ARE SCALE ECONOMIES IN BANKING ELUSIVE OR ILLUSIVE? EVIDENCE OBTAINED BY INCORPORATING CAPITAL STRUCTURE AND RISK-TAKING INTO MODELS OF BANK PRODUCTION

Abstract

This paper explores how to incorporate banks' capital structure and risk-taking into models of production.In doing so, the paper bridges the gulf between (1) the banking literature that studies moral hazard effects of bank regulation without considering the underlying microeconomics of production and(2) the literature that uses dual profit and cost functions to study the microeconomics of bank production without explicitly considering how banks' production decisions influence their riskiness.Various production models that differ in how they account for capital structure and in the objectives they impute to bank managers-cost minimization versus value maximization-are estimated using U.S. data on highest-level bank holding companies.Modeling the bank's objective as value maximization conveniently incorporates both market-priced risk and expected cash flow into managers' ranking and choice of production plans.Estimated scale economies are found to depend critically on how banks' capital structure and risktaking is modeled.In particular, when equity capital, in addition to debt, is included in the production model and cost is computed from the value-maximizing expansion path rather than the cost-minimizing path, banks are found to have large scale economies that increase with size.Moreover, better diversification is associated with larger scale economies while increased risk-taking and inefficient risktaking are associated with smaller scale economies.For a review of the scale economies literature, see Hughes (1999a). 1 It is possible that a bank taking on more risk engages in less credit assessment and less monitoring, in 2 which case costs need not rise.In this case, the effect of taking on more risk would not offset the diversification effect and so not obscure potential scale economies.See Bhattacharya and Thakor (1993) for a review of this literature.3 Calomiris and Kahn (1991) and Flannery (1994) analyze the incentive advantage of demandable debt, and 4 Mester, Nakamura, and Renault (1998) offer empirical evidence of the informational advantage of banks over nonbank lenders.The means are calculated as the mean estimate of scale economies calculated at each observation rather than the scale economies evaluated at the mean of the data.* Significantly different from zero at the 1 percent level.† Significantly different from one at the 5 percent level.‡ Significantly different from one at the 10 percent level.

Cite this work

No public copy is stored for this record, so only the metadata is cited.

Stored only when both papers are in the corpus — 81 citations exist upstream.

Papers that cite the same references — the relational fallback while embeddings are still backfilling.