Measuring potential profit gains using a multi-stage production technology: evidence from the Chinese banking industry

We propose an improved nonparametric methodology for assessing banking performance by extending the profit-oriented approach for measuring bank efficiency. Unlike existing studies that treat banks’ non-performing assets as an input or assume that loans must decrease to accommodate a fall in undesirable outputs such as non-performing loans, we model the banking technology as a multi-stage process incorporating intermediate, final, desirable, and undesirable outputs. Our performance measure is defined in monetary terms, allowing us to estimate potential gains in profits without assigning any weights to the objective function components. These gains are divided into cost decreases, income increases, and potential reductions in risk exposure. We operationalize our model using a sample of 49 Chinese banks for the period 2010–2021. Our results suggest that banks’ unrealized profit potential has increased over time and that the state-owned banks have fared particularly well in tapping into this potential.