Showing papers in "Journal of Banking and Finance in 1996"

A study of bank efficiency taking into account risk-preferences

Abstract: I use the stochastic cost frontier approach to investigate efficiency of banks operating in the Third Federal Reserve District, accounting for the quality and riskiness of bank output. In addition to the mean and mode of the conditional distribution of the one-sided error term, I calculate confidence intervals for the inefficiency measures based on the conditional distribution. The results indicate that Third District banks are operating at cost-efficient output levels and product mixes, but are not efficiently using their inputs. The second part of the article relates the inefficiency measures to several correlates.

The technical efficiency of large bank production

Abstract: Significant difficulties in commercial banking in the late 1980s raise questions about bank performance and efficiency. With the use of data envelopment analysis (DEA), we consider the relative technical efficiency of 201 large banks from 1984 to 1990. Bank technical inefficiency averages just over 5 percent, much lower than found in existing estimates. Larger and more profitable banks have higher levels of technical efficiency. At the same time, however, larger banks are more likely to operate under decreasing returns to scale.

Operational efficiency in banking: An international comparison

Abstract: In this paper, we estimate a global cost function for international banks to test for both input and output inefficiencies. Our results for 1988–1992 suggest that for banks in 15 countries, the prevalence of input X-inefficiencies far outweighs that of output inefficiencies (as measured by economies of scale and scope). Moreover, our results suggests that the distribution-free model overestimates the magnitude of X-inefficiencies relative to the stochastic cost frontier approach. Large banks in separated banking countries (that prohibit the functional integration of commercial and investment banking) had the largest measure of input inefficiency amounting to 27.5 percent of total costs as well as significant levels of diseconomies of scale. All other banks have X-inefficiency levels ranging in the area of fifteen percent of total costs with slight economies of scale for small banks.

An evaluation of volatility forecasting techniques

Abstract: The existing literature contains conflicting evidence regarding the relative quality of stock market volatility forecasts. Evidence can be found supporting the superiority of relatively complex models (including ARCH class models), while there is also evidence supporting the superiority of more simple alternatives. These inconsistencies are of particular concern because of the use of, and reliance on, volatility forecasts in key economic decision-making and analysis, and in asset/option pricing. This paper employs daily Australian data to examine this issue. The results suggest that the ARCH class of models and a simple regression model provide superior forecasts of volatility. However, the various model rankings are shown to be sensitive to the error statistic used to assess the accuracy of the forecasts. Nevertheless, a clear message is that volatility forecasting is a notoriously difficult task.

The effect of mergers and acquisitions on the efficiency and profitability of EC credit institutions

Abstract: Based on a sample of 492 takeovers we examine the performance effects of acquisitions and mergers between EC credit institutions over the period 1988–1993. The sample is subdivided according to the degree of managerial leverage on the part of the acquirer and the degree of operational integration. The results indicate that domestic mergers among equal-sized partners significantly increase the performance of the merged banks. Improvement of cost efficiency is also found in cross-border acquisitions. On the other hand, domestic takeovers are found to be influenced predominantly by defensive and managerial motives such as size maximization.

The structure-performance relationship for European banking

Abstract: The relationship between market structure and performance has been studied extensively for American banking. In contrast, little work has been done to investigate this relationship for European banking. Two explanations of a positive correlation between profitability and concentration have been advanced, the traditional structure-performance hypothesis (SCP) and the efficient-structure hypothesis. Previous empirical tests of the alternative hypotheses have yielded mixed results but the tests were not robust because they did not incorporate measures of efficiency directly in the model. This study applies a stochastic cost frontier as proposed by Aigner et al. (1977) to derive measures of X-inefficiency and scale-inefficiency, under the assumption that the errors are distributed half-normal. We incorporate these measures of inefficiencies directly into the tests as proposed by Berger and Hannan (1993). We do not find a positive and significant relationship between concentration and profitability for a sample of banks across 11 European countries over a four year period, 1988–1991. However, we do find evidence to support one of the two versions of the efficient-structure hypothesis for banks located in countries with low concentration of banks. Since little support is found for either of the SCP hypotheses, a simple policy of strict limitations on cross-border acquisitions and growth is not warranted.

Australian IPO pricing in the short and long run

Abstract: We analyse both initial underpricing and post-listing returns for Australian IPOs. Our results are consistent with the view that unique institutional characteristics may have overwhelmed previous Australian tests of equilibrium models of IPO underpricing. The results also show that Australian IPOs significantly underperform market movements in the three-year period subsequent to listing. Further investigation of these anomalous post-listing returns lead us to reject various ‘speculative bubble’ explanations. Rather, the evidence suggests a curvilinear relationship between initial and subsequent returns, although the economic significance of the relationship is low.

A note on the weak form efficiency of capital markets: The application of simple technical trading rules to UK stock prices - 1935 to 1994

Abstract: Brock et al. (1992) found technical trading rules to have predictive ability with regards to the Dow Jones Index. The current paper considers whether this result can be replicated on UK data. The paper also considers whether investors could earn excess returns from technical analysis in a costly trading environment. The paper concludes that although the technical trading rules examined do have predictive ability in terms of UK data, their use would not allow investors to make excess returns in the presence of costly trading.

Capital and risk in property-liability insurance markets

Abstract: This paper investigates the capital and portfolio risk decisions of property-liability insurance firms. A theoretical model based on option pricing theory is developed which predicts a positive relationship between insurer capital and risk, as firms balance these two factors to achieve their desired overall insolvency risk. The implications of the model are then tested empirically using a simultaneous equations methodology. The results support the predictions of the model. They also provide evidence that managerial incentives play a role in determining capital and risk in insurance markets. The findings have significant implications for insurance solvency regulation.

The day-of-the-week effect: The international evidence

Abstract: We re-examine the day-of-the-week effect for eleven indexes from nine countries during the 1969–1992 period. The standard methodology as well as the moving average methodology are used and we find returns to be lower at the beginning of the week (but not necessarily on Monday) for the full period. As in Chang et al. (International evidence on the robustness of the day-of-the-week effect, Journal of Financial and Quantitative Analysis 28 (1993), 497–514), the anomaly disappears for the most recent period in the USA. However, the effect is still strong for European countries, Hong-Kong and Toronto.

Cross-border acquisitions and shareholder wealth: Tests of the synergy and internalization hypotheses

Abstract: In this paper, we test the synergy and internalization hypotheses for international acquisitions using a sample of foreign acquisitions of U.S. firms during the period 1979–1990. The major findings include: First, shareholders of our paired sample of U.S. targets and foreign acquirers experienced significantly positive combined wealth gains, $68 million on average, indicating that cross-border takeovers are generally synergy-creating activities. Second, shareholders of the U.S. targets realized significant wealth gains, regardless of the nationality of acquirers. Third, the Japanese acquisitions in our sample generated the largest net wealth gains, $398 million on average, which was shared by both target shareholders (43%) and acquirer shareholders (57%). Fourth, foreign acquirers benefitted from the targets' R&D capabilities, supporting the ‘reverse-internalization’ hypothesis.

Pricing Black-Scholes options with correlated credit risk

Abstract: This paper presents an improved method of pricing vulnerable Black-Scholes options under assumptions which are appropriate in many business situations. An analytic pricing formula is derived which allows not only for correlation between the option's underlying asset and the credit risk of the counterparty, but also for the option writer to have other liabilities. Further, the proportion of nominal claims paid out in default is endogenous to the model and is based on the terminal value of the assets of the counterparty and the amount of other equally ranking claims. Numerical examples compare the results of this model with those of other pricing formulas based on alternative assumptions, and illustrate how the model can be calibrated using market data.

Efficiency and technical progress in banking Empirical results for a panel of German cooperative banks

Abstract: Using 1989–1992 individual data of 757 German cooperative banks and applying the intermediation approach we specify a multi-product translog cost function for this part of the German banking industry. For all size classes moderate economies of scale can be identified. There is also evidence of economies of scope which supports the notion of universal banking. As for cost efficiency, we find that the average banks in all size classes deviate considerably from the best practice cost frontier. All banks enjoy growth of total factor productivity, which is higher for the smaller banks in the sample.

Monitoring, loan renegotiability, and firm value: The role of lending syndicates

Abstract: The positive response in capital markets to announcements of private financings is well documented and typically rationalized as a reflection of valuable monitoring and screening services provided by banks and other private lenders. This paper investigates the hypothesis that the capacity to renegotiate private debt contracts relatively inexpensively complements monitoring as a source of value to borrowers. The context for our study is lending by syndicates of private lenders. As the number of lenders increases, contracting costs increase and the value associated with the capacity to renegotiate should decline. Our evidence supports this hypothesis. We conduct additional tests to determine whether our results are robust to alternative interpretations, such as information leakage or the prospect that syndicate size proxies for information-related variables. Syndicate size remains related to the scale of the market's reaction, after taking various borrower and loan characteristics into account.

Valuing futures and options on volatility

Abstract: This paper presents simple closed-form expressions for volatility futures and option prices and examines their implications for the characteristics of these securities. We show that the properties of these volatility derivatives are fundamentally different from those of conventional option and futures contracts. This analysis also provides insights into the role that volatility derivatives may play in managing and hedging volatility risk in financial markets.

The design of financial systems: An overview

Abstract: I examine the multifaceted aspects of financial system design, focusing on the real effects of this design. My exploration of the key issues and my review of the related literature pertain to three dimensions of financial system design: (i) the permissible scope of activities for banks and other depository financial intermediaries, (ii) the regulations dictating the structure of the banking industry, and (iii) information disclosure requirements in the financial market. I address a diverse set of issues such as borrowers' choices of financing source and how these are affected by financial system design, the impact of financial system design on the capital structure and corporate control decisions of nonfinancial firms, the relationship between financial system architecture and the liability claims of banks, the issues surrounding the desired permissible scope of banking and bank industry structure, and the overall design of a financial system.

Systemic risk in the netting system

Abstract: In interbank clearing networks, a bank experiencing sudden liquidity or solvency problems may prevent settlement of the claims of its direct creditors, which may in turn jeopardize settlement of other institutions. The paper presents an empirical assessment of the potential size of this ‘domino effect’ in the Italian netting system. A participant's settlement failure is simulated and the impact on the rest of the system measured. On average, only about 4 percent of participants were large enough to trigger systemic crises; less than 1 percent defaulted due to systemic reasons; the average monetary loss was less than 3 percent of the daily flow of funds through the clearing system. Similar simulations by other authors for the U.S. system yielded a much larger impact of systemic risk. We argue that the difference is mainly due to the much smaller volume of funds flowing through the Italian system and to structural differences.

Do consumers pay for one-stop banking? Evidence from an alternative revenue function

Abstract: In providing financial services jointly, banks may reduce costs due to complementarities in production (cost economies of scope) or raise revenues from complementarities in consumption (revenue economies of scope). Cost economies of scope between bank deposits and loans have been found to be small. Revenue economies of scope are investigated here for the first time and found to be insignificant over 1978–1990 for both small and large banks and for those on or off the revenue-efficient frontier. The lack of complementarities between deposits and loans — where benefits are most likely to occur — suggests that claims of important synergies from an expansion of banking powers be taken with caution.

Trading frequency and event study test specification

Abstract: We examine the effects of thin trading on the specification of event study tests. Simulations of upper and lower tail tests are reported with and without variance increases on the event date across levels of trading volume. The traditional standardized test is misspecified for thinly traded samples. If return variance is unlikely to increase, then Corrado's rank test provides the best specification and power. With variance increases, the rank test is misspecified. The Boehmer et al. standardized cross-sectional test (Event-study methodology under conditions of event-induced variance, Journal of Financial Economics 30, pp. 253–272) is properly specified, but not powerful, for upper-tailed tests. Lower-tailed alternative hypotheses can best be evaluated using the generalized sign test.

Takeover bids and the relative prices of shares that differ in their voting rights

Abstract: The relative prices of shares that differ only in their voting rights are modelled. In our model, voting rights become valuable when a control contest is decided through takeover bids for outside votes. The study shows how the value of the voting right depends on the initial ownership distribution, the share structure, and the ability of the incumbent manager versus a rival for control. Empirical support for the model is provided using Swedish stock market data.

Commercial bank mutual fund activities: Implications for bank risk and profitability

Abstract: This paper examines the risk structure of bank holding companies and the effect of mutual fund activities on bank risk and profitability over the period 1987–1994. Findings from structural change tests indicate a significant decline in bank risk occurred near the mid-point of the study. Results from a confirmatory factor analytic model employed to examine the impact of mutual fund activities on banks suggest that mutual fund activities moderated bank industry systematic risk during the sample period. Mutual fund activities also increased the profitability of banks. These results suggest that mutual funds represent a productive avenue of expansion for bank holding companies.

Cost structures in multinational and domestic banking

Abstract: Prior research on international banking has proposed many reasons for the multinationalization of U.S. banks but provided little empirical support for its propositions. Using a pooled-time series data set from 1987 to 1990, this study analyzes the ray and expansion path scale economies and expansion path subadditivity of U.S. based multinational banks (MNBs), both at the firm and the plant levels. It also measures and analyzes inefficiencies for these banks. Inefficiencies are measured relative to a ‘thick frontier’ cost function. A similar analysis is conducted for domestic banks (DBs) for comparison purposes. No support is found for the prior belief that similar cost structures exist for MNBs and DBs. In general, we find that MNBs are able to fully exploit economies of scale, and face lesser diseconomies from joint production and lower inefficiencies than DBs.

Foreign acquisitions in the United States: Effect on shareholder wealth of foreign acquiring firms

Abstract: This paper examines shareholder wealth gains for 195 foreign firms that acquired U.S. target firms during 1983–1992. We find that foreign acquirers experience positive and significant abnormal returns of nearly two percent over days (−10, +10) when they acquire targets in the United States; however, U.S. acquiring firms do not gain at all from their purchases of foreign firms over the same period. Analysis of abnormal returns reveals that Japanese, British, Australian and Dutch acquirers gain significantly from purchases of U.S. firms. Bidder abnormal returns are not related to relative size of target to bidder, or to the extent of their overseas exposure, or to the target's RD they do not exhibit an industry factor nor are they affected by the value of foreign currency. There is support for the hypothesis that competition among bidding firms for the same target decreases the returns to the acquirers; we find that the 1986 Tax Act has led to no gains to foreign buyers of U.S. firms.

Additional evidence on the information-based contagion effects of bank failures

Abstract: Recent theoretical models addressed the question of the nature of bank runs and what triggers them. Two competing hypotheses emerged: pure panic and information-based contagion. This study provides additional evidence consistent with the latter hypothesis. Three observable bank characteristics are examined as proxy measures for the interim private information used by rational depositors in assessing the riskiness of a bank's long-lived assets that may trigger bank runs. The three factors are (1) the distance of the solvent banks' headquarters from the headquarters of each failed bank; (2) the size of the solvent banks; and (3) the capital ratio as a proxy for their solvency. The analysis is conducted in the context of the five large bank failures that occurred in the Southwest region of the US during the mid-1980s. Weekly abnormal returns of 33 Southwestern BHCs, in ten critical failure-related event dates are regressed on the three observable bank characteristics. Our findings suggest that distance and capital adequacy are negatively related to the magnitude of the contagion effect, whereas size is positively related.

Executive ownership, corporate value, and executive compensation: A unifying framework

Abstract: This study presents an integrated investigation into the factors affecting executive ownership, the market value of the firm, and executive compensation by explicitly incorporating the simultaneity of the process determining these variables into the empirical estimation. Overall, the results of the study support the notion that a firm's market value, executive stock ownership, and executive compensation are jointly determined. Further, the findings suggest that executive stock ownership and executive compensation may serve as a type of bond by which top executives are induced to act in the best interests of shareholders. The study also finds that a firm's q ratio and an executive's job-specific experience (as well as firm size) are important determinants of executive compensation. This result is generally consistent with the view that the firm optimally establishes its managerial compensation plan in response to both its operating environment and the specific personal characteristics of its chief executive(s).

A friction model of daily Bundesbank and Federal Reserve intervention

Abstract: This paper takes a novel approach to derive a central bank intervention reaction function. A GARCH model for exchange rates is amended to allow interventions to have an effect on both the mean and the variance of exchange rate returns. An intervention reaction function is obtained by combining the model with a loss function for the central bank. Estimation results for the implied friction model reproduce the familiar ‘leaning against the wind’ policy by the Bundesbank and the Federal Reserve. Furthermore, the central banks appear to have reacted to increases in the conditional variance of daily DM/$-returns.

Scale and scope economies at large banks: Including off-balance sheet products and regulatory effects (1984–1991)

Abstract: This paper examines the impact of the risk-based capital (RBC) requirements on bank cost efficiencies. We take into consideration both on- and off-balance sheet (OBS) products and allow product mixes to differ across banks and to vary over time. Our empirical results suggest that the cost structures of large banks are significantly different during the pre-RBC and post-RBC periods. That is, the RBC change seemed to reduce the optimal bank size that achieves maximum scale and scope economies, so that some of the large banks that previously were efficient became too large and inefficient. The results suggest that regulations that encourage large banks to expand their production and product mixes any further will likely result in a less efficient banking industry.

The accuracy of the tick test : evidence from the Australian Stock Exchange

Abstract: In the absence of information regarding whether a trade is buyer or seller initiated, many researchers have employed the ‘tick’ rule as a proxy. These researchers have been supported in their endeavours by the work of Lee and Ready (1991) which suggests that the tick rule is 90% accurate. Unfortunately, the difficulty of securing data on this issue has made Lee and Ready's paper somewhat unique in that there have been few attempts to confirm their result in US markets and no attempts in other markets. The purpose of this work is to test the robustness of their result in the Australian securities market. Using cleaner intra-day data we mimic the Lee and Ready study to cast some doubt upon the robustness of their findings in different markets. Our results suggest an overall accuracy of approximately 74% as opposed to Lee and Ready's 90%. However, accuracy in excess of 90% is documented when zero ticks are excluded. Further analysis provides evidence that a volatile or trending market will decrease the accuracy of the tick rule. It is also demonstrated that the tick rule is less likely to accurately classify seller initiated trades and small buyer initiated trades.

Testing for micro-structure effects of international dual listings using intraday data

Abstract: This paper examines the impact on the liquidity of NYSE/AMEX listed stocks when they were subsequently listed on the London or the Tokyo Stock Exchanges. It can be argued that the increased competition from foreign market makers will reduce the monopoly rents that specialists can earn, thereby improving their quotes. We find, however, that spreads do not decrease following a dual listing, though the depth of the quotes increases as predicted. The apparent increase in depth disappears once we account for changes in price, volume and return variance. We also find that the level of informed trading increases, which increases the cost to the specialist of providing liquidity, and explains why spreads do not decline in spite of increased competition. Consistent with an increase in informed trading, we also document an increase in trading activity.

The arbitrage pricing theory, macroeconomic and financial factors, and expectations generating processes

Abstract: Empirical tests of the arbitrage pricing theory (APT) using prespecified observed variables rely on the construction of unexpected components of the variables. In this paper we show that traditional techniques employed in this area may lead to false inferences regarding the statistical significance or otherwise of estimated risk premia. We put forth an alternative methodology to generate the unexpected components which treats expectations formation as a learning process. In the light of given criteria that the unexpected components should satisfy this technique leads to more reliable inferences regarding tests and applications of the APT.