Measuring the efficiency of capital allocation in commercial banking

Commercial banks leverage their equity capital with demandable debt that participates in the economy's payments system. The distinctive nature of this debt generates an unusual degree of liquidity risk that can, at times, threaten the payments system. To reduce this threat, insurance protects deposits; and to reduce the moral hazard problems of the debt contract and deposit insurance, bank regulation constrains risk-taking and defines standards of capital adequacy. The inherent liquidity risk of demandable debt as well as potential regulatory penalties for poor financial performance creates the potential for costly episodes of financial distress that affects banks' employment of capital. ; The existence of financial-distress costs implies that many banks are likely to take actions, such as holding additional capital, that increase bank safety at the expense of short-run returns. While such a strategy may reduce average returns in the short run, it may maximize the market value of the bank by protecting charter value and protecting against regulatory interventions. On the other hand, some banks whose charter values are low may have an incentive to follow a higher risk strategy, one that increases average return at the expense of greater risk of financial distress and regulatory intervention. ; This paper examines how banks' employment of capital in their production plans affects their \"market value\" efficiency. The authors develop a market-based measure of production efficiency and implement it on a sample of publicly traded bank holding companies. Our evidence indicates that banks' efficiency and, hence, the market value of their assets are influenced by the level and allocation of capital. However, even controlling for the effect of size, we find that the influence of equity capital differs markedly between banks with higher capital-to-assets ratios and those with lower ratios. For inefficient banks with higher capital-to-assets ratios, marginal increases in capitalization and asset quality boost their market-value efficiency. For inefficient banks with lower levels of capitalization, the signs of these effects are reversed. Controlling for asset size, it appears that less capitalized banks cannot afford to mimic the investment strategy of more capitalized banks, which may be using this greater capitalization to signal their safety to financial markets.