In this paper, we estimate the efficiency of financial intermediation of the Russian banks using a stochastic production frontier approach. Furthermore, we estimate the impact of various determinants on the efficiency score of banks. Banks play a crucial role in providing low cost capital to the rest of the economy. So, an efficient banking system is essential for sustained growth at low cost of capital.

We estimate the efficiency level of Russian banks and compare to international practice. Compared to many other countries, intermediation efficiency of the Russian banking industry remains very low at about 40% where as it is over 90% in the U.S. and the U.K. In the E.U. the average is about 75%. We estimate separate efficiency measures of the banks in obtaining funds in terms of deposits as well as the efficiency in credit intermediation. Accordingly, Russian banks are much less efficient in obtaining funds in terms of deposits than in financial intermediation. The distribution of banks according to deposit efficiency is skewed to the lower end. However, there has been a modest improvement since 2000 as inefficient banks drop out of the system. However, collecting deposits for inefficient banks is very costly. Banks with 50% or less efficiency score account for more than 80% of deposit interest costs.

The overall efficiency in intermediating credit is relatively better compared to raising funds at 41%. Efficient banks provide about 60% of total credits to the economy while the rest are provided by banks with efficiency scores of less than 50%. Low efficiency in banking results in misallocation of capital and other funds thus raising the cost of capital. However, since 2000 there has been a significant improvement in the intermediation efficiency of the banks.

The primary sources that contribute to low efficiency are equity asset ratio, non performing loans, interest rate volatility, inflation rate volatility and real effective exchange rate volatility. The results indicate the need for major restructuring in the Russian banking industry. Restructuring can be in the form of mergers and acquisitions. Establishment of the deposit insurance system provides and opportunity to revoke the licenses of some of the inefficient banks. This would improve better allocation of banks‘ resources.