Bank capitalization and cost: evidence of scale economies in risk management and signaling
With seemingly minor amendments to the standard techniques of measuring banking technology, we have uncovered important empirical phenomena that point to the crucial role played by financial capital in banking and financial intermediation. The authors employ a standard cost function, conditioned on the level of financial capital, but they model the demand for financial capital so that it can logically serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. This allows scale economies to be computed without assuming that the bank chooses a level of capitalization that minimizes cost. Hence, a wider range of cost configurations is accommodated. ; The authors find evidence that bank managers are risk averse and use the level of financial capital to signal the level of risk. For any given vector of outputs, risk-averse managers increase the level of financial capital to control risk and employ additional amounts of labor and physical capital to improve risk management and to preserve capital. When scale economies are calculated, increasing size and the consequent improvement in diversification allow risk-averse banks to economize on their costly tradeoff and achieve significant scale economies. When these roles of financial capital are ignored in analyzing banking costs, the measured scale economies disappear. Our results seem to reconcile the disparity between the finding of constant returns to scale of previous studies that ignored financial capital and assumed risk-neutral bank managers and the recent wave of large bank mergers, which bankers claim are driven in part by scale economies.
|Date of creation:||1997|
|Contact details of provider:|| Postal: 10 Independence Mall, Philadelphia, PA 19106-1574|
Web page: http://www.philadelphiafed.org/
More information through EDIRC
|Order Information:|| Web: http://www.phil.frb.org/econ/wps/index.html Email: |
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Loretta J. Mester, 1994. "How efficient are Third District banks?," Business Review, Federal Reserve Bank of Philadelphia, issue Jan, pages 3-18.
When requesting a correction, please mention this item's handle: RePEc:fip:fedpwp:96-2. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Beth Paul)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.