Efficient, profitable and safe banking: an oxymoron? Evidence from a panel VAR approach

E ciency is considered a key factor when evaluating a bank's performance. Moreover, e ciency enhancement is an explicit policy objective in the Single Market Directive of the European Commission. But e ciency improvements may come at the expense of deteriorating bank pro ts and excessive risk-taking. Both the quantitative e ects and dynamic reactions of performance in response to e ciency improvements remain often unclear on both theoretical and empirical grounds. We analyze the dynamic relations between e ciency and performance in the German banking market. To this end we use panel data for all German banks for the years from 1993 to 2004 and estimate impulse response functions (IRF) derived from a vector autoregressive model. The IRF estimate the response of a shock in e ciency on pro ts or default probabilities. The former is estimated with stochastic frontier analysis, the latter is estimated with a hazard rate model. The results indicate that a positive unit shift in e ciency reduces the probability of default and increases pro ts. On the one hand, we nd evidence that the long-run impact of pro t e ciency on risk is larger than for cost e ciency. However, cost e ciency impacts with a shorter time lag on the probability of default. On the other hand, cost e ciency has on average a slightly larger impact on pro ts than pro t e ciency.