Bank Risk-Adjusted Efficiency Using a Composite Risk Management Index

Abstract

Purpose – The purpose of this paper is to examine the relationship between risk management and efficiency. To achieve this, risk-adjusted efficiency is calculated on a longitudinal sample of 589 banks over a period from 2015 to 2021. Design/methodology/approach – This study employs a Data Envelopment Analysis “Benefit-of-the-Doubt” (Data Envelopment Analysis BoD) model to construct a Risk Management Index (RMI) based on the CAMEL (Capital Adequacy, Asset Quality, Management Efficiency, Earnings, and Liquidity) framework. The attained RMI is then used to empirically test the relationship between risk management and bank efficiency. Findings – The empirical analysis showsthat there is a positive and significant relationship between bank RMI and efficiency, with a strong negative and significant relationship between earnings and efficiency. The authors conclude that using a composite RMI is valuable as it facilitates the ranking and comparison of bank risk management quality. Originality/value – This paper is among the first to develop aRMI forthe estimation ofrisk-adjusted efficiency. Risk proxies, including Loan Loss Reserves and Non-Performing Loans, are integrated within a specific CAMEL framework to construct the RMI. Utilizing the RMI as a performance measure, rather than relying solely on profitability ratios, is deemed more appropriate as it aids in identifying critical areas for effective risk management, such as Asset Quality