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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
  • Choon-Geol Moon

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 Philadelphia in its series Working Papers with number 00-4.

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Date of creation: 2000
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Handle: RePEc:fip:fedpwp:00-4

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Keywords: Bank capital ; Bank supervision ; Production (Economic theory);

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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, vol. 2(3), pages 281-98, September.
  2. Loretta J. Mester, 1989. "Testing for expense preference behavior: mutual versus stock savings and loans," Working Papers 89-27, Federal Reserve Bank of Philadelphia.
  3. Gorton, Gary & Rosen, Richard, 1995. " Corporate Control, Portfolio Choice, and the Decline of Banking," Journal of Finance, American Finance Association, vol. 50(5), pages 1377-1420, December.
  4. Joseph P. Hughes, 1997. "Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling," Departmental Working Papers 199601, Rutgers University, Department of Economics.
  5. Jondrow, James & Knox Lovell, C. A. & Materov, Ivan S. & Schmidt, Peter, 1982. "On the estimation of technical inefficiency in the stochastic frontier production function model," Journal of Econometrics, Elsevier, vol. 19(2-3), pages 233-238, August.
  6. Loretta J. Mester & Leonard I. Nakamura & Micheline Renault, 2001. "Checking accounts and bank monitoring," Working Papers 01-3, Federal Reserve Bank of Philadelphia.
  7. Mark J. Flannery, 1991. "Debt maturity and the deadweight cost of leverage: optimally financing banking firms," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  8. Grossman, Richard S, 1992. "Deposit Insurance, Regulation, and Moral Hazard in the Thrift Industry: Evidence from the 1930's," American Economic Review, American Economic Association, vol. 82(4), pages 800-821, September.
  9. Deborah J. Lucas & Robert L. McDonald, 1992. "Bank Financing and Investment Decisions with Asymmetric Information about Loan Quality," RAND Journal of Economics, The RAND Corporation, vol. 23(1), pages 86-105, Spring.
  10. Joseph P. Hughes & William W. Lang & Loretta J. Mester, 1998. "The dollars and sense of bank consolidation," Working Papers 98-10, Federal Reserve Bank of Philadelphia.
  11. Clark, Jeffrey A, 1996. "Economic Cost, Scale Efficiency, and Competitive Viability in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(3), pages 342-64, August.
  12. 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.
  13. 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.).
  14. Humphrey, David B & Pulley, Lawrence B, 1997. "Banks' Responses to Deregulation: Profits, Technology, and Efficiency," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(1), pages 73-93, February.
  15. 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, issue Oct, pages 1-14.
  16. Braeutigam, Ronald R. & Daughety, Andrew F., 1983. "On the estimation of returns to scale using variable cost functions," Economics Letters, Elsevier, vol. 11(1-2), pages 25-31.
  17. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
  18. Douglas D. Evanoff, 1998. "Assessing the impact of regulation on bank cost efficiency," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q II, pages 21-32.
  19. Hughes, Joseph P, et al, 1996. "Efficient Banking under Interstate Branching," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 1045-71, November.
  20. Joseph Hughes, 1999. "Incorporating risk into the analysis of production," Atlantic Economic Journal, International Atlantic Economic Society, vol. 27(1), pages 1-23, March.
  21. 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.
  22. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
  23. McAllister, Patrick H. & McManus, Douglas, 1993. "Resolving the scale efficiency puzzle in banking," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 389-405, April.
  24. English, M. & Grosskopf, S. & Hayes, K. & Yaisawarng, S., 1993. "Output allocative and technical efficiency of banks," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 349-366, April.
  25. Mester, Loretta J., 1991. "Agency costs among savings and loans," Journal of Financial Intermediation, Elsevier, vol. 1(3), pages 257-278, June.
  26. Hughes, Joseph P., 1999. "Measuring efficiency when competitive prices aggregate differences in product quality and risk," Research in Economics, Elsevier, vol. 53(1), pages 47-76, March.
  27. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
  28. Deaton, Angus S & Muellbauer, John, 1980. "An Almost Ideal Demand System," American Economic Review, American Economic Association, vol. 70(3), pages 312-26, June.
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