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Efficient Risk-Taking and Regulatory Covenant Enforcement in a Deregulated Banking Industry

  • Joseph P. Hughes

    ()

    (Rutgers University)

  • Choon-Geol Moon

    ()

    (Hanyang University)

  • Robert DeYoung

    ()

    (Federal Reserve Bank of Chicago)

Over the past two decades, a variety of deregulatory measures have increased competition in the U.S. commercial banking industry. While increased competitive rivalry creates incentives for banks to operate more efficiently, it also creates incentives for banks to take additional risk, potentially threatening the safety of banking and payments system. Commercial bank regulators have responded to this increased potential for risk-taking by formally linking bank supervision and regulation to the level of risks that banks take. In this study we analyze the safety and soundness (CAMEL) ratings assigned by bank supervisors to commercial banks, and search for evidence that these ratings reflect not just the level of risk taken by banks, but also the risk-taking efficiency of those banks (i.e., whether taking an increased level of risk generates higher expected returns). We find that supervisors do distinguish between the risk-taking of efficient banks and the risk-taking of inefficient banks, and that they permit efficient banks more latitude in their investment strategies than inefficient banks. However, we also find that supervisors maintain incentives for both efficient and inefficient banks to manage their risk more efficiently.

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Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 200007.

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Date of creation: 27 Jun 2000
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Handle: RePEc:rut:rutres:200007
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  1. Joseph P. Hughes & Loretta J. Mester, 1998. "Bank Capitalization And Cost: Evidence Of Scale Economies In Risk Management And Signaling," The Review of Economics and Statistics, MIT Press, vol. 80(2), pages 314-325, May.
  2. Jalal D. Akhavein & Allen N. Berger & David B. Humphrey, 1997. "The effects of megamergers on efficiency and prices: evidence from a bank profit function," Finance and Economics Discussion Series 1997-9, Board of Governors of the Federal Reserve System (U.S.).
  3. Joseph P. Hughes & William W. Lang & Loretta J. Mester, 1995. "Recovering technologies that account for generalized managerial preferences: an application to non-risk neutral banks," Working Papers 95-8, Federal Reserve Bank of Philadelphia.
  4. Black, Fischer, 1975. "Bank funds management in an efficient market," Journal of Financial Economics, Elsevier, vol. 2(4), pages 323-339, December.
  5. Joseph P. Hughes & William W. Lang & Loretta J. Mester, 1998. "The dollars and sense of bank consolidation," Working Papers 98-10, Federal Reserve Bank of Philadelphia.
  6. Deborah J. Lucas & Robert L. McDonald, 1992. "Bank Financing and Investment Decisions with Asymmetric Information about Loan Quality," RAND Journal of Economics, The RAND Corporation, vol. 23(1), pages 86-105, Spring.
  7. Santomero, Anthony M, 1984. "Modeling the Banking Firm: A Survey," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 576-602, November.
  8. Simon H. Kwan & Robert A. Eisenbeis, 1995. "An analysis of inefficiencies in banking: a stochastic cost frontier approach," Proceedings 465, Federal Reserve Bank of Chicago.
  9. Rebel Cole & Jeffery Gunther, 1998. "Predicting Bank Failures: A Comparison of On- and Off-Site Monitoring Systems," Journal of Financial Services Research, Springer, vol. 13(2), pages 103-117, April.
  10. Allen N. Berger & Loretta J. Mester, 1997. "Inside the black box: what explains differences in the efficiencies of financial institutions?," Working Papers 97-1, Federal Reserve Bank of Philadelphia.
  11. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
  12. R. Alton Gilbert, 1993. "Implications of annual examinations for the Bank Insurance Fund," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 35-52.
  13. Deaton, Angus S & Muellbauer, John, 1980. "An Almost Ideal Demand System," American Economic Review, American Economic Association, vol. 70(3), pages 312-26, June.
  14. Rebecca S. Demsetz & Marc R. Saidenberg & Philip E. Strahan, 1996. "Banks with something to lose: the disciplinary role of franchise value," Economic Policy Review, Federal Reserve Bank of New York, issue Oct, pages 1-14.
  15. Hughes, Joseph P, et al, 1996. "Efficient Banking under Interstate Branching," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 1045-71, November.
  16. DeYoung, Robert & Hasan, Iftekhar & Kirchhoff, Bruce, 1998. "The Impact of Out-of-State Entry on the Cost Efficiency of Local Commercial Banks," Journal of Economics and Business, Elsevier, vol. 50(2), pages 191-203, March.
  17. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
  18. Berger, Allen N & Davies, Sally M & Flannery, Mark J, 2000. "Comparing Market and Supervisory Assessments of Bank Performance: Who Knows What When?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 641-67, August.
  19. 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.
  20. Fama, Eugene F., 1985. "What's different about banks?," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 29-39, January.
  21. Robert DeYoung & Mark J. Flannery & William W. Lang & Sorin M. Sorescu, 1998. "The informational advantage of specialized monitors: the case of bank examiners," Working Paper Series WP-98-4, Federal Reserve Bank of Chicago.
  22. James, Christopher, 1987. "Some evidence on the uniqueness of bank loans," Journal of Financial Economics, Elsevier, vol. 19(2), pages 217-235, December.
  23. Katerina Simons & Stephen Cross, 1991. "Do capital markets predict problems in large commercial banks?," New England Economic Review, Federal Reserve Bank of Boston, issue May, pages 51-56.
  24. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 391-405, December.
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