Joseph P. Hughes

A quality and risk-adjusted cost function for banks: evidence on the " too-big-to-fail" doctrine

We estimate a multiproduct cost function model incorporating measures of bank output quality and the probability of failure. We model a banks uninsured deposit price as an endogenous variable depending on the banks output level, output quality, financial capital level, and risk measures. Accounting for these aspects in the cost model significantly affects measures of scale and scope economies. We find evidence that the “too-big-to-fail” doctrine significantly affects the price a bank pays for its uninsured deposits. For large banks, an increase in size, holding default risk and asset quality constant, significantly lowers the uninsured deposit price.

Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling

We amend the standard cost model to account for the role of financial capital in banking. The cost function is conditioned on the level of capital, but we model the demand for financial capital so that it can serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. Scale economies are then computed without assuming that the bank chooses a level of capitalization that minimizes cost. We find evidence of substantial scale economies and that bank managers are risk averse and use the level of financial capital to signal the level of risk.

Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function

Earlier studies found little evidence of scale economies at large banks; later studies using data from the 1990s uncovered such evidence, providing a rationale for very large banks seen worldwide. Using more recent data, we estimate scale economies using two production models. The standard risk-neutral model finds little evidence of scale economies. The model using more general risk preferences and endogenous risk-taking finds large scale economies. We show that these economies are not driven by too-big-to-fail considerations. We evaluate the cost implications of breaking up the largest banks into banks of smaller size.

Efficiency in Banking: Theory, Practice, and Evidence

Great strides have been made in the theory of bank technology in terms of explaining banks’ comparative advantage in producing informationally intensive assets and financial services and in diversifying or offsetting a variety of risks. Great strides have also been made in explaining sub-par managerial performance in terms of agency theory and in applying these theories to analyze the particular environment of banking. In recent years, the empirical modeling of bank technology and the measurement of bank performance have begun to incorporate these theoretical developments and yield interesting insights that reflect the unique nature and role of banking in modern economies. This chapter gives an overview of two general empirical approaches to measuring bank performance and discusses some of the applications of these approaches found in the literature.

Do Bankers Sacrifice Value to Build Empires? Managerial Incentives, Industry Consolidation, and Financial Performance

Bank consolidation is a global phenomenon that may enhance stakeholders value if managers do not sacrifice value to build empires. We find strong evidence of managerial entrenchment at U.S. bank holding companies that have higher levels of managerial ownership, better growth opportunities, poorer financial performance, and smaller asset size. At banks without entrenched management, both asset acquisitions and sales are associated with improved performance. At banks with entrenched management, sales are related to smaller improvements while acquisitions are associated with worse performance. Consistent with scale economies, an increase in assets by internal growth is associated with better performance at most banks.

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

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.

Measuring the performance of banks: theory, practice, evidence, and some policy implications

The unique capital structure of commercial banking – funding production with demandable debt that participates in the economy’s payments system – affects various aspects of banking. It shapes banks’ comparative advantage in providing financial products and services to informationally opaque customers, their ability to diversify credit and liquidity risk, and how they are regulated, including the need to obtain a charter to operate and explicit and implicit federal guarantees of bank liabilities to reduce the probability of bank runs. These aspects of banking affect a bank’s choice of risk vs. expected return, which, in turn, affects bank performance. Banks have an incentive to reduce risk to protect the valuable charter from episodes of financial distress and they also have an incentive to increase risk to exploit the cost-of-funds subsidy of mispriced deposit insurance. These are contrasting incentives tied to bank size. Measuring the performance of banks and its relationship to size requires untangling cost and profit from decisions about risk versus expected-return because both cost and profit are functions of endogenous risk-taking. This chapter gives an overview of two general empirical approaches to measuring bank performance and discusses some of the applications of these approaches found in the literature. One application explains how better diversification available at a larger scale of operations generates scale economies that are obscured by higher levels of risk-taking. Studies of banking cost that ignore endogenous risk-taking find little evidence of scale economies at the largest banks while those that control for this risk-taking find large scale economies at the largest banks – evidence with important implications for regulation.

A Primer on market discipline and governance of financial institutions for those in a state of shocked disbelief

Self regulation encouraged by market discipline constitutes a key component of Basel II’s third pillar. But high-risk investment strategies may maximize the expected value of some banks. In these cases, does market discipline encourage risk-taking that undermines bank stability in economic downturns? This paper reviews the literature on corporate control in banking. It reviews the techniques for assessing bank performance, interaction between regulation and the federal safety net with market discipline on risk-taking incentives and stability, and sources of market discipline, including ownership structure, capital market discipline, product market competition, labor market competition, boards of directors, and compensation.

Profit-maximizing input demand under rate-of-return regulation : Pathological substitution and output effects

Abstract Cost-minimizing and profit-maximizing input demand for the firm subject to rate-of-return regulation are examined. Unregulated cost and profit functions which are conditional on the rate of employment of the rate-base input are shown to be identically equal to the regulated cost and profit functions, evaluated at the regulated optimum. Shephards lemma and Hotellings lemma applied to the conditional cost and profit functions, evaluated at the regulated optimum, yield the regulated input demands. For both the profit-maximizing and cost-minimizing demands, own-price effects are not necessarily negative nor are the cross-price effects in general equal. Moreover, the profit-maximizing output effect is not necessarily negative. Various decompositions of input demand are explored to explain these conclusions.

Factor Demand in the Multi-Product Firm

In this paper the comparative-static behavior of the multi-product firm is examined and shown to be sharply different in certain circumstances from that of the single-product firm in received theory. The theory of the multiproduct firm has been largely neglected, probably because most formulations of its problem have led to the conclusion that, aside from the problem of interdependent demand and joint production, it is a straightforward extension of the theory of the single-product firm (e.g., [3, 319-32]). Ralph W. Pfouts [7] has shown, though, that if the multi-product firm is able to switch some of its fixed factors from one product line to another, then when one or more of the fixed factors is fully employed, the firm can no longer be viewed as a collection of single-product firms. It is confronted with the unique problem of rationing some of its fixed factors among the many product lines. This distinctive class of quasi-variable factors leads, not only to complications of the usual multi-product firms equilibrium conditions for cost minimization [7] and for profit maximization [6], but also to somewhat surprising comparativestatic properties of the equilibria.1 In particular, for a given vector of output levels, the cost-minimizing demand for a factor of production summed over all product lines will be inversely related to the factor price; however, the demand for the factor in an individual product line may not be. That is to say, the direct substitution effect of the change in price may not be negative for a factor in a single product line, although summed over all lines, it will be. Moreover, while the effect on the cost-minimizing demand for the ith factor of a change in the price of the jth factor equals in aggregate the effect on the cost-minimizing demand for the jth factor of a change in the price of the ith factor, such is not