Measuring efficiency when market prices are subject to adverse selection

In perfectly competitive markets, prices aggregate inputs and outputs into a money metric that allows production plans to be ranked by their profitability. When informational asymmetries in competitive markets lead to adverse selection, prices in these markets assume an additional role that conveys information about product quality. In the case of banking production, quality is linked to risk because prices are linked to credit quality. ; The problem of efficiency measurement is complicated by the additional role because quality varies with price and price is a decision variable of firms operating in these markets. The effect of these endogenous components of prices on financial performance is illustrated with a production-based model and a market-value model that generate "best- practice" frontiers. Unlike the standard profit function's frontier, these frontiers are not conditioned on prices so that they compare the financial performance of firms with different quality-linked prices. Hence, they identify the most efficient pricing strategies as well as the most efficient production plans. ; These two alternative models for measuring efficiency are employed to study the efficiency of highest level bank holding companies in the United States in 1994. The contractural interest rates these banks obtain on their loans and other assets are shown to influence their expected profit, profit risk, market value, and efficiency.Banks and banking - Costs

Efficiency in banking: theory, practice, and evidence

Great strides have been made in the theory of bank technology in terms of explaining banks’ comparative advantage in producing informationally intensive assets and financial services and in diversifying or offsetting a variety of risks. Great strides have also been made in explaining sub-par managerial performance in terms of agency theory and in applying these theories to analyze the particular environment of banking. In recent years, the empirical modeling of bank technology and the measurement of bank performance have begun to incorporate these theoretical developments and yield interesting insights that reflect the unique nature and role of banking in modern economies. This paper gives an overview of two general empirical approaches to measuring bank performance and discusses some of the applications of these approaches found in the literature.Banks and banking - Research

Who said large banks don't experience scale economies? Evidence from a risk-return-driven cost function

Earlier studies found little evidence of scale economies at large banks; later studies using data from the 1990s uncovered such evidence, providing a rationale for very large banks seen worldwide. Using more recent data, the authors estimate scale economies using two production models. The standard risk-neutral model finds little evidence of scale economies. The model using more general risk preferences and endogenous risk-taking finds large scale economies. The authors show that these economies are not driven by too-big-to-fail considerations. They evaluate the cost implications of breaking up the largest banks into banks of smaller size.Production (Economic theory) ; Risk ; Systemic risk ; Banks and banking

Bank capitalization and cost: evidence of scale economies in risk management and signaling

With seemingly minor amendments to the standard techniques of measuring banking technology, we have uncovered important empirical phenomena that point to the crucial role played by financial capital in banking and financial intermediation. The authors employ a standard cost function, conditioned on the level of financial capital, but they model the demand for financial capital so that it can logically serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. This allows scale economies to be computed without assuming that the bank chooses a level of capitalization that minimizes cost. Hence, a wider range of cost configurations is accommodated. ; The authors find evidence that bank managers are risk averse and use the level of financial capital to signal the level of risk. For any given vector of outputs, risk-averse managers increase the level of financial capital to control risk and employ additional amounts of labor and physical capital to improve risk management and to preserve capital. When scale economies are calculated, increasing size and the consequent improvement in diversification allow risk-averse banks to economize on their costly tradeoff and achieve significant scale economies. When these roles of financial capital are ignored in analyzing banking costs, the measured scale economies disappear. Our results seem to reconcile the disparity between the finding of constant returns to scale of previous studies that ignored financial capital and assumed risk-neutral bank managers and the recent wave of large bank mergers, which bankers claim are driven in part by scale economies.Bank capital ; Economies of scale ; Risk

Are All Scale Economies in Banking Elusive or Illusive: Evidence Obtained by Incorporating Capital Structure and Risk Taking into Models of Bank Production

This paper explores how to incorporate banks' capital structure and risk-taking into models of production. In doing so, the paper bridges the gulf between (1) the banking literature that studies moral hazard effects of bank regulation without considering the underlying microeconomics of production and (2) the literature that uses dual profit and cost functions to study the microeconomics of bank production without explicitly considering how banks' production decisions influence their riskiness. Various production models that differ in how they account for capital structure and in the objectives they impute to bank managers -- cost minimization versus value maximization -- are estimated using U.S. data on highest-level bank holding companies. Modeling the bank's objective as value maximization conveniently incorporates both market-priced risk and expected cash flow into managers' ranking and choice of production plans. Estimated scale economies are found to depend critically on how banks' capital structure and risk-taking is modeled. In particular, when equity capital, in addition to debt, is included in the production model and cost is computed from the value-maximizing expansion path rather than the cost-minimizing path, banks are found to have large scale economies that increase with size. Moreover, better diversification is associated with larger scale economies while increased risk-taking and inefficient risk-taking are associated with smaller scale economies.

Are scale economies in banking elusive or illusive? Evidence obtained by incorporating capital structure and risk-taking into models of bank production.

This paper explores how to incorporate banks' capital structure and risk-taking into models of production. In doing so, the paper bridges the gulf between (1) the banking literature that studies moral hazard effects of bank regulation without considering the underlying microeconomics of production and (2) the literature that uses dual profit and cost functions to study the microeconomics of bank production without explicitly considering how banks' production decisions influence their riskiness. ; Various production models that differ in how they account for capital structure and in the objectives they impute to bank managers--cost minimization versus value maximization--are estimated using U.S. data on highest-level bank holding companies. Modeling the banks' objective as value maximization conveniently incorporates both market-priced risk and expected cash flow into managers' ranking and choice of production plans. ; Estimated scale economies are found to depend critically on how banks' capital structure and risk-taking is modeled. In particular, when equity capital, in addition to debt, is included in the production model and cost is computed from the value-maximizing expansion path rather than the cost-minimizing path, banks are found to have large scale economies that increase with size. Moreover, better diversification is associated with larger scale economies while increased risk-taking and inefficient risk-taking are associated with smaller scale economies.Bank capital ; Bank supervision ; Production (Economic theory)

The dollars and sense of bank consolidation

For nearly two decades banks in the United States have consolidated in record numbers--in terms of both frequency and the size of the merging institutions. Rhoades (1996) hypothesizes that the main motivators were increased potential for geographic expansion created by changes in state laws regulating branching and a more favorable antitrust climate. To look for evidence of economic incentives to exploit these improved opportunities for consolidation, the authors examine how consolidation affects expected profit, the riskiness of profit, profit efficiency, market value, market-value efficiencies, and the risk of insolvency. Their estimates of expected profit, profit risk, and profit efficiency are based on a structural model of leveraged portfolio production that was estimated for a sample of highest-level U.S. bank holding companies in Hughes, Lang, Mester, and Moon (1996). Here, the authors also estimate two additional measures that gauge efficiency in terms of the market values of assets and of equity. Their findings suggest that the economic benefits of consolidation are strongest for those banks engaged in interstate expansion and, in particular, interstate expansion that diversifies banks' macroeconomic risk. Not only do these banks experience clear gains in their financial performance, but society also benefits from the enhanced bank safety that follows from this type of consolidation.Bank mergers

Recovering Risky Technologies Using the Almost Ideal Demand System: An Application to U.S. Banking

We argue for a shift in the focus of modeling production from the traditional assumptions of profit maximization and cost minimization to a more general assumption of managerial utility maximization that can incorporate risk incentives into the analysis of production and recover value-maximizing technologies. We show how this shift can be implemented using the Almost Ideal Demand System. In addition, we suggest a more general way of measuring efficiency that can incorporate a concern for the market value of firms' assets and equity and identify value-maximizing firms. This shift in focus bridges the gap between the risk-incentives literature in banking that ignores the microeconomics of production and the production literature that ignores the relationship between production decisions and risk.

Measuring the efficiency of capital allocation in commercial banking

Commercial banks leverage their equity capital with demandable debt that participates in the economy's payments system. The distinctive nature of this debt generates an unusual degree of liquidity risk that can, at times, threaten the payments system. To reduce this threat, insurance protects deposits; and to reduce the moral hazard problems of the debt contract and deposit insurance, bank regulation constrains risk-taking and defines standards of capital adequacy. The inherent liquidity risk of demandable debt as well as potential regulatory penalties for poor financial performance creates the potential for costly episodes of financial distress that affects banks' employment of capital. ; The existence of financial-distress costs implies that many banks are likely to take actions, such as holding additional capital, that increase bank safety at the expense of short-run returns. While such a strategy may reduce average returns in the short run, it may maximize the market value of the bank by protecting charter value and protecting against regulatory interventions. On the other hand, some banks whose charter values are low may have an incentive to follow a higher risk strategy, one that increases average return at the expense of greater risk of financial distress and regulatory intervention. ; This paper examines how banks' employment of capital in their production plans affects their "market value" efficiency. The authors develop a market-based measure of production efficiency and implement it on a sample of publicly traded bank holding companies. Our evidence indicates that banks' efficiency and, hence, the market value of their assets are influenced by the level and allocation of capital. However, even controlling for the effect of size, we find that the influence of equity capital differs markedly between banks with higher capital-to-assets ratios and those with lower ratios. For inefficient banks with higher capital-to-assets ratios, marginal increases in capitalization and asset quality boost their market-value efficiency. For inefficient banks with lower levels of capitalization, the signs of these effects are reversed. Controlling for asset size, it appears that less capitalized banks cannot afford to mimic the investment strategy of more capitalized banks, which may be using this greater capitalization to signal their safety to financial markets.Bank capital

Efficient banking under interstate branching

Nationally chartered banks will be allowed to branch across state lines beginning June 1, 1997. Whether they will depends on their assessment of the profitability of such a delivery system for their services and on their preferences regarding risk and return. The authors investigate the probable effect of interstate branching on banks' risk-return tradeoff, accounting for the endogeneity of deposit volatility. If interstate branching improves the risk-return tradeoff banks face, banks that branch across state lines may choose a higher level of risk in return for higher profits. The authors find distinct efficiency gains due to geographic diversity.Branch banks ; Interstate banking