In recent years European banking systems have become
increasingly integrated and liberalized on the road to
greater product and service deregulation.
The progressive process of financial integration emphasizes
the importance of enhancing competition and leading
towards improved efficiency of financial institution.
Regulators have tried to counterbalance various incentives
by creating capital adequacy as a prominent role in the
entire banking regulatory process.
Due to both regulatory and market pressures European
banks have been under pressure to boost their
This paper analyses the relationship between capital, risk
and efficiency for a large sample of European banks
between 1992 and 2000 from 15 European countries.
Bank-specific data were obtained from the Bank-scope
database that includes balance sheet and income statement
information on European (and other) banks.
Researchers focused on different bank ownership types as
non-quoted (and/or private) firms might pursue different
objectives than their joint-stock competitors.
Jensen and Meckling
(1976), Fama (1980)
Lack of capital market discipline for firms weakens
owners’ control over management, making management
freer to pursue its own agenda, and thus providing it with
fewer incentives to be efficient.
Purroy and Salas,
2000; Berenguer et al.,
Mutual banks may have competitive/efficiency
advantages even if they show expense preference
Altunbas et al. (2001) Public and mutual banks have slight cost and profit
efficiency advantages over their private commercial
Hughes and Moon
It is necessary to recognize explicitly, the concept of
efficiency in the empirical models, linking the
relationship between bank capital and risk.
Purpose of the Study
The purpose of the study is to examine the
relationship between capital, risk and efficiency in
Likewise, the study focuses to investigate the elements
of capital, risk and efficiency in the European banking
The study furthermore examines the impact on
financial strength of the corporate sector and bank
risk taking and capital levels.
Significance of the Study
The study basically helps apprehend the relationship
between capital, risk and efficiency in European
This study is relevant to examine how the capital, risk
and efficiency in European banking can better be
improved if attention is given to a number of variables.
Zellner’s Seemingly Unrelated Regression (SUR)
approach has been used in the research.
This allows for simultaneity between banks’ risk,
capital and efficiency.
Further, this also helps controlling important bank
and country-specific factors.
For the explanatory variables bank specific and
country specific variables has been used.
Model 1: Banking Sector Risk
LLRLij = a + b ETAij + c INEFFij + d NLTAij + e LNTAij + f
LAODEPij + g INSBOCj + h SOLVENCYj + i LAOACj + j
LLPOACj + YEARj ………………………………………………(1)
Model 2: Bank Capital Levels
ETAij = a + b INEFFij + c NLTAij + d LNTAij + e ROAij + f LAODEPij
+ g INSBOCj + h SOLVENCYj + i LAOACj + j ROCCj +
k COIRCj + l OEPOACj + m LLPOACj +
Model 3: Determinants of Bank Cost Inefficiency.
INEFFij = a + b ETAij + c LLRLij + d NLTAij + e LNTAij + f
LAODEPij + g INSBOCj + h SOLVENCYj + i LAOACj +
jCOIRCj + k OEPOACj + l LLPOACj + YEARj ………….(3)
Where: Bank-specific variables are:
LLRLij Loan-Loss Reserves for bank i in country j
ETAij Equity to Assets Ratio for bank i in country j
INEFFij Cost Inefficiency for bank i in country j
NLTAij Net Loans to Total Assets for bank i in country j
LNTAij Natural log of Total Assets for bank i in country j
ROAij Return-on-Assets for bank i in country j
LAODEPij Liquid Assets to Customer and Short-term deposits for
bank i in country j
Country-specific variables are:
INSBOCj Interest rate spreads over 3-year government bonds in
SOLVENCYj Current assets to current liabilities for non-financial
companies in country j
LAOACj Banking system liquid assets to total assets in country j
ROCCj Banking system return on capital in country j COIRCj
Banking system cost to income ratios in country j
OEPOACj Banking system operating expenses to total assets in
LLPOACj Banking system loan-loss provisions to total loans in
YEARj Yearly dummy variables for 1992 to 2000
Change in risk Change in capital Change in inefficiency
Variables (DLLRij) (DETAij) (DINEFFij)
(0.0618) (0.0813) (0.0862)
D1993 0.021 −0.140 −1.269∗
(0.1510) (0.1810) (0.1995)
D1994 −0.821 −0.261 −0.914∗
(0.1463) (0.1736) (0.1914)
D1995 −0.137 −0.287 −0.652∗
(0.1412) (0.1684) (0.1861)
D1996 −0.068 −0.299 −0.952∗
(0.1378) (0.1644) (0.1816)
D1997 −0.095 −0.365+ −0.828∗
(0.1366) (0.1631) (0.1801)
D1998 −0.124 −0.127 −0.692∗
(0.1352) (0.1596) (0.1761)
D1999 −0.199 −0.256 −0.898∗
(0.1352) (0.1631) (0.180)
CONS 0.646∗ −0.881 0.625
(0.2462) (0.7993) (0.469)
Observations 17,356 17,356 17,356
R square 0.0142 0.0433 0.0098
Table 4. Contd..
• + significant at 5%; ∗ significant at 1%
• Top quartile of cost efficient banks are used as the sample.
• Bottom quartile of cost efficient banks are used as the sample.
Conclusion This paper analyses the relationship between capital, risk and
efficiency for a large sample of European banks between 1992 and
Inefficient European banks appear to hold more capital and take on
Empirical evidence is found showing the positive relationship
between risk on the level of capital (and liquidity), possibly
indicating regulators’ preference for capital as a means of restricting
Unlike the previous literature that focuses on US banking, authors
do not find any strong relationship between inefficiency and bank
The financial strength of the corporate sector has a positive
influencing reducing bank risk-taking and capital levels.
There are no major differences in the relationships between capital,
risk and efficiency for commercial and savings banks although there
are for co-operative banks.
In the case of co-operative banks authors do find that
capital levels are inversely related to risks and we find
that inefficient banks hold lower levels of capital.
Some of these relationships also vary depending on
whether banks are among the most or least efficient
The cost inefficiencies have a low co-relation with
bank cost income ratios of around 0.1 and therefore are
not expected to presented multi-collinearity problems
in estimation of the model.