Abstract
A simultaneous equation framework is used to test hypotheses about the interrelationships among bank interest rate and credit risk-taking, capitalization, and operating efficiency. A positive effect of inefficiency on risk-taking was found and supports the moral hazard hypothesis that poor performers are more vulnerable to risk-taking than high performance banking organizations. A positive effect of inefficiency on the level of capital is attributable to regulatory pressure on underperforming institutions. At the same time, firms with more capital are found to operate more efficiently than less well-capitalized banking organizations. A U-shaped relationship is detected between inefficiency and loan growth, indicating that operating efficiency improves at a decreasing rate as loan growth rate increases. This supports the hypothesis that entrenched managers who pursue a growth objective to enhance their own wealth tend to operate inefficiently.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
Aigner, D., C. A. K. Lovell, and P. Schmidt. Formulation and Estimation of Stochastic Frontier Production Function Models. Journal of Econometrics 6 (1977), 21–37.
Benston, G. J. “Deposit Insurance and Bank Failure.” Federal Research Bank of Atlanta Economic Review 68 (March 1983), 4–17.
Benston, G. J., and M. Carhill. “The Failure and Survival of Thrifts: Evidence from the Southeast.” In G. Hubbard, ed., Financial Markets and Financial Crises, National Bureau of Economic Research Report. Chicago and London University of Chicago Press. 1991, pp. 305–384.
Berger, A. N., and R. DeYoung. “Problem Loans and Cost Efficiency in Commercial Banks.” Working paper, Office of the Comptroller of the Currency, 1995.
Berger, A. N., and D. B. Humphrey. “The Dominance of Inefficiencies over Scale and Product Mix Economies in Banking.” Journal of Monetary Economics 28 (1991), 117–148.
Berger, A. N., W. C. Hunter, and S. G. Timme. “The Efficiency of Financial Institutions: A Review and Preview of Research Past, Present, and Future.” Journal of Banking and Finance 17 (1993), 221–249.
Buser, S. A., A. H. Chen, and E. J. Kane. “Federal Deposit Insurance, Regulatory Policy, and Optimal Bank Capital.” Journal of Finance 36 (1981), 51–60.
Cebenoyan, A. S., E. S. Cooperman, C. A. Register, and S. C. Hudgins. The Relative Efficiency of Stock Versus Mutual S & Ls: A Stochastic Cost Frontier Approach. Journal of Financial Services Research 7 (June 1993), 151–170.
Duan, J. C., A. F. Moreau, and C. W. Sealey. “Fixed-rate Deposit Insurance and Risk-shifting Behavior at Commercial Banks.” Journal of Banking and Finance 16 (1992), 715–742.
Flannery, M. J., “Deposit Insurance Creates a Need for Bank Regulation.” Federal Reserve Bank of Philadelphia Business Review (Jan.-Feb.1982), 17–27.
Flannery, M. J. and S. M. Sorescu. “Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983–1991.” Journal of Finance 51 (September 1996) 1347–1377.
Furlong, F. “Changes in Bank Risk-taking.” Federal Reserve Bank of San Francisco Economic Review (Spring 1988) 45–55.
Galai, D., and R. Masulis. “The Option Pricing Model and the Risk Factor of Stock.” Journal of Financial Economics 3 (1976), 53–81.
Goodman, L. S., and A. M. Santomero. “Variable-rate Deposit Insurance: A Re-examination.” Journal of Banking and Finance 10 (1986), 203–218.
Gorton, G., and R. Rosen. “Corporate Control, Portfolio Choice, and the Decline of Banking.” Journal of Finance 50 (December 1995), 1377–1420.
Hughes, J. P., W. Lang, L. J. Mester, and C.-G. Moon. “Recovering Technologies that Account for Generalized Managerial Preferences: An application to Non-Risk-Neutral Banks.” Federal Reserve Bank of Philadelphia Working Paper.
Hughes, J., and C. G. Moon. “Measuring Bank Efficiency When Managers Trade Return for Reduced Risk.” Working paper, Department of Economics, Rutgers University.
Jensen, M. “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.” American Economic Review 76 (1986), 323–329.
Jondrow, J., C. A. K. Lovell, I. S. Materov, and P. Schmidt. On Estimation of Technical Inefficiency in the Stochastic Frontier Production Function Model. Journal of Econometrics 19 (1982), 233–238.
Kahane, Y. “Capital Adequacy and the Regulation of Financial Intermediaries.” Journal of Banking and Finance 1 (1977), 207–218.
Kane, E. J. “No Room for Weak Links in the Chain of Deposit-Insurance Reform.” Journal of Financial Services Research 1 (1987), 77–111.
Keeley, M. C. “Deposit Insurance, Risk, and Market Power in Banking.” American Economic Review 80 (December 1990), 1183–1200.
Kim, D., and A. Santomero. “Risk in Banking and Capital Regulation.” The Journal of Finance 43 (December 1988), 1219–1233.
Koehn, M., and A. Santomero. “Regulation of Bank Capital and Portfolio Risk.” Journal of Finance 35 (December 1980), 1235–1244.
Kwan, S. H. “Risk Taking Behavior of Banking Firms.” In: Proceedings of the 27th annual conference on bank structure and competition, Federal Reserve Bank of Chicago 1991, pp. 177–198.
Leibenstein, H. “Allocative Efficiency versus X-Efficiency.” American Economic Review 56 ( June 1966), 392–415.
Marcus, A. J. “Deregulation and Bank Financial Policy.” Journal of Banking and Finance 8 (1984), 557–565.
Marcus, A. J., and I. Shaked. “The Valuation of FDIC Deposit Insurance Using Option-Pricing Estimates.” Journal of Money, Credit, and Banking 16 (1984), 446–460.
Merton, R. C. “An Analytical Derivation of the Cost of Deposit Insurance and Loan Guarantees—An Application of Modern Option Pricing Theory.” Journal of Banking and Finance 1 (June 1977), 3–11.
Merton, R. C. “Financial Innovation and the Management and Regulation of Financial Institutions.” Journal of Banking and Finance 19 (June 1995), 461–481.
Mester, L. J. “Efficiency in the Savings and Loan Industry.” Journal of Banking and Finance 17 (April 1993), 267–286.
Pennacchi, G. C. “A Re-examination of the Over-(or Under) Pricing of Deposit Insurance.” Journal of Money, Credit, and Banking 19 (1987), 340–360.
Pyle, D. H. “Deregulation and Deposit Insurance Reform.” Federal Reserve Bank of San Francisco Economic Review (Spring 1984), 5–15.
Pyle, D. H. “Capital Regulation and Deposit Insurance.” Journal of Banking and Finance 10 (June 1986), 189–201.
Ronn, E., and A. Verma. “Pricing Risk-adjusted Deposit Insurance: An Option-based model.” Journal of Finance 41 (September 1986), 871–895.
Saunders, A., E. Strock, and N. G. Travlos. “Ownership Structure, Deregulation, and Bank Risk Taking.” Journal of Finance 45 (June 1990), 643–654.
Shrieves, R. E., and D. Dahl. “The Impact of Regulation on Bank Equity Infusions.” Journal of Banking and Finance 14 (December 1990), 1,209–1,228.
Stultz, R. “Managerial Discretion and Optimal Financing Policies.” Journal of Financial Economics 26 (July 1990), 3–27.
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Kwan, S., Eisenbeis, R.A. Bank Risk, Capitalization, and Operating Efficiency. Journal of Financial Services Research 12, 117–131 (1997). https://doi.org/10.1023/A:1007970618648
Issue Date:
DOI: https://doi.org/10.1023/A:1007970618648