My research has focused on incorporating endogenous risk-taking into the analysis of banking production, which uncovers evidence of large economies of scale across banks of all sizes with the largest economies at the largest financial institutions - a result that suggests proposed restrictions to limit the size of financial institutions, if effective, may put large banks at a competitive disadvantage in global markets where competitors are not similarly constrained. Moreover, size restrictions may not be effective since they work against market forces and create incentives for firms to avoid them. Avoiding the restrictions could thereby push risk-taking outside of the more regulated financial sector without necessarily reducing systemic risk. I have also examined the role of the too-big-to-fail policy in contributing to measured scale economies at the largest financial institutions.
In addition, I have applied stochastic frontier estimation, frequently used in production economics, to measure agency problems and financial performance. Stochastic frontiers can estimate potential market value and the systematic failure to achieve it - market-value inefficiency, which I have applied to financial institutions to evaluate the efficiency of their investment strategies and capital structure.
I have been a Visiting Scholar at the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Philadelphia, the Federal Reserve Bank of New York, and the Office of the Comptroller of the Currency.
My research has been published in such journals as the American Economic Review, the Journal of Economic Theory, the Journal of Money, Credit, and Banking, and the Review of Economics and Statistics, the Journal of Financial Intermediation, the Journal of Banking and Finance, and the Journal of Financial Services Research.
Bad Is a Bad Loan? Distinguishing Inherent Credit Risk
from Inefficient Lending (Does the Capital Market
Price This Difference?) with Choon-Geol Moon
(Hanyang University), 2017
We develop a novel technique to decompose banks’ ratio of nonperforming loans to total loans into two components: first, a minimum ratio that represents best-practice lending given the volume and composition of a bank’s loans, the average contractual interest rate charged on these loans, and market conditions such as the average GDP growth rate and market concentration; and, second, a ratio, the difference between the bank’s observed ratio of nonperforming loans, adjusted for statistical noise, and the best-practice minimum ratio, that represents the bank’s proficiency at loan making. The best-practice ratio of nonperforming loans, the ratio a bank would experience if it were fully efficient at credit-risk evaluation and loan monitoring, represents the inherent credit risk of the loan portfolio and is estimated by stochastic frontier techniques.
We apply the technique to 2013 data on top-tier U.S. bank holding companies. We divide them into five size groups. The largest banks with consolidated assets exceeding $250 billion experience the highest ratio of nonperformance among the five groups. Moreover, the inherent credit risk of their lending is the highest among the five groups. On the other hand, their inefficiency at lending is one of the lowest among the five. Thus, the high ratio of nonperformance of the largest financial institutions appears to result from lending to riskier borrowers, not inefficiency at lending. Small community banks under $1 billion also exhibit higher inherent credit risk than all other size groups except the largest banks. In contrast, their loan-making inefficiency is highest among the five size groups.
Restricting the sample to publicly traded bank holding companies and gauging financial performance by market value, we find the ratio of nonperforming loans to total loans is on average negatively related to financial performance except at the largest banks. When nonperformance is decomposed into inherent credit risk and lending inefficiency, taking more inherent credit risk enhances market value at many more large banks while lending inefficiency is negatively related to market value at all banks. Market discipline appears to reward riskier lending at large banks and discourage lending inefficiency at all banks."Market Discipline Working For and Against Financial Stability: The Two Faces of Equity Capital in U. S. Commercial Banking" with Loretta J. Mester (Federal Reserve Bank of Cleveland) and Choon-Geol Moon (Hanyang University), 2016 (pdf)
second Basel Capital Accord points to market
discipline as a tool to reinforce capital
standards and supervision in promoting bank
safety and soundness. The Bank
for International Settlements contends that
market discipline imposes strong incentives on
banks to operate in a safe and efficient manner
– in particular, to maintain an adequate capital
base to absorb potential losses from their risk
"Capital Regulation: Less Really Can Be More When Incentives Are Socially Aligned," Comments on Richard J. Herring, "The Evolving Complexity of Capital Regulation" presented at a conference on "The Interplay of Financial Regulations, Resilience, and Growth" sponsored by the Federal Reserve Bank of Philadelphia and the Wharton School. (pdf)
Capital regulation has become increasingly complex as the largest financial institutions arbitrage differences in requirements across financial products to increase expected return for any given amount of regulatory capital, as financial regulators amend regulations to reduce arbitrage opportunities, and as financial institutions innovate to escape revised regulations -- a regulatory dialectic. This increasing complexity makes monitoring bank risk-taking by markets and regulators more difficult and does not necessarily improve the risk sensitivity of measures of capital adequacy. Explaining the arbitrage incentive of some banks, several studies have found evidence of dichotomous capital strategies for maximizing value: a relatively low-risk strategy that minimizes the potential for financial distress to protect valuable investment opportunities and a relatively high-risk strategy that, in the absence distress costs due to valuable investment opportunities, "reaches for yield" to exploit the option value of implicit and explicit deposit insurance. In the latter case, market discipline rewards risk-taking and, in doing so, tends to undermine financial stability. The largest financial institutions, belonging to the latter category, maximize value by arbitraging capital regulations to "reach for yield." This incentive can be curtailed by imposing "pre-financial-distress" costs that make less risky capital strategies optimal for large institutions. Such potential costs can be created by requiring institutions to issue contingent convertible debt (COCOs) that converts to equity to recapitalize the institution well before insolvency. The conversion rate significantly dilutes existing shareholders and makes issuing new equity a better than than conversion. The trigger for conversion is a particular market-value capital ratio. Thus, the threat of conversion tends to reverse risk-taking incentives -- in particular, the incentive to increase financial leverage and to arbitrage differences in capital requirement across investments.
"Is Bigger Necessarily Better in Community Banking" with Julapa Jagtiani (Federal Reserve Bank of Philadelphia), and Loretta J. Mester (Federal Reserve Bank of Cleveland), 2016 (pdf)
We investigate the relative performance of publicly traded community banks (those with assets less than $10 billion) versus larger banks (those with assets between $10 billion and $50 billion). A body of research has shown that community banks have potential advantages in relationship lending compared with large banks, although newer research suggests that these advantages may be shrinking. In addition, the burdens placed on community banks by the regulatory reforms mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act and the need to increase investment in technology, both of which have fixed-cost components, may have disproportionately raised community banks' costs. We find that, on average, large banks financially outperform community banks as a group and are more efficient at credit-risk assessment and monitoring. But within the community bank segment, larger community banks outperform smaller community banks. Our findings, taken as a whole, suggest that there are incentives for small banks to grow larger to exploit scale economies and to achieve other scale-related benefits in terms of credit-risk monitoring. In addition, we find that small business lending is an important factor in the better performance of large community banks compared with small community banks. Thus, concern that small business lending would be adversely affected if small community banks find it beneficial to increase their scale is not supported by our results.
Costs and the Value of Investment Opportunities of U.
S. Bank Holding Companies with Stochastic Frontier
Estimation," with Loretta J. Mester (Federal
Reserve Bank of Cleveland) and Choon-Geol Moon (Hanyang
University), 2015 (pdf)
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
"Measuring the Performance of Banks:
Theory, Practice, Evidence, and Some Policy
Implications," with Loretta J. Mester, in The Oxford
Handbook of Banking, second edition, edited by
Allen N. Berger, Philip Molyneux, and John Wilson,
Oxford University Press, 2015, 247-270. (pdf)
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 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 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.
"Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function," with Loretta J. Mester, Journal of Financial Intermediation, 2013, 22:4, 559-585. (pdf)Abstract
The Great Recession focused attention on large financial institutions and systemic risk. We investigate whether large size provides any cost advantages to the economy and, if so, whether these cost advantages are due to technological scale economies or too-big-to-fail subsidies. Estimating scale economies is made more complex by risk-taking. Better diversification resulting from larger scale generates scale economies but also incentives to take more risk. When this additional risk-taking adds to cost, it can obscure the underlying scale economies and engender misleading econometric estimates of them. Using data pre- and post-crisis, we estimate scale economies using two production models. The standard model ignores endogenous risk-taking and finds little evidence of scale economies. The model accounting for managerial risk preferences and endogenous risk-taking finds large scale economies, which are not driven by too-big-to-fail considerations. We evaluate the costs and competitive implications of breaking up the largest banks into smaller banks.
on Market Discipline and Governance of Financial
Institutions for Those in a State of Shocked
Disbelief," with Loretta J. Mester, for Efficiency and
Productivity Growth in the Financial Services Industry,
edited by Fotios Pasiouras, pp. 19-47, John Wiley and
Sons, 2013. (pdf)