Risk-taking behavior, earnings quality, and performance in Spanish banking: A profit frontier approach

After the financial crisis of 2007–2008 two bank performance dimensions, among others, have become partly subject to debate. One of them is bank efficiency, and the other one bank risk taking behavior. The literature on bank efficiency and productivity has expanded remarkably since almost three decades ago, and has regained momentum over the last few years in the aftermath of the financial crisis. Regarding bank risk taking behavior, whose focus has been usually on its links to monetary policy, the interest has been comparatively minor but it has also increased exponentially more recently. This paper mixes these two stems of research. Specifically, we test if more inefficient banks are riskier when selecting their borrowers, when charging interests and pledge collateral, and if these links between inefficiency and risk change depending on the type of bank. We perform this analysis on the Spanish banking system, which has been severely affected by the burst of the housing bubble and has gone through deep restructuring. In order to test our hypotheses, we build a database with information on banks and savings banks, their borrowers (non-financial firms), and the links between them. On the methodology side, we also try to contribute to the literature by considering a novel profit frontier approach. Our results suggest that more inefficient banks are riskier when selecting their borrowers, and that his high risk-taking behavior is not offset by higher interest rates.