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Problem loans at New England banks, 1989 to 1992: evidence of aggressive loan policies

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  • John S. Jordan
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    Abstract

    The New England banking industry experienced serious problems between 1989 and 1992. As the region's economy deteriorated, banks failed at an unprecedented rate and many others barely survived. Banking problems were widespread, but they were not uniform. The ratio of nonperforming loans to total loans was in excess of 10 percent for some New England banks, below 1 percent for others, even though all faced the external shock of the collapse in the region's real estate market.> This study attempts to determine whether a 'skills' hypothesis or a 'policies' hypothesis better explains the differences among banks in the severity of their loan problems. The 'skills' hypothesis posits that banks with the greatest loan problems were those that employed managers with deficient skills. The 'policies' hypothesis posits that banks with the greatest loan problems were those that chose higher loan-to-asset ratios, held a greater concentration of riskier types of loans, or accepted riskier loan customers. The author uses an analysis of profit and cost efficiency to help identify the hypothesis that better explains the disparity. He finds evidence in support of the 'policies' hypothesis. Conscious decisions by bank managers regarding the riskiness of their loan portfolios, as well as the level of capital to hold, help explain why some New England banks were able to survive the real estate crisis while others failed.

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    Bibliographic Info

    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (1998)
    Issue (Month): Jan ()
    Pages: 23-38

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    Handle: RePEc:fip:fedbne:y:1998:i:jan:p:23-38

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    Related research

    Keywords: Bank loans ; Bank failures;

    References

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    1. Joseph P. Hughes & William Lang, 1997. "Recovering Technologies That Account for Generalized Managerial Preferences: An Application to Non-Risks-Neutral Banks," Departmental Working Papers 199521, Rutgers University, Department of Economics.
    2. Mester, Loretta J., 1996. "A study of bank efficiency taking into account risk-preferences," Journal of Banking & Finance, Elsevier, vol. 20(6), pages 1025-1045, July.
    3. Allen N. Berger & David B. Humphrey, 1997. "Efficiency of Financial Institutions: International Survey and Directions for Future Research," Center for Financial Institutions Working Papers 97-05, Wharton School Center for Financial Institutions, University of Pennsylvania.
    4. Allen N. Berger & Loretta J. Mester, 1997. "Inside the black box: what explains differences in the efficiencies of financial institutions?," Finance and Economics Discussion Series 1997-10, Board of Governors of the Federal Reserve System (U.S.).
    5. Robert Tannenwald, 1995. "Differences across First District banks in operational efficiency," New England Economic Review, Federal Reserve Bank of Boston, issue May, pages 41-60.
    6. Allen N. Berger & Robert DeYoung, 1996. "Problem loans and cost efficiency in commercial banks," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 219-236.
    7. Ralph C. Kimball, 1997. "Specialization, risk, and capital in banking," New England Economic Review, Federal Reserve Bank of Boston, issue Nov, pages 51-73.
    8. Marcus, Alan J & Shaked, Israel, 1984. "The Valuation of FDIC Deposit Insurance Using Option-pricing Estimates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 446-60, November.
    9. Joseph P. Hughes & William W. Lang & Loretta J. Mester & Choon-Geol Moon, 1996. "Safety in numbers? Geographic diversification and bank insolvency risk," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 202-218.
    10. Ronn, Ehud I & Verma, Avinash K, 1986. " Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-95, September.
    11. Mitchell, Karlyn & Onvural, Nur M, 1996. "Economies of Scale and Scope at Large Commercial Banks: Evidence from the Fourier Flexible Functional Form," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(2), pages 178-99, May.
    12. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
    13. Timothy H. Hannan & Gerald A. Hanweck, 1986. "Bank insolvency risk and the market for large certificates of deposit," Working Papers in Banking, Finance and Microeconomics 86-1, Board of Governors of the Federal Reserve System (U.S.).
    14. Joseph P. Hughes & Loretta J. Mester, 1991. "A quality and risk-adjusted cost function for banks: evidence on the " too-big-to-fail" doctrine," Working Papers 91-21, Federal Reserve Bank of Philadelphia.
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    Cited by:
    1. Shen, Chung-Hua & Chen, Ting-Hsuan, 2010. "Estimating banking cost efficiency with the consideration of cost management," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(4), pages 424-435, November.

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