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

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  • Joseph P. Hughes
  • Loretta J. Mester
  • Moon Choo-Geol

Abstract

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.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Chicago in its series Proceedings with number 700.

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Length: 233-264
Date of creation: 2000
Date of revision:
Publication status: Published in Conference on Bank Structure and Competition (2000 : 36th) ; The changing financial industry structure and regulation : bridging states, countries, and industries
Handle: RePEc:fip:fedhpr:700

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Keywords: Economies of scale;

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References

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  1. Evanoff, Douglas D & Israilevich, Philip R & Merris, Randall C, 1990. "Relative Price Efficiency, Technical Change, and Scale Economies for Large Commercial Banks," Journal of Regulatory Economics, Springer, Springer, vol. 2(3), pages 281-98, September.
  2. Joseph P. Hughes & William W. Lang & Loretta J. Mester, 1995. "Recovering technologies that account for generalized managerial preferences: an application to non-risk neutral banks," Working Papers 95-8, Federal Reserve Bank of Philadelphia.
  3. Clark, Jeffrey A, 1996. "Economic Cost, Scale Efficiency, and Competitive Viability in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 28(3), pages 342-64, August.
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  7. Joseph P. Hughes, 1997. "Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling," Departmental Working Papers, Rutgers University, Department of Economics 199601, Rutgers University, Department of Economics.
  8. Rebecca S. Demsetz & Marc R. Saidenberg & Philip E. Strahan, 1996. "Banks with something to lose: the disciplinary role of franchise value," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Oct, pages 1-14.
  9. Joseph P. Hughes & William Lang & Loretta J. Mester & Choon-Geol Moon, 1998. "The Dollars and Sense of Bank Consolidation," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 99-04, Wharton School Center for Financial Institutions, University of Pennsylvania.
  10. Flannery, Mark J, 1994. "Debt Maturity and the Deadweight Cost of Leverage: Optimally Financing Banking Firms," American Economic Review, American Economic Association, American Economic Association, vol. 84(1), pages 320-31, March.
  11. Hughes, Joseph P., 1999. "Measuring efficiency when competitive prices aggregate differences in product quality and risk," Research in Economics, Elsevier, Elsevier, vol. 53(1), pages 47-76, March.
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  15. Loretta J. Mester & Leonard I. Nakamura & Micheline Renault, 2002. "Checking Accounts and Bank Monitoring," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 99-02, Wharton School Center for Financial Institutions, University of Pennsylvania.
  16. Berger, Allen N. & Mester, Loretta J., 1997. "Inside the black box: What explains differences in the efficiencies of financial institutions?," Journal of Banking & Finance, Elsevier, Elsevier, vol. 21(7), pages 895-947, July.
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