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Safety in numbers? Geographic diversification and bank insolvency risk

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  • Joseph P. Hughes
  • William W. Lang
  • Loretta J. Mester
  • Choon-Geol Moon

Abstract

The Riegle-Neal Interstate Banking and Branching Efficiency Act, passed in September 1994 and effective June 1, 1997, will allow nationally chartered banks to branch across state lines. This act will remove impediments to interstate expansion and permit the consolidation of existing interstate networks ; What will be the impact of this legislation on bank performance and bank safety? Removing impediments to geographic expansion should improve the risk-return tradeoff faced by most banks. However, this paper argues that economic theory does not tell us whether an improvement in the risk-return tradeoff will lead to a reduction in the volatility of bank returns or in the probability of insolvency. ; The authors investigate the role of geographic diversification on bank performance and safety using bank holding company data. The authors find that an increase in the number of branches lowers insolvency risk and increases efficiency for inefficient bank holding companies; an increase in the number of states in which a bank holding company operates increases insolvency risk but has an insignificant effect on efficiency. Branch expansion raises the risk of insolvency for efficient bank holding companies, while an increase in the number of states has an insignfiicant effect on insolvency risk

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 96-14.

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Date of creation: 1996
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Handle: RePEc:fip:fedpwp:96-14

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Keywords: Bank failures ; Interstate banking;

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References

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  1. Allen N. Berger & Robert DeYoung, 1997. "Problem loans and cost efficiency in commercial banks," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1997-8, Board of Governors of the Federal Reserve System (U.S.).
  2. 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.
  3. Jalal D. Akhavein & Allen N. Berger & David B. Humphrey, 1997. "The effects of megamergers on efficiency and prices: evidence from a bank profit function," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1997-9, Board of Governors of the Federal Reserve System (U.S.).
  4. Joseph P. Hughes & William Lang & Loretta J. Mester & Choon-Geol Moon, 1996. "Efficient banking under interstate branching," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 1045-1075.
  5. Joseph P. Hughes & Loretta J. Mester, 1997. "Bank capitalization and cost: evidence of scale economies in risk management and signaling," Working Papers 96-2, Federal Reserve Bank of Philadelphia.
  6. Hancock, Diana, 1985. "The Financial Firm: Production with Monetary and Nonmonetary Goods," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 93(5), pages 859-80, October.
  7. 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.
  8. Blair, Roger D & Heggestad, Arnold A, 1978. "Bank Portfolio Regulation and the Probability of Bank Failure: A Note," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 10(1), pages 88-93, February.
  9. Koehn, Michael & Santomero, Anthony M, 1980. " Regulation of Bank Capital and Portfolio Risk," Journal of Finance, American Finance Association, vol. 35(5), pages 1235-44, December.
  10. 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.
  11. Loretta J. Mester, 1994. "How efficient are Third District banks?," Business Review, Federal Reserve Bank of Philadelphia, issue Jan, pages 3-18.
  12. Rebecca S. Demsetz & Philip E. Strahan, 1995. "Diversification, size, and risk at bank holding companies," Research Paper 9506, Federal Reserve Bank of New York.
  13. Peter S. Rose, 1995. "Diversification and interstate banking," Proceedings 461, Federal Reserve Bank of Chicago.
  14. Chong, Beng Soon, 1991. "The Effects of Interstate Banking on Commercial Banks' Risk and Profitability," The Review of Economics and Statistics, MIT Press, vol. 73(1), pages 78-84, February.
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Citations

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Cited by:
  1. 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, vol. 21(7), pages 895-947, July.
  2. Mitchell Berlin & Loretta J. Mester, 1997. "On the Profitability and Cost of Relationship Lending," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 97-43, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Enzo Dia, 2002. "A Reconciliation of the Evidence about Bank Lending with Portfolio Theory," Working Papers, University of Milano-Bicocca, Department of Economics 56, University of Milano-Bicocca, Department of Economics, revised Sep 2002.
  4. John S. Jordan, 1998. "Problem loans at New England banks, 1989 to 1992: evidence of aggressive loan policies," New England Economic Review, Federal Reserve Bank of Boston, issue Jan, pages 23-38.
  5. Viral V. Acharya & Iftekhar Hasan & Anthony Saunders, 2002. "The effects of focus and diversification on bank risk and return: evidence from individual bank loan portfolios," Proceedings 905, Federal Reserve Bank of Chicago.
  6. Francisco Pérez García & Javier Quesada Ibañez & Joaquín Maudos Villarroya & José Manuel Pastor Monsálvez, 1999. "- Cost And Profit Efficiency In European Banks," Working Papers. Serie EC, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie) 1999-12, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  7. Enzo Dia, 2004. "The bank’s risk insurance and the EMU," Working Papers, University of Milano-Bicocca, Department of Economics 72, University of Milano-Bicocca, Department of Economics, revised May 2004.
  8. Evelyn Hayden & Daniel Porath & Natalja von Westernhagen, 2006. "Does Diversification Improve the Performance of German Banks? Evidence from Individual Bank Loan Portfolios," Working Papers 110, Oesterreichische Nationalbank (Austrian Central Bank).
  9. Akhigbe, Aigbe & Stevenson, Bradley A., 2010. "Profit efficiency in U.S. BHCs: Effects of increasing non-traditional revenue sources," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(2), pages 132-140, May.

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