Are Scale Economies in Banking Elusive or Illusive? Evidence Obtained by Incorporating Capital Structure and Risk-Taking into Models of Bank Production

FRB of Philadelphia Working Paper No. 00-04

46 Pages Posted: 21 Aug 2000

See all articles by Loretta J. Mester

Loretta J. Mester

Federal Reserve Banks - Federal Reserve Bank of Cleveland; University of Pennsylvania - The Wharton School

Joseph P. Hughes

Rutgers, The State University of New Jersey - Department of Economics

Choon-Geol Moon

Hanyang University

Date Written: May 2000

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 banks' 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 risk-taking 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 risk-taking are associated with smaller scale economies.

JEL Classification: D20, D21, G21, L23

Suggested Citation

Mester, Loretta J. and Hughes, Joseph P. and Moon, Choon-Geol, Are Scale Economies in Banking Elusive or Illusive? Evidence Obtained by Incorporating Capital Structure and Risk-Taking into Models of Bank Production (May 2000). FRB of Philadelphia Working Paper No. 00-04, Available at SSRN: https://ssrn.com/abstract=237812 or http://dx.doi.org/10.2139/ssrn.237812

Loretta J. Mester (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

University of Pennsylvania - The Wharton School

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Joseph P. Hughes

Rutgers, The State University of New Jersey - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

Choon-Geol Moon

Hanyang University ( email )

17 Haegdang-dong
Seongdong-ku
Seoul, 133-791
KOREA

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
622
Abstract Views
2,813
rank
49,863
PlumX Metrics