Bank Risk, Capitalization and Inefficiency

This paper employs a simultaneous equations approach to measuring the tradeoffs between risk, capitalization and measured inefficiencies in a sample of 254 large bank holding companies over the period 1986 through 1991. The results confirm the belief that these three variables are simultaneously determined. Furthermore, asymmetries were identified in the relationship between risk and inefficiencies. Support was found in the asset risk equations for the hypothesis that less efficient institutions took on more risk to off set this inefficiency, thereby transferring risk to the deposit insurance finds. Similarly, less efficient institutions tended to be less well capitalized, a result that may also be associated with differences in management quality. Finally, evidence is provided that risk averse managers tend to expend real resources to reduce asset risk, which makes them appear to be inefficient, when compared to efficiency measures derived under the assumption of risk neutrality. This paper was presented at the Financial Institutions Center's October 1996 conference on "