| 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 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 vs.
expected return, which, in turn, affects bank performance. Banks have an
incentive to reduce risk to protect the valuable charter 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 the performance of banks
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 risktaking. ; 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 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. ; Prepared for the Oxford
Handbook of Banking, 2nd edition |