Bank Risk, Capitalization, and Operating Efficiency

Abstract

In this paper, the relation between bank risk-taking and operating efficiency is investigated in a simultaneous equations setting. While inefficiency is found to have positive effects on both credit risk and interest rate risk, it also has a positive effect on capitalization. The positive effect of inefficiency on risk-taking supports the moral hazard hypothesis that firms with poor performance are more vulnerable to risk-taking than high performance banking organizations. The positive effect of inefficiency on the level of capital is attributable to regulatory pressure on under performing firms to have more capital. Regulators prefer to discipline weak and inefficient firms by imposing higher capital requirement rather than through imposing portfolio restrictions, possibly because capital is more transparent and can be measured accurately. We also find that credit risk, interest rate risk, and capitalization seem to be jointly determined, reinforcing and compensating each other. At the same time, operating efficiency is affected by and related to bank risk-taking. Firms with more capital are found to operate more efficiently than firms with less capital, indicating that the level of capitalization is a good proxy for performance. We find mixed results regarding the effects of credit risk and interest rate risk on operating efficiency. Interestingly, a U-shaped relationship between inefficiency and loan growth rate is detected. Up to a certain point, operating efficiency improves at a decreasing rate as loan growth rate increases. This is consistent with the hypothesis that sustainable loan growth is accomplished by good management, which operates close to the efficient frontier. However, at excessive growth rate, operating efficiency decreases with loan growth. The finding supports the hypothesis that entrenched managers who pursue a growth objective to enhance their own wealth tend to operate inefficiently.