INSTRUCTIONS: Make a thoughtful argument about the followin topic
A number of mysteries have survived intensive investigation. Though the question of whether the Loch Ness creature is elusive or simply illusive is better known, no less baffling is the case of commercial banking's missing scale economies. The story of these missing economies is a cautionary tale about the importance of accounting for risk in modeling production.
In the last two decades commercial banks in the U.S. have merged in record numbers to create banks of record size. The bankers involved in these mergers invariably claim to see scale economies in their merged institutions, which provide an important economic justification for consolidation. Banking textbooks implicitly confirm these sightings as they hypothesize about the sources of such economies. However, when the empirical evidence is sent to the academic laboratory for confirmation, the econometric tests applied to it usually conclude that smaller banks enjoy only slight economies of scale while larger banks experience slight diseconomies of scale.(n1) Thus, the empirical evidence usually contradicts the testimony of bankers and textbook authors. Where, then, are the scale economies?
The standard textbook explanation usually focuses on the relationship of scale to diversification and to the ability to spread the costs of various centralized functions over a larger scale. The investment in information technology, for example, does not increase in proportion to the size of the bank. In addition, as the number of a bank's loans and deposits increases with its size, the bank's exposure to credit risk and to liquidity risk can be reduced by better diversification of assets and liquid liabilities. In turn, the potential that an increase in size can better diversify risk implies the potential for economies of scale in risk management and for a lower riskpremium on the cost of uninsured, borrowed funds, ceteris paribus.
However, other things are not constant, which may provide an important clue to the whereabouts of the missing scale economies. By reducing the risk attached to any given production plan, better diversification can decrease the marginal cost of risk-taking and provide an incentive for banks to take additional risk to earn a higher expected return. For example, in response to better diversification of deposits that diminishes liquidity risk, banks may reduce their holdings of liquid government securities and increase the proportion of their assets held in illiquid, but more profitable, loans. Similarly, in response to better diversification of loans that diminishes banks' exposure to credit risk and, hence, to insolvency risk, they may make riskier loans and reduce the ratio of equity capital to total assets to improve the return on their equity. Of course, this additional risk-taking is costly both in terms of the additional resources required to manage the risk and the higher riskpremium that must be paid for uninsured, borrowed funds. This additional cost may obscure the scale economies generated by better diversification when no account is taken of risk. On one hand, an increased scale of operations that improves diversification may result in a less-than-proportionate increase in cost, ceteris paribus. However, on the other hand, the additional cost of increased endogenous risk may cause cost to increase proportionately with scale or even more than proportionately and give the appearance that there are no scale economies.
If accounting for endogenous risk is critical to detecting risk-related scale economies, is it possible, then, that the assumptions made about risk by the standard techniques of measuring scale economies yield their generally negative result? I shall answer, "Yes," to this question and argue that the standard dual cost and profit functions usually neglect important relationships among the firm's production choices, its financial structure, and its exposure to market-priced risk.
First, the standard analysis generally assumes, either explicitly or implicitly, that firms face market-priced riskwhich does not vary with their production decisions. Production plans are chosen to minimize cost and to maximize profit, given the prices of inputs and outputs, including the required return on shareholders' equity. To the extent that these prices include a risk premium, treating prices in their entirety as parametric assumes that risk does not vary with production decisions. Hence, the return required on firms' debt and equity is independent of their production decisions. In the case of banks, this assumption logically rules out the possibility that scale-related improvements in diversification could lower the cost of borrowed funds and induce banks to alter their exposure to risk.
Second, the standard analysis assumes that firms minimize cost and maximize profit--goals that are not generally equivalent to maximizing value. When production decisions influence the firm's exposure to market-priced risk and its associated discount rate on cash flows, the firm must evaluate production plans by their effects both on expected profitability and on the discount rate. A production plan that increases not only expected cash flows, but also the discount rate, may not increase the firm's market value. In addition, such phenomena as the potential for costly episodes of financial distress and convex tax rates can make trading current expected profits for reduced risk a value-maximizing strategy. In such cases, it is more reasonable to describe profit by a subjective probability distribution that is conditional on the production plan. Value maximization ranks production plans not just by the first moment of the conditional probability distribution, but also by higher moments that reflect the riskiness of production plans. However, the standard dual representations rank production plans solely by their first moments, expected profit and cost, since higher moments characterizing risk are assumed to not vary across production plans.
In the case of banking where production decisions influence a bank's exposure to market-priced risk, where deposit insurance is mispriced, and where financial distress can entail liquidity crises, regulatory intervention, and even the loss of a bank's valuable charter, value-maximizing banks are likely to take risk as well as profitability into account in making production decisions. By assuming that risk does not vary with production decisions, the standard dual representation may misstate scale economies when a proportionate variation in outputs is accompanied by a costly variation in risk-taking. These considerations suggest that scale economies should be measured along the value-maximizing expansion path, not the cost-minimizing path.
The cautionary tale of banking's missing scale economies illustrates the importance of incorporating endogenous riskinto the analysis of production and suggests how productionanalysis should be amended. In the following sections, I consider these issues in detail. In the second section, I describe how production plans and financial structure can influence a firm's exposure to market-priced risk and how value-maximizing firms rank production plans when risk is endogenous to their production decisions. In the third section, I argue that the methods for incorporating debt and equity into the production model and its measure of cost affect their ability to detect scale economies due to diversification and other risk-related phenomena. In the fourth section, I show that the Most Preferred Production System, developed by Hughes et al. [1995, 1996, forthcoming] (hereafter designated as HLMM), incorporates endogenous risk and accommodates value-maximizing behavior. In the fifth section, I describe a technique of efficiency measurement, developed by Hughes and Moon , that derives estimates of each firm's expected return on equity and return risk using the Most Preferred Production System and measures each firm's inefficiency by the difference between its expected return and the best-practice (efficient) return at the firm's observed level of return risk. In the concluding sixth section, I describe the evidence of scale economies in banking that this model detects and consider how it is able to uncover these elusive economies by accounting for endogenous risk and capital structure.
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