Does labour regulation affect technical and allocative efficiency? Evidence from the banking industry

In light of the ongoing restructuring of the European banking industry and the challenging macroeconomic environment, banks have increased their efforts to reduce operating costs. Yet, the institutional features that affect banks' ability to adjust costs and in particular personnel expenses, which comprise a significant part of banks' non-interest cost structure, have not been adequately studied. This paper investigates the effect of labour market institutions and regulations on bank performance in 15 European countries over the period 2005-2010, using the Fraser index for labour regulation and its disaggregated sub-components. We propose a novel methodology to measure performance, based on the seminal work of Kumbhakar and Tsionas (2005), which allows the estimation of technical and allocative efficiency and the examination of the effect of labour market regulations in a single stage. Results indicate the existence of a positive relationship between the liberalisation of EU labour markets and allocative efficiency, while the effect on technical efficiency appears to be negative, although not statistically significant. When looking at the disaggregated components of the labour index, we further confirm that different forces are at play.