Loretta J. Mester

Inside the Black Box: What Explains Differences in the Efficiencies of Financial Institutions?

Over the past several years, substantial research effort has gone into measuring the efficiency of financial institutions. Many studies have found that inefficiencies are quite huge, on the order of 20% or more of total banking industry costs and about half of the industry?s potential profits. There is no consensus on the sources of the differences in measured efficiency. This paper examines several possible sources, including differences in efficiency concept, measurement method, and a number of bank, market, and regulatory characteristics. We review the existing literature and provide new evidence using data on U.S. banks over the period 1990-95.

A study of bank efficiency taking into account risk-preferences

Abstract I use the stochastic cost frontier approach to investigate efficiency of banks operating in the Third Federal Reserve District, accounting for the quality and riskiness of bank output. In addition to the mean and mode of the conditional distribution of the one-sided error term, I calculate confidence intervals for the inefficiency measures based on the conditional distribution. The results indicate that Third District banks are operating at cost-efficient output levels and product mixes, but are not efficiently using their inputs. The second part of the article relates the inefficiency measures to several correlates.

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.

Efficiency in the savings and loan industry

Abstract The stochastic econometric cost frontier approach is modified to investigate efficiency in mutual and stock S & Ls using 1991 data on U.S. S & Ls. This methodology allows both the cost frontier and error structures to differ between S & Ls of these two ownership forms. A likelihood ratio test indicates that the data support this unrestricted model, which implies efficient mutual and stock S & Ls use different production technologies. Various measures of inefficiency show that on average stock S & Ls are less efficient than mutual S & Ls. The second part of the article relates the inefficiency measures to several correlates.

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.

On the Profitability and Cost of Relationship Lending

We provide evidence on the costs and profitability of relationship lending by banks. We derive bank-specific measures of loan rate smoothing for small business borrowers in response to exogenous shocks to their credit risk and to interest rates, and then estimate cost and profit functions to examine how smoothing affects bank costs and profits. Our results suggests that, in general, loan rate smoothing in response to a credit risk shock is not part of an optimal long-term contract between a bank and its borrower, while loan rate smoothing in response to an interest rate shock is.

Measuring efficiency at U.S. banks: Accounting for heterogeneity is important

Estimates of bank cost efficiency can be biased if bank heterogeneity is ignored. The author compares X-inefficiency measures derived from a model that constrains the cost frontier to be the same for all banks in the nation and a model that allows the cost functions and error terms to differ across Federal Reserve Districts. The author finds that the data reject the single cost function model; X-inefficiency measures based on the single cost function model are, on average, higher than those based on the separate cost functions model; the distributions of the one-sided error terms on which X-inefficiency measures are based are wider for the single cost function model than for the separate cost functions models; and the ranking of Districts by the level of X-inefficiency differs in the two models. The differences in efficiency across Districts reflect more than just differences in bank size, geographic size, or population of the Districts. These results suggest that it is important when studying X-inefficiency to account for differences across the markets in which banks are operating and, more generally, that since X-inefficiency is, by construction, a residual, it will be particularly sensitive to omissions in the basic model.

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.

Agency costs among savings and loans

Abstract When the managers of a firm are not its owners, agency problems result if managers take actions that maximize their own utility rather than the value of the firm. This paper investigates the existence of agency problems in mutual savings and loans. Using a more general approach than in previous studies, I show that mutual S&Ls were operating with an inefficient output mix while stock S&Ls were not, suggesting an agency problem among mutual S&Ls. The results cast doubt on a common argument that mutuals convert to stock S&Ls to capture economies of scale.