The Performance of Financial Institutions: Modeling, Evidence, and Some Policy Implications

Oxford Handbook of Banking, 3rd edition, Forthcoming

44 Pages Posted: 5 Oct 2018

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 Bank of Cleveland; University of Pennsylvania - The Wharton School

Date Written: June 25, 2018

Abstract

The unique capital structure of commercial banking – funding production with demandable debt that participates in the economy’s payments system – affects various aspects of banking. It shapes commercial banks’ comparative advantage in providing financial products and services to informationally opaque customers, their ability to diversify credit and liquidity risk, and how they are regulated, including the need to obtain a charter to operate and explicit and implicit federal guarantees of bank liabilities to reduce the probability of bank runs. These aspects of banking affect a bank’s choice of risk versus expected return, which, in turn, affects bank performance. Banks have an incentive to reduce risk to protect their valuable charters from episodes of financial distress, and they also have an incentive to increase risk to exploit the cost-of-funds subsidy of mispriced deposit insurance. These are contrasting incentives tied to bank size. Measuring bank performance and its relationship to size requires untangling cost and profit from decisions about risk versus expected return because both cost and profit are functions of endogenous risk-taking. 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. One application explains how better diversification available at a larger scale of operations generates scale economies that are obscured by higher levels of risk-taking. Studies of commercial banking cost that ignore endogenous risk-taking find little evidence of scale economies at the largest banks, while those that control for this risk-taking find large scale economies at the largest banks – evidence with important implications for regulation.

Keywords: Bank, Efficiency, Risk, Cost, Profit, Scale Economies, X-Inefficiency

JEL Classification: D20, D21, G21, L23

Suggested Citation

Hughes, Joseph P. and Mester, Loretta J., The Performance of Financial Institutions: Modeling, Evidence, and Some Policy Implications (June 25, 2018). Oxford Handbook of Banking, 3rd edition, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3247813

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 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

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