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Loanable funds, risk, and bank service output

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  • J. Christina Wang
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    Abstract

    This paper develops a unified theory of bank operations that integrates theories of financial intermediation, asset pricing, and production. In a simple dynamic model, banks maximize the present value of future profits generated through three categories of qualitatively distinct functions: (1) resolving information asymmetry in order to make loans, (2) providing transaction services, and (3) financing loans with borrowed funds. Risk determines the rate of return on the funds and in turn the discount rate for future profits. But risk affects the quantity of bank services generated in the first two functions only to the extent that assets of different risk require different amounts of information processing. The model thus coherently accounts for portfolio risk in measuring bank service output. It then recognizes that only functions (1) and (2) create bank value added, whereas the borrowed funds are merely an intermediate input in the provision of bank services. Furthermore, the funds and the production function for value added are separable in a bank's optimization solution. This model can resolve some long-standing debates in the literature on bank production, such as distinguishing between the input and output roles of deposits. It also provides a theoretical basis for measuring banking output in the National Income Accounts. This banking model implies a new measure of bank output that imputes the implicitly priced services as the part of net interest income that is free of risk-related returns on loanable funds. The new measure differs significantly from the ones commonly used, suggesting a need to reexamine the conclusions of a large body of empirical literature.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 03-4.

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    Date of creation: 2003
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    Handle: RePEc:fip:fedbwp:03-4

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    Keywords: Banks and banking ; Value added;

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    References

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    Cited by:
    1. J. Christina Wang & Susanto Basu & John G. Fernald, 2009. "A General-Equilibrium Asset-Pricing Approach to the Measurement of Nominal and Real Bank Output," NBER Chapters, in: Price Index Concepts and Measurement, pages 273-320 National Bureau of Economic Research, Inc.
    2. J. Christina Wang, 2003. "Service output of bank holding companies in the 1990s and the role of risk," Working Papers 03-6, Federal Reserve Bank of Boston.
    3. Susanto Basu & Robert Inklaar & J. Christina Wang, 2008. "The value of risk: measuring the service output of U. S. commercial banks," Working Papers 08-4, Federal Reserve Bank of Boston.
    4. J. Christina Wang, 2003. "Productivity and economies of scale in the production of bank service value added," Working Papers 03-7, Federal Reserve Bank of Boston.

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