Measuring efficiency when market prices are subject to adverse selection

Abstract

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