The Intermediation Approach

The traditional meaning of intermediation refers to the job of bringing together of borrowers and savers (Chorafas, 1998). In this perspective, the intermediation approach treats banking firms as intermediaries, between borrowers (also known as investors) and savers. The intermediation service is provided by banks through collection of surplus funds from savers, in the form of deposited and purchased funds; and subsequent utilization of these funds in the form of loans to investors, as well as different types of securities and investments.

There has been a longstanding debate about what outputs are generally produced by the banks (Berger and Humphrey, 1992), and also about what inputs are used in this process (Leightner and Lovell, 1998). The treatment of deposits, as either an input or an output variable, has particularly faced longstanding controversy, in the banking literature. This controversy arises from the dual characteristics inherent in deposits. On the one hand, deposits are related to the liquidity levels, payment services and safekeeping provided to the depositors. Based on these characteristics deposits are considered to be outputs (Worthington, 1998). On the other hand, Berger and Humphrey (1997) point out that deposits are paid for partially through interest payments. In addition, the funds obtained through deposits serve as raw material for

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investible funds (Elyasiani and Mehdian, 1990). Considering these two characteristics, deposits can be categorized as inputs.

Under the intermediation approach, major outputs include loans and other assets. It is observed that in contrast to the production approach42, input set under the intermediation approach includes not only operating expenses but also borrowed funds and related interest expenses, because funds constitute the major ‘raw material’ that is transformed in intermediation process. Because interest expenses normally constitute major part of total costs, therefore, intermediation approach is considered suitable for assessing entire financial institutions (Berger and Humphrey, 1997). Moreover, as any competitive firm aims to minimize both its operating and financial cost, therefore, intermediation approach is considered better than production approach for assessments focusing on competitive viability of firms (Berger et al., 1987).

Different ways used to deal with the identification of variable sets for banks have led to the establishment of various sub approaches. Three main approaches, which have been developed under the umbrella of intermediation approach, include; the user cost approach, the asset approach, and the value added approach. All three of these variants to the intermediation approach use financial data, and are focused on intermediation function of bank (Das and Ghosh, 2006).

4.4.5.1.

The User Cost Approach

This approach was first applied by Hancock (1985) to the analysis of banking sector firms. According to this approach, the contribution of any financial product towards bank revenue forms the basis for its categorization, as either an input or an output variable. For example, an asset will be considered an output, if financial returns from this asset are more than opportunity costs of funds; and it will be treated as an input if

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the inverse is true. Similarly, a liability will be considered an output if its financial cost is less than the opportunity cost; and an input if such financial cost exceeds the associated opportunity cost.

4.4.5.2.

The Asset Approach

The asset approach, proposed by Sealey and Lindley (1977), is based on a reduced form model of banking activity, that focuses entirely on the intermediary role played by banks between the depositors and the end users of bank assets. This approach considers only balance sheet items, and does not take into account the profit and loss accounts of firms. As such the output set under this approach comprises of earning assets of banks (such as loans, securities, and investments); while, the input set includes deposits, labour, capital and other liabilities.

According to Camanho and Dyson (2005), the asset approach faces two limitations. Firstly, this approach is more suitable for such banks, whose main function is the purchase of funds from other banks, for conversion into loans. However, for a vast majority of banks, their role extends beyond the purchase of funds to provision of a number of services to their depositor. Such services are not accounted for, under the asset approach. Another limitation of the asset approach is based on the fact that only balance sheet data is included in the output set; with the result that any financial products such as securities or investment funds sold by a bank are ignored, despite their importance for the revenue generation.

4.4.5.3.

The Value Added Approach

The value added approach, as proposed by Berger et al. (1987) , treats different balance sheet items as outputs, if these assets or liabilities are making any substantial contribution towards the bank value added. The remaining balance sheet items are treated as inputs, intermediate products or unimportant outputs; based upon the specifics

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of these items. Generally, the outputs under this approach include different categories of deposits and loans, as these are major contributors towards bank value added. Purchased funds of different types are considered as financial inputs, as these items need very few physical inputs (Berger et al., 1987).