Measuring Agency Costs and the Value of Investment Opportunities of U. S. Bank Holding Companies with Stochastic Frontier Estimation

Research Handbook on Competition in Banking and Finance, eds. Jacob A. Bikker and Laura Spierdijk, Edward Elgar Publishing, Forthcoming

36 Pages Posted: 30 Jun 2016

See all articles by Joseph P. Hughes

Joseph P. Hughes

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

Loretta J. Mester

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

Choon-Geol Moon

Hanyang University

Date Written: May 1, 2016

Abstract

By eliminating the influence of statistical noise, stochastic frontier techniques permit the estimation of the best-practice value of a firm’s investment opportunities and the magnitude of a firm’s systematic failure to achieve its best-practice market value – a gauge of the magnitude of agency costs. These frontiers are estimated from the performance of all firms in the industry and, thus, capture best-practice performance that is, unlike Tobin’s q ratio, independent of the managerial decisions of any particular firm.

Using the frontier measure of performance applied to 2007 data on top-tier, publicly traded U. S. bank holding companies, we obtain evidence on market discipline: we find that higher managerial ownership at most banks tends to align the interests of insiders with those of outside owners and to be associated with improved financial performance; at most banks, higher blockholder ownership is associated with improved financial performance obtained from blockholders’ monitoring; and, at most banks, higher product-market concentration is associated with poorer financial performance and the so-called managerial quiet life.

Using the frontier measure of investment opportunities, we find evidence that banks with relatively higher-valued investment opportunities achieve less of their potential market value, while banks with lower-valued opportunities achieve more of their potential value. In spite of their lower-valued opportunities, these banks, on average, achieve the same Tobin’s q ratio and, thus, appear better able to exploit their less valuable investment opportunities. Our results suggest that higher-valued opportunities may reduce managers’ performance pressure and provide a stronger incentive to consume agency goods.

Keywords: banking, efficiency, ownership structure, competition

JEL Classification: C58, G21, G28

Suggested Citation

Hughes, Joseph P. and Mester, Loretta J. and Moon, Choon-Geol, Measuring Agency Costs and the Value of Investment Opportunities of U. S. Bank Holding Companies with Stochastic Frontier Estimation (May 1, 2016). Research Handbook on Competition in Banking and Finance, eds. Jacob A. Bikker and Laura Spierdijk, Edward Elgar Publishing, Forthcoming , Available at SSRN: https://ssrn.com/abstract=2800299 or http://dx.doi.org/10.2139/ssrn.2800299

Joseph P. Hughes (Contact Author)

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

75 Hamilton Street
New Brunswick, NJ 08901
United States

Loretta J. Mester

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

Choon-Geol Moon

Hanyang University ( email )

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

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