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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

Author

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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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(This abstract was borrowed from another version of this item.)
(This abstract was borrowed from another version of this item.)
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Suggested Citation

  • Joseph P. Hughes & Loretta J. Mester & Choon-Geol Moon, 2000. "Are scale economies in banking elusive or illusive? evidence obtained by incorporating capital structure and risk-taking into models of bank production," Proceedings 700, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhpr:700
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    References listed on IDEAS

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    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, vol. 21(7), pages 895-947, July.
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    22. Joseph P. Hughes & William Lang & Loretta J. Mester & Choon-Geol Moon, 1995. "Recovering Technologies that Account for Generalized Managerial Preferences: An Application to Non-Risk-Neutral Banks," Center for Financial Institutions Working Papers 95-16, Wharton School Center for Financial Institutions, University of Pennsylvania.
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    Economies of scale;

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