Modelling of non-performing loans in banking efficiency

This paper examines the formulation of non-performing loans as either bad or reverse outputs. On the one hand, when non-performing loans are modelled as bad outputs, they are jointly produced with good outputs and they are considered as by-products. Therefore, the reduction of non-performing loans without reducing good loans is impossible. On the other hand, when non-performing loans are modelled as reverse outputs the null-joint property no longer holds and it is feasible to reduce their production level without affecting the production of good loans. The paper models the banking efficiency using the Intermediation approach which considers deposits and other liabilities as inputs which are used for the production of various earning assets such as loans. We apply this model to evaluate the performance of 98 European banks for the year 2014. Furthermore, we provide comparative empirical results under three alternative formulations, i.e. reverse output, bad output with common abatement factor and bad output with bank-specific abatement factor.