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Consumer Behavior and the Stickiness of CreditCard Interest Rates

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  • Paul S. Calem
  • Loretta J. Mester

Abstract

We present evidence on the objective function of bank management - that is, are they risk neutral and minimize expected profits or are they risk-averse and trade off profit for risk reduction? We extend the model of Hughes and Mester (1993) to allow a bank’s choice of its financial capital level to reflect its preference for return versus risk. A multiproduct cost function, which incorporates asset quality and the risk faced by a bank’s uninsured depositors, is derived from a model of utility maximization. The utility function represents the bank management’s preferences defined over asset levels, asset quality, capital level, and profit. Endogenizing the bank’s choice of capital level in this way permits the demand for financial capital to deviate from its cost-minimizing level. The model consists of the cost function, share equations, and demand for financial capital to deviate from its cost-minimizing level. The model consists of the cost function, share equations, and demand for financial capital equation, which are estimated jointly. We then are able to explicitly test whether bank managers are acting in shareholders’ interest and maximizing expected profits, or whether they are maximizing a utility function that exhibits risk aversion. We believe this is the first such test.

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Bibliographic Info

Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 03-94.

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Handle: RePEc:fth:pennfi:03-94

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