relative to management forecasts, as part of the performance evaluation
system of senior management (James, 1996).
2.5.1.5.1. Credit Scoring
The implementation of risk-based capital allocation will hinder the effectiveness of

the financial intermediation mechanism in lending to high-return destination. This is
because these lending opportunities are associated with higher credit and business
risk (See Box 2 above), which lead to a lower-quality loan portfolio. Business units
that seek out high-risk, high return opportunities contribute to a greater volatility of
the bank’s overall market value, resulting in higher costs of raising external funds
and a reduction in its competitiveness in the wholesale market. Due to these factors
such business units will face a higher capital charge than those that lend to less
risky, lower return destinations.
However, banks have begun to downstream their service offerings towards the
marginal, small-enterprise sector (Harper & Arora, 2005). This pool of clientele is
typically informationally opaque, request for loans that are small in size and lack
strong financial statements marketable assets that are suitable for collateral. In
Namibia, Bank Windhoek has a branch solely dedicated to lending to the emerging
SME sector and other banks in Namibia will soon follow. As banks move towards
lending to the marginal, small-enterprise sector the risk of their overall portfolio is
likely to increase. The final level of risk will depend on the approach used to
evaluate business loan applications.
Various approaches are used to evaluate business loan applications, depending on

a bank’s stage of development and strategy. These include financial statement
lending, which is based primarily on financial statements; asset-based lending,
which is based primarily on collateral and relationship lending, which is based
primarily on “soft” or non-quantitative information about the firm and its owner
gained through contact over time (or a combination of these).
Credit scoring is another way to evaluate business credit applications that can
complement the techniques described above. It is defined as the process of
assigning a single quantitative measure or score to a potential borrower
representing an estimate of the borrower’s future loan performance (Feldman,
1997). It uses a statistical approach to predict a borrower’s willingness, rather than
ability to pay in time based on previous loan applicants with similar characteristics.
Credit scoring was originally applied to consumer loans and mortgages because
commercial loans were thought to be too heterogeneous and documentation was
thought not to be sufficiently standardised either within or across institutions
(Rutherford, 1995). Its application to commercial credits arose from the
determination by credit analysts in the early 1990s that the loan repayment
prospects of the individual were highly predictive of the loan repayment prospects of
their business.
The modification of the original credit scoring models to small business lending
occurred when the Robert Morris Associates (an association of commercial loan
officers and credit risk managers from over 3,000 member financial institutions in the
U.S.) joined with Fair, Isaac & Co. (a computer software modeller based in San
Francisco) to create the Small Business Scoring Service – SBSS (Latimer, 1995).
The developers of SBSS determined that key indicators of a business's health

assessed by the original credit scoring models - including its age, net worth and
profitability - hardly mattered in evaluating the probability of loan default for small
businesses. Therefore, they augmented the original credit scoring models by
including information about the character and reliability of the small business owner
such as the owner’s monthly income, outstanding debt, financial assets,
employment tenure, home ownership, and previous loan defaults or delinquencies
(Akhavein, Frame & White, 2001).
The resulting model greatly reduced the costs of lending to the marginal, small
enterprise sector by enabling the pricing of small business loans based on degree of
risk, differential handling of late payments and delinquencies, differential handling of
collections based on outcome predictions, estimation of the amount of profit an
account was likely to generate, identification of applicants who may be candidates

for other services and targeting of prospective customers.
Box 3: Types of Credit-Scoring Systems
- A generic model that predicts the likelihood of a business loan applicant

paying in a severely delinquent manner based upon a sample of
businesses from across all industry segments, utilizing a wide range of
commercial information.
- An industry-specific model that predicts the probability of delinquent

payment based upon a sample of firms within a given industry.
- A model that predicts the likelihood of business owner payment

performance based on the owner’s payment behaviour.
- A scoring model developed from a sample of businesses that most

resemble the bank’s actual borrowers (Rowland, 1995).
The implication of the adoption of SBSS by banks in Namibia is that it could reduce
the credit and business risk of SME branches and make them less of a liability when
assessed using risk management methods. Another implication is that small
business owners who have been scrupulous about paying off personal debts are
more likely to get a new loan than those with a troubled credit history, even if their
enterprises have impressive balance sheets.
The adoption of SBSS requires banks that are down streaming into the marginal,
small-scale enterprise sector to view the issue of collateral from a different
perspective.20 By not relying so much on financial statements for small enterprise
lending, which tend to be unsophisticated or may understate income for tax reasons,
SBSS is more effective than the original credit scoring models for small business
lending. By enabling banks to evaluate business loan applications based on the
owner’s personal and business finances, which is important where entrepreneurs
keep debt in the business and cash in their personal account, SBSS allows a bank
that is willing to make large personal loans to self-employed people not to give the
same clients a hard time when they apply for business loans by taking the owner
and the business as the same entity. This inclusion of personal profiles in loan
assessment is relevant to Namibia where a small businesses’ future is closely tied to
the owner's creditworthiness (Grossman, Mwatotele, Stork & Tobias, 2005).
The ability of SBSS models to improve collection activity depends on the information
base on which they rely. The personal information used is usually obtained from one
or more consumer credit bureaus and may be combined with data from business
credit bureaus and basic business-specific data collected by the bank. Currently the
20
The use of SBSS conflicts with the limited liability rule in the case of default where the applicant
enterprise is a corporation.
existence of domestic, independent credit rating agencies that could provide this
information in Namibia is limited. However, Compuscan, an off-the-shelf SBCS is
used by microlenders in South Africa, Namibia and Botswana.21
To create a database from which a SBSS can be developed, banks should collect
data on all previous (approved and rejected) and current loan applicants and
existing customers. This pool of data will allow the creation of a SBSS that will
automate the loan assessment process and reduce the time loan officers spend
evaluating referrals, which are not a revenue generating activity and do not
contribute to improvements in alternative profit X-efficiency and efficient credit
allocation.
2.5.2. External Factors
This section describes external factors that affect alternative profit X-efficiency that
are beyond the control of bank managers. An empirical analysis to determine which
of these influences bank efficiency has important implications for public policy and
academic research.
2.5.2.1. Bank Size
According to microeconomic theory on scale economies, bank size is negatively

related to alternative profit X-efficiency because bigger banks suffer from scale
diseconomies due the difficulties of managing a larger entity. However, no
consistent picture emerges from empirical studies that have investigated the
relationship between bank size and profit efficiency (Mester, 1993 and 1996).
2.5.2.2. Organisational Form and Governance
Organisational form and governance is influenced by bank M&A activity, ownership

form and structure as well as financial market influence.
2.5.2.2.1. Mergers and Acquisitions
M&A theory postulates a positive relationship between mergers and alternative profit
X-efficiency. There are three main competing hypotheses as to why this relationship
exists.
First, the efficient structure hypothesis argues that the positive relationship exists
because relatively more efficient banks with Iower costs of production, superior
management and production technologies, compete more aggressively for and gain
market share leading to higher profits, which is reflected in higher alternative profit
X-efficiency.
Second, the relative market power hypothesis argues that the positive relationship
exists because banks with well-differentiated products are able to exercise market
21
See www.compuscan.co.za for more information.
power in pricing these products resulting in their capture of market share (Berger &
Humphrey, 1997). Ikhide (2000) points out that banks offer basically the same
facilities, thus this competition is mainly non-price in form through advertising,
quality improvement, product packaging and services, as opposed to underpricing.
Finally, the market power hypothesis (also known as the structure-conduct-

performance hypothesis) argues that the positive relationship may be due to banks
in concentrated markets, where there are limited alternative sources of financial
services, exercising market power to charge prices that deviate widely from their
equilibrium levels and are unfavourable to consumers (lower deposit rates, higher
loan rates), which results in high profits, which is reflected in higher alternative profit
x-efficiency.
On the contrary, an opposing negative influence of M&A activity on bank efficiency

can arise because M&A is correlated with bank size which is postulated to be
negatively related to bank efficiency.
2.5.2.2.2. Holding Company Features
Theory postulates that ownership by a holding company is positively associated with

bank efficiency due to the discipline it imposes on banks. Weak evidence exists that
banks in holding companies are more efficient than independent banks (Mester,
1996). This finding is based on the efficient structure hypothesis that postulates that
more efficient banks may tend to acquire other banks and the holding company is
the vehicle that allows them to do that (Berger & Mester, 1997).
However, a multi-layered, holding company should be negatively associated with

bank efficiency because banks with complicated organisational forms or internal
management structures could be less efficient. The negative relationship between
bank efficiency and multi-layered holding companies should be more pronounced if
the holding company is located outside of a country because banks are more
difficult to control and the ultimate bank owners suffers from information asymmetry
disadvantages compared to those whose holding companies are located in a
country. Empirical studies show that the more complex structure of multi-layered
holding companies does not seem to harm bank efficiency.
Finally, theory postulates that a publicly traded holding company should be

positively associated with bank efficiency because outside shareholders can exert
pressure on bank management.
2.5.2.3. Other Bank Characteristics
The age of bank and the risks that it takes are also postulated to be related to
alternative profit X-efficiency.
2.5.2.3.1. Age
According to the ‘learning by doing’ hypothesis theory postulates that age should be
positively related to bank efficiency since bank production improves over time
(Mester, 1996).
2.5.2.3.2. Risk
Theory postulates that risk is positively related to bank efficiency because a risk-
loving bank will issue more loans, which are more highly valued than securities. In
addition, due to higher market power existing in loan markets compared to other
product markets in which banks operate the relative market power hypothesis
postulates that the potential for higher profits due to adverse pricing by more
powerful banks is increased.
2.5.2.4. Market Characteristics
The characteristics of the market in which a bank operates influence bank efficiency.
Based on the quiet life hypothesis, competition is expected to be negatively related
to profit efficiency because banks in less competitive markets can charge higher
prices for their services but might feel less pressure to keep costs down. There is
limited evidence that banks operating more concentrated markets are less efficient,
supporting the quiet life theory that inefficiency has been sustainable in banking
because competition has not been robust (Berger & Hannan, 1996).
2.5.2.5. Regulation
The identity of the bank’s primary regulator helps to account for the regulatory
regime that bank’s face arising from the charter. Publicly owned banks are regulated
by independent statutes while commercial banks are regulated by the BoN. The
differences in the nature of regulation may influence bank efficiency. However,
empirical studies show that only weak relationships exist between regulator identity
and bank efficiency.
Besides explicit regulation by the BoN, commercial bank depositors also impose
implicit regulation on a bank. The information asymmetry that exists between banks
and their depositors concerning the risk of a bank’s assets arising from fixed
payments to depositors, as opposed to equity payments, which vary with financial
success, creates an incentive for banks to substitute riskier assets to seek a greater
payoff. However, the higher expected payoff is unlikely to increase the value of
equity more than it decreases the value of debt, resulting in a fall in the market value
of the bank to the detriment of depositors. Whenever, such asset substitution is
suspected depositors have an incentive to withdraw their savings.
Since banks are highly leveraged with relatively short-term liabilities, typically in the
form of deposits and relatively illiquid assets - usually loans to firms or households,
this withdrawal can lead to a liquidity crunch, which could lead to bank failure or a
run on banks causing economic instability. The threat of withdrawal when risk
shifting is suspected reduces a bank’s incentive to engage in asset substitution,
which transfers value from debt holders and improves the value of bank assets
(Hughes, Lang, Moon & Pagano, 1997).
In addition, to explicit bank regulation and the implicit regulation arising from the
threat of depositor withdrawal, bank deposits are also protected by deposit
insurance. This insurance is designed to overcome the asymmetry of information in
the banking system (Diamond and Dybvig, 1983). This eliminates the need for
depositors to fear asset substitution. With the establishment of deposit insurance,
depositors no longer have an incentive to monitor banks since their deposits are
guaranteed up to a certain limit (Saidenburg & Schuermann, 2003). These benefits
do not accrue to Namibia because it has no explicit deposit insurance scheme.
3. NAMIBIA’S BANKING SECTOR
3.1. Regulatory Framework
Banks in Namibia fall under the jurisdiction of the Common Monetary Area (CMA).
Under this framework monetary policy in Namibia is determined by the South African
Reserve Bank (SARB), which is South Africa’s Central Bank. To mitigate potentially
adverse effects of shocks due to loss of monetary policy control, governors from
each Central Bank in the CMA meet on a quarterly basis at a Governors Forum to
exchange views about recent economic developments in their respective countries.
This forum takes place shortly before the meeting of the quarterly, Monetary Policy
Committee at the SARB, which incorporates the views expressed by the Governors
in the formulation of monetary policy for the CMA.
In addition, under the CMA, Namibia does not have the freedom to alter its
exchange rate at will but has ceded this responsibility to South Africa through a
pegged exchange rate. This arrangement implies a loss in autonomy of exchange
rate and exchange control policies, which exposes Namibia to asymmetric
macroeconomic shocks (Jenkins & Thomas, 1996).
Domestically, the primary regulator for commercial banks is the BoN. It was formed
in 1990 following Namibia’s independence and inherited its legal framework from the
Banks Act 23 of 1965, for the banking industry, and Building Societies Act of 1986,
for building societies. In 1998, these were replaced by the Banking Institutions Act 2
of 1998. This Act represents a legal framework encapsulating internationally
adopted banking standards and supervisory practices that are based on the Core
Principles for Effective Banking Supervision recommended by the Basel Committee
on Banking Supervision (BCBS). Provisions of the Act include the implementation of
prudential requirements, regulations and guidelines and a bank risk reporting
system. The provisions are reviewed regularly in order to conform to local and
international developments arising from recommendations by the Basel Committee.
The BoN’s main role is to promote monetary and financial stability in the interest of
the nation’s sustainable economic growth and development. Despite its lack of direct
control over monetary policy instruments, it still influences monetary policy in
Namibia by focusing on ensuring stability and efficiency in the banking industry. This
function is based on Post-Keynesian principles, described in the earlier section.
The publicly-owned banks in Namibia are regulated by independent statutes

enacted by Acts of Parliament. The Agricultural Bank of Namibia (Agribank) is
regulated by Agribank Act No. 5 of 2003 (Agribank, 2003). The Namibia Post Office
Savings Bank (NamPost) is regulated under the Post and Telecomm Act. No. 19 of
1992.
3.2. Banks in Namibia
Currently the privately-owned banks in Namibia include Bank Windhoek, Standard

Bank Namibia, First National Bank Namibia and Nedbank Namibia. The publicly-
owned institutions include Agribank, NamPost and the Development Bank of
Namibia. Although, NamPost is a depository institution it does not lend to borrowers
either in the private or public sector. The features of banks in Namibia are
summarised in Table 2 below.
Table 2: Summary of Banks in Namibia from 1998 to 2003
Bank Standard Agricultural Bank Nedbank First Development

Bank Bank of Windhoek Namibia National Bank of
Namibia Namibia Bank Namibia
Namibia
Establishment date in 1915 1922 1948 1973 1990 2002

Namibia
Regulator Bank of Government Bank of Bank of Bank of Government

Namibia Namibia Namibia Namibia
Average Branches 21 6 22 n/a 27 -

(1998-2003)
Average Service 17 0 12 n/a 11 -

Centres (1998-2003)
Average Automated 67 0 44 n/a 77 -

Teller Machines
(1998-2003)
Average Mobile n/a 0 n/a n/a 6 -

Agencies (1998-2003)
Average Mini-ATM n/a- 0 n/a n/a 99 -

(1998-2003)
Internet Banking Yes No Yes Yes Yes No
Insurance Subsidiaries Yes No Yes No Yes No
Holding Company Yes No Yes Yes Yes No

Ownership
Holding Company South - Namibia South Namibia -

Location Africa Africa
Multi-Structure Holding No No No No Yes No

Company
Publicly Traded Holding Yes No No Yes Yes No

Company
Merger or Acquisition No No No Yes Yes No

Participation
Note: n/a means that data was not available in the bank’s annual reports
The privately owned banks can be categorised as domestically or foreign owned.

DeYoung and Nolle (1996) define a bank as foreign-owned if at least 25 percent of
its shares are owned by foreign residents or institutions for at least 10 years while
Demigürç-Kurt and Huizinga (1998) define a bank as foreign-owned if 50 percent or
more of its shares are owned by foreign residents or institution. Based on the latter
definition, all privately owned banks in Namibia, except Bank Windhoek, are foreign-
owned by South African-based owners. This implies that Namibia’s banking sector is
subject to a dual regulatory arrangement arising from legislation passed by the
SARB (Ikhide, 2000). This has an effect on the BoN’s role of ensuring stability and
efficiency in the banking industry and influencing monetary policy through the Post
Keynesian channel.
3.3. Market Features
The banking sector in most developing countries is oligopolistic features. This is

defined as a market structure in which a few banks dominate the industry (Griffiths &
Wall, 1996). A less formal definition of oligopoly is a where two banks alone hold
more than 75 percent of the market share, the remaining 25 percent of which is
shared by less than ten banks (Athanassopoulos, Soteriou & Zenios, 1997).
Empirical evidence indicates that the input (deposit) market’s banking sector in
Namibia is oligopolistic (Adongo & Stork, 2005).
We use the Herfindahl-Hirschman index (H-Index) to assess the market structure of

the output (loan) market for banks in Namibia. It is a microeconomic measure of the
concentration of market power in an industry.
2480
2467
2453
2460
2439
2440
2420
2400
Index Score
2400
2380
2368
2364
2360
2340
2320
2300
1998 1999 2000 2001 2002 2003
Year
Figure 1: Herfindahl-Hirschman Index Scores for the Output Market Structure

of Namibia’s Banking Sector from 1998 to 2003
The H-Index scores range from zero, for a perfectly competitive industry, to 10,000
(1002), for a pure monopoly. Therefore, the higher the index’s score the less
competitive the market. According to the interpretation of the United States
Department of Justice and Federal Trade Commission, who developed the index,
any score above 1,800 represents a highly concentrated industry that indicates the
presence of oligopoly. Therefore, Figure 1 above illustrates that the output market
structure of Namibia’s banking sector is oligopolistic.
After a period of no growth between 1998 and 1999, the size of the banking sector
in Namibia, measured in terms of total assets, had increased by 28.85 percent by
2003 in real terms. 22 This is illustrated in Figure 2 below.
22
Real values are obtained by normalising using the Consumer Price Index (1995=100)
25000
19649
20000
18034
16959
14951 13627 14476
15000
N$ ('000s)
10000
5000
0
1998 1999 2000 2001 2002 2003
Figure 2: Size of Namibia’s Banking Sector from 1998 to 2003 in Real NAD
This growth can be attributed to various factors:
• The growth of local markets due to a larger pool of income earners as

historical inequalities continued to be addressed, which led to an increase in
the demand for banking services;
• The use of new service delivery channels in new market areas (de novo
expansion);
• The domestic and cross-border M&A activities of banking entities arising from
the need to obtain a size that would enable them to increase or, at least,
maintain their domestic market shares and reduce operating costs by
exploiting economies of scale (Kamberoglou, Liapis, Simigiannis, Tzamourani,
2002).
• The expansion by banks into assurance in search of alternative sources of

funds and profits from synergies and cross-selling of banking and insurance
products and for a cost-effective way to insure deposits in a banking
environment that lacks an explicit deposit insurance mechanism.
The largest bank in terms of size, measured by average total assets from 1998 to
2003 was Standard Bank Namibia, while the smallest was Agribank. This is
illustrated in Figure 3 below.
Average Total Assets Agribank

Source: Banks’ Annual Reports 1998 to 2003 5%
Bank
Windhoek
21%
Standard Bank
Namibia
31%
Nedbank
16%
First National
Bank Namibia
27%
Figure 3: Relative Size of Banks in Namibia from 1998 to 2003
The different banks are exposed to differing levels of risk depending on the portion
of their overall loan portfolio allocated to the business sector. This is illustrated in
Figure 4 below.
1.2
0.9972
1
0.8
0.6 0.5501 0.5501

0.5143
0.4533
0.4
0.2
0
First National Bank Windhoek Nedbank Standard Bank Agribank
Bank Namibia Namibia
Source: Banks’ Annual Reports
Figure 4: Relative Ratios of Business Loans to Total Loans for Banks in

Namibia from 1998 to 2003
4. MEASURING ALTERNATIVE PROFIT X-EFFICIENCY
There is no agreement in frontier analysis literature on the best methodology that

can be used to measure bank efficiency. The problem arises because even though
the different methods yield quite similar X-efficiency estimates for overall banking
sector when applied to the same data set, they produce different results when
ranking individual banks in the sector (Berger, 1994). This suggests that overall
alternative profit X-efficiency for the overall banking sector may be a more
appropriate guide for policy purposes than rankings (Berger & Humphrey, 1997).
This section begins by selecting an efficiency concept, estimation technique,

approach and functional form and then goes on to describe the sample, data and
procedure that this study adopted to complete the first step of the two-step approach
required to achieve its objectives (Coelli, Prasada & Battese, 1998).
4.1. Efficiency Concept
Concepts for measuring efficiency fall into three categories: revenue, cost and profit
efficiency. These concepts established an economic foundation for analysing bank
efficiency because they are based on economic optimisation in reaction to market
prices, competition and other business conditions, rather than being based solely on
the use of technology.
4.1.1. Revenue Efficiency
Revenue efficiency measures the change in a bank’s revenue adjusted for random
error, relative to the estimated revenue obtained from producing an output bundle as
efficiently as the best-practice bank in a sample facing the same exogenous
variables. It is not usually directly measured but is inferred from measurements of an
output distance function, which measures output efficiencies.
Revenue efficiency occurs when banks charge higher prices for higher quality
services, which result in higher revenues if these banks have the market power to
extract some of the consumer surplus that arises. Empirical studies have found that
revenue inefficiency can be attributed primarily to technical inefficiency as opposed
to allocative inefficiency (Berger, Humphrey & Pulley, 1995).
The main shortfall of the revenue concept is that it does not take into account the
increased costs of producing higher quality services and thus focus on only one side
of the overall financial picture of a bank (DeYoung & Nolle, 1996).
4.1.2. Cost Efficiency
Cost efficiency measures the change in a bank’s variable cost adjusted for random
error, relative to the estimated cost needed to produce an output bundle as
efficiently as the best-practice bank in a sample facing the same exogenous
variables, which include variable input prices, variable output quantities and fixed
netputs (inputs and outputs). It arises due to technical inefficiency, which results in
the use of an excess or sub-optimal mix of inputs given input prices and output
quantities.
Ikhide (2000) argues that costs are less vulnerable that revenues and profits to
extraordinary factors that can affect different banks or categories of banks
disproportionately such as variations in open-market interest rates.
However, using costs alone in evaluating efficiency may not be sufficient to make
inferences about banks’ overall performance, as it does not take revenues into
account. Thus it does not account well for the revenue gains from provision of higher
quality services, as described above or from shifts in bank lending portfolios
between securities and loans (which have higher returns on average than
securities). Also, cost efficiency evaluates performance holding output quantities
statistically fixed at their observed levels, which may not correspond to the optimally
efficient levels that involve a different scale and mix of outputs. Therefore, a bank
that is relatively cost efficient at its current output may or may not be cost efficient at
its optimal output. In addition, the use of constant outputs prevents the evaluation of
whether any revenue changes from shifts in output offset cost changes except in the
special case in which outputs remain constant. This hinders the use of cost
efficiency in anti-trust policy analysis because it depends on the assumption that the
output of the consolidated banks equals the sum of the separate outputs of the
banks prior to the merger.
4.1.3. Standard Profit Efficiency
In instances where banks provide additional or higher quality services, costs rise but
revenues may increase by more than the cost increase. Looking at efficiency from
either the cost minimisation or revenue maximisation perspective fails to capture the
goal of banks to maximise profits by raising revenues as well as reducing costs and
does not account well for unmeasured changes in output quality (Berger & Mester,
1999). This shortfall is overcome by the profit efficiency concept.
Standard profit efficiency measures the change in a bank’s variable profits adjusted
for random error, relative to the estimated profit needed to produce an optimal
output bundle as efficiently as the best-practice bank in a sample, facing the same
exogenous variables, which include variable input prices, variable output prices and
fixed netputs.
It reflects the goal of profit maximisation by incorporating both cost and revenue
issues that result from varying inputs as well as outputs. Therefore, it more
completely describes the economic goals of banks, which require that effort is spent
to raise revenues as well as reduce costs. This corresponds well with the social
benefit concept, which is useful for policy analysis. This concept refers to the real
value of output produced and is represented by the change in revenues for given
prices less the real value of resources consumed, which is represented by the
change in costs (Akhavein, Berger & Humphrey, 1997).
Standard profit efficiency can be categorised into output and input components.
Output profit inefficiency includes the output technical inefficiency, which is the
failure to produce as much output as planned and allocative inefficiency, which
arises from misresponding to output prices, including the cost and revenue effects of
deviating from the profit-maximising production plan.
It can also be categorised into technical and allocative components. Technical profit
inefficiency is defined as the loss of profits from failing to meet the production plan
as a result of the outputs being too low or the inputs being too high. Allocative
inefficiency is defined as the loss of profits from making non-profit-maximising
choices of netputs in the production plan. It is modelled as if the bank were
responding to shadow relative prices rather than actual relative prices.
Even if banks are economically efficient (technically and allocatively efficient),

standard profit inefficiency still exists if bank are choosing the wrong level of output
in order to maximise profits (Mester, 2003). Therefore, a bank might do a slightly
better job at minimising costs than its counterparts, but it makes less profit because
it does not do a good job in selecting its output mix. The worst a bank can do has no
limit because it can always use more inputs without producing more outputs. This
means that standard profit efficiency can be negative, since banks can throw away
more than 100% of their potential profits (Akhavein, Berger & Humphrey, 1997).
Accountants measure profit efficiency as the percentage change in a bank’s variable

profit relative to assets. This measure overstates efficiency because variable profits
measures earnings before taxes and fixed costs while the numerator used in the
resulting ratio (ROA) measures earnings after tax and fixed costs (DeYoung & Nolle,
1996 and KPMG, 2004a & 2004b).
Profit efficiency also uses book values obtained from financial statement data
available in banks’ annual reports. These values vary with factors such as
accounting conventions, capital structures of different banks, market power and
macroeconomic conditions in the markets in which the bank operates (Hughes,
Lang, Moon & Pagano, 1997). The use of standard profit efficiency is justified as
long as the assumptions on which it is based hold. Where this is not the case,
alternative profit efficiency is adopted.
4.1.4. Alternative Profit X-efficiency
Alternative profit X-efficiency measures the change in a bank’s variable profits

adjusted for random error, relative to the estimated variable profit needed to produce
an optimal output bundle as efficiently as the best-practice bank in a sample, facing
the same exogenous variables, which include variable input prices, variable output
quantities, fixed netput quantities and environmental factors. It attributes changes in
efficiency to best practice, resulting from management efforts and environmental
variables.
The alternative profit efficiency function employs the same dependent variable as
the standard profit function and the same exogenous variables as the cost function.
Therefore it differs from the standard profit function in that variable output quantities
are used in place of variable output prices and overcomes the shortfalls of the cost
function by including profit in its dependent variable.
The standard profit function specification assumes that banks do not have the
capacity to fix output prices while the alternative profit specification assumes that
banks have no capacity to expand output. Although, it is unrealistic to expect that
banks actually take their outputs as given, this cost is outweighed by the benefit the
alternative profit concept provides for analysing bank efficiency in developing
countries where the assumptions underlying the cost and standard profit X-efficiency
measures do not hold (Berger & Mester, 1997). Alternative profit X-efficiency is
important where the following conditions exist:
4.1.4.1. Substantial Unmeasured Differences in Quality of Output
Inaccuracies in X-efficiency can arise if one does not control for unmeasured
differences in quality that are likely to arise because financial statement data do not
fully capture the heterogeneity of a bank’s output. In addition, the amount of service
flow associated with financial products is by necessity usually assumed to be
proportionate to the value of the stock of assets or liabilities on the balance sheet.
Alternative profit X-efficiency controls for the unmeasured differences in quality by

considering the additional revenue that covers the cost of generating higher quality
output through its dependent variable. If customers in a competitive banking industry
are willing to pay for the additional services provided by some banks, they can
survive in competitive equilibrium because they receive higher revenues that just
compensate for their extra costs. Therefore, unlike cost efficiency, it does not
penalise banks for producing more costly outputs.
Standard profit efficiency, by holding output prices fixed, is less able to account for
differences in revenue that compensate for differences in product quality, since
these revenue differences may be partly reflected in measured prices.
Also, by taking output prices as given, the standard profit efficiency function,
assumes that a bank can sell as much output as it wishes without having to lower its
prices. This may be unrealistic and could lead to an understatement of standard
profit efficiency for banks with output below efficient scale that have to reduce their
prices to increase output. In addition, by taking output prices as given, it does not
account for the effects of service quality where banks are making poor service
quality choices relative to a best-practice bank, which is reflected in lower output
prices and revenues.
Other approaches to controlling for unmeasured differences in quality include

incorporating variables that are intended to control for the quality of bank output
(Mester, 1996).
4.1.4.2. Output is not Completely Variable
Alternative profit X-efficiency includes output quantities as an independent variable

(as opposed to output prices), which essentially holds outputs statistically constant.
Therefore it compares the ability of banks to generate profits for the same levels of
output. This controls for the lack of variability in outputs and prevents a scale bias
where large banks are labelled as having higher profit efficiencies than smaller
banks because the latter cannot adjust their size quickly to reach the same output
levels as the former. The standard profit efficiency function does not control for this
because it treats large and small banks as if they should have the same variable
outputs when facing the same exogenous variables.
4.1.4.3. Output Markets are Oligopolistic
A lack of perfect competition in the banking industry results in banks exercising

some market power over the prices they charge, such as in the oligopolistic
Namibian banking industry (Adongo & Stork, 2005). By including output quantities
as an independent variable the alternative profit X-efficiency function controls for the
possibility that outputs are relatively fixed and prices are chosen by the bank in the
short run. This allows for efficiency differences in the setting of prices and service
quality where optimising banks set their prices to the point where the market just
clears for their output and choice of service quality. It also controls for efficiency
differences where banks with market power may be able to increase revenues more
than costs when increasing service quality because there may not be adequate
competition. Furthermore, it controls for efficiency differences where banks
economise on service quality and keep costs relatively low (skimping).
The exercise of market power that raises prices over time may be measured as an
exogenous improvement in business conditions when applying the standard profit
efficiency concept, but may be measured as an improvement in best practice when
applying the alternative profit X-efficiency concept, neither of which is precisely
correct.
4.1.4.4. Output Prices are not Accurately Measured
Since engineering information on the technology of banking is not widely available,

efficiency studies rely on accounting measures of costs, revenues, profits, outputs
and inputs drawn from financial statements in a bank’s annual reports. Although
financial statement figures do not directly measure prices they are assumed to be
accurate. Financial statement proxies for prices are often constructed as ratios of
revenue flows to stocks of assets. This may incorporate noise due to problems in
matching revenue flows with the stock of assets, time periods in which they were
earned and differences in asset duration, risk, liquidity and collateral. By including
output quantities as an independent variable, the alternative profit X-efficiency
reduces this effect and controls for inaccuracies in the output price data drawn from
financial statements.
Empirical evidence shows that measured output prices do not have the theoretically
predicted strong positive relationship with profits, and that output quantities do
strongly predict profits suggesting that the alternative profit X-efficiency function is a
better measure than the standard profit X-efficiency function. However this result
may reflect the scale bias problem discussed above where output quantities are not
completely variable over the short term (Humphrey and Pulley, 1997).
Furthermore, empirical literature shows that the alternative profit X-efficiency

function fits the data better than the standard profit X-efficiency function (Humphrey
and Pulley, 1997), which implies that when it is applied, output variables as a group
are measured with less noise.
Because the alternative profit X- efficiency concept is suited to the idiosyncratic

features of developing country banking sectors, this paper adopts it to achieve its
objectives. However, some studies recommend that one should try to apply all three
measures for comprehensiveness and to check for robustness (Berger & Mester,
1997).
4.2. Efficiency Technique
Techniques for measuring efficiency can be distinguished as either non-parametric

or parametric. They differ based on the restrictions imposed on the best practice
frontier, the distributional assumptions imposed on the random error and inefficiency
terms and the degree of dispersion in the estimates of average efficiency (Berger &
Humphrey, 1997).
4.2.1. Non-Parametric
Non-parametric techniques impose very few restrictions on the structure of the

alternative profit X-efficiency frontier. They include the data envelopment analysis
(DEA) and free disposable hull (FDH) techniques.
DEA is a linear programming technique that maximises an alternative profit X-

efficiency function of weighted inputs and outputs subject to given restrictions solely
on the basis of the data. It does not impose any distributional assumptions on the
error and inefficiency term or require the specification of a particular form for the
alternative profit X-efficiency function.
It disentangles efficiency differences from random error by assuming that random

error is zero and attributes all deviations from the alternative profit X-efficiency
frontier to inefficiency because it is non-stochastic (Berger & Mester, 1999). This
non-stochastic property makes the method very sensitive to outliers, measurement
errors and number of constraints specified. 23
23
Bootstrapping techniques have been used to overcome this deficiency
The FDH frontier is either congruent with or interior to the DEA frontier (Tulkens,
1993).
Although non-parametric techniques do not impose restrictive assumptions on the

alternative profit X-efficiency function their non-stochastic property is a key
deficiency. This property implies that there is no measurement error in constructing
the frontier, no luck that temporarily gives a bank better measured efficiency from
one time period to another and that there are no inaccuracies created by accounting
rules that would make measured outputs and inputs deviate from economic outputs
and inputs.
The non-stochastic property also creates a problem where errors exist in the best
practice bank. This will alter the measured efficiency of all other banks that are
compared to it or linear combinations involving it with measured efficiency being
confounded with random deviations from the efficiency frontier (Berger & Humphrey,
1997).
Prices are necessary for value information on output, without which it is not possible
to compare banks that tend to specialise in different inputs or outputs and cannot
determine whether the output being produced is optimal. By ignoring prices and
revenue the nonparametric techniques only capture technical inefficiency and
cannot account for allocative inefficiency. This does not correspond to the
alternative profit X-efficiency concept.
4.2.2. Parametric
Parametric techniques pre-specify a functional form for the alternative profit X-

efficiency frontier (Casu & Molyneaux, 2003). They include the thick frontier
approach (TFA), stochastic frontier approach (SFA) and the distribution-free
approach (DFA).
The TFA identifies a 'thick frontier' consisting of banks that are on a frontier plus
those close to it. The functional form it specifies assumes that deviations from
potential alternative profit X-efficiency within the highest and lowest quartiles of
observations (stratified by size class) represent random error, while deviations in
potential alternative profit X-efficiency between the highest and lowest quartiles
represent inefficiencies. This reduces the impact of outliers in estimating the
alternative profit X-efficiency frontier. The TFA only provides an estimate of the
general level of alternative profit X-efficiency in the overall banking sector but not for
the individual banks.
The SFA, also known as the econometric frontier approach, estimates the
alternative profit X-efficiency for a bank as a conditional mean or mode of the
distribution of the inefficiency term, given the observation of the composed error
term. It attributes deviations from the alternative profit X-efficiency frontier to
inefficiency or random error or both.
SFA disentangles the inefficiency and random error terms by assuming that
inefficiencies cannot be negative and follow an asymmetric half-normal distribution,
random error follows a symmetric, standard normal distribution, and that both are
orthogonal to the profit X-efficiency function’s exogenous variables.
The half-normal assumption for the distribution of inefficiencies is relatively inflexible

and assumes that most banks are clustered near full efficiency. In addition, for SFA
to yield meaningful estimates, the profit residuals must skew leftward. Where this
does not occur it causes a great deal of frustration because panel estimation for the
affected period is not possible (Berger & Mester, 1997 and Greene, 1990).
The choice of the half-normal distribution is fairly arbitrary. Empirical studies find that
when the inefficiency term is unconstrained, it behaved much more like a symmetric
normal distribution. The specification of a truncated normal distribution for
inefficiency empirically yields minor, but statistically significant, different results
(Berger and DeYoung, 1996). However, the use of this and other alternative,
symmetric functions such as the gamma and exponential normal distributions may
make it difficult to separate inefficiency from random error in a composed error
framework, since it may be close to the symmetric, normal distribution assumed for
the random error.
Although the efficiencies estimated by the SFA are reasonably consistent with those
of the DFA (Berger & Mester, 1997), the latter is more appropriate where panel data
is available, because this enables standard models of fixed and random effects to
be estimated without the need to make any assumption about the distribution of the
inefficiency term. In a fixed effects model, dummy variables need to be specified for
each bank in the panel data set. Differences in the fixed effects estimated across
banks represent inefficiencies. In a random effects model the average predicted
residual for each bank in the panel is the estimate of that bank's average
inefficiency. However, DFA is limited in unbalanced panels because it results in
some biases when measuring relative efficiencies of individual banks, which affects
their rankings (Akhavein, Berger & Humphrey, 1997).
DFA specifies a functional form for the frontier that estimates alternative profit X-
efficiency for each bank. This estimate is then used to determine the difference
between its average residual and the average residual of the best practice bank on
the frontier, which gives a single alternative profit X-efficiency measure for each
bank.
Since it is the average of a bank’s residuals from all of the regressions it estimates
how well a bank tends to do relative to its competitors over a range of conditions
over time, rather than its relative efficiency at any one point in time. This is useful
since relative efficiencies among the different banks may shift somewhat over time
because of changes in management, technical change, regulatory reform, the
interest rate cycle, and other environmental influences. By averaging over a number
of conditions, DFA gives a better indication of a bank’s longer-term performance
than any of the other methods, which rely on a bank’s performance under a single
set of circumstances (Berger & Humphrey, 1997).
DFA uses less arbitrary assumptions than SFA to disentangle inefficiencies from
random error. It assumes that efficiency differences are stable over time resulting in
a core or average efficiency for each bank, which persists over time and that
random error (including any temporary fluctuations in efficiency) averages out over
time. However, the stability or relative efficiencies across banks do not necessarily
carry over to changes in the overall level or distribution of efficiency (Berger &
Humphrey, 1997). This implies that rankings may be preferred to the overall level of
efficiency in a banking sector for policy analysis under the DFA because they are
neutral with respect to changes in the distribution of measured efficiency over time,
which seems to occur (Akhavein, Berger & Humphrey, 1997).
The reasonableness of the DFA assumptions depends on the length of period

studied. If too short a period is chosen, the random errors might not average out, in
which case random error would be attributed to inefficiency. If too long a period is
chosen, the bank’s average efficiency might not be constant over the time period
because of changes in environmental conditions (possibly due to financial reform)
making it less meaningful.
Empirical investigation into the number of years that may be needed to strike a
balance between the benefits from having another residual to help average the
random error to get more precise estimates of the inefficiency term and the costs of
extra information from adding another year, which increases the likelihood that the
efficiency in the extra year has drifted further away from its average level, indicates
that a six year time period reasonably balances these concerns (Mester, 2003).
For further precision the DFA approach performs a truncation for banks with very
low or very high alternative profit X-efficiencies prior to calculating the inefficiency
terms. This adjustment is made to assign less extreme values of inefficiency to
these banks because the presence of extreme values may indicate that random
error has not been completely purged by averaging (DeYoung & Nolle, 1996). This
prevents outliers from defining the efficient frontier.
There are two alternative methods for truncation. The first involves truncating
residuals at the fifth and 95th percentiles of the sample distributions within their
asset deciles. Average residuals for individual banks that are greater than the 95th
percentile, or less than the fifth percentile, of the distribution of average residuals
within each asset decile are set equal to those threshold values. The second
method truncates residuals uniformly at the fifth and 95th percentiles for the entire
sample using the BHHH algorithm. If the moments of the distribution are dominated
by large banks, it truncates large bank residuals frequently, but truncates small bank
residuals infrequently; creating a bias that overstates estimated inefficiency in small
banks relative to large banks (DeYoung & Nolle, 1996). In addition, some authors
use more arbitrary methods of selecting the point of truncation (Maudos et al, 2002).
This paper adopts the DFA and applies it to the panel data set defined in this study
using the random effects approach. It uses the arbitrary technique used by Maudos
et al. (2002) to perform additional truncation because of the small number of banks
in Namibia.
4.3. Approach
Four main approaches are followed in estimating bank X-efficiency: the production,
user-cost, value-added and intermediation approaches. Although, they all measure
bank outputs as transaction-based flows they differ on whether deposits should be
considered as inputs or outputs, on which there is a longstanding debate.
The production approach views banks as using K and L as inputs to produce both
loans and deposits as outputs. Since bank services are difficult to measure outputs
are measured as a stock of numbers of accounts i.e. by the number of deposits and
loans, with average output size being used as a proxy for their characteristics. This
approach only incorporates operating costs in the servicing of deposits and loans,
although empirical evidence shows that interest costs make up the majority of bank
costs, depending on the phase of the interest rate cycle and are included in the
profit maximisation plans of any efficient firm (Berger & Humphrey, 1997). Interest
expenses are important because banks often substitute between spending
additional real resources to provide better service and paying higher rates on
deposits. Moreover, interest expenses are substitutes for directly incurred operating
expenses and often represent operating expenses incurred at other banks from
which the funds were borrowed (Berger & Humphrey, 1993).24
The production approach is preferred if branch level efficiency is being measured to

investigate a bank’s operational efficiency and productivity because branches
primarily process customer documents for the institution as a whole and branch
managers typically have little influence over bank funding and investment decisions.
Other approaches that specify deposits as an output are the value added and user
cost approaches. The value-added approach considers all liabilities and assets of
the bank to have at least some of the characteristics of an output involving the
creation of value added, and for which customers bear an opportunity cost through
lower interest rates on deposits (Casu & Molyneaux, 2003).
The intermediation approach (also known as the asset approach), views a bank’s
production process as one of financial intermediation with its inputs as the raw
material that is transformed in the financial intermediation process. It is attributed to
Sealey and Lindley (1977) and focuses on the stock of financial value in accounts
because transaction service flow data is not usually available (Berger & Humphrey,
1997).
K and L and the value of all deposits, purchased funds and financial equity capital
are considered as inputs that provide funds and generate costs. The value of all
loans and securities, including loan origination and monitoring services, are
considered as outputs that use bank funds and generate revenues (Mester, 2003).
Although, the intermediation approach recognises that financial inputs are
24
Interest expenses on purchased funds often represent physical inputs involved in raising the funds at
the institutions from which the funds were purchased.
sometimes paid for with depositor service fees instead of with interest payments (as
in the production approach), it considers this as incidental, since the funds raised
would be worthless without the assets in which they are invested.
Specifying deposits as a variable input captures a bank’s limited ability to substitute

between deposits and purchased funds in the short run. Assuming that they are
fixed inputs may bias estimates of alternative profit X-efficiency against foreign-
owned banks, which in most cases use a higher proportion of purchased funds as a
source of lending funds as opposed to the domestic counterparts (DeYoung & Nolle,
1996). In addition, because deposits and other liabilities by themselves generate
negative cash flows and reduce profits, there is a practical difficulty in specifying
deposits as a variable output, as in other approaches, because it is difficult to
generate a positive output price for deposits.
The intermediation approach does not analyse the implications of the fact that a
large number of small accounts are much more costly to service than a small
number of large accounts because its outputs are computed as outstanding
amounts in all these accounts. This is captured under the production approach.
However, the use of the intermediation approach in studies of bank efficiency is

empirically supported (Mester, Nakamura, and Renault, 1998). This approach is also
more appropriate for evaluating entire banks because it includes total costs as
opposed to only operating costs (which do not include interest expenses).
Furthermore, the intermediation approach is more appropriate when the purpose of

measuring bank efficiency is to evaluate the implications of deregulation (or
regulation) on the banking sector, the effects of integration into the global financial
architecture that accompanies financial liberalisation and for analysing the impact of
bank mergers on efficiency (Casu & Molyneaux, 2003).
This paper will adopt the intermediation approach to investigate alternative profit X-
efficiency for Namibian banks. Despite our preference neither it nor the production
approach is perfect because neither fully captures the dual roles of banks in
providing transactions/document processing services and being financial
intermediaries that transfer funds from savers to investors. The choice of one over
the other is shown to affect inferences regarding efficiency (Berger & Humphrey,
1997).
Some studies resolve this issue with a dual approach that captures both the input
and output characteristics of deposits. The former exist because they are paid for in
part by interest payments and provide the institution with the raw material for
offering loans and investing. The latter exist because they are associated with a
substantial amount of liquidity, safekeeping, and payments services provided to
depositors. Other studies have first treated deposits as an input and then as an
output and find that efficiency is somewhat higher when deposits are specified as an
output (Berger & Humphrey, 1997).
4.4. Functional Form
This section describes the model that this study adopts, its variables, the estimated
functional form and the ways we control for various potentially biasing factors.
4.4.1. Model
The alternative profit X-efficiency function aims to maximise variable profits given a
set of independent variables, based on the theory of duality. The specification of
included variables is important because it determines the reference point for other
bank’s in the industry. The basic functional relationship has the following form:
aπ it = f ( wit , yit , zit ,vit ) + ε it (1)
Where: 25
aπ is variable profits (variable revenues less variable costs).
f denotes the functional form.
w is the variable input prices vector, which is closely linked to interest rates.
y is the variable output quantities vector.
z is the fixed netputs vector, which is included to account for their effects on
variable costs and the substitutability or complementarity with variable netputs. It
represents factors that the bank cannot adjust in the short-run and for which there is
difficulty in obtaining accurate price information.
v is the environmental variables vector that represents external influencing factors

that the management has no control over.
ε is the composed error term consisting of an X-inefficiency and random error term.
This composed error term is assumed to be multiplicatively separable from the rest
of the function to simplify measurement and fits an upper boundary to the data as
opposed to an average relationship.
i represents each respective bank; i =1…n;
t represents the time period under consideration; t=1…6.
We specify the functional relationship in (1) in logarithmic form as follows:
ln(aπ + θ )it = ln f ( wit , yit , zit , vit ) + ln uit + ln eit (2)
25
See Appendix A for definitions of each component of variable vectors in equation (1) and their
associated descriptive statistics.
[ ]
u it ~ N 0,σ 2 uit and eit = N 0, σ 2 eit 
Where;
θ is a constant added to every bank’s profit before logging so that the natural log is
taken of a positive number (or at least zero), since minimum profits can be negative.
min
 aπ 
It is defined as   + 1 and is the absolute value of the minimum alternative
 w3 z3 
profit over all banks for the same year plus one.
u it is the alternative profit X-inefficiency term that reduces profits below the best-
practice frontier. It can be thought of as the resources that are used inefficiently or
wasted and is zero for the best-practice bank.26 Since it is a residual, omitted (or
extraneous) variables can have large effects on its value. It is specified as a half-
normal distribution in this study.
eit is the random error term that incorporates measurement error and luck that may
temporarily give banks high or low profits. It has a mean of zero each period and is
uncorrelated with the other independent variables.
4.4.2. Estimated Function
Nonparametric and parametric techniques have different degrees of dispersion and

rank the same banks differently. The solution to this problem involves adding more
flexibility to the parametric approaches and introducing a degree of random error
into the nonparametric approaches.
For parametric approaches the Fourier-flexible function (FFF) has been adopted to
solve this problem. It is a global approximation that adds orthogonal, Fourier,
trigonometric (sine and cosine) terms to a standard translog function (Berger &
Humphrey, 1993). This gives the data more freedom to choose shapes for the
efficiency frontier, which greatly increases flexibility by allowing for many inflection
points that help fit the frontier to the data wherever it is most needed.
This study applies a translog functional form to the data set and includes second-
order terms to account for the U-shaped relationship of the frontier (Berger &
Mester, 1997). This functional form does not adequately fit data that is not near the
mean output size or product mix (Mitchell & Onvural, 1996). It also forces the
average frontier curve to have a symmetric U-shape in logs, which forces large and
small banks to lie on a U-shaped (or possibly flat) frontier and disallows other
possibilities, such as an average frontier curve that falls up to some output point and
remains flat thereafter.
26
The figure in Appendix B shows an example.
Although, the translog form is not as good as the FFF from a statistical viewpoint,
the improvement in fit of the latter is not significant from an economic viewpoint.
Empirical evidence shows that there is a small difference in average efficiency and
very little difference in efficiency dispersion or rankings of alternative profit X-
efficiency estimates obtained by using the translog functional form relative to those
obtained by using the FFF (Berger & Mester, 1997).
In addition, the FFF consumes a large amount of degrees of freedom. Therefore, its
use is recommended for a regional study but not for the present study that focuses
on a relatively small panel dataset (Berger & Mester, 1997).
The specific alternative profit X-efficiency function that we estimate is:
aπ 2
wi 1 2 2 wi wj 3
yk
ln[( ) + θ ] = α + ∑ βi ln( ) + ∑∑ βij ln( ) ln( ) + ∑γk ln( )
w3z3 i =1 w3 2 i =1 j =1 w3 w3 k =1 z3
1 3 3 yk ym 2
zr 1 2 2 zr zs
+ ∑∑γkm ln( ) ln( ) + ∑δr ln + ∑∑δrs ln( ) ln( )
2 k =1 m=1 z3 z3 r =1 z3 2 r =1 s=1 z3 z3
2 2 2 2
wi yk wi zr
+ ∑∑ηik ln( ) ln( ) + ∑∑ ρir ln( ) ln( )
(3)27
i =1 k =1 w3 z3 i =1 r =1 w3 z3
3 2
yk zr 1
+ ∑∑τkr ln( ) ln( ) +υ1 ln v + υ11 ln(v) ln(v) + ln uit + ln εit
k =1 r =1 z3 z3 2
The variables yk / z3 ,
zr / z3 and v have 1 added to them before log transformation
for every bank to avoid taking the natural log of zero. In addition, we exclude factor
share equations, which embody Shephard’s or Hotelling’s Lemma restrictions,
because they assume that banks have perfect allocative efficiency, which is not
suitable for this study.
Other functional specifications used to estimate bank efficiency include the modified,
Fuss, normalised quadratic function that includes quantity equations, which embody
cross-equation restrictions to help in identification (Akhavein, Berger & Humphrey,
1997) and the managerial expenditure function, the dual to the managerial utility
maximisation problem in which managers trade off risk and return and incorporate
revenue and risk terms and the tax rate (Hughes, Lang, Mester, and Moon, 2000).
The functional forms in current bank efficiency literature cannot fully take into
account differences in the products and technologies of small and large banks that
balance sheet entries do not distinguish. For example, a NAD 1 billion loan issued
by a large bank may be a different product requiring different monitoring and
screening policies and procedures than 10,000 loans of NAD 10,000 each that may
be issued by smaller banks.
27
The standard symmetry restrictions (
βij = βji, γkm = γmk , δrs = δsr ) apply to the function.
4.4.3. Homogeneity
The dependent and input variables in Equation (3) are normalised by the price of
labour ( w3 ) in order to impose linear homogeneity on the model, so that on the X-
efficient frontier, a doubling of all input prices and output quantities doubles
alternative profit X-efficiency. Although we impose this normalisation, the
homogeneity restriction does not have to be imposed on the alternative profit X-
efficiency function, if the FFF is adopted (Berger & Mester, 1997). However, it is
required by the translog function to satisfy duality theory.
4.4.4. Heteroscedasticity
One potential difficulty in disentangling the effects of scale inefficiencies from

u
alternative profit X-efficiency in it is the presence of heteroscedasticity. Although,
Berger and Humphrey (1997) argue that the problem of confounding scale and
alternative profit X-inefficiencies is not substantial, this study addresses it by
controlling for heteroscedasticity. This is done by normalising aπ , y and z with
financial equity capital (
z 3 ).
This specification implies that this study measures alternative profit X-efficiency by
how well a bank is able to earn aπ / z3 (ROE) normalised by w3 and with θ added,
by using deposit funds and labour to produce loans and securities given a set of
external environmental conditions (Akhavein, Berger & Humphrey, 1997).
ROE measures how well a bank is using its financial capital, which has economic
meaning and is closer to the goal of the bank than maximising the level of profits,
particularly in a highly leveraged industry such as banking. This measure is also of
importance to shareholders who will put pressure on publicly traded banks to
maximize ROE as opposed to depositors who do not do the same because their
returns are usually guaranteed by deposit insurance, where it exists. Unfortunately,
ROE here is an accounting measure, which does not perfectly correspond to the
market value of the bank, which is of greater economic interest (Berger & Mester,
1997).
Where banks are of different sizes, large banks tend to have higher profits than
small banks, for a given set of prices, because they were able to gain size over a
period of decades, which is difficult for small banks to do in the short run due to
market size or regulatory restrictions that tie the allowable size of the bank to its
z
existing 3 (reserves) level. Failure to control for heteroscedasticity from this source
could result in larger banks being measured as more alternative profit X-efficient
because their higher
z 3 levels allow them to disburse more loans.
The incorporation of z 3 in the alternative profit X-efficiency function also enables

this study to account for different risk preferences on the part of banks All efficiency
concepts, including alternative profit, assume that bank’s are risk neutral. A bank’s
risk depends on the amount of z 3 available to absorb portfolio losses, as well as on
the portfolio risks themselves. If some banks are more risk averse than others, they
may hold a higher level of z 3 than is needed to maximise profits. Ignoring z 3 would
result in a mismeasurement of alternative profit X-efficiency, even though banks are
behaving optimally given their risk preferences (Hughes, Lang, Mester & Moon,
1997)..
A bank’s insolvency risk affects bank profits via the risk premium the bank has to
pay for purchased funds ( w1 ), which are uninsured, and through the intensity of risk
management activities. To some extent, controlling for the interest rates paid on
purchased funds helps account for differences in risk, but these rates are not always
perfectly measured.
A bank's z3 levels, even apart from risk, directly affects its profits by providing a
cheaper alternative to deposits as a funding source for loans because interest paid
on deposits counts as a cost, but interest paid on purchased funds do not as they
are usually tax-deductible. Since alternative profit X-efficiency is affected by the
proportion of equity relative to deposits used by banks to finance lending,
incorporating z 3 allows us to control for heteroscedasticity from this source.
In addition, large banks tend to have lower capital to loan ratios than small banks
due to the diversification benefits conferred by a large size. This allows them to shift
their portfolios toward loans and away from securities for a given level of equity thus
allowing them to better manage the increased portfolio risk with the same amount of
equity capital and obtain higher returns (Berger & Mester, 1997).
An alternative interpretation of this observation is that the small banks are relatively
newly established and thus have a higher capital to loan ratios as they are less
affected by past credit restrictions. Since financial markets associate low levels of
capital with higher default risk, thinly capitalised large banks may have to pay higher
rates for purchased funds.28 A large, higher-risk bank cannot afford to increase its
capital to loan asset ratio as a signal to the market because the opportunity cost of
holding this extra capital is greater for them (Hughes, Lang, Moon & Pagano, 1997).
The inclusion of z 3 allows us to control for these effects (DeYoung & Nolle, 1996).
Failure to control for z 3 will result in large banks having much larger random errors
and variances than small banks. Since the uit term is derived from a composite
residual this large variance will affect its estimation. In contrast, banks of different
sizes have ROE ( aπ / z3 ), that typically varies very little. This keeps the normalised
variables from being skewed for large banks so that the dependent and independent
variables of large and small banks are roughly of the same order of magnitude.
28
Financial markets don’t consider that some large banks may be able to profitably exploit the deposit
insurance subsidy to increase lending and thus take greater risk (Hughes, Lang, Moon & Pagano,
1997). This may not be applicable to Namibia because it does not have an explicit deposit insurance
scheme.
z 3 is preferred to the value of physical capital as a control for heteroscedasticity

because the latter is very small in banking and can be increased much more quickly
and easily than the former (Akhavein, Berger & Humphrey, 1997).
We also control for heteroscedasticity by including off-balance sheet guarantees

( z1 ), which tend to be concentrated in large banks. If this was not included, scale
bias may result because larger banks would have to lower profits disproportionately
relative to their measured outputs.
Normalisation by z 3 and the inclusion of z1 in the alternative profit X-efficiency

function only partially address the problem of heteroscedasticity because large
banks tend to have lower margins, smaller overheads, pay relatively low direct taxes
and have lower loan loss provisioning than small banks (Demigurc-Kurt & Huizinga,
1998). This could still introduce heteroscedasticity into the estimated function.
4.4.5. External Environment
Environmental influences on alternative profit X-efficiency may arise either from its
own bad management or bad luck from external environmental conditions. We
control for the external environment by including the market average of NPLs to total
loan ratio ( v ) for each year (Berger & Humphrey, 1997). This measure is almost
entirely exogenous to any individual bank and allows this study to control for
negative shocks that impact common macroeconomic conditions that affect all
borrowers. However, v is limited because defaults happen rarely in a single year
and dependence on common factors makes it difficult to assume within year
independence (Saidenburg & Schuermann, 2003).
In principle, v could include other variables that account for differences in the
environment in which the bank operates that are exogenous to its management’s
decision making but may affect performance, e.g., variables that account for
demand, like income growth, unemployment rate or whether the bank is located in
an urban or rural area. Alternatively, we could leave these other variables out of the
frontier specification, but then determine whether these factors influence alternative
profit X-efficiency (Mester, 2003). We use the latter option in this study because
these variables are closely related to NPL and would make interpretation of the
coefficients on v more difficult.
Other studies include both v and NPL to test the hypothesis that a management is
inefficient in managing its portfolio (bad management) or has made a conscious
decision to reduce short-run expenses by cutting back on loan origination and
monitoring resources even though its loans are highly risky and of a lower quality
than that of another bank (skimping). High NPLs could also reflect a business-
intensive loan mix or unfamiliarity with domestic borrowers (relevant to foreign-
owned banks). This study does not include NPL on its own because it is
endogenous to X-efficiency (DeYoung & Nolle, 1996).
4.5. Sample
With the exception of one institution (Agribank), the sample used in this paper
includes commercial banks in Namibia that have been in continuous existence from
1998 through 2003. The exclusion of banks that were acquired such as City Savings
and Investment Bank and those that were not in existence over the duration of the
sample period such as the Development Bank of Namibia reduced our sample size
to five banks.
We do not include the BoN because it does not lend directly to the private sector but
lends to the Government or banks. Therefore, it does not provide the type of
financial services that conform to intermediation theory. Due to its uniqueness in the
banking system, the difficulty in measuring some of its outputs and the complicated
and multiple objectives it pursues, it is not easy to apply the standard techniques of
measuring efficiency described in this paper. However, certain central bank activities
such as payment services provision do lend themselves to efficiency measurement
and this has been attempted in some studies (Mester, 2003). We do not include the
NamPost because it also does not lend to the private sector.
Following DeYoung and Nolle (1996) this paper does not include banks reporting a
nonpositive amount of total loans, securities, purchased fund or deposits (which
would make the alternative profit X-efficiency ratios meaningless). It also excludes
banks with less than twenty full time employees in any year during the sample
period (micro banks).29
1998 is selected as the start of our sample period, in part because it was the year
that the Banking Institutions Act was enacted based on the introduction of the Basel
I Capital Accord. This paper assumes that this had a great impact on how banks in
Namibia operated, relative to previous years. Investigation of its effect is beyond the
scope of this paper.
The choice of a six year period is based on the adoption of the DFA. This ensures
that external factors do not have a substantial effect on internal firm performance
(Berger & Mester, 1999). Some authors argue that this period is too short for any
meaningful trend analysis or statistical robustness (Ikhide, 2000), which is right in a
small panel to some extent. However, despite the fact that the number of banks is
not large and the consistency of the estimators may be questioned, the results
obtained can be considered indicative of conditions in the Namibian banking system.
Furthermore, because this study aims to provide a template for rolling its
methodology out to a continental study of the banking sector in Africa, it will allow us
to revisit the Namibian banking sector findings in the context of a regional study that
incorporates more banks.
29
Some studies exclude all banks with less than USD 50,000 in physical capital (DeYoung & Nolle,
1996).
4.6. Data
The banking information and data used in this paper is obtained financial statements
contained in each individual bank’s annual reports over the period 1998 to 2003.
This data is assumed to be relatively accurate and clean as required by legal
obligation and regulatory bodies. The extension of this data to a continental study is
relatively easy because banks in different local markets with various market
structures and economic conditions have financial statement data that describe
relatively homogeneous products (Akhavein, Berger & Humphrey, 1997).30
However, data on total deposits, total loans, total securities etc. are not as precise
as data on sub-categories of bank deposits and loans (Akhavein, Berger &
Humphrey, 1997).
Due to the need for higher frequency data to enable the analysis of its dynamic
structure, this study relied on an econometric technique based on an exponential
interpolation method that is linear in logs to create an interpolated quarterly series
from the available annual data series (Jefferies & Kayawe, 1998). 31
Since this study aims to provide a template for a continental study all data is
measured in United States dollars (USD) (1USD = NAD6.2 and 1USD= BWP 5.6).32
The use of a single currency will allow cross-country comparisons of the alternative
profit X-efficiency for different banking sectors. The data is in real values obtained
by dividing all variable values with the consumer price index (CPI) for the relevant
year in each country (1995=100). This controls for the effect of inflation on input and
output prices and profitability.33
4.7. Procedure
The alternative profit X-efficiency function is estimated separately for each period in
a panel data set (i.e. for each year’s data from 1998 to 2003), by maximum
likelihood using Limited Dependent Variables (LIMDEP) version 7.0 that is the
econometric software this paper uses to estimate alternative profit X-efficiency for
banks in Namibia. This allows greater flexibility in modelling differences in behaviour
across individual banks (Gujarati, 2003).
30
Extensive data on profit X-efficiency variables for each individual country can be obtained from the
London-based International Bank Credit Analysis Ltd’s Bankscope database. This would be a potential,
cost-effective source of banking data for a continental study.
31 xˆt +1 = xt xt + 2
The exponential interpolation formula used is . It is based on Intriligator (1978).
xt +12
From this we can derive the exponential extrapolation formula = xt + 2
xt
32
Botswana’s national currency is called the pula (BWP).
33
Inflation is associated with higher profitability because bank income tends to increase more with
inflation than bank costs (Demigurc-Kurt & Huizinga, 1998).
The parameters are allowed to vary with output prices and also reflect changes in
the external environment. Errors in choosing output quantities do not affect
~
(
alternative profit X-efficiency except through the point of evaluation f wb , y b , z b , v b )
and only to the extent that the best-practice bank is not operating at the same
(w, y, z, v )
as bank b. The resulting parameter estimates along with their minimum
or maximum values are then substituted into the formula below.
aπ x =
aπ~ b { ~
[( )] [ ]}
w3 z3 × exp f wb , y b , z b , v b × exp ln u~ b − θ
=
[( )]
b
aπ max { ~
[ ]}
w3 z3 × exp f wb , y b , z b , v b × exp ln u~ max − θ
(4)
The addition of θ to the dependent variable before logging means that ln u% is not
multiplicatively separable. To offset the nonlinearities introduced by this term and by
exponentiating, the numerators and denominators are averaged over the sample
period before dividing to estimate the average residual for each bank b as an
efficiency ratio that represents its alternative profit X-efficiency ( aπ x ). This corrects
the average-practice, alternative profit function such that it predicts the sample’s
average, alternative profit for each year when evaluated at the mean value of
business conditions.
Averaging the numerator and denominator before dividing in (4) ensures that input
prices actually faced by a bank are more likely to be exogenous than those actually
paid by the bank. This is also likely to average out some of the computational errors
in measuring input prices paid by individual banks. In addition, any mistakes the
bank makes in setting prices for its inputs given the market price conditions will be
counted properly as inefficiencies, rather than just high or low prices or good or bad
business conditions.
An aπ x ratio of 0.70 indicates that a bank is losing about 30% of the potential profits
that it could be earning if it were as X-efficient as the best practice bank i.e. it
requires 30% more X-efficiency to meet the same profit objectives as the X-efficient
bank on the frontier (Berger & Humphrey, 1997).
For banks with very low or very high alternative profit X-efficiency estimates we
truncate extreme values to account for random error that has not been completely
purged by averaging. However, given the small number of banks in this sample we
cannot truncate based on bank sizes categorised into deciles as there are not
enough banks in Namibia to do this.34 Therefore, the method used by Maudos et al.
(2002) is used to obtain the alternative profit X-efficiency estimates for the overall
banking sector. This truncation method substitutes the estimate of the most extreme
bank closest to alternative profit X-efficiency frontier with the estimate of the second
most X-efficient bank. Similarly, it substitutes the least X-efficient bank’s profit X-
efficiency estimate with the second least X-efficient one.
34
Truncation based on size categories divided into deciles can be performed in a continental
study
4.8. Results and Discussion
When we apply the methodology described above to the sample data set for
Namibia we obtain the results in Appendix C.1. This estimated function allows us to
obtain the alternative profit X-efficiency estimates for banks in Namibia. These
results are summarised in Table 3 below.
The differences in the obtained estimates are attributed to managerial best practice,
residual X-inefficiency and the change in business conditions that are exogenous to
the bank. They are based on the best-practice bank in Namibia as opposed to the
best practice theoretically available, which fully reflects the available technology and
optimal responses to market prices and other business conditions (Berger & Mester,
1999). The standard deviation of the individual alternative profit X-efficiency
estimates is about 1.4%, which confirms that these estimates are quite tightly
distributed around the average figure.
Table 3: Ranking of Banks in Namibia according to Alternative Profit X-

efficiency
Bank Individual Alternative Profit Alternative Profit X-Efficiency
X-Efficiency Estimate (%) Estimate Relative to Frontier (%)
Nedbank Namibia 85.3 100
Bank Windhoek 84.1 98.6
Standard Bank Namibia 83.3 97.6
Agricultural Bank of
Namibia 82.5 96.7
First National Bank

Namibia 81.7 95.8
MEAN 83.4 97.7
Table 3 shows that from 1998 to 2003 Nedbank was the most alternative profit X-
efficient bank in Namibia. This finding suggests that its management was more
successful than its counterparts in stimulating best-practice processes through
aligning its inputs with the strategy of the bank, specifying the production function of
the bank in the most efficient manner to produce outputs and transforming raw
inputs into effective human resources, capital and technology for the given
production technology (Frei, Harker & Hunter, 1998). Therefore, according to this
study’s assumption that credit allocation efficiency is proxied by a bank’s own X-
efficiency our findings suggests that Nedbank was more successful at allocating
credit efficiently than its counterparts in Namibia between 1998 and 2003.
This finding suggests that a branch level X-efficiency study carried out on Nedbank
Namibia and possibly Bank Windhoek could illuminate internal factors that resulted
in their relatively high rankings compared to their counterparts in Namibia.
Table 3 also shows that from 1998 to 2003 First National Bank Namibia was the
most alternative profit X-inefficient bank in Namibia. One interpretation of this is that
it traded current profits for rapid expansion of market share by participating in more
M&As, constructing more physical branches, providing wider ATM facilities and
other products of financial engineering aimed at customer convenience relative to its
counterparts as illustrated in Table 2 in Section 3. These efforts showed up as lower
alternative profit X-efficiency because the higher amount of fixed assets employed to
expand market share may have raised costs but not enough revenues to start
generating high returns (Berger & Mester, 1999). Since our alternative profit X-
efficient function does not fully capture customer satisfaction, which is an important
determinant of the revenues and profits of a bank (KPMG, 2004c), whether this
strategy is more successful from a customer satisfaction viewpoint is not addressed
in this study. However, it is partly controlled for through the dependent variable
because customer satisfaction is assumed to be one factor that determines profit
levels.
First National Bank Namibia’s low ranking may also be due to the effect of its M&A
activity on its banking operations over the sample period. Ideally, it should be
excluded from the analysis because these effects cannot be easily isolated from X-
efficiency factors.
The rankings of individual banks obtained in this study are quite different from those
obtained in other studies that measured efficiency in Namibia using alternative
concepts and methods (Ikhide, 2000 & Bedari, 2004). Therefore, estimates of mean
or median efficiency of the overall banking sector are a more reliable guide for policy
purposes than the rankings of banks by their relative efficiencies, due to its
consistency (Berger & Humphrey, 1997).
The mean level of alternative profit X-efficiency for the overall banking sector in
Namibia is 83.4%. This suggests that banks in Namibia were losing 16.6% (100 -
83.4) of their potential profits between 1998 and 2003 due to inefficiency. The
estimated level of alternative profit X-efficiency for the overall banking sector in
Namibia fares well relative to other studies that had been conducted internationally
as of 1997, where the mean level of potential profits lost by banking sectors in all
studies, regardless of methodology, was 50% (Berger & Humphrey, 1997).
When we perform a truncation similar to Maudos et al. (2002) the profit X-efficiency
of the overall Namibian banking industry falls to 83.3%. This minimal reduction
suggests that random error has been significantly purged.
Due to the small size of the panel used in Namibia these estimates should be
considered as indicative rather than certain. A more robust analysis will result in the
context of a continental study, which includes more banks.
When we apply the methodology described above to the sample data set for
Botswana we obtain the results in Appendix C.2.35 This estimated function allows us
35
The sample dataset for Botswana includes all financial intermediaries except insurance companies
(as opposed to banks only).
to obtain the alternative profit X-efficiency estimates for banks in Botswana. These
results are summarised in Table 4 below.
They are based on the best-practice bank in Botswana as opposed to the best
practice theoretically available, which fully reflects the available technology and
optimal responses to market prices and other business conditions (Berger & Mester,
1999). The standard deviation of the individual alternative profit X-efficiency
estimates is 10.16%. This confirms that the Botswana estimates are widely
distributed around the average figure.
Table 4: Ranking of Banks in Botswana according to Alternative Profit X-

efficiency
Bank Individual Alternative Alternative Profit X-

Profit X-Efficiency Efficiency Estimate
Estimate (%) Relative to Frontier (%)
Botswana Development
Corporation 78.9 100
First National Bank
Botswana 73.6 93.4
Botswana Savings Bank 67.1 85.1
National Development Bank 65.2 82.7
Standard Chartered Bank
Botswana 61.2 77.6
Stanbic Bank Botswana 60 76.1
Barclays Bank Botswana 57.6 73
Botswana Building Society 45.7 58
MEAN 63.7 80.7
Table 4 shows that from 1998 to 2003, Botswana Development Corporation, a

domestic, publicly-owned, NBFI, was the most alternative profit X-efficient financial
intermediary in Botswana. This may be because it does not take deposits and
therefore does not incur costs arising from interest expenses on deposits like its
other banking counterparts. Therefore, according to this study’s assumption that
credit allocation efficiency is proxied by a bank’s own X-efficiency our findings
suggests that Botswana Development Corporation was more successful at
allocating credit efficiently than its counterparts in Botswana between 1998 and
2003.
The mean level of aπ x for the overall financial intermediary sector in Botswana is
63.7%. This suggests that financial intermediaries in Botswana were losing 36.3%
(100 - 63.7) of potential profits due to inefficiency between 1998 and 2003. The
estimated level of alternative profit X-efficiency for the overall financial intermediary
sector in Botswana also fares well relative to other studies that had been conducted
internationally as of 1997, where the mean level of potential profits lost due to
inefficiency in all studies, regardless of methodology, was 50% (Berger &
Humphrey, 1997).
When we perform a truncation the alternative profit X-efficiency of the overall

financial intermediary sector in Botswana rises to 64.5%. This minimal appreciation
suggests that random error has been significantly purged.
The differences between mean alternative profit X-efficiencies in Namibia and

Botswana can be attributed to idiosyncratic, country-specific factors reflecting
different regulatory environments, different managerial strategies and different
adoption levels of financial and technological innovations to address challenges in
different local environments (Casu & Molyneaux, 2003). However, it can also be
attributed to the fact that the sample in Namibia is smaller than that of Botswana,
which in addition to banks, includes all NBFIs, except insurance companies that
were in continuous existence between 1998 and 2003.36
Therefore, a direct comparison between banks in different countries should not be

attempted unless the institutions are evaluated relative to the same frontier. As a
demonstration of how a continental study would be conducted we apply the
methodology described above to an overall panel containing sample data for both
Namibia and Botswana.37 The results of this are summarised in Appendix C.3 and
illustrated in the Table 5 below.
Table 5 illustrates that the rankings of banks in each individual country changes
when DFA is applied to a translog, alternative profit, X-efficiency function in a cross-
country panel relative to a within-country panel. In addition, the significance of the
results reduces as illustrated in Appendix C.3. This reduced significance of the
results could be potentially addressed by adopting the FFF function, which is
possible in the cross-country panel due the larger data set.
This study leaves the discussion of the results for the cross-country panel until a
continental study is undertaken that applies DFA to a continental, panel, dataset of
financial intermediaries in Africa using a FFF, alternative profit, X-efficiency function.
36
Insurance companies hold privately placed corporate bonds and commercial mortgages as assets
and contracts with policyholders and obligations to future retirees as liabilities. This gives them
some idiosyncratic features that make them differ from the other financial intermediaries.
37
v for each country controls for country-specific environmental conditions.
Table 5: Ranking of Banks in Botswana and Namibia based on a Single

Alternative Profit X-efficiency Frontier
Bank Individual Alternative Alternative Profit X-

Profit X-Efficiency Efficiency Estimate
Estimate (%) Relative to Frontier (%)
Agricultural Bank of Namibia 92.1 100
Nedbank Namibia 82.5 89.6
First National Bank Namibia 77.9 84.6
Standard Bank Namibia 74 80.3
National Development Bank
Botswana 73.9 80.2
First National Bank Botswana 73.1 79.4
Standard Chartered Botswana 72.4 78.6
Stanbic Bank Botswana 70.7 76.8
Botswana Savings Bank 69.8 75.8
Botswana Development
Corporation 68.8 74.7
Bank Windhoek Namibia 64.8 70.3
Barclays Bank Botswana 62.6 68
Botswana Building Society 57.6 62.5
MEAN 72.3 78.5
5. IDENTIFYING EXTERNAL INFLUENCING FACTORS
This section focuses on describing the methodology that this study adopted to
complete the second step of the two-step approach required to achieve its
objectives (Coelli, Prasada & Battese, 1998). It begins with a description of the
sample, data, model and its variables and then goes on to describe the procedure
used to identify the factors influencing the alternative profit X-efficiency of Namibia’s
banking sector.
5.1. Sample
With the exception of one institution (Agribank), the sample used in this paper
includes commercial banks in Namibia that have been in continuous existence from
1998 through 2003. 1998 is selected as the start of our sample period because it
was the year that the Banking Institutions Act was enacted based on the introduction
of the Basel I Capital Accord. This should have had an great impact on how banks in
Namibia operated, relative to previous years. Investigation of its effect is beyond the
scope of this paper.
The sample does not include the NamPost, which does not lend to the private
sector. In addition, it does not include BoN, which does not lend directly to the
private sector but lends to the Government or banks. Therefore, it does not provide
the type of financial services that conform to intermediation theory.
5.2. Data
The banking information and data used in this paper is obtained from each individual
bank’s annual reports over the period 1998 to 2003. The data, which is collected
from financial statement reports, is assumed to be relatively accurate and clean as
required by legal obligation and regulatory bodies.38 However, data on total deposits
and total loans is not as precise as data on sub-categories of bank deposits and
loans (Akhavein, Berger & Humphrey, 1997).
All quantitative data are measured in United States dollars (USD) (1USD = NAD
6.2).39 Real values are used to control for the effect of inflation on input and output
prices and the alternative profit X-efficiency estimate (Demirgüç-Kurt & Huizinga,
1998).
38
Extensive data for banks from individual countries can be obtained from the London-based,
International Bank of Credit Analysis Ltd’s, Bankscope database. This would be a potential, cost-
effective source of data for a continental study.
39
Namibia’s national currency is the Namibian dollar (NAD).
5.3. Model
We use an ANCOVA model to identify the factors that influence the alternative profit
X-efficiencies of the banking sector in Namibia. This is specified as follows:
aπˆ x = α 0 + α 1 BS it + α 2 OGit + α 3 OCit + α 4 MCit + α 5 Rit + u it (5)
Where: 40
BS represents the bank size vector;
OG represents the organizational form and governance vector;
OC represents the other bank characteristics vector;
MC represents the market characteristics vector;
R represents the primary regulator vector;
u represents the error term
i represents the ith bank
t represents the year i=1…6
The qualitative, independent variables are defined using zero-one dummy variables
to account for non-monotonicity and non-linearities in their relationship with
alternative profit X-efficiency. The quantitative independent variables are specified
as logged, continuous variables.
The independent variables included in the model do not cover the full range of
variables that could potentially be included. Some studies have included variables
that capture HRM policy, empowerment and technology separately (Frei, Harker &
Hunter, 1998). This study does not include such factors because they are directly
under the control of management and are incorporated in the alternative profit X-
efficiency function specified in the first step. We also do not include z3 and NPLs in
the model because they are included in the alternative profit X-efficiency function as
well (Adongo & Stork, 2005a).
In principle, this study could include other variables that account for differences in
the environment in which banks in Namibia operate that are exogenous to
management decision making but may affect performance, e.g., variables that
account for demand, like income growth, unemployment rate or whether the bank is
located in an urban or rural area. Some other variables that could be included are
the standard deviation of ROA to capture bank risk, a bank’s choice of investment
portfolios, its mix of funding sources between core deposits and purchased funds,
40
The component variables of each vector are defined and described in Appendix D
legal or taxation variables, financial structure and measures that capture

deregulation. This will be pursued in a future, continental study because tax and
legal regimes can only be examined in a cross-country context if the sample
analysed covers a 6 year time period.
Equation (5) makes indicative rather than conclusive findings i.e. it provides a
summary of association rather than causality, which makes it essentially, a
correlation analysis (Collins, 2002). This is because the standard error of the
dependent variable, alternative profit X-efficiency, is not accounted for.
In addition, alternative profit X-efficiency is estimated using variables that are

correlated with the independent variables in equation (1). Therefore, the dependent
and independent variables are not completely exogenous and this endogeneity can
bias the coefficient estimates on all the regressors (Casu & Molyneaux, 2003).
Other studies have attempted to overcome this shortfall by using truncated

regression models to account for the fact that alternative profit X-efficiency scores
are censored (Lovell, Walters & Wood, 1995). Still other studies propose the use of
a stochastic frontier model to account for the fact that the included explanatory
variables fail to explain the entire variation in the calculated X-efficiencies and the
unexplained variation mixes with the regression residuals, adversely affecting
statistical inference (Bhattacharyya et al., 1997 in Casu & Molyneaux, 2003). Finally,
studies that use the data envelopment analysis approach to estimate alternative
profit X-efficiency adopt the Tobit regression model to overcome this obstacle.
The final verdict on which model can control for the econometric issues of this
second-step regression is a potential area for future research. One approach would
be to conduct a sub-set analysis in a continental study with more banks, which is
useful when confidence intervals are large. This would involve analyzing subsets of
banks with relatively high and relatively low efficiency values to explore the
robustness of the posited relationships (Berger & Humphrey, 1997).
5.3.1. Estimated Function
The function estimated in this study is specified as follows:
ln EPit = β1SMLBANK it + β 2 MEDBANKit + β 3 LRGBANK it + β 4 HUGBANKit + β 5 MERGEDit +

β 6 ACQUIRED + β 7 INBHC + β 8 MUL _ LAYit + β 9OUTSTit + β PUB _ TRADEDit + β11 AGE +
10
ln β12 LGTA+ it + β13 HERFit + β14 SHAREit + β15GOVit + ε it

(6)
5.4. Procedure
To identify factors that influence the alternative profit X-efficiency in Namibia’s

banking sector, OLS is applied to a panel data set of the variables specified in
equation (6) using data from 1998 to 2003. The overall alternative profit X-efficiency
estimates for the Namibian banking sector in each period that are obtained by
applying the methodology described in Section 4 are regressed on the independent

variables that are not under the control of a bank’s management but account for
differences in the environment in which the bank operates.
Limited Dependent Variables (LIMDEP) version 7.0 is the econometric software

used to undertake the effort to provide empirical evidence of variables that influence
the alternative profit X-efficiency of Namibia’s banking sector, which is the proxy for
its efficiency in credit allocation.
5.5. Results and Discussion
The results of the application of the methodology described above are summarized
in Appendix E. This section focuses on a discussion of these results.
5.5.1. Bank Size
The bank size variables are operationalized with dummy variables to allow for non-
monotonicity and nonlinearities in the relationship between bank size and aπ x .
None of these variables are statistically significant at the 5 % or 10% levels as
illustrated by their p values. This result can be explained by the procedure used to
control for heterogeneity arising from bank size differences in the first step. This is
done by normalizing each variable using financial equity capital to control for scale
bias. Therefore, this result is essentially a confirmation that the adoption of this
procedure was successful.
5.5.2. Organizational Form and Governance
The organizational form variables are also measured with dummy variables to
determine whether a relationship exists between bank organisational form and
alternative profit X-efficiency.
They are all statistically significant at the 5 % or 10% level.
Mergers are statistically significant at the 5% level. Therefore, mergers influenced

alternative profit X-efficiency in Namibia from 1998 to 2003. This implies that
alternative profit X-efficiency measures can play an important role in anti-trust policy
in Namibia.
Theory states that mergers can influence alternative profit X-efficiency due to lower
per unit bank costs, post-merger; the ability of the consolidated banking organization
to diversify risk by shifting their output mixes to less risky portfolio allocations; or the
ability to shift the output mix to higher-risk, higher-expected return investments due
to higher reserve capital levels. The influence may also be due to the exercise of
additional market power arising from oligopoly in setting higher prices for its output,
which raises profits by extracting more surpluses from consumers, without any
improvement in X-efficiency (Adongo & Stork 2005a).
Acquisitions are statistically significant at the 10% level. Therefore, acquisitions

influenced alternative profit X-efficiency in Namibia from 1998 to 2003. The influence
can be through the same the same channels as for mergers above.
Whether or not a bank is owned by a holding company is statistically significant at

the 5% level. Therefore, holding company ownership influenced alternative profit X-
efficiency in Namibia from 1998 to 2003. Over this period Nedbank, which was the
most alternative profit X-efficient bank in Namibia, was owned by a consortium of
overseas banks and Nedcor Bank South Africa (Nedbank Annual Reports).
Theory states that banks are involved in cross-border mergers and acquisition
activity in various industries and the holding company is the vehicle that allows them
to do so. The negative influence of ownership by a holding company may be
because of an indirect reporting structure, which leads to slightly weaker policy
compliance than direct reporting structures.
Whether or not a bank’s holding company is multi-layered is statistically significant

at the 5% level. Therefore, multi-layered, holding company structures influenced
alternative profit X-efficiency in Namibia from 1998 to 2003. The negative influence
of a multi-layered holding company could be due to the more complicated reporting
structures, as outlined in the paragraph above. A bank management’s ability to align
a bank’s inputs and production processes to its overall strategy may be hindered,
resulting in less success in allocating credit efficiently arising from weaker
implementation of production or risk management decisions.
Whether or not a bank’s holding company is inside or outside the country is

statistically significant at the 1% level. This The negative influence implies that
banks with holding companies located outside Namibia suffer from information
asymmetry disadvantages compared to those whose holding companies are located
in a country.
Whether or not the holding company is publicly traded is also statistically significant
at the 1% level. The positive influence implies that outside shareholders can exert
pressure on the ultimate owners of a bank that can have positive implications for
efficiency in Namibia’s banking sector. Therefore, the bank holding companies that
are not listed on any stock exchange should be encouraged to do so.
5.5.3. Other Bank Characteristics
Both variables capturing other bank characteristics are statistically significant at the
5 % level.
A bank’s age influenced alternative profit X-efficiency in Namibia from 1998 to 2003.
Theory argues that this occurs through the learning by doing hypothesis (Mester,
1996). However, the negative influence could be because the ICT innovations
required in modern-day banking would be easier for a relatively newer entrant to
adopt as they are less hindered by traditional practices and norms.
The ratio of loans to gross total asset is also statistically significant at the 5% level.
Therefore, the amount of total loans offered influenced alternative profit X-efficiency
in Namibia from 1998 to 2003. This negative influence could be due to higher credit
and business risk that more lending entails. This implies that risk management in
general and small business credit scoring in particular can contribute to improving
the credit allocation efficiency of the banking sector in Namibia to the extent that it
assists banks in controlling the risks arising from lending to the micro and marginal,
small-scale enterprise sector, which represents a higher risk segment relative to
non-marginal small-scale, medium and large-scale enterprise investment
opportunities.
5.5.4. Market Characteristics
The two market characteristics variable we include that capture the banking
industry’s market structure proxy for the banking industry’s market power.
The H-Index is not statistically significant at the 5% level. This result can be
explained by the fact that the alternative profit function controls for oligopoly in a
banking sector by using output quantities rather than output prices as one of its
independent variables. Therefore, this result is essentially a confirmation that the
adoption of this procedure was successful.
The share of local market deposit concentration is included as a robustness check

for the H-Index. It is significant at the 5 % level. This suggests that market power
influenced alternative profit X-efficiency for banks in Namibia from 1998 to 2003.
The positive influence provides empirical evidence that the market power hypothesis
for mergers is confirmed in Namibia (Berger & Hannan, 1997). Therefore, although
M&A is positively associated with alternative profit X-efficiency in Namibia’ banking
sector the adverse effects on pricing work in the opposite direction and should be
considered by the regulator in any anti-trust assessment of potential M&A deals.
5.5.5. Regulator
We also include variables that capture the identity of the banking industry’s
regulator.
Bank regulation by the Government is not statistically significant at either the 5% or

10 % level.
In addition, to the variables included in the ANCOVA model; factors such as

business cycle changes and measurement error in the accounting figures could
explain some of the variation in alternative profit X-efficiency (Berger & Humphrey,
1993). These are captured in the error term.
6. CONCLUSION
This study modelled the internal activities of banks in Namibia using an input-output,
production function and applied frontier analysis to estimate the alternative profit X-
efficiencies for banks in Namibia using DFA.
It found that Nedbank Namibia was the most alternative profit X-efficient bank in
Namibia between 1998 and 2003. Over this period its holding company comprised
of a consortium of overseas banks and Nedcor Bank South Africa. This finding
suggests that a branch level X-efficiency study carried out on Nedbank Namibia and
possibly Bank Windhoek could illuminate internal factors that have resulted in their
relatively high rankings compared to their counterparts in Namibia.
The study also found that the mean level of alternative profit X-efficiency in
Namibia’s banking sector from 1998 to 2003 was 83% suggesting that banks in
Namibia lost approximately 17% of their potential profits between 1998 and 2003
due to inefficiency. This finding fares well relative to other studies that had been
conducted internationally as of 1997, where the mean level of potential profits lost
by banking sectors in all studies, regardless of methodology, was 50%. However,
the small, panel dataset for Namibia included banks that were engaged in M&A
activity over the sample period (that ideally should have been excluded). Therefore,
the results of bank efficiency in Namibia can only be conclusive if more robust
findings are obtained in the context of a continental study.
This study extended the methodology to a panel dataset for all financial
intermediaries in Botswana, excluding insurance companies. It found that alternative
profit X-efficiency figures in Botswana had wider variation than those in Namibia.
This could be attributed to Botswana’s larger sample size that included both banks
and NBFIs. This finding suggests that to improve the within-country findings for
Namibia an inclusion of all financial intermediaries i.e. banks and NBFIs may be a
better option than a data set consisting of banks alone.
In addition, a cross-country panel dataset for Namibia and Botswana was analysed
as a pilot initiative for a future continental study consisting of all financial
intermediaries in Africa, excluding insurance companies. It found that the estimates
and rankings of banks changed from the within-country sample and that the
significance of the results of the cross-country rankings fell.
This finding suggests that the FFF should be explored as opposed to the translog
function that was used in this study in a continental study. In addition, a more
rigorous truncation technique could also be applied rather than the informal one
used in this paper that was adopted due to the small, sample size. Finally, financial
intermediaries that have been involved in M&A activity should be dropped from the
analysis as their alternative profit X-efficiency estimates could be spurious.
The study then went on to apply the overall mean efficiency estimates obtained in
the first step by specifying an ANCOVA model for a panel dataset of banks in
Namibia to identify external factors that influenced the alternative profit X-efficiency
in Namibia’s banking sector from 1998 to 2003.
The study found that merger & acquisition activity, market power, age, risk and
holding company ownership, structure, location and whether or not it is publicly
traded; influenced the alternative profit X-efficiency of Namibia’s banking sector
between 1998 and 2003.
The method used in the first step of this study represents robust, empirical tool that
will assist institutions such as NEPRU to monitor the impact of various events, such
as regional integration and M&A activity, on bank efficiency. In addition, it will
motivate practitioners to improve efficiency in the banking sector. The findings
arising from the second step of this study are useful in directing the efforts of
regulatory bodies to areas that they can intervene to improve the effectiveness of
the banking sector in Namibia in allocating credit efficiently, which has positive
implications for economic growth.
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Appendix A
Variables in the Alternative Profit X-efficiency Function

Symbol Definition Mean Standard
Deviation
DEPENDENT VARIABLE
aπ Variable profits including variable revenues from 45.72 37.6
interest and fee income less variable costs which
includes variable operating (including z2 ) and
interest costs arising from w
INDEPENDENT VARIABLE
Variable Input Price Vector ( w )
w1 Price of purchased funds (all liabilities except 115.02 60.1

deposits).
w2 Price of domestic deposits. a 199.75 116.59
w3 Price of Labour (1000’s of constant USD per 0.1 0.02

employee)
Variable Output Quantities
y1 Consumer Loans 931.08 606.56
y2 Business Loans (all other loans excluding loans to 1110.56 409.26

the public sector)
y3 Securities (all non-loan financial assets i.e. Gross 482.07 351.96

y y z
Total Assets - 1 - 2 - 2
Fixed Net puts
z1 Off-balance sheet guarantees (commitments, letters 139.38 95.36

of credit, etc.) measured using Basel Accord risk
weights to be risk equivalent to loans. b
z2 Physical capital (book value of plant and equipment)c 45.57 18.44
z3 Financial equity capital. c 331.85 150.13
Environmental Variables
v Market average non-performing loans to total loans 1.01 0.02
ratio. e
Number of Panel Observations: 120
Notes:
a. Some studies define the price of core deposits as interest expenses less service charges on deposit
accounts, divided by core deposits (DeYoung & Nolle, 1996).
b. Although, it is not a perfect measure of portfolio risk because it makes few distinctions between
types of loans; risk-weighted assets are included as a fixed factor to control for the costs associated
with risky assets. This is because it is assumed that output is proportional to the perceived credit
risk on which these risks are based (DeYoung & Nolle, 1996). It captures inter-bank differences in
loan to asset ratios. Guarantees are specified as fixed instead of variable primarily because of the
difficulty of obtaining accurate price information
c. Including the price of

z 3 , rather than its level, assumes that banks on the frontier are selecting the
cost-minimising level of capital. However, this might not be the case because of regulations that set a
minimum capital-to-asset ratio or because of risk-aversion on the part of bank managers (Mester,
2003).
d. Physical capital and financial equity capital are treated as fixed inputs because they are slow to
adjust and it is difficult to measure their price. Other studies calculate it as the ratio of depreciation
to fixed assets
e. We use the market average rather than each individual bank’s NPL ratio because it covers
exogenous market condition that affect loan performance and is less likely to reflect bank
managers’ decisions.
f. All variables are beginning and end of quarter interpolated averages and are in 1000’s of USD.
Appendix B
The estimated frontier is indicated below. Firm j is fully efficient. Its actual profit lies
below the frontier due to random error. Firm i is inefficient. The difference in bank i's
profit and the frontier value at the same y is due to both random error and
inefficiency (Mester, 2003).
Appendix C
Alternative Profit X-Efficiency Regression Results
C.1 Namibia
Variable Coefficient Standard Error Probability
Constant -6.491994442 3.6481008 0.0751
LW 3.218925018 0.90971514 0.0004
LW2 -0.401563039 0.14106463 0.0044
LY -3.384456031 1.0267189 0.001
LY2 1.708635788 .59161521 0.0039
LZ -5.289884436 1.7816972 0.003
LZ2 -6.462982631 1.1251376 0.000
WY -0.05729322818 0.23993992 0.8113
WZ 1.379548289 0.30568061 0.000
YZ -0.7409211443 0.41162025 0.0719
LV -1.656447375 1.5502722 0.2853
LV2 0.7607350682 0.70023445 0.2773
LM Statistic = 23.54392 Log-Likelihood Function = 49.8159
σ 2 v = 0.002, σ 2u = 0.06714
No. of Panel Observations = 120
C.2 Botswana
Constant -0.707816177 2.7122673 0.7941
LW -1.11333245 0.61072994 0.0683
LW2 0.04291490188 0.090045035 0.6337
LY 1.352362465 1.3116088 0.3025
LY2 -2.596801024 0.78123596 0.0009
LZ 0.7503976378 2.6378703 0.7760
LZ2 -1.016202544 1.2907762 0.4311
WY 0.4181585798 0.17254441 0.0154
WZ -0.06229920393 0.31482461 0.8431
YZ 0.6482743765 0.81049829 0.4238
LV 4.871371374 0.98456956 0.000
LV2 -1.301346476 0.31622258 0.0000
LM Statistic = 79.76773 Log-Likelihood Function = -207.2186
σ 2v = 0.07598, σ 2 u = 0.94828
No. of Panel Observations =192
C.3 Botswana and Namibia Panel

Constant 9.704610118 2.3970396 0.0001
LW -3.185621862 0.65617546 0.000
LW2 0.3458208499 0.10601868 0.0011
LY 3.209260140 1.2732045 0.0117
LY2 -2.862872654 0.44983346 0.0000
LZ -0.4252033497 2.5322129 0.8666
LZ2 0.09521651455 0.69560235 0.8911
WY 0.2232537609 0.13354666 0.0946
WZ 0.3151360175 0.32296242 0.3292
YZ 0.05837209741 0.53620497 0.9133
LV 0.8181351532 0.81476067 0.3153
LV2 0.04276390037 0.28056852 0.8789
LM Statistic = 0.3042449 Log-Likelihood Function = -419.8176
σ 2v = 0.71788, σ 2 u = 0.40233
Appendix D
Variables in Correlation Analysis

Variable Definition Mean Standard
Deviation
Dependent Variable
aπˆx Estimated Alternative Profit -0.1956 0.1699

Efficiency in logarithmic form
Bank Size Variables
SMLBANK Dummy equals one if bank has - 0.25
gross total assets of less than
USD 1 million
MEDBANK Dummy equals one if bank has - 0.47
gross total assets of between
USD 1 million and USD 5 million
LRGBANK Dummy equals one if bank has - 0.43
gross total assets of between
USD 5 million and USD 10 million
HUGBANK Dummy equals one if bank has - 0.13
gross total assets of over USD 10
million
Organisation Form/Governance
MERGED Dummy equals one if bank - 0.18
survived one or more bank level
mergers during the period (i.e.
absorbed the assets of one or
more other banks)
Dummy equals one if bank - 0.18
ACQUIRED acquired a different bank during
the period
INBHC Dummy equals one if bank is - 0.4
owned by a bank holding
company
MUL_LAY Dummy equals one if the bank is - 0.4
in a multi-layered bank holding
company i.e. the direct holder is
not the highest holder
OUTST Dummy equals one if the bank’s - 0.49
highest holding company is
located outside the country
PUB_TRADED Dummy equals one if the bank’s - 0.49
highest holding company is
registered and traded on a
financial market
Other Bank Characteristics
AGE Number of years bank has 45.1 31.67
existed
LGTA Ratio of total loans to gross total -0.2109 0.0993
assets in logarithmic form
Market Characteristics
HERF Herfindahl index of local output 2415.17 40.5
market concentration
SHARE Bank’s share of local deposit 0.2 0.11
market concentration (used as a
robustness check for HERF)
Regulator
BON Dummy equals one if the bank is - 0.4
regulated by the Bank of Namibia
GOVT Dummy equals one if the bank is - 0.4
regulated by the Government.
Number of Panel Observations 120
Note: For a continental study it will be useful to include variables unique to each country such as
national income and unemployment rate.
Appendix E
Correlation Analysis Results for Namibia

Variable Coefficient Standard Error t-ratio Probability
SMLBANK 1.3144 1.2683 1.036 0.3024

MEDIUMBANK 1.3684 1.307 1.047 0.2975
LARBANK 1.3291 1.347 0.987 0.3260
HUGBANK 1.2198 1.3606 0.896 0.3720
MERGED 0.2617 0.09204 2.843 0.0054
ACQUIRED 0.1701 0.09121 1.865 0.0649
INBHC -1.4523 0.5477 -2.652 0.0092
MUL_LAY -0.4429 0.1952 -2.270 0.0253
OUTST -0.495E+15 0.1923E+15 -2.574 0.0114
PUB_TRAD 0.495E+15 0.1923E+15 2.574 0.0114
AGE -0.00853 0.0038 -2.245 0.0268
LLGTA -0.776 0.252 -3.079 0.0026
HERF -0.0003923 0.000553 -0.709 0.4798
SHARE 3.9056 1.446 2.701 0.0081
GOVT 0.2034E-04 0.000226 0.090 0.9286
R-squared = 0.222223
F[14, 105]= 2.14 p value = 0.0149
Durbin-Watson Statistic = 1.66955

Adongo Stork Hasheela (2005) X Efficiency Namibia

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Factors Influencing the Alternative Profit

X- Efficiency of Namibia’s Banking Sector

THE NAMIBIAN ECONOMIC POLICY RESEARCH UNIT

• Namibia Economic Review & Prospects

• Namibia Business Climate Survey

• Travel and Meeting Reports

• NEPRU News Bulletin

• NEPRU Policy Brief

All rights reserved. No part of this publication may be reproduced or transmitted in

 Copyright 2005 by the Namibian Economic Policy Research Unit.

NEPRU Working Paper ISSN 1026-9258

First published in 2005 by the Namibian Economic Policy Research Unit

The efficiency of the overall financial sector in allocating credit to investment

2.1. Importance of X-efficiency........................................................................... 5

2.3. Alternative Ways to Measure Efficiency ...................................................... 8

2.4. Other Factors ............................................................................................ 12

3. NAMIBIA’S BANKING SECTOR ....................................................................... 27

3.1. Regulatory Framework .............................................................................. 27

3.3. Market Features ........................................................................................ 29

4. MEASURING ALTERNATIVE PROFIT X-EFFICIENCY ................................... 33

4.2. Efficiency Technique ................................................................................. 38

4.3. Approach ................................................................................................... 42

4.4. Functional Form ........................................................................................ 44

4.5. Sample ...................................................................................................... 50

4.8. Results and Discussion ............................................................................. 53

5. IDENTIFYING EXTERNAL INFLUENCING FACTORS .................................... 58

5.1. Sample ...................................................................................................... 58

5.5. Results and Discussion ............................................................................. 62

Table 1: Definition of Small Business by Ministry of Trade and Industry in

Table 2: Summary of Banks in Namibia from 1998 to 2003 .....................................28

Table 3: Ranking of Banks in Namibia according to Alternative Profit X-

Table 4: Ranking of Banks in Botswana according to Alternative Profit X-

Table 5: Ranking of Banks in Botswana and Namibia based on a Single

Figure 1: Herfindahl-Hirschman Index Scores for the Output Market Structure of

Figure 3: Relative Size of Banks in Namibia from 1998 to 2003 ..............................32

Figure 4: Relative Ratios of Business Loans to Total Loans for Banks in

Box 1: Economies of Scale and Scope.......................................................................5

Box 2: Risk Categories .............................................................................................20

Box 3: Types of Credit-Scoring Systems ..................................................................22

The remainder of this paper is organised as follows Section two provides a

A positive link between financial intermediation and economic growth is empirically

Banks, as financial intermediaries, provide various services for depositors and

The level of intra-bank efficiency is represented by alternative profit X-efficiency in

The effectiveness of management is also affected by its own preferences. Publicly

At the external level, a bank’s X-efficiency is influenced by the pressure applied by

Furthermore, the level of competition in a banking industry determines the pressure

Box 1: Economies of Scale and Scope

Scope economies refer to changes in product mix related to cost. It focuses on

Due to the negligibility of scope economies, X-inefficiencies are usually found to

2.1. Importance of X-efficiency

X-efficiency is also important for the effectiveness of monetary policy. According to

In this era of post-globalisation where the pace of financial sector liberalisation is

Due to the absence of systematic internal controls in X-inefficient banks,

The negative aspects of inappropriate financial liberalisation particularly affect small-

2.2. Purpose of an X-Efficiency Measure

Measuring the X-efficiency of banks in Namibia is important for policymakers,

In addition, X-efficiency measures can motivate a bank’s management to adopt

Furthermore, when X-efficiency measures are regressed on potential determinants

environmental factors that suggest managerial arrangements and environmental

X-efficiency measures can also be of assistance in monitoring the dynamics in the

Also, the information provided by the X-efficiency measures on the relative

Finally, the Basel Committee on Banking Supervision (BCBS), through the