Do Banks Have an Edge?

Abstract

Overall, no! We show that the level and time series variation in cash flows for most bank activities are well matched by capital market portfolios with similar interest rate and credit risk to what banks report to hold. Ignoring operating expenses, bank loans earn high returns and transaction deposits pay low interest rates, consistent with these activities having a potential edge. The edge among these activities is insufficient to cover the large operating expenses of banks. A large portion of the aggregate US banking sector closely resembles a tax inefficient passive mutual fund. The residual risks of bank activities, presumably generated by the unique components of the bank business model, generate systematic risks that are uncompensated.

Keywords: Banking, Efficiency, Bank Deposits, Bank Funding Advantage, Leverage, Maturity Transformation, Replicating Portfolio

JEL Classification: G12, G21, G32