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Efficiency of banks in the Third Federal Reserve District

  • Loretta J. Mester

Over the years, scholars from several different fields, including corporate finance, transaction cost economics, and law, have challenged the famous Modigliani & Miller Irrelevance Hypothesis. Under what conditions, they have inquired, does the choice between debt and equity finance affect the firm’s average cost of capital? Although these scholars have made substantial progress in selected areas, no unified theory of corporate finance has yet emerged. This paper proposes a new theory based on what Oliver Williamson has described as the "measurement branch" of transaction cost economics. The valuation hypothesis, as I characterize it, asserts that debt and equity finance reflect the value of the corporate enterprise in various alternative uses. By defining property rights -- and residual claimancy -- to these value flows, corporate financial claims provide their holders with the incentive to specialize in gathering accurate information about the value of the firm’s intangible assets and thus to avoid the pricing errors that can distort ex ante investment. The resulting improvement in resource allocation maximizes the net value of the firm, or, what amounts to the same thing, minimizes its average cost of capital. According to the valuation hypothesis, moreover, the corporation’s hierarchy of financial claims identifies an overall quasi-rent structure that serves as a real-world proxy for asset specificity that promises to operationalize the specific assets hypothesis. As thus conceived, the valuation hypothesis resolves a number of anomalies in the literature on security, bankruptcy, and corporate reorganizations, and sheds considerable light on the optimal choice of business form.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 94-1.

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Date of creation: 1993
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Handle: RePEc:fip:fedpwp:94-1
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  1. Loretta J. Mester, 1987. "Efficient production of financial services: scale and scope economies," Business Review, Federal Reserve Bank of Philadelphia, issue Jan, pages 15-25.
  2. Allen N. Berger & David B. Humphrey, 1990. "The dominance of inefficiencies over scale and product mix economies in banking," Finance and Economics Discussion Series 107, Board of Governors of the Federal Reserve System (U.S.).
  3. Mester, Loretta J., 1991. "Agency costs among savings and loans," Journal of Financial Intermediation, Elsevier, vol. 1(3), pages 257-278, June.
  4. 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.
  5. Schmidt, Peter & Sickles, Robin C, 1984. "Production Frontiers and Panel Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 2(4), pages 367-74, October.
  6. Allen N. Berger & David B. Humphrey, 1992. "Megamergers in banking and the use of cost efficiency as an antitrust defense," Finance and Economics Discussion Series 203, Board of Governors of the Federal Reserve System (U.S.).
  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. Greene, William H., 1990. "A Gamma-distributed stochastic frontier model," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 141-163.
  9. Saxonhouse, Gary R, 1976. "Estimated Parameters as Dependent Variables," American Economic Review, American Economic Association, vol. 66(1), pages 178-83, March.
  10. Loretta J. Mester, 1994. "How efficient are Third District banks?," Business Review, Federal Reserve Bank of Philadelphia, issue Jan, pages 3-18.
  11. Mester, Loretta J., 1993. "Efficiency in the savings and loan industry," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 267-286, April.
  12. Jeffrey A. Clark, 1988. "Economies of scale and scope at depository financial institutions: a review of the literature," Economic Review, Federal Reserve Bank of Kansas City, issue Sep, pages 16-33.
  13. Mester, Loretta J., 1992. "Traditional and nontraditional banking: An information-theoretic approach," Journal of Banking & Finance, Elsevier, vol. 16(3), pages 545-566, June.
  14. Stevenson, Rodney E., 1980. "Likelihood functions for generalized stochastic frontier estimation," Journal of Econometrics, Elsevier, vol. 13(1), pages 57-66, May.
  15. Douglas D. Evanoff & Philip R. Israilevich, 1991. "Productive efficiency in banking," Economic Perspectives, Federal Reserve Bank of Chicago, issue Jul, pages 11-32.
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