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Problem loans at New England banks, 1989 to 1992: evidence of aggressive loan policies

  • John S. Jordan
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    The New England banking industry experienced serious problems between 1989 and 1992. As the region's economy deteriorated, banks failed at an unprecedented rate and many others barely survived. Banking problems were widespread, but they were not uniform. The ratio of nonperforming loans to total loans was in excess of 10 percent for some New England banks, below 1 percent for others, even though all faced the external shock of the collapse in the region's real estate market.> This study attempts to determine whether a 'skills' hypothesis or a 'policies' hypothesis better explains the differences among banks in the severity of their loan problems. The 'skills' hypothesis posits that banks with the greatest loan problems were those that employed managers with deficient skills. The 'policies' hypothesis posits that banks with the greatest loan problems were those that chose higher loan-to-asset ratios, held a greater concentration of riskier types of loans, or accepted riskier loan customers. The author uses an analysis of profit and cost efficiency to help identify the hypothesis that better explains the disparity. He finds evidence in support of the 'policies' hypothesis. Conscious decisions by bank managers regarding the riskiness of their loan portfolios, as well as the level of capital to hold, help explain why some New England banks were able to survive the real estate crisis while others failed.

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    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (1998)
    Issue (Month): Jan ()
    Pages: 23-38

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    Handle: RePEc:fip:fedbne:y:1998:i:jan:p:23-38
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    1. Mitchell, Karlyn & Onvural, Nur M, 1996. "Economies of Scale and Scope at Large Commercial Banks: Evidence from the Fourier Flexible Functional Form," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(2), pages 178-99, May.
    2. Robert Tannenwald, 1995. "Differences across First District banks in operational efficiency," New England Economic Review, Federal Reserve Bank of Boston, issue May, pages 41-60.
    3. Joseph P. Hughes & Loretta J. Mester, . "A Quality and Risk-Adjusted Cost Function for Banks: Evidence on the "Too-Big-To-Fail" Doctrine," Rodney L. White Center for Financial Research Working Papers 25-92, Wharton School Rodney L. White Center for Financial Research.
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    6. Berger, Allen N. & DeYoung, Robert, 1997. "Problem loans and cost efficiency in commercial banks," Journal of Banking & Finance, Elsevier, vol. 21(6), pages 849-870, June.
    7. 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.
    8. Joseph P. Hughes & William W. Lang & Loretta J. Mester & Choon-Geol Moon, 1996. "Safety in numbers? Geographic diversification and bank insolvency risk," Working Papers 96-14, Federal Reserve Bank of Philadelphia.
    9. Timothy H. Hannan & Gerald A. Hanweck, 1986. "Bank insolvency risk and the market for large certificates of deposit," Working Papers in Banking, Finance and Microeconomics 86-1, Board of Governors of the Federal Reserve System (U.S.).
    10. Ronn, Ehud I & Verma, Avinash K, 1986. " Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-95, September.
    11. Marcus, Alan J & Shaked, Israel, 1984. "The Valuation of FDIC Deposit Insurance Using Option-pricing Estimates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 446-60, November.
    12. Mester, Loretta J., 1996. "A study of bank efficiency taking into account risk-preferences," Journal of Banking & Finance, Elsevier, vol. 20(6), pages 1025-1045, July.
    13. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
    14. Ralph C. Kimball, 1997. "Specialization, risk, and capital in banking," New England Economic Review, Federal Reserve Bank of Boston, issue Nov, pages 51-73.
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