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

The elusive scale economies of the largest banks and their implications for global competitiveness

In the wake of the financial crisis that began in 2007, policy makers have focused again on the largest financial firms to consider the association of their size with systemic risk. An equally important question examines whether their size benefits the economy. In particular, is the size of our largest financial institutions the result of technological cost advantages that improve the efficiency of their capital allocation and liquidity and enhance their international competitiveness? Or is it the result, not of technological cost advantages, but of safety-net subsidies that confer too-big-to-fail cost advantages and foster moral hazard in investment decisions. This paper reviews the evidence of large scale economies that increase with size and considers the credibility of this evidence by examining details of how scale economies are measured and why evidence of scale economies eludes many investigations. A method of estimating scale economies developed by Hughes, Lang, Mester, and Moon (1996) distinguishes the underlying scale effects on cost from the effects on costs of size-related changes in risk-taking, which can obscure technological cost advantages, such as those due to better diversification. It reviews evidence that technology, not too-big-to-fail subsidies, accounts for the cost advantage of the largest financial institutions. Finally, it considers the implications of scale economies for scaling back the operations of the largest financial institutions and for the global competitiveness of smaller institutions

A new cost efficiency measure for not-for-profit firms: Evidence of a link between inefficiency and large endowments

Cost functions and cost efficiency are commonly estimated for industries with detailed data on production and cost, both for firms that are for profit as well as not for profit. The data on not-for-profits obtained from the IRS Form 990 lack these details and, consequently, encourage substitution of the ratio of program expenses to total expenses to gauge performance. While a larger program expense ratio captures better administrative cost efficiency, it does not gauge best-practice cost and the extent to which an organization's administrative costs exceed best practice. Using the Form 990 data, this study constructs an administrative cost function for not-for-profits and uses the distribution-free technique of estimating a best-practice cost frontier to gauge the relative efficiency of not-for-profit organizations. Focusing on not-for-profit hospitals and their holdings of liquid assets, the empirical evidence is consistent with Jensen's free cash flow hypothesis: hospitals holding liquid assets in excess of a benchmark have lower program expense ratios and lower cost efficiency. In addition, the CEOs of more cost efficient hospitals earn higher compensation. The agreement of the evidence on agency problems related to excess holdings of liquid assets from the program expense ratio and administrative cost efficiency reinforce the credibility of the latter as a measure of the performance of not-for-profit organizations

Capital regulation: Less really can be more when incentives are socially aligned. Comments on Richard J. Herring "The Evolving Complexity of Capital Regulation". "The Interplay of Financial Regulations, Resilience, and Growth", Federal Reserve Bank of Philadelphia June 16-17, 2016

Capital regulation has become increasingly complex as the largest financial institutions arbitrage differences in requirements across financial products to increase expected return for any given amount of regulatory capital, as financial regulators amend regulations to reduce arbitrage opportunities, and as financial institutions innovate to escape revised regulations - a regulatory dialectic. This increasing complexity makes monitoring bank risk-taking by markets and regulators more difficult and does not necessarily improve the risk sensitivity of measures of capital adequacy. Explaining the arbitrage incentive of some banks, several studies have found evidence of dichotomous capital strategies for maximizing value: a relatively low-risk strategy that minimizes the potential for financial distress to protect valuable investment opportunities and a relatively high-risk strategy that, in the absence distress costs due to valuable investment opportunities, "reaches for yield" to exploit the option value of implicit and explicit deposit insurance. In the latter case, market discipline rewards risk-taking and, in doing so, tends to undermine financial stability. The largest financial institutions, belonging to the latter category, maximize value by arbitraging capital regulations to "reach for yield." This incentive can be curtailed by imposing "pre-financial-distress" costs that make less risky capital strategies optimal for large institutions. Such potential costs can be created by requiring institutions to issue contingent convertible debt (COCOs) that converts to equity to recapitalize the institution well before insolvency. The conversion rate significantly dilutes existing shareholders and makes issuing new equity a better than than conversion. The trigger for conversion is a particular market-value capital ratio. Thus, the threat of conversion tends to reverse risk-taking incentives - in particular, the incentive to increase financial leverage and to arbitrage differences in capital requirement across investments

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