Structure-Performance Linkages in the Korean Banking Sector and Policy Implications

Two competing hypotheses, the market structure hypothesis and the efficient structure hypothesis, have been proposed in regard to the relationship between structure and performance in the banking sector. The purpose of this paper is to identify the major determinants of profitability in the Korean banking sector for the period of 1992~2002 by testing the two competing hypotheses in an integrated model which incorporates the variables representing both hypotheses. The results indicate that bank efficiency has a significant effect on bank profitability and support the efficient structure hypothesis. The unique feature of this paper is the estimation of allocative inefficiency by the directional technology distance function and the use of this estimate in explaining bank performance. Another contribution of this paper is a finding that the major determinants of bank profitability in Korea have changed between pre-and post-crisis periods. Before the currency crisis, all three variables- market concentration, market share and efficiency-were significant explanatory variables. However, after the crisis, the measures of efficiency stand out as the most significant variable, and the importance of equity ratio was also noted. This paper also provides several policy implications for bank regulatory reform.