We estimate banks’ technical efficiency using directional distance functions, a generalization of the radial distance functions that allow us to credit banks for their efforts to increase outputs and decrease resource use and bad loans. We find that once bad loans are considered, banks’ efficiency increases significantly. In addition, omitting bad loans may result in the underestimation of the performance of good credit quality banks. These results suggest that a significant aspect of banking production, credit quality, needs to be considered when evaluating banks’ performances for regulatory purposes.
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