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Measuring Agency Costs and the Value of Investment Opportunities of U.S. Bank Holding Companies with Stochastic Frontier Estimation

Listed author(s):
  • Joseph P. Hughes

    ()

    (Rutgers University)

  • Loretta J. Mester

    ()

    (Federal Reserve Bank of Cleveland)

  • Choon-Geol Moon

    ()

    (Hanyang University)

By eliminating the influence of statistical noise, stochastic frontier techniques permit the estimation of the best-practice value of a firm’s investment opportunities and the magnitude of a firm’s systematic failure to achieve its best-practice market value – a gauge of the magnitude of agency costs. These frontiers are estimated from the performance of all firms in the industry and, thus, capture best-practice performance that is, unlike Tobin’s q ratio, independent of the managerial decisions of any particular firm. Using the frontier measure of performance applied to 2007 data on top-tier, publicly traded U. S. bank holding companies, we obtain evidence on market discipline: we find that higher managerial ownership at most banks tends to align the interests of insiders with those of outside owners and to be associated with improved financial performance; at most banks, higher blockholder ownership is associated with improved financial performance obtained from blockholders’ monitoring; and, at most banks, higher product-market concentration is associated with poorer financial performance and the so-called managerial quiet life. Using the frontier measure of investment opportunities, we find evidence that banks with relatively higher-valued investment opportunities achieve less of their potential market value, while banks with lower-valued opportunities achieve more of their potential value. In spite of their lower-valued opportunities, these banks, on average, achieve the same Tobin’s q ratio and, thus, appear better able to exploit their less valuable investment opportunities. Our results suggest that higher-valued opportunities may reduce managers’ performance pressure and provide a stronger incentive to consume agency goods.

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Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 201605.

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Length: 36 pages
Date of creation: 24 Jun 2016
Publication status: Published Posted at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2800299
Handle: RePEc:rut:rutres:201605
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  1. Hughes, Joseph P. & Mester, Loretta J. & Moon, Choon-Geol, 2001. "Are scale economies in banking elusive or illusive?: Evidence obtained by incorporating capital structure and risk-taking into models of bank production," Journal of Banking & Finance, Elsevier, vol. 25(12), pages 2169-2208, December.
  2. Clifford G. Holderness, 2003. "A survey of blockholders and corporate control," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 51-64.
  3. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  4. Michel A. Habib & Alexander Ljungqvist, 2005. "Firm Value and Managerial Incentives: A Stochastic Frontier Approach," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2053-2094, November.
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  6. Allen N. Berger & Timothy H. Hannan, 1998. "The Efficiency Cost Of Market Power In The Banking Industry: A Test Of The "Quiet Life" And Related Hypotheses," The Review of Economics and Statistics, MIT Press, vol. 80(3), pages 454-465, August.
  7. James S. Ang & Rebel A. Cole & James Wuh Lin, 2000. "Agency Costs and Ownership Structure," Journal of Finance, American Finance Association, vol. 55(1), pages 81-106, 02.
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  10. Yermack, David, 1996. "Higher market valuation of companies with a small board of directors," Journal of Financial Economics, Elsevier, vol. 40(2), pages 185-211, February.
  11. Hughes, Joseph P. & Lang, William W. & Mester, Loretta J. & Moon, Choon-Geol, 1999. "The dollars and sense of bank consolidation," Journal of Banking & Finance, Elsevier, vol. 23(2-4), pages 291-324, February.
  12. David F. Hendry, 2013. "Econometric Modelling: The ‘Consumption Function’ In Retrospect," Scottish Journal of Political Economy, Scottish Economic Society, vol. 60(5), pages 495-522, November.
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  14. Morck, Randall & Shleifer, Andrei & Vishny, Robert W., 1988. "Management ownership and market valuation : An empirical analysis," Journal of Financial Economics, Elsevier, vol. 20(1-2), pages 293-315, January.
  15. Bauer, Paul W., 1990. "Recent developments in the econometric estimation of frontiers," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 39-56.
  16. DeYoung, Robert & Spong, Kenneth & Sullivan, Richard J., 2001. "Who's minding the store? Motivating and monitoring hired managers at small, closely held commercial banks," Journal of Banking & Finance, Elsevier, vol. 25(7), pages 1209-1243, July.
  17. Yermack, David, 2006. "Flights of fancy: Corporate jets, CEO perquisites, and inferior shareholder returns," Journal of Financial Economics, Elsevier, vol. 80(1), pages 211-242, April.
  18. McConnell, John J. & Servaes, Henri, 1995. "Equity ownership and the two faces of debt," Journal of Financial Economics, Elsevier, vol. 39(1), pages 131-157, September.
  19. Julia Campos & Neil R. Ericsson & David F. Hendry, 2005. "General-to-specific modeling: an overview and selected bibliography," International Finance Discussion Papers 838, Board of Governors of the Federal Reserve System (U.S.).
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