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Measuring efficiency when market prices are subject to adverse selection

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  • Joseph P. Hughes

Abstract

In perfectly competitive markets, prices aggregate inputs and outputs into a money metric that allows production plans to be ranked by their profitability. When informational asymmetries in competitive markets lead to adverse selection, prices in these markets assume an additional role that conveys information about product quality. In the case of banking production, quality is linked to risk because prices are linked to credit quality. ; The problem of efficiency measurement is complicated by the additional role because quality varies with price and price is a decision variable of firms operating in these markets. The effect of these endogenous components of prices on financial performance is illustrated with a production-based model and a market-value model that generate "best- practice" frontiers. Unlike the standard profit function's frontier, these frontiers are not conditioned on prices so that they compare the financial performance of firms with different quality-linked prices. Hence, they identify the most efficient pricing strategies as well as the most efficient production plans. ; These two alternative models for measuring efficiency are employed to study the efficiency of highest level bank holding companies in the United States in 1994. The contractural interest rates these banks obtain on their loans and other assets are shown to influence their expected profit, profit risk, market value, and efficiency.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 98-3.

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Date of creation: 1998
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Handle: RePEc:fip:fedpwp:98-3

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Keywords: Banks and banking - Costs;

References

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  1. Deaton, Angus S & Muellbauer, John, 1980. "An Almost Ideal Demand System," American Economic Review, American Economic Association, American Economic Association, vol. 70(3), pages 312-26, June.
  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, Federal Reserve Bank of Philadelphia 95-8, Federal Reserve Bank of Philadelphia.
  3. Berger, Allen N. & Hancock, Diana & Humphrey, David B., 1993. "Bank efficiency derived from the profit function," Journal of Banking & Finance, Elsevier, Elsevier, vol. 17(2-3), pages 317-347, April.
  4. Jalal D. Akhavein & Allen N. Berger & David B. Humphrey, 1996. "The Effects of Megamergers on Efficiency and Prices: Evidence from a Bank Profit Function," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 96-03, Wharton School Center for Financial Institutions, University of Pennsylvania.
  5. Joseph P. Hughes & Choon-Geol Moon, 1997. "Efficient Banking Under Interstate Branching," Departmental Working Papers, Rutgers University, Department of Economics 199609, Rutgers University, Department of Economics.
  6. 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.
  7. Allen N. Berger & David B. Humphrey, 1997. "Efficiency of Financial Institutions: International Survey and Directions for Future Research," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 97-05, Wharton School Center for Financial Institutions, University of Pennsylvania.
  8. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(4), pages 305-360, October.
  9. 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.
  10. 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, Federal Reserve Bank of Philadelphia 91-21, Federal Reserve Bank of Philadelphia.
  11. Ferrier, Gary D. & Grosskopf, Shawna & Hayes, Kathy J. & Yaisawarng, Suthathip, 1993. "Economies of diversification in the banking industry : A frontier approach," Journal of Monetary Economics, Elsevier, Elsevier, vol. 31(2), pages 229-249, April.
  12. 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, Elsevier, vol. 19(2-3), pages 233-238, August.
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Cited by:
  1. Hughes, Joseph P. & Lang, William W. & Mester, Loretta J. & Moon, Choon-Geol, 1999. "The dollars and sense of bank consolidation," Journal of Banking & Finance, Elsevier, Elsevier, vol. 23(2-4), pages 291-324, February.

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