Full text of Financial Industry Studies : December 1997

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FEDERAL RESERVE BANK OF DALLAS
DECEMBER 1997

FINANCIAL INDUSTRY

Rethinking Bank Efficiency and Regulation:
How Off-Balance-Sheet Activities Make a Difference
Thomas F. Siems and Jeffrey A. Clark

Government Guarantees and Banking:
Evidence from the Mexican Peso Crisis
Robert R. M o o r e

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Financial Industry Studies
Federal Reserve Bank of Dallas

Robert D. McTeer, Jr.
President and Chief Executive Officer

Helen E. Holcomb
First Vice President and Chief Operating Officer

Robert D. Hankins
Senior Vice President

W. Arthur Tribbie
Vice President

Economists
Jeffery W. Gunther
Robert R. Moore
Kenneth J. Robinson
Thomas F. Siems
Sujit "Bob" Chakravorti
Financial Analysts
Robert V. Bubel
Karen M. Couch
Susan P. Tetley
Kelly Klemme
Edward C. Skelton
Graphic Designer
Lydia L. Smith
Editors
Jeffery W. Gunther
Robert R. Moore
Kenneth J. Robinson
Publications Director
Kay Champagne
Copy Editors
Anne L. Coursey
Monica Reeves
Design & Production
Laura J. Bell

Financial Industry Studies is published by the
Federal Reserve Bank of Dallas. The views expressed
are those of the authors and should not be attributed
to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy of the publication
containing the reprinted article is provided to the
Financial Industry Studies Department of the Federal
Reserve Bank of Dallas.
Financial Industry Studies is available free of
charge by writing the Public Affairs Department,
Federal Reserve Bank of Dallas, P.O. Box 655906,
Dallas, Texas 75265-5906, or by telephoning
(214) 922-5254 or (800) 333-4460, ext. 5254.

Contents
Rethinking Bank
Efficiency and
Regulation:
How Off-Balance-Sheet
Activities Make a
Difference
Thomas F. Siems and Jeffrey A. Clark

Page 1

Government Guarantees
and Banking:
Evidence from the
Mexican Peso Crisis
Robert R. Moore

Page 13

Without question, fundamental economic, technological, and
political forces have stimulated financial innovation and created
new forms of intermediation and other fee-based activities for
financial institutions. These activities, which are not traditionally
captured on bank balance sheets, have made it even more difficult to get an accurate picture of a bank's condition. Most previous bank-efficiency models and measures are based only on
traditional on-balance-sheet figures, which may be misleading as
banks embrace nontraditional activities. In this article, Thomas
Siems and Jeffrey Clark demonstrate the importance of including
a measure for off-balance-sheet activities in these models. In
doing so, they no longer find evidence of a statistically significant
relationship between profit efficiency and size. This result, contradicting earlier bank-efficiency research, implies that banks of
many sizes and types are competitively viable, which strengthens
the view that ongoing consolidation in the banking industry will
not harm and may improve overall profit efficiency. The authors'
results suggest that failing to account for off-balance-sheet activities can have important statistical and economic effects on derived
efficiency estimates by seriously understating actual bank output.
Moreover, if the traditional efficiency computations are inaccurate,
then the traditional regulatory process might be one step behind
as well.

What can an examination of Mexico and Argentina during
the 1994 peso crisis reveal about the effects of bank supervisory
policies? In both countries, the inflation-adjusted value of deposits
declined from December 1994 to June 1995. The nature of those
deposit flows differed, however. At banks in Mexico, deposit
growth and financial strength were unrelated. In contrast, deposit
growth in Argentina tended to be higher at financially strong
banks than at weak ones. Because government guarantees were
more extensive in Mexico than in Argentina, the difference in
behavior in the two countries would be expected. Thus, an important cost of government guarantees is their potential for undermining the market mechanism that would otherwise tend to
channel funding toward stronger banks and away from weaker
ones.

Rethinking Bank
Efficiency and
Regulation: How
Off-Balance-Sheet
Activities Make a
Difference

In today's fast-changing world of banking,
accurately modeling bank efficiency—how
banks transform inputs into outputs—has
become more difficult. Fundamental economic,
technological, and political forces have stimulated financial innovation and created new
forms of intermediation and other fee-based
activities not traditionally captured on the balance sheet. With banking's financial intermediation role evolving and broadening through
more off-balance-sheet activities such as loan
securitizations, backup lines of credit, and financial derivatives, "traditional" bank efficiency and
performance measures may no longer provide
an accurate evaluation of a bank's condition.

Thomas F. Siems and Jeffrey A. Clark

What follows is an assessment of bank
profit-efficiency measures that includes an estimate for off-balance-sheet activities as described
in Boyd and Gertler (1994). We find that excluding this off-balance-sheet proxy as an output is
not supported statistically and may distort traditional efficiency measures. In addition, the
often-held view that efficiency tends to differ for
banks in different size classes is not supported
by our analyses. Once off-balance-sheet activities are accounted for, no efficiency differences
are found for banks in size classes of more
than $25 million in total assets. As a result,
banks across many asset-size ranges appear to
be competitively viable and relatively equally
efficient when off-balance-sheet activities are
taken into consideration. This finding contradicts earlier research and suggests that ongoing
consolidation in the banking industry will not
harm and may improve overall profit efficiency.

hinks across many

asset-size ranges appear to be
competitively viable and
relatively equally efficient when
off-balance-sheet activities are
taken into consideration.

This finding also may have some important implications for banking policy. The shift
among banks, especially larger ones, to more
nontraditional activities necessitates the rethinking of the traditional bank regulation process.
Because of the swift changes affecting the way
banks conduct business and provide intermediation services, the traditional regulatory process
may have difficulty keeping pace with emerging
technologies and financial globalization. As a
result, banking regulators should consider shifting their focus even more from analyses of
traditional balance-sheet activities to a more
thorough evaluation of an institution's riskmanagement processes and behavior. They
should also consider placing greater reliance on
market forces to discipline bank activities.
Thomas F. Siems is an economist
at the Federal Reserve Bank of Dallas.
Jeffrey A. Clark is a professor
at Florida State University.

FEDERAL RESERVE BANK OF DALLAS

THE DECLINE IN TRADITIONAL BANKING ACTIVITIES
In recent years, there has been a growing
shift in banking activities from traditional on-

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

balance-sheet intermediation to off-balancesheet activities. Traditional banking, in which
banks attract deposits to make loans, is being
replaced by new forms of intermediation and
other fee-based activities. The decline in traditional U.S. banking activities is primarily the
result of economic forces, financial innovations,
and regulatory restrictions. To compete in this
changing environment, many banks are providing nontraditional financial opportunities —
ranging from standby letters of credit to newer
financial derivatives products — moving many
banking activities off the balance sheet.1

Chart 1

Growth of Financial Derivatives Activities
at U.S.-lnsured Commercial Banks
Notional value, trillions of dollars
25
U8 Contracts on commodities and equities
[ ~ | Interest rate contracts
20

Foreign exchange contracts

Economic Forces
Edwards and Mishkin (1995) argue that
"fundamental economic forces have undercut
the traditional role of banks in financial intermediation." These forces, according to Edwards
and Mishkin, include banks' diminished importance as a source of funds to nonfinancial borrowers, their deteriorating income advantages
due to the growth of commercial paper and
junk bond markets, and increased asset securitizations. As a result of these forces, competition
from nonbank financial services providers has
increased, which has significantly squeezed
profit margins by eroding both cost and income
advantages.

0
1990

See Boyd and Gertler (1994); Kaufman
Mishkin (1995) for arguments supporting the decline in traditional banking
and the rising importance of offbalance-sheet activities.
A word of caution about notional
cipal is the amount upon which interest
based. Notional principal typically does
not change hands; it is simply a quantity
that is used to calculate payments and
does not give any indication of the
underlying risk exposures. Nevertheless, as a time-series measurement,
notional amounts do indicate the growing importance of off-balance-sheet
activities in the banking industry.

1993

1994

1995

1996

lators have been responsible for ensuring that
banks follow safe and sound management practices. Kaufman and Mote (1994) argue that,
while the overall evidence does not support a
recent decline in the banking industry, "banking
has not grown as rapidly as it might have if
banks had not been constrained from providing
new products quickly in response to changes in
market conditions." In other words, banking
may have grown more rapidly under alternative
regulatory regimes. For example, today's banks
could be more efficient and the cost of banking
to consumers could be less if restrictive regulations—such as those preventing expansion
across state lines and the separation of commercial and investment banking activities—had
been removed earlier.

Banks have responded to increased competition by changing the way they provide
traditional services and embracing new technologies to expand into nontraditional activities.
Boyd and Gertler (1994) observe that "after correcting for both the mismeasurement of foreign
bank loans and the exclusion of off-balancesheet activities, any evidence of a substantial
decline in commercial banks' share of intermediated assets vanishes." Indeed, the growth of
off-balance-sheet activities has been swift and
strong. Chart 1 documents the 224 percent
increase in the notional value of financial derivatives activities that occurred at U.S. commercial
banks between 1990 and 1996.2 By comparison,
banks' total on-balance-sheet assets increased
just 38 percent over the same period.

LOOKING BEYOND THE BALANCE SHEET
Given the increasing growth of noninterest income from the expansion of off-balancesheet activities, the need to acquire information
concerning these activities has grown commensurately. Until recently, requirements for reporting off-balance-sheet activities were minimal. In
fact, banking regulators did not require detailed
reporting of derivatives activities until 1990.
These requirements were modified in 1995 to
provide greater detail. The development and
implementation of these disclosures have been
slow partly because of the difficulties inherent
in accurately measuring and accounting for offbalance-sheet instruments, especially derivatives
products.

amounts: for derivatives, notional prinand other payments in a transaction are

1992

DATA SOURCE: FFIEC Reports of Condition and Income.

Financial Innovations

and Mote (1994); and Edwards and

1991

Regulatory Restrictions
Deposit insurance and other banking
reforms introduced in the 1930s addressed
depositor confidence. They also effectively
diminished the disciplinary role the market
mechanism provides by encouraging banks to
maintain adequate capital levels and restrict
excessive risk-taking. As a result, banking regu-

A report by the General Accounting Office
(1996) contends that accounting and disclosure
issues related to nontraditional financial activi-

ties continue to be of concern. In a review of
twelve banks and thrifts that were derivatives
end users,3 the General Accounting Office (GAO)
found that inadequate accounting standards for
derivatives-hedging activities continue to be a
major unresolved problem that adversely affects
the quality of information available to users
of financial statements. The GAO recommends
comprehensive market-value accounting for all
financial instruments as a way to resolve many
of the accounting problems associated with
derivatives.4

efficiency measures is to adjust total assets to
include the credit-equivalent amounts of offbalance-sheet assets as reported in the RiskBased Capital Schedule of the Federal Financial
Institutions Examination Council's (FFIEC) Consolidated Reports of Condition and Income.
Since 1990, banks have been required to compute risk-based capital by categorizing assets
and the credit-equivalent amounts of offbalance-sheet items according to various risk
categories.6 In effect, the sum of these creditequivalent amounts approximates the amount
of on-balance-sheet assets that would result in
comparable relative risk exposures to the bank,
not the actual volume of their off-balance-sheet
activities or their ability to generate income or
incur costs.

Moreover, the Financial Accounting Standards Board (FASB) has plans to move forward
with an accounting standard that would require
the fair value of all derivatives to be reported in
financial statements.5 Many organizations are
concerned about this proposal, however, stating
that it has not received formal public comment,
that it will not improve the financial reporting of
derivatives activities, and that it could constrain
prudent risk-management practices.
The absence of a consensus on the appropriate way to measure off-balance-sheet activities does not alleviate the need to assess their
role in bank efficiency and performance. A
crude measure of the growing importance of
off-balance-sheet activities to a bank's bottom
line is noninterest income as a share of total
bank income (Chart 2). Over the 1960-80 period,
noninterest income as a percent of total income
averaged 19 percent, but since the late 1970s it
has steadily increased to about 35 percent.
One way to incorporate some measure of
off-balance-sheet activities into traditional bank

The credit-equivalent amounts of offbalance-sheet activities almost certainly understate the true level of off-balance-sheet assets
and their ability to generate income.7 One
reason for the understatement is that reported
credit-equivalent amounts exclude certain activities, such as loan servicing, consulting, and trust
department services. That is, only the amounts
of credit equivalents for those activities that regulators think will entail significant risk are
reported. None of the on-balance-sheet assets
are carried at their credit-equivalent amounts; if
they were, then bank on-balance-sheet assets
would also be understated. Hence, the actual
value for off-balance-sheet assets is most likely
greater than this measure.
Because of the apparent tendency for this
credit-equivalent off-balance-sheet measure to
understate the on-balance-sheet asset equivalence of off-balance-sheet activities, its use may
produce erroneous results. The measure's deficiencies in approximating off-balance-sheet
assets led Boyd and Gertler (1994) to emphasize
the ability of off-balance-sheet activities to generate profit, which we consider here. The
Boyd-Gertler measure, which we refer to as
BGEST, takes an entirely different approach by
focusing on the capitalization of noninterest
income. This estimate can be best viewed as the
hypothetical on-balance-sheet asset holdings
needed to generate a bank's noninterest income
stream. Assuming that on- and off-balance-sheet
assets are equally profitable, Boyd and Gertler
derive the following measure of off-balancesheet equivalent assets:

Chart 2

Share of Noninterest Income in Total Income
for U.S.-lnsured Commercial Banks, 1960-96
Percent

A derivatives end user is a counterparty
that engages in a derivatives contract
with the intent of managing its own risk
exposures. By contrast, a derivatives
dealer is a counterparty that enters into
a derivatives contract in order to earn
fees or trading profits by acting as an
intermediary.

There are many difficulties in implementing market-value accounting and
market-valuation models. Although
improving the transparency of derivatives activities is the main challenge,
accounting, public disclosure, and
regulatory reporting requirements all
continue to lag the marketplace. For
more on this issue see Berger, King,
and O'Brien (1991).

FASB is an independent organization
funded by the private sector, with a
stated mission to set accounting and
reporting standards that protect the
consumers of financial informationmost notably, investors and creditors.
More information about FASB and its
derivatives project is available on their
Web site at <http://www.rutgers.edu/
accounting/raw/fasb>.

Since 1990, banks reporting total assets
of $1 billion or more and all banks with
total capital of less than 8 percent of
adjusted total assets must compute
the credit-equivalent amounts of offbalance-sheet activities listed in the
Risk-Based Capital Schedule. Adjusted
total assets equals total assets less
cash, U.S. Treasury securities, U.S.
Government agency obligations, and 80
percent of U.S. Government-sponsored
agency obligations plus the allowance

DATA SOURCE: Federal Deposit Insurance Corporation, FDIC
Historical

Statistics

on Banking

for loan and lease losses and selected

1934-1996,

In this formulation, BGEST denotes the derived
estimate of off-balance-sheet assets, Nil de-

<http://www.fdic.gov/databank/sob/hist96/
index. html>.

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

off-balance-sheet items.
7

See Boyd and Gertler (1994).

Table 1

Asset-Size Categories

egory

1995
Number of
U.S.-insured
commercial banks

Total assets

Average increase
in total assets
by adding BGEST
(percent)

1
2

< $25 million
$25 m i l l i o n - $ 5 0 million

1,715
2,352

47
23

3
4

$50 million —$100 million

2,511

$100 m i l l i o n - $ 3 0 0 million

2,186

$300 m i l l i o n - $ 5 0 0 million
$ 5 0 0 m i l l i o n - $ 1 billion

388

is likely that as banks expand into nontraditional activities, over time and across asset-size
groupings, traditional bank-efficiency measures
that exclude off-balance-sheet activities will
become less accurate snapshots of true bank
efficiency. Developing accounting practices that
more accurately measure and disclose these
activities remains an area of great concern and
one that requires further research.

33
46

6
7
8

$5 b i l l i o n - $ 1 0 billion

> $10 billion

265
277
62

$1 b i l l i o n - $ 5 billion

275

65
91

PROFIT EFFICIENCY AND
OFF-BALANCE-SHEET ACTIVITIES

SOURCE; FFIEC Reports of Condition and Income, authors' calculations.

The credit-equivalent off-balance-sheet
measure derived from the Reports of
Condition and Income were also considered in our analysis, but the results
were qualitatively similar to those
obtained when the off-balance-sheet
proxy was excluded from the models.
We also considered a measure similar
to BGEST that excludes service charges
on deposit accounts from noninterest
income and includes them in interest
income. Our results using this measure
were not quantitatively or qualitatively
different from results obtained by using
BGEST.

Moreover, from microeconomic theory,
a firm selling output capacity should
add products to its output mix as long
as the marginal revenue from the product is greater than or equal to the marginal cost associated with the use of
the productive capacity necessary to
produce the product. Since average
production costs are fairly constant
over a large range of output and assuming reasonably competitive output
markets, profit margins may not be
significantly different across products.
Thus, the assumption of equal rates of
return for on- and off-balance-sheet
activities may indeed be reasonable,
and the development of accurate measures for off-balance-sheet activities is
certainly an area of further research.
See Clark (1988); Berger, Hunter, and
Timme (1993); Clark (1996); Berger
and Humphrey (1997); and Berger and
Mester (1997) for extensive reviews of
the literature on bank efficiency. See
Jagtiani and Khanthavit (1996) and
Jagtiani, Nathan, and Sick (1995) for
cost efficiency studies that include a
measure for off-balance-sheet activities.
See Berger and Mester (1997) for a
profit-efficiency study that also includes
a measure for these activities.
See Amihud, Dodd, and Weinstein
(1986); Jensen and Meckling (1976);
and Siems (1996) for studies that present and discuss various hypotheses for
why banks expand size and output mix.

Given the documented growth in banks'
off-balance-sheet activities, along with the
apparent ability for these activities to alter traditional measures of bank efficiency, a more systematic, statistical investigation of their role is
warranted to determine their statistical and economic significance. While a large number of
studies have examined various aspects of bank
efficiency from the cost side, only a few have
explicitly included a measure for off-balancesheet activities.10 As in most bank cost-efficiency
studies, the papers that include a measure for
off-balance-sheet activities report that there
appears to be a cost disadvantage associated
with both the increasing size and the changing
output mix of large banks. In other words, these
studies conclude that it would be cost inefficient
for large banks to expand their production and
product mixes any further and suggest that large
banks have financial incentives to shrink somewhat in order to capture scale economies.

notes noninterest income, A0 denotes onbalance-sheet assets, / denotes interest income,
E denotes interest expense, and LLP denotes
the loan-loss provision. Thus, BGEST is a measure obtained in units of on-balance-sheet assets
that would generate the observed level of
noninterest income produced primarily by offbalance-sheet activities.
Although a somewhat crude asset-equivalent measure, BGEST has several advantages
over the credit-equivalent off-balance-sheet
measure. The most important advantage is that
it computes asset equivalents for all off-balancesheet activities, not just those regulators think
entail significant risk.8 One potential criticism
of the BGEST measure, however, is the underlying assumption that off-balance-sheet activities
earn a rate of return equal to that of on-balancesheet assets. Nevertheless, when capitalizing
fee income in this way to generate hypothetical asset equivalents, Boyd and Gertler
obtain a more comprehensive measure of bank
output.9

But before using these results to infer that
banks should be discouraged from expanding
any further because doing so would likely result
in a less efficient banking industry, it is important to consider several factors. First, there has
been a significant increase in both bank mergers and off-balance-sheet activities since 1990. A
growing number of these mergers and much of
the growth in off balance-sheet activities have
involved large banks, which these studies suggest are already too large to be cost efficient.
Thus, either bank decisions to expand size and
output mix are inconsistent with maximizing
shareholder wealth, or these decisions depend
on factors other than, or in addition to, cost efficiency that these studies have not adequately
captured.11
Second, these studies utilize only the creditequivalent asset measure of off-balance-sheet
activity. As discussed above, this measure has
been criticized for significantly understating offbalance-sheet activities. Thus, it may not be
adequately capturing the impact that the recent

Table 1 shows the number of U.S.-insured
commercial banks in nine asset-size categories
for 1995, along with their average increases
in total assets. These increases are determined
by adding the BGEST off-balance-sheet asset
measure to total assets. As discussed, these estimates of off-balance-sheet assets are crude
approximations. Indeed, the challenge lies in
being able to accurately measure them. Regulators must be careful not to put too much
weight on traditional bank-efficiency and performance measures because banking continues
to change.
Although BGEST measures the asset equivalence of off-balance-sheet activities with some
potential degree of error, it is still possible to
draw inferences about how its inclusion would
affect traditional measures of bank efficiency. It

surge in off-balance-sheet activities may suggest.
Third, a number of recent studies have
identified the presence of X-inefficiency—deviations from the most efficient, or best-practice,
frontier within size classifications. Such inefficiencies typically result when firms do not use
the least costly combination of inputs in producing outputs and thereby fail to match the
performance of banks on the efficient frontier.
Although there is no consensus on the best
methodology to compute X-inefficiency, nearly
all recent studies conclude that there are relatively large X-inefficiency differences across
bank-size classifications and that these inefficiencies dominate scale and scope inefficiencies. Berger, Hancock, and Humphrey (1993)
find that larger banks are substantially less Xinefficient on average, or closer to the frontier,
than smaller banks. In addition, Clark (1996)
finds that the presence of X-inefficiency may
distort conventional measures of size and output-mix cost efficiencies. However, the studies
that explicitly incorporate estimates for offbalance-sheet activity neither test nor make
adjustments for the presence of X-inefficiency
in their data.

approach to allow an evaluation of potential
X-inefficiency effects.13 In this approach, a bestpractice profit frontier is estimated using data
drawn from the most profitable banks in each of
several size categories. Any error in estimating
this frontier is assumed to be random and not
the result of other inefficiency effects. The thick
frontier methodology compares estimates of
profit derived from the best-practice profit
function with those derived from a profit function estimated using data from low-profit, or
worst-practice, banks. Thus, while this methodology does not provide exact point estimates of
individual firm-level inefficiency, it can provide
estimates of overall profit X-inefficiency across
size categories.
As is standard in the literature, profit Xinefficiency is computed to determine whether
a systematic relationship exists between bank
size and X-inefficiency differences. If such a
relationship is found, the profit X-inefficient
banking organizations should be excluded from
further analyses, and derived efficiency estimates
should be based only on the best-practice
profit frontier. Failure to eliminate such institutions may lead to erroneous results by confounding scale and scope economies with
X-inefficiency effects.14
Data from the 1995 FFIEC Reports of Condition and Income were used to assemble a
sample of 9,831 banks with complete data.15
Using this sample, two thick frontier subsamples
are formed. The best-practice frontier includes
the top profit quartile (25 percent) of banks in
each size category, as measured by return on
equity.16 In implementing this approach, the full
sample is first sorted by a measure of total assets
that combines on-balance-sheet assets with the
BGEST measure for off-balance-sheet activities.
Then, within each of the nine asset-size categories, the quartile of banks with the highest
rates of return on equity is selected to form the
best-practice frontier. A second profit frontier,
needed to evaluate profit X-inefficiency,
includes the quartile of least profitable banks
and is formed from the 25 percent of banks in
each asset-size group with the lowest rates of
return on equity.

Finally, and most important, it is possible
that increasing size and changing output mix
may be revenue efficient even if they are not
cost efficient. If revenue efficiencies exceed any
cost inefficiencies, increases in size and changes
in output mix can be justified. Several recent
studies highlight the need to reexamine bank
efficiency using a profit function approach.12 By
focusing on profit efficiency instead of cost efficiency, the combined revenue and cost effects
of alternative output levels and mixes and input
levels and mixes can be assessed. Although
most studies do not directly incorporate a measure for off-balance-sheet activities, some report
evidence suggesting that profit efficiency is
greater for larger banks, despite whether these
activities are controlled for. According to Berger,
Hunter, and Timme (1993), this result suggests
that larger banks may have an advantage in
terms of achieving high-value output bundles.
However, failing to control for off-balance-sheet
activities may be contributing to this result
because the expansion of these activities has
occurred disproportionately at larger banks.

Once we measure overall profit X-inefficiency, we compute two other efficiency measures using the estimated best-practice profit
function: profit elasticity and profit
expansion
path suhadditivity. Profit elasticity measures the
percentage change in profit to equal percentage
changes in all outputs in the product mix in
order to capture only changes in size. Profit expansion path subadditivity measures the relation-

METHODOLOGY AND DATA
Profit X-inefficiency occurs when profits
are lower than those produced by the best-practice banks after removing random error. To separate random error, we employ the thick frontier

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

See Berger, Hancock, and Humphrey
(1993); Berger, Hunter, and Timme
(1993); Swamy, Akhavein, and Taubman (1994); and Humphrey and Pulley
(1997) for studies that argue that bank
efficiency should be computed using a
profit function approach.

The thick frontier approach is one of the
main parametric frontier approaches
used by researchers to evaluate efficiency. Berger and Humphrey (1997)
summarize studies that have applied
various frontier approaches to evaluate
the efficiency of financial institutions in
various countries.

" The empirical evidence presented in
Berger and Humphrey (1991); Mester
(1993); and Berger, Hancock, and
Humphrey (1993) supports using only
the X-efficient, or best-practice, frontier
in estimating scale and scope efficiencies.
15

The initial sample consisted of a total of
9,942 banks. The elimination of banks
resulting in negative 8GfS7"computations brought the number of banks to
9,831.

It is necessary to scale net income
because the sample is broken into nine
broadly defined but adjacent size categories. The rate of return on equity
(ROE) is selected over the rate of return
on assets (ROA) for two reasons. First,
ROE is arguably the more appropriate
measure of profitability from the standpoint of both owners and regulators.
Second, ROE is a more comprehensive
profit performance measure than ROA
because it also incorporates the degree
of financial leverage utilized by the bank.

Table 2

Estimated Profit Inefficiency (INEFF)
INEFF when
excluding an
off-balance-sheet
measure

Category

PE when
excluding an
off-balance-sheet
measure

Total assets

PE when
including
BGEST

.663*

< $25

$25 million-$50

$50 million-$100

$100 million-$300

$300 million-$500

$500 million—$1

$1 billion-$5

$ 5 billion — $ 1 0

> $ 1 0

.818t

.832*

.911

.917t

.963

million

.965t

.985

million

.985^

.994

.991

.996

.993

.992

1.055

.982

million
million
million

billion

billion
billion

billion

1.020

.481

* significantly different f r o m 1 at t h e 1 p e r c e n t level.
t significantly different f r o m 1 at t h e 5 p e r c e n t level.
$ significantly different f r o m 1 at t h e 10 p e r c e n t level.
S O U R C E : F F I E C R e p o r t s of C o n d i t i o n a n d I n c o m e , a u t h o r s ' c a l c u l a t i o n s .

PROFIT ELASTICITY
To measure size-related profit efficiency
using the profit-function parameter estimates, a
measure of profit elasticity is computed that is
similar to the cost-elasticity measure used in
most cost-efficiency studies.25 Profit elasticity,
PE, is intended to capture the responsiveness of
profit to an equally proportionate increase in all
outputs. Averages of the explanatory variables
are found within each size category and then
used to compute PE for that category. That is,
PE measures the percentage change in profit
that results from an equal, proportionate change
in all outputs in the product mix. Product mix
is being held locally constant so that PE will
capture only changes in size.

even larger percentage increase in net income.
As a result, profit efficiency can be improved
through increases in size as long as PE > 1.
When PE < 1, profit efficiency declines with
increases in size so that expanding output does
not increase profits by as much.
Table 3 provides estimates of PE derived
from the parameters of best-practice profit functions estimated with data from the high-profit
frontier. Estimated profit elasticities for the
model that excludes the BGEST off-balancesheet measure indicate the presence of statistically significant, though decreasing, profit
diseconomies extending to about the $500 million on-balance-sheet asset size. This result suggests that proportionately expanding all outputs
does not proportionately increase profits by as
much. While PE exceeds a value of one for
banks in size categories of $5 billion and above,
these estimates are never statistically different
from one. Thus, above the roughly $500 million
total asset size, there does not appear to be any
significant profit diseconomies associated with
further increases in size.

If profits rise proportionately with increases in size, then PE = 1. If profits increase
disproportionately more (less) than a proportionate increase in all outputs, then PE > 1 (< 1).
A value of PE > 1 indicates that a given percentage increase in size is associated with an
Chart

Average Profit X-lnefficiency
INEFF

When the BGEST proxy is included in the
model, the resulting estimates of PE suggest an
alternative inference. All PE estimates are less
than one, but only the estimate obtained for the
smallest bank category (less than $25 million in
total assets) is statistically significant. Thus, with
the exception of those banks, there appear to
be no significant profit efficiencies or inefficiencies associated with alternative sizes. That is,
the statistically significant profit diseconomies
found in the model that excludes BGEST seem
to disappear (except for the smallest banks); the
view that profit improvements are proportionate
to increases in size for all asset-size categories

Asset-size category

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

See the appendix for a more formal
description of the INEFF calculation.
This excludes the INEFF measure for
the largest size category in the model.
Efficiency computations for the largest
size category are unstable because the
category contains fewer banks, which
are of widely varying sizes. The variance
of the prediction error for predicted
profits gets very large when the values
of the explanatory variables are far from
their mean values, which clearly happens
for the largest size category.
We use on-balance-sheet assets to provide a comparison with other studies.
See the appendix for a formal description of this profit-elasticity measure.

Table 4

Estimated Profit Expansion Path Subadditivity (PEPSUB)
Adjacent
size
categories
1
2
3
4
5
6
7
8

to
to
to
to
to
to
to
to

PEPSUB when
excluding an
off-balance-sheet
measure

2
3
4
5
6
7
8
9

.168*

.083t
,036t
.015f
.009
.005
-.002
.025

the profit of a larger bank (given its output mix)
can be duplicated by the profits of a smaller
bank (given its output mix) and that of a hypothetical bank, which, together with the smaller
bank, duplicates the outputs of the larger bank.
If the profits of the larger bank exceed the sum
of the profits of the smaller and hypothetical
banks, then a profit advantage exists for the
larger bank.
If profit (or net income) of the larger bank
exceeds the combined net incomes of the
smaller bank and the hypothetical bank, then
PEPSUB > 0 and the larger bank's size and
output-mix combination provides a profitability
advantage over the smaller bank with different output mixes. Under these circumstances,
smaller banks will not be competitively viable
in the long run. If PEPSUB < 0, then larger
banks do not have a profit-efficient size and
output mix and will not be competitively viable
in the long run.
Table 4 provides estimates of PEPSUB for
adjacent asset-size categories estimated using
the high-profit frontier.27 The PEPSUB estimates
for the model without the off-balance-sheet
measure indicate that statistically significant
profit expansion path subadditivity can be
found through the first five asset-size categories.
This suggests that increasing size and changing
output mix improve profit efficiency up to
approximately the $500 million asset size. So
among the smaller size categories, this measure
suggests that smaller banks will not be competitively viable in the long run. Beyond $500
million in assets, however, increasing size and
changing output mix have no statistically significant influence on profit efficiency.

PEPSUB when
including
BGEST
.088
.037
.014
.006
.003
.004
.011
.232

* significantly different from 0 at the 1 percent level,
t significantly different from 0 at the 5 percent level.
SOURCE: FFIEC Reports of Condition and Income, authors' calculations.

See the appendix for a formal derivation
of the profit expansion path subadditivity measure. Berger, Hanweck, and

greater than $25 million cannot be statistically
rejected when including the BGEST off-balancesheet output measure in the model. Locally, in
asset-size categories ranging between $100 million and $10 billion, the respective profit elasticities are extremely close to a value of one. An
elasticity value of one indicates that net income
expands at approximately the same rate as asset
size. Thus, with the exception of the smallest
size category, there is no scale-related profitefficiency advantage or disadvantage associated
with expansion.
The above result is important for two
reasons. First, it suggests that omitting the proxy
for off-balance-sheet assets from the profit function leads to estimates that incorrectly support
the notion that local profit diseconomies exist
with increases in size for banks with up to $500
million in total on-balance-sheet assets. Second,
it suggests that there is no single optimum bank
size but rather a wide range of sizes throughout
which there is little or no difference in scalerelated profit efficiencies.

But, similar to the results for PE, when
BGEST is incorporated into the model to proxy
off-balance-sheet activities, the results indicate
that the combined effects of changing size and
output mix have no statistically significant
impact on profit efficiency. Although the estimates for PEPSUB are always greater than zero,
they are never statistically significant. Thus,
once the off-balance-sheet measure BGEST is
included in the profit function, there is no
longer evidence suggesting that smaller banks
are not competitively viable.

Humphrey (1987) introduced a measure
to compute expansion path subadditivity
with a focus on costs. The measure
gives the proportional cost increase
from two-firm instead of one-firm production of outputs. As explained in
Berger, Hunter, and Timme (1993),
expansion path subadditivity provides a
more reasonable representation of the
opportunity of existing banking firms to
change their outputs than scope economies by combining the scale and product mix effects of moving from each
size class mean to the mean of the next
largest size class.
Consistent with the literature, adjacent
size classes are used to evaluate expansion path subadditivity. Furthermore,
given the ranges used to represent the
nine size categories, the relevant move
is to the next largest asset-size category, not to the largest.

PROFIT EXPANSION PATH SUBADDITIVITY
The estimates of PE presented above are
derived under the assumption that size increases are unaccompanied by changing output
mix. Because off-balance-sheet activities are
more common in larger banks, the relationship
between size and profit efficiency should be
examined when output-mix changes are not
held constant. In other words, the combined
effects of size and output mix should be examined to see whether there is a profit incentive to
either grow or shrink. To do this, we adapt a
commonly used competitive viability measure,
which we call profit expansion path subadditivity (PEPSUB).26 This measure examines whether

EFFICIENCY RESULTS SUMMARY
Taken together, the profit-efficiency results
presented here indicate that BGEST helps to
explain the differences in net income across
different size banks by including a useful output
measure for off-balance-sheet activities. We pro-

vide evidence that excluding a measure for
these activities is not supported statistically and
may distort efficiency computations. When including the BGEST measure as an output in the
profit function, however, no evidence of a statistically significant relationship between profit
efficiency and size remains, except for the
smallest size category.
Moreover, given that other studies that
have addressed off-balance-sheet activities
report that the largest banks appear to be cost
inefficient, the absence of profit inefficiency
found here suggests that off-balance-sheet
activities are revenue efficient. The inclusion of
BGEST with on-balance-sheet assets seems to
indicate that traditional measures used to evaluate efficiency are distorted. This result contradicts earlier efficiency research that concludes
that increased consolidation in the banking
industry would likely result in a less efficient
banking industry. Instead, banks appear to be
relatively equally efficient across most size categories, and no apparent profit economies or diseconomies are evident when including the
BGEST off-balance-sheet output in the models.
This result implies that banks of many sizes and
types are competitively viable and that ongoing
consolidation in the banking industry will not
harm and may improve overall profit efficiency.

Traditional bank regulation focuses on indepth knowledge of individual institutions and
relies primarily on the evaluation of traditional
bank efficiency and performance outcomes. But
this approach cannot be utilized in the new
banking environment—characterized by financial innovation and more off-balance-sheet
activities. Bank regulators, therefore, are faced
with the difficult task of having to accurately
quantify the risks and returns from nontraditional activities and then incorporate them into
new measures of efficiency and performance.
Or, they may have to rethink the regulatory
process so that these risks are evaluated and
curbed more by banks themselves, with increased reliance on market discipline.
While incremental improvements to maintain capital requirements, update supervisory
oversight and monitoring capabilities, and restrict risky activities can be effective in the short
run, regulators should also consider more radical changes to bank regulation in the long run.
Such approaches might include the precommitment approach to capital requirements proposed by Kupiec and O'Brien (1995), reduced
regulatory oversight in exchange for limited
access to the government safety net discussed in
Hoenig (1996), privatizing the FDIC as an insurance company and redefining the social contract by rethinking the role banks play in society
addressed by the Bank Administration Institute
and McKinsey & Company (1996), or adopting
some form of a collateralized banking system as
outlined in Edwards (1996). These proposed
changes to the regulatory process are important
because of the difficulties inherent in identifying, monitoring, and controlling risks from
state-of-the-art financial innovation.

POLICY IMPLICATIONS
These results also highlight a common
situation faced by bank regulators: if the traditional efficiency computations are inaccurate
because they lack a growing and significant
output measure, then the traditional regulatory
process might be one step behind as well.
Banking regulators are primarily concerned with
maintaining the safety and soundness of the
banking system. Key to this effort is early identification of a bank's troubled status so that failure can be avoided, or the resolution costs
minimized, and any potential contagion effects
eschewed. 28
One of the most important causes of bank
failure that is consistently identified in the research is the quality of bank management—a
crucial element of institutional success but difficult to measure empirically.29 Yet, closely related
to the quality of bank management is bank efficiency: the process of transforming banking
inputs into outputs. Accurately modeling this
transformation process as a proxy for management quality has proved effective in differentiating between banks that survive and those
that fail.30

FEDERAL RESERVE BANK OF DALLAS

CONCLUSION
We have shown that the use of traditional
methods and measures to evaluate bank efficiency can be misleading for banks that have
embraced nontraditional activities. Using a
traditional set of inputs and on-balance-sheet
outputs in a profit function model utilizing the
thick frontier approach, we find statistically significant profit diseconomies and profit expansion path subadditivity out to an asset size of
approximately $500 million. In particular, the
profit elasticity results suggest that expanding output while holding mix constant up to
roughly this asset size does not increase profits
at nearly the same rate. However, when product
mix is allowed to vary, the profit expansion
path subadditivity results suggest that increas-

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

Understanding the causes of bank
failure and the development of accurate
bank failure-prediction models has
become an important area of research.
See Barr and Siems (1997) and Cole,
Cornyn, and Gunther (1995) for more
on bank failure-prediction models.
See Siems (1992); Seballos and
Thomson (1990); Pantalone and Piatt
(1987); and Graham and Horner (1988)
for evidence that bank failures are primarily the result of mismanagement.
See Barr, Seiford, and Siems (1993) for
a data envelopment analysis approach
to measuring bank efficiency that finds
significant differences in average efficiency scores between surviving and
failing institutions.

Economies in Banking," Journal of Monetary

ing size—again up to approximately $500 million in assets—appears to provide a profitability
advantage.
In contrast, we find that when including
the Boyd and Gertler (1994) proxy for off-balance-sheet activities as an essential and necessary output in our profit function model,
evidence of a statistically significant relationship
between profit efficiency and size can no longer
be found. Moreover, excluding the Boyd and
Gertler off-balance-sheet approximation from
the profit function models is not supported
statistically, and its absence may distort traditional efficiency computations by seriously
understating actual bank output. This result—
which contradicts earlier bank-efficiency research
—implies that banks of many sizes and types
are competitively viable and suggests that ongoing consolidation in the banking industry will
not harm and may improve overall profit efficiency.

Economics

28 (August): 117-48.
(1997), "Efficiency of Financial Institutions:
International Survey and Directions for Future Research,"

European Journal of Operational

Research

98 (April):

175-212.
Berger, Allen N., William C. Hunter, and Stephen G. Timme
(1993), "The Efficiency of Financial Institutions: A Review
and Preview of Research Past, Present, and Future,"

Journal of Banking and Finance 17 (April): 2 2 1 - 4 9 .
Berger, Allen N., Kathleen Kuester King, and James M.
O'Brien (1991), "The Limitations of Market Value
Accounting and a More Realistic Alternative," Journal of

Banking and Finance 15 (September): 7 5 3 - 8 3 .
Berger, Allen N., and Loretta J. Mester (1997), "Inside the
Black Box: What Explains Differences in the Efficiencies
of Financial Institutions?" Journal of Banking and

Finance

21 (July): 8 9 5 - 9 4 7 .

REFERENCES

Boyd, John H., and Mark Gertler (1994), "Are Banks
Dead? Or Are the Reports Greatly Exaggerated?"

Amihud, Yakov, Peter Dodd, and Mark Weinstein (1986),
"Conglomerate Mergers, Managerial Motives, and

Federal Reserve Bank of Minneapolis Quarterly

Stockholder Wealth," Journal of Banking and

Summer, 2 - 2 3 .

Finance

Review,

10 (October): 4 0 1 - 1 0 .
Carroll, Raymond J., and David Ruppert (1988), TransforBank Administration Institute and McKinsey & Company

mation and Weighting in Regression

(1996), Building

Chapman and Hall).

Based

Better Banks: The Case of

Performance-

(New York/London:

Regulation.
Clark, Jeffrey A. (1988), "Economies of Scale and Scope

Barr, Richard S., Lawrence M. Seiford, and Thomas F.

at Depository Financial Institutions: A Review of the Litera-

Siems (1993), "An Envelopment-Analysis Approach to

ture," Federal Reserve Bank of Kansas City

Measuring the Managerial Efficiency of Banks," Annals of

Review, September/October, 1 6 - 3 3 .

Operations

Economic

Research 45 (December): 1 - 1 9 .
(1996), "Economic Cost, Scale Efficiency and

Barr, Richard S., and Thomas F. Siems (1997), "Bank

Competitive Viability in Banking," Journal of Money,

Failure Prediction Using DEA to Measure Management

Credit, and Banking 28 (August): 3 4 2 - 6 4 .

Quality," in Interfaces

in Computer

tions Research: Advances
tion, and Stochastic

Science and

in Metaheuristics,

Modeling

Technologies,

OperaClark, Jeffrey A., and Thomas F. Siems (1997), "Competi-

Optimiza-

tive Viability in Banking: Looking Beyond the Balance

ed. Richard

S. Barr, Richard V. Helgason, and Jeffery L. Kennington

Sheet," Federal Reserve Bank of Dallas Financial Industry

(Boston: Kluwer Academic Publishers), 3 4 1 - 6 5 .

Studies Working Paper no. 5 - 9 7 (Dallas, December).

Berger, Allen N., Diana Hancock, and David B. Humphrey

Cole, Rebel A., Barbara G. Cornyn, and Jeffery W.

(1993), "Bank Efficiency Derived from the Profit Function,"

Gunther (1995), "FIMS: A New Monitoring System for
Banking Institutions," Federal Reserve Bulletin 81

Journal of Banking and Finance 17 (April): 3 1 7 - 4 7 .

(January): 1-15.
Berger, Allen N., Gerald A. Hanweck, and David B.
Humphrey (1987), "Competitive Viability in Banking:

Edwards, Franklin R. (1996), The New Finance:

Scale, Scope, and Product Mix Economies," Journal of

tion and Financial Stability (Washington, D.C.: The AEI

Monetary Economics

Press).

20 (December): 5 0 1 - 2 0 .

Regula-

Berger, Allen N., and David B. Humphrey (1991), "The

Edwards, Franklin R., and Frederic S. Mishkin (1995),

Dominance of Inefficiencies Over Scale and Product Mix

"The Decline of Traditional Banking: Implications for

Financial Stability and Regulatory Policy," Federal

Market Risks," Finance and Economics Discussion Series

Reserve Bank of New York Economic

Working Paper no. 9 5 - 3 6 (Washington, D.C.: Federal

Policy

Review,

July, 2 7 - 4 5 .

Reserve Board of Governors, July).

General Accounting Office (1996), Financial

Actions

Taken or Proposed

Derivatives:

Mester, Loretta J. (1993), "Efficiency in the Savings and

Since May 1994, GAO/GGD/

Loan Industry," Journal of Banking and Finance 17

AIMD-97-8 (Washington, D.C.: Government Printing

(April): 2 6 7 - 8 6 .

Office, November).
Pantalone, Coleen C., and Marjorie B. Piatt (1987), "PreGraham, Fred C., and James E. Horner (1988), "Bank

dicting Commercial Bank Failure Since Deregulation,"

Failure: An Evaluation of the Factors Contributing to the

Federal Reserve Bank of Boston Economic

Failure of National Banks," Issues in Bank Regulation

July/August, 3 7 - 4 7 .

Review,

(Fall): 8 - 1 2 .
Pulley, Lawrence B., and Yale M. Braunstein (1992), "A
Hoenig, Thomas M. (1996), "Rethinking Financial Regula-

Composite Cost Function for Multiproduct Firms with an

tion" (Speech at the World Economic Forum Annual

Application to Economies of Scope in Banking," Review

Meeting, Davos, Switzerland, February 2).

of Economics

Humphrey, David B., and Lawrence B. Pulley (1997),

Pulley, Lawrence B., and David B. Humphrey (1993),

"Banks' Responses to Deregulation: Profits, Technology,

"The Role of Fixed Costs and Cost Complimentarities in

and Efficiency," Journal of Money, Credit, and

and Statistics 74 (May): 2 2 1 - 3 0 .

Determining Scope Economies and the Cost of Narrow

Banking

Banking Proposals," Journal of Business

29 (February): 7 3 - 9 3 .

66 (July):

437-62.
Jagtiani, Julapa, and Anya Khanthavit (1996), "Scale and
Scope Economies at Large Banks: Including Off-Balance

Seballos, Lynn D., and James B. Thomson (1990),

Sheet Products and Regulatory Effects (1984-1991),"

"Underlying Causes of Commercial Bank Failures in the

Journal of Banking and Finance 20 (August): 1271-87.

1980s," Federal Reserve Bank of Cleveland

Commentary,

Economic

September.

Jagtiani, Julapa, Alii Nathan, and Gordon Sick (1995),
"Scale Economies and Cost Complimentarities in

Siems, Thomas F. (1992) "Quantifying Management's

Commercial Banks: On- and Off-Balance-Sheet Activi-

Role in Bank Survival," Federal Reserve Bank of Dallas

ties," Journal of Banking and Finance

Economic

19 (October):

Review, First Quarter, 2 9 - 4 1 .

1175-89.
(1996), "Bank Mergers and Shareholder Wealth:
Jensen, Michael C., and William H. Meckling (1976),

Evidence from 1995's Megamerger Deals," Federal

"Theory of the Firm: Managerial Behavior, Agency Costs,

Reserve Bank of Dallas Financial Industry

and Ownership Structure," Journal of Financial

August, 1 - 1 2 .

Economics

Studies,

3 (October): 3 0 5 - 6 0 .
Swamy, P.A.V.B., Jalal D. Akhavein, and Stephen B.
Kaufman, George G., and Larry R. Mote (1994), "Is

Taubman (1994), "A General Method of Deriving the

Banking a Declining Industry? A Historical Perspective,"

Efficiencies of Banks from a Profit Function," Finance and

Federal Reserve Bank of Chicago Economic

Economics Discussion Series Working Paper no. 9 4 - 1 1

Perspec-

(Washington, D.C.: Federal Reserve Board of Governors,

tives 18 (May/June): 2 - 2 1 .

May).
Kupiec, Paul H., and James M. O'Brien (1995), "A PreCommitment Approach to Capital Requirements for

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

Appendix
The methodology we use to compute profit efficiency is well established in the literature. This appendix
provides a broad overview of the methodology and equations used to compute the various efficiency measures
we employ in this study. Interested readers are directed
to Clark (1988); Berger, Hancock, and Humphrey (1993);
Berger, Hunter, and Timme (1993); and Berger and
Humphrey (1997) for more details on bank
efficiency models.

A GENERALIZED INDIRECT PROFIT FUNCTION
The profit function to be estimated has the composite specification similar to profit functions utilized in
several other recent studies. 1 The general composite
profit function utilizes a quadratic structure for outputs
and a log quadratic structure for input prices. 2 It is best
viewed as a flexible, second-order approximation to a
wide class of specifications and takes the following general form:
p(6)

oo + l am zm +1PiYi
m
i

<e>+*

The superscript 0 indicates the application of the
B o x - C o x transformation to both sides of the expression.
The i outputs included in the profit function appear
as y „ the k input prices appear as rk, and Zm denotes
the m additional variables that are included to capture
other influences on profitability that are neutral with
respect to the included outputs. 3 In all instances the
measure of profit, P, employed as the dependent variable is net income. 4 A nonlinear least squares procedure
is used to estimate the parameters using a method discussed in Carroll and Ruppert (1988) and Clark (1996). 5

MEASURING PROFIT X-INEFFICIENCY

Humphrey and Pulley (1997) use a measure of
profit X-inefficiency similar to this in their study:

Pqi^QI
=

PQ4^QI

i
where P denotes profit (net income) and y, denotes the
/'th output. PE captures the responsiveness of profit to
an equally proportionate increase in all outputs. Variable
averages are found within each size category and then
used to evaluate profit elasticity for that size category.
When PE > 1, profits increase disproportionately more
than a proportionate increase in all outputs. When PE < 1,
profit elasticity declines, so a proportionate increase in
outputs does not increase profits by as much.

PROFIT EXPANSION PATH SUBADDITIVITY

The following PEPSUB measure was recently
used by Clark and Siems (1997):
=

P(QL)-[P(QS)

P(QH)]

P(QL)

where P() denotes the profit function, QL denotes the
mean output mix of banks in a given large-size category,
QS denotes the mean output mix of banks in the next
smallest size category, and QH denotes the output mix of
a hypothetical-size bank necessary to duplicate the output mix of the large-size banks so that QH= QL- QS. 7
Consistent with the literature, adjacent size classes are
used to evaluate expansion path subadditivity. For most
banks, the relevant move is to the next largest asset-size
category, not to the largest. PEPSUB is computed
across size categories to see whether the combined
changes in size and product mix provide a profit incentive to grow or shrink.
When PEPSUB > 0, the profit from the large bank
exceeds the combined profits from the smaller bank and
the hypothetical bank, which indicates that the smaller
bank will not be competitively viable in the long run.
When PEPSUB < 0, the larger bank does not have a
profit-efficient size and output mix and will not be competitively viable in the long run.

E Q M

FQqi

PE = X 0 P / 3 y , ) - ( y , / P ) .

Poi*Q1

INEFF measures the difference between the efficient
technology used by the high-profit banks ((301) and the
inefficient technology used by the low-profit banks (P04),6
using the data for the efficient frontier as a base where
X Q 1 is the mean value of each explanatory variable
across all banks in the most profitable frontier and EQQ 1
represents average equity capital across all banks in the
most profitable frontier. Thus, the difference in predicted
profitability between the high- and low-profit banks can
be rewritten as
INEFF

The following profit elasticity measure is the counterpart of the cost elasticity measure used in many cost
efficiency studies:

+ \ 1 1 P i Y i Y j + 1 1 Yt In rk
i j
i k

•exp 5 A l n r f c + X E 5 « l n ' i t l n ' /
k
k I

INEFF

MEASURING PROFIT ELASTICITY

™
ROE,„

FIOEQ4

where ROEq, denotes the predicted rate of return on
equity. INEFF, therefore, measures the percent difference in predicted profit between the most profitable and
least profitable quartiles.

See Pulley and Braunstein (1992); Pulley and Humphrey (1993); and
especially Humphrey and Pulley (1997).

Cross-product terms between the output and input price vectors link these
two structures so that separability is not imposed.

The simplifying assumption that the variables ZM are neutral with respect
to the y, outputs significantly reduces the number of parameters that must
be estimated and the high probability of multicollinearity problems that
may result by eliminating a whole set of second-order and interaction
terms.

Humphrey and Pulley (1997) report that dropping output quantities from
the profit function, while including output prices, is strongly rejected by the
data. In contrast, they report that dropping output prices does not appear
to quantitatively or statistically alter their results.

The method is a two-stage iterative procedure with a maximum of 400
iterations and a tolerance level of 0.0001.

The (3's are the parameter estimates obtained from the respective profit
functions.

We use P{0L)

in the denominator as a matter of convenience to convert

the measure into a percentage. In theory, QH = 0L - OS could be negative. but the size categories are so large that this does not happen.

Government
Guarantees and
Banking: Evidence
from the Mexican
Peso Crisis

Ongoing growth in Mexico is pushing the
1994 peso crisis further into the background.
Mexico's gross domestic product (GDP), which
has been growing since the second quarter
of 1996, rose 8.1 percent in the third quarter
of 1997 on a year-over-year basis. However,
Mexico's economy continues to show some lingering effects from the crisis. While inflation has
moderated, it remains above its precrisis level.
And the Mexican government estimates that its
cost of addressing stress in the banking industry
may amount to 8.4 percent of 1996 GDP on a
present-value basis.1
Mexico is not the only country that experienced significant economic fluctuations following the December 1994 peso devaluation,
(see the box entitled "Synopsis of the Peso
Crisis"). Argentina also suffered turmoil in its
banking system and economy. As in Mexico, the
banking system in Argentina experienced a
sharp reduction in the inflation-adjusted value
of bank deposits.
Argentina and Mexico differed, however,
in the supervisory policies they pursued both
before and after the devaluation. When the peso
crisis occurred, Mexico had a deposit insurance
system in place that provided extensive coverage of bank deposits. After the onset of the
crisis, these government guarantees were augmented by additional programs to assist banks
and their borrowers. Argentina, in contrast, did
not provide deposit insurance at the onset of
the peso crisis but thereafter adopted a limited
deposit insurance system and offered some
support to its banks.
Government guarantees weaken the link
between a bank's financial strength and the
safety of its deposits. In so doing, they diminish
depositors' incentive to avoid financially weak
banks. Hence, to the extent that government
guarantees were extensive in Mexico but negligible in Argentina, I would expect deposit growth
at individual banks to be unrelated to bank
financial strength in Mexico but to be positively
related to bank financial strength in Argentina.
The empirical examination below supports
these expectations and highlights an important
cost of government guarantees: guarantees can
suppress the market forces that would otherwise tend to channel funding toward stronger
banks and away from weaker ones.

Robert R. Moore

wile [government]

guarantees are reassuring
to depositors, they weaken
the competitive advantage that
would otherwise accrue to
financially strong banks.

BANKING POLICY BACKGROUND
How governments should respond to
financial difficulties in banking has long been
debated. Some analysts argue that government

Robert R. Moore is an economist
at the Federal Reserve Bank of Dallas.

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

I would like to thank Bill Gruben, Moises
Schwartz, and Carlos Zarazaga for helpful comments and Agustin Villar for
providing data on Argentinean banks.
' Bank of Mexico (1997).

Synopsis of the Peso Crisis
Mexico's Exchange Rate

T h e "peso crisis" refers to the economic turmoil that followed Mexico's a b a n d o n m e n t of a policy that set explicit limits on the exchange rate
between pesos a n d U.S. dollars. T h e Mexican government initiated a policy of exchange-rate-based
stabilization in March 1988. Several modifications
were made to this policy between March 1988 and
December 1994, but throughout this period the
government was committed to keeping the peso
within a specified range of values.

Pesos per U.S. dollar, monthly average

9 -i

O n December 20, 1994, Mexico devalued
the upper limit on the peso's value by 15 percent
a n d two days later allowed the exchange rate to
float. T h e accompanying chart s h o w s the subsequent decline in the value of the peso a n d the
increase in its volatility. A decline in G D P and an
increase in inflation and interest rates are s o m e of
the other c h a n g e s in the Mexican economy that followed the devaluation. T h e s e negative effects are
all considered part of the peso crisis. (For a more
detailed description of the crisis, see Gould 1996.)

Mar.
'88

See Bernanke and Gertler (1995) and
the citations therein for a discussion of
credit's role in the macroeconomy.
See Kane (1989) and Barth (1991) for
more on the evolution of the thrift crisis.

Mar.
'90

Mar.
'91

Mar.
'92

Mar.
'93

Mar.
'94

Mar.
'95

Mar.
'96

SOURCE: Instituto Nacional de Estadfstica Geograffa e
Informatica (INEGI) database.
T h e inflation-adjusted value of bank deposits contracted in Colombia but to a smaller degree than in
Mexico or Argentina. Other countries in the region
experienced a slump in share prices a n d a rise in
interest rates. T h e s e spillover effects represented
a potentially significant source of stress on the
affected countries' banking systems.

T h e effects of the crisis extended beyond
Mexico. Argentina experienced a decline in bank
deposits a n d an increase in interest rates. T h e
impact of the Mexican peso crisis on other Latin
A m e r i c a n countries varied in magnitude and form.

See, for example, Kareken (1985).

Mar.
'89

A complete welfare analysis of the desirability of forbearance needs to consider several
factors, including its impact on solvent institutions and the effect the anticipation of forbearance has on the incentive to adopt risky
banking strategies. The policy's desirability also
depends on whether the cost to the government
of honoring deposit guarantees increases or
decreases under forbearance—that is, whether
closing an insolvent institution as soon as possible costs less than allowing the institution to
attempt to grow out of its problems. Finally, the
effect of forbearance on preserving lending
flows and ameliorating weakened macroeconomic performance needs to be considered.
These factors contributed to the debate
about government assistance to financial institutions in several recent episodes in the United
States. When problems developed in the thrift
industry, forbearance policies were pursued. As
capital ratios at thrifts declined, the Federal
Home Loan Bank Board reduced the amount
of capital thrifts were required to hold and
adopted an accounting methodology that artificially inflated the amount of capital thrifts carried on their books. 4 Thrifts with depleted
capital then had an incentive to pursue high-risk
strategies to restore their capital positions. Kane

assistance to the industry is undesirable because
it distorts market incentives in a harmful way.2
These analysts argue that policies that attempt
to reduce the problems associated with banking
distress create incentives that make such distress
more likely. Shifting the costs associated with
bad outcomes to the government reduces the
incentive to avoid risks and thus makes risktaking more likely.
Others argue that there are no close substitutes for bank credit for some borrowers;
therefore, reductions in the supply of such credit
can negatively affect the economy. 3 Under this
view, government assistance allows troubled
banks to continue lending to viable businesses
that might otherwise have difficulty obtaining
credit.
Such government assistance could come
in the form of regulatory forbearance, whereby
regulators temporarily refrain from imposing
their customary standards for bank safety and
soundness. If, for example, a bank did not have
enough capital to meet regulatory requirements,
regulators could allow the bank to continue
operating. Regulators might pursue such a
policy if they believed the bank's weak capital
position was transitory and imposing the usual
standard would be deleterious.

tees. If government guarantees are available,
then penetrating this veil with a strong supervisory system is important. With these issues in
mind, the remainder of this article examines the
extent of government banking guarantees in
Mexico and Argentina and the relationship
between those guarantees and deposit flows
and bank financial condition.

(1989) argues that forbearance allowed thrifts to
pursue high-risk strategies that ultimately increased the cost to the taxpayer of paying for
thrift failures.
While the effects of the thrift crisis were
felt nationwide, the situation in Texas was especially severe. Short and Gunther (1988) report
that the continued operation of insolvent thrifts
in Texas under forbearance policies created an
unfavorable operating environment for solvent
financial institutions. In particular, they find
that solvent banks and thrifts in Texas offered
higher interest rates on deposits than did their
counterparts elsewhere in the country. Consequently, they conclude that the forbearance
that kept insolvent thrifts operating in Texas
penalized the solvent institutions.
More recently, financial problems among
New England banks again raised the issue of the
appropriate policy on weakened financial institutions in a regional downturn. Peek and Rosengren (1995) show that reductions in bank credit
in New England during the 1990-91 recession
were linked to reductions in bank capital. They
point out that in a regional downturn, greater
account of the macroeconomic consequences of
bank regulatory actions is needed. While not an
explicit call for regulatory forbearance, this is
at least suggestive of easing standards when a
region's financial industry and economy are weak.
Current U.S. policy is tilted away from
government assistance to banks. In the wake of
the bank and thrift crisis, the United States
moved away from forbearance. In particular,
the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA) ties regulatory actions to bank capital. Under FDICIA, a
bank is subject to greater regulatory restraints as
its capital ratio falls, culminating in closure
when it falls below a critical level. These
"prompt corrective action" features of FDICIA
limit regulators' ability to forbear.5
Kaufman (1996) argues that FDICIA-type
legislation offers a useful system for counterbalancing the effects of government guarantees in
banking in developing countries. As Mishkin
(1996) and others discuss, building a strong
bank supervisory system to limit the potentially
harmful effects of government guarantees is
particularly important for developing countries.
Because the banking system plays such a significant role in allocating capital in developing
countries, banking disruptions will have an
especially severe economic impact. Moreover,
difficulties in acquiring information in developing countries may create a veil behind which
the banks can abuse the government guaran-

FEDERAL RESERVE BANK OF DALLAS

RECENT BANKING POLICIES IN MEXICO
AND ARGENTINA
A government's bank supervisory policies
influence the relationship between banks and
their depositors. Policies that guarantee deposits
diminish depositors' concern about the soundness of their bank. This loss of concern tends to
be more complete when government guarantees are extensive. While such guarantees are
reassuring to depositors, they weaken the competitive advantage that would otherwise accrue
to financially strong banks. By reducing that
advantage, economic theory suggests that
extensive government guarantees diminish
banks' incentive to pursue policies that build
financial strength.
Economists describe market discipline as
the extent to which bank depositors — or bank
liability holders in general — reduce banks'
incentives to take risk. Gilbert (1990) reviews
the related literature and reports that evidence
of market discipline is mixed. Bank liability
holders' sensitivity to a bank's risk profile
depends on whether those liability holders
believe they are covered by government guarantees. When government safety nets are prevalent—as they are in many countries—bank
liability holders have little incentive to respond
to changes in bank risk. Consequentially, neither the volume nor the price of bank liabilities
would respond to such changes. An examination of Mexico and Argentina in the wake of the
devaluation can potentially provide new evidence on the influence of liability holders on
banks' risk-taking incentives and contribute to
the market discipline literature. Because Argentina stands out as a country that offers a setting
with relatively limited safety nets, it provides an
environment in which market discipline may be
likely to occur.6

Such a policy has been endorsed by
the Shadow Financial Regulatory Committee, a group of independent authorities that seeks to influence public policy
on the financial industry. See Shadow
Financial Regulatory Committee (1992)
for some of its views on FDICIA.
The following description of government guarantees shows that Mexico has

Mexico Before the Devaluation
Even before the peso crisis, the Mexican
government provided an important guarantee to
depositors in its banking system through
deposit insurance. The coverage offered by
Mexico's deposit insurance fund, FOBAPROA

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

a more extensive set of guarantees than
Argentina, based on the explicit guarantees established in the two countries.
However, implicit government guarantees may also be important. Because of
complexities associated with implicit
guarantees, the discussion that follows
is limited to explicit guarantees.

ment bears part of the losses on those loans,
with the bank bearing the remainder. In addition, the government purchases these loans with
long-term, nonmarketable government bonds
that pay capitalized interest until maturity. This
program provides incentives to attract new
capital to banks and insulates the banks from
part of the losses on the affected loans.

(Bank Fund for the Protection of Savings), is
extensive. FOBAPROA explicitly offers full coverage of deposits, with limited exceptions. 7 Such
coverage could leave depositors with little concern about the condition of their bank, depending on their faith in the FOBAPROA guarantee.

Mexico After the Devaluation

See Bank of Mexico (1996) for details
regarding FOBAPROA's commitment to
insuring bank liabilities.

® The UDI program moves the restructured loans off the balance sheet and
replaces them with special government
securities. The government estimates
its cost (in present value) for this program at 21.6 billion pesos. In addition,
the government estimates its cost for
the additional benefits program for UDI
mortgages at 27.2 billion pesos (Bank
of Mexico 1997).
9

Gruben and Welch (1996) discuss the
government's assistance to banks
during the peso crisis in the context of
the evolution of the Mexican financial
system.

Urbina-Nandayapa (1995).

The central bank charter limited the
maturity and amount of loans to any
one borrower. The convertibility law
constrained the aggregate amount of
central bank lending by tying the monetary base to foreign reserves.

Calomiris (1996) discusses the tendency for governments to increase
support of the banking system during
times of financial stress.

Argentina has maintained an exchange
rate of one peso for one U.S. dollar, so
the insurance limits correspond to
$10,000 and $20,000.

" Republic of Argentina (1996).
,s

See note 14 above.

As banks and their borrowers suffered
financial stress during the peso crisis, the government stepped in to provide support beyond
the FOBAPROA guarantee. Some of these programs aid banks directly, while others help
them indirectly by assisting their borrowers.
By supporting troubled banks, these programs
further insulate depositors from the condition
of their bank.
One program to help borrowers is the UDI
(units of inversion) restructuring program,
which indexes loans to the rate of inflation. The
principal balance appreciates at the rate of inflation, and the borrower pays the real rate of
interest on that principal balance. 8 Moreover,
the government funds discounted payments for
borrowers with mortgages in the UDI program.
When inflation and nominal interest rates
soared during the peso crisis, some borrowers
could not make the payments on their loans; the
restructuring of those loans under the UDI
program reduced the borrowers' monthly payments. Thus, borrowers that might have been
driven into default by the rise in nominal interest rates were not, insulating lenders from
inflation-induced defaults.9

Argentina Before the Devaluation
Before the Mexican crisis, Argentina
offered the banking system little in the way of
government guarantees. Not only was there no
deposit insurance, but the government's ability
to guarantee liquidity through the lender-of-lastresort function was limited by the central bank's
charter and by a convertibility law.11 In this environment, depositors would have viewed the
financial strength of their bank as an important
determinant of deposit safety.

Argentina After the Devaluation
Although Argentina took several steps to
help its banking system after the peso devaluation, the support was not so pervasive that it
precluded exit from the industry.12 Of the 204
banks operating in December 1994, fourteen
had been closed and forty-eight were merged
with other banks by March 1997.
Part of the assistance to the banking industry took the form of deposit insurance. In April
1995, Argentina initiated insurance coverage of
up to 10,000 pesos for short-term deposits and
up to 20,000 pesos for long-term deposits.13 This
insurance applies to both dollar- and pesodenominated deposits.14 Although such insurance could leave small depositors unconcerned
about the condition of their bank, larger depositors would have the incentive to remain
attuned to the financial condition of their bank,
especially if other government support of the
banking industry is limited.
Another step taken to support Argentinean
banks was a reduction in reserve requirements,
which provided banks with additional liquidity
to satisfy depositor withdrawals. In addition,
banks were allowed to satisfy the reserve
requirements with dollar-denominated reserves
at Argentina's central bank; this flexibility
reduced banks' exposure to potential devaluations.15
Argentina also established several programs to assist banks directly. The central bank
set up two funds, totaling $1 billion, for buying
assets from illiquid banks. The government
established an additional $2 billion fund for
facilitating mergers of troubled banks and eased

The ADE (Immediate Support Program
for Debtors) program also assists financially
troubled borrowers.10 ADE offers interest subsidies and loan restructuring to distressed borrowers for up to eighteen months, in the hope
that those borrowers can resume free market
interest payments after they have recovered
from their current difficulties. Here, too, banks
may benefit indirectly from assistance to their
borrowers.
PROCAPTE (Temporary Capitalization Program) provides direct capital assistance to banks
through convertible subordinated debt. Unlike
an issue of subordinated debt to the private sector, this debt does not provide banks with new
funding because the government requires that
they hold compensating reserve deposits
against the PROCAPTE debt.
Finally, the loan-purchase/recapitalization
program also assists capital-impaired banks.
Under this program, the government purchases
two pesos in loans from a bank for each peso
in new capital the bank attracts. The govern-

a restriction that had limited the central bank's
loans to illiquid banks to thirty days or less.16
While these measures provided relief to
banks, Argentina's convertibility law continued
to constrain the extent of government assistance
significantly. As discussed by Zarazaga (1995),
the convertibility law ties Argentina's monetary
base to its foreign reserves. Specifically, the
monetary base cannot exceed foreign reserves
by more than 25 percent, under the stipulated
exchange rate of one Argentinean peso per U.S.
dollar. This limit restricted the government's
ability to finance its bank assistance through
money creation.17

Chart 2

Inflation-Adjusted Bank Deposits in
Argentina and Mexico
Index, D e c e m b e r 1994 = 100
120

Real deposits - Argentina

105 100 -

80 -|

AGGREGATE BANKING EFFECTS
Chart 1 shows the large increases in interest rates banks in Mexico and Argentina faced
following the onset of the peso crisis. In both
countries, interest rates were higher in early
1995 than they had been in several years. As the
chart shows, interest rates in Mexico rose more
than they did in Argentina. Banks in both countries, however, experienced an increase in the
cost of deposit funding.
As interest rates rose during the peso crisis, bank deposits fell, consistent with a reduction in the supply of bank deposits. Chart 2
shows what happened to the inflation-adjusted
amount of deposits in Argentina and Mexico.18
From December 1994 to June 1995, inflationadjusted deposits fell by 13-6 percent in Argentina and by 12.9 percent in Mexico. Despite the
similarity in the percentages, the reductions
occurred in different ways. In Mexico, the nominal value of deposits actually increased by 15.8

S O U R C E S : Comision Nacional Bancaria, "Boletfn Estadfstico de
B a n c a Multiple," v a r i o u s issues; I N E G I d a t a b a s e ;
S a l o m o n B r o t h e r s ; C e n t r a l B a n k of A r g e n t i n a ;
author's calculations.

percent between December 1994 and June
1995, but a 32.9 percent increase in the price
level eroded their real value. In Argentina, however, prices rose only 1.1 percent, so the decline
in the real value of deposits reflects an approximately equal drop in their nominal value.19
The analysis of deposit flows at individual
banks below considers those that occurred
between December 1994 and June 1995. As
Chart 2 shows, in both Argentina and Mexico
the aggregate value of deposits reached quarterly peaks in December 1994. By June 1995,
the worst of the slide in the inflation-adjusted
value of deposits was over in both countries.
Thus, considering the changes in deposits that
occurred at individual banks during this period
captures the worst of the crisis in terms of
the decline in the inflation-adjusted value of
deposits.

Chart 1

Deposit Rates in Mexico and Argentina
Percent

Dec. Mar. June Sept. Dec. Mar. June Sept. Dec. Mar. June Sept. Dec.
'93
'94
'94
'94
'94
'95
'95
'95
'95
'96
'96
'96
'96

Percent

Argentina

Mexico

BANK FINANCIAL CONDITION AND DEPOSIT
FLOWS DURING THE PESO CRISIS
Although both Argentina and Mexico have
extended government assistance to their banking systems, the degree to which that assistance
has supplanted free market forces in shaping
banking outcomes remains an empirical issue.
To the extent that depositors view the government guarantees of their deposits as incomplete,
there is an incentive for depositors to reduce
their exposure to relatively weak banks when
the banking system is under stress. Thus, evidence on the link between deposit flows and
financial condition at individual banks can shed

S O U R C E S : M i g u e l A. B r o d a a n d A s s o c i a t e s , " C a r t a E c o n o m i c a " ;
INEGI databases.

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

Carrizosa, Leipziger, and Shah (1996).
See Caprio, et al. (1996) for more on
the constraints a currency board imposes on the lender-of-last-resort function.
Throughout this article, "deposits" in
Mexican banks refers to captacidn

directa, or direct funding. Direct funding
predominantly consists of deposits but
includes certain repurchase agreements
and bankers' acceptances.
The difference in inflation in Mexico and
Argentina during the peso crisis reflects
the variation in monetary policies in the
two countries.

To the extent that accounting systems
differ across countries, the data may
not be directly comparable. Analyzing
the countries separately may ameliorate
this problem. Suppose, for example,
that the accounting measures of pastdue loans differ in two countries but are
linear functions of the same underlying,
fundamental measure. Examining statistical significance in regressions of
deposit flows on past-due loans in the
two countries would be meaningful
despite the differences in accounting
systems. Conducting a statistical test
for the equality of slope coefficients in
the countries would remain problematic.
Differences in the strength of the countries' banking systems at the onset of
the crisis and differences in macroeconomic policies could also affect the
results.
Rojas-Suarez and Weisbrod (1996)
argue that suitable measures of capital
may be unavailable for Latin American
banks. Based on the rates offered on
deposits, they conclude that bank
liability holders in both Mexico and
Argentina identified risky banks.
The other banks in operation between
December 1994 and June 1995 are
unsuitable because they were in operation for only a short time before the
onset of the peso crisis and thus had
unseasoned asset portfolios and a
developing depositor base.
While the evidence shows depositors
behaving independent of banks' financial condition, other creditors may have
considered banks' financial condition.
Bank of Mexico (1996) reports that
weak banks faced higher rates in the
interbank market, providing evidence of
that market penalizing weak banks.

light on the role of free market forces in shaping banking outcomes.
Before proceeding with the empirical
analysis, some caveats are worth noting. There
are potential pitfalls in making international
comparisons based on accounting data.20 Also,
differences in the link between deposit growth
and individual bank strength in the two countries could stem from factors other than differences in supervisory policies.21 Mexico was
directly affected by the crisis, while Argentina
was only affected indirectly through spillover
effects, as mentioned in the box. The spillover
effects from the crisis, however, had the potential to disrupt an affected country's banking system significantly through higher interest rates
and deposit outflows, among other factors.
Moreover, the similarity in the decline in inflation-adjusted deposits in Mexico and Argentina
suggests that the crisis stressed both banking
systems intensely.

Chart 3

Deposit Growth and Asset Quality in Mexico
Real Deposit Growth, December 1994-June 1995
Percent

30
20

10 -

o
-10

difficult. These variables may have influenced deposit flows, but the small
number of observations masks their
influence.

-20

•• • • • • •

-30 -40 -50

Ratio of p a s t - d u e l o a n s to total a s s e t s
as of D e c e m b e r 31, 1994, p e r c e n t

SOURCES: Comision Nacional Bancaria, "Boletfn Estadfstico de
Banca Multiple"; INEGI database; author's calculations.

While keeping these caveats in mind, the
empirical work proceeds to examine the link
between deposit flows and bank characteristics.
Various financial characteristics could play a
role in shaping depositors' perceptions of the
soundness of their banks. A natural candidate
would be some measure of banks' capital adequacy, given the traditional view of capital as
protecting debt holders.22 Other potential financial characteristics include measures of asset
quality, such as the ratio of past-due loans to
total assets. In any case, detailed analyses using
numerous financial measures are not practical
because only sixteen banks in Mexico are suitable for regression analysis over the relevant
period.23

where DEPGRO is the percentage change in
inflation-adjusted deposits between December
1994 and June 1995; PDIVTA is past-due loans as
a percentage of total assets, included to measure
the quality of the asset portfolio; EQ/TA is equity capital as a percentage of total assets, included to measure the ability to maintain solvency
in case of financial losses; TA is the logarithm of
total assets in millions of Mexican pesos, included to control for the potential influence of
bank size on depositor behavior; and DEP/L is
deposits as a percentage of total liabilities,
included to control for the potential influence of
liability composition on depositor behavior. All
explanatory variables are as of December 1994.
There are sixteen observations. Standard errors
are shown in parentheses.

Mexico
Chart 3 shows the connection between
deposit flows and financial condition at individual Mexican banks. A casual inspection of
the chart reveals the lack of a relationship
between the ratio of past-due loans to total
assets and deposit growth. Moreover, the slope
of the regression line is not statistically different
from zero. Hence, depositors did not systematically discriminate among banks in terms of their
past due loan-to-asset ratio in choosing where
to hold deposits.24
The following regression confirms and
extends the results from Chart 3:

None of the explanatory variables is individually significant at the 10 percent level. The
variables are also not jointly significant at the 10
percent level. Thus, the evidence does not support the notion that the financial variables in the
regression influenced deposit flows.25 Given that
deposit flows were unrelated to bank financial
condition, the evidence is consistent with depositors behaving as if they perceived the insurance coverage of their deposits as completely
shielding them from risk associated with their
bank's financial condition.

DEPGRO = 59.3 + •473 PDIVTA - .888 EQ/TA
(79.0) (3.83)
(3.51)
- 8.38 TA - .386 DEP/L,
(6.57)
(.662),

Results for Argentina differ noticeably
from those for Mexico. Chart 4 reveals that higher ratios of past-due loans to total assets are
associated with greater declines in deposits.

Argentina

However, with only sixteen observations, identifying effects statistically is

Moreover, this tendency is statistically significant. Thus, the results are consistent with depositors discriminating among banks based on
the quality of asset portfolios.
The following regression model shows the
relationship between deposit flows and bank
financial characteristics:

Chart 5

Deposits at the Top 20 Argentinean Banks
Grouped by December 1994 Ratios of
Past-Due Loans to Total Assets
Billions of p e s o s
45
PBj Less than 6 percent

DEPGRO = - 122* - 1.05 PLWTA]
(64.5)
(.307)
+ .821 EQ/TA* + 2.98 TA
(.432)
(4.70)
+ 1.07 DEP/Li,
C256),

| Between 6 and 9 percent

Greater than 9 percent

where * and f denote statistical significance at
the 10 percent and 1 percent levels, respectively. The model is identical to the one for Mexico,
except that TA is the logarithm of total assets
measured in millions of Argentinean pesos, and
there are twenty observations instead of sixteen.26
The results show that higher deposit
growth is associated with lower ratios of past
due loans to assets, higher ratios of capital to
assets, and higher ratios of deposits to liabilities.
The first two results are consistent with deposits
moving to banks with greater intrinsic financial
strength.27 The last result may reflect the effect
of the government's move to cut reserve
requirements. Banks with a larger fraction of
their liabilities coming from deposits would
receive a greater boost to liquidity from the
reduction in reserve requirements. The results
support the view that depositors discriminated
based on the financial condition of banks. Such

Dec.
'94

Mar.
'95

June
'95

Sept.
'95

Dec.
'95

Mar.
'96

June
'96

Sept.
'96

Dec.
'96

S O U R C E S : C e n t r a l B a n k of A r g e n t i n a , a u t h o r ' s c a l c u l a t i o n s .

discrimination is consistent with depositors viewing the safety of their deposits as linked to the
financial strength of their bank.
The results for Argentina show that greater
financial strength was accompanied by more
rapid deposit growth from December 1994 to
June 1995. Did the deposits the stronger banks
gained during this time flow back to the weaker banks after the worst of the crisis was over?
To address this question, Chart 5 tracks deposits
at the top twenty Argentinean banks from
December 1994 to December 1996, with the
banks grouped by their past-due loan-to-asset
ratio as of December 1994. The banks with the
poorest asset quality had $4.7 billion in assets in
December 1994 but never regained that level of
deposits despite the strong growth in total
Argentine deposits between December 1994
and December 1996. Banks in the medium- and
high-asset-quality groups, however, had deposit
growth of 37 and 38 percent, respectively, over
that same period. Thus, the tendency for deposit growth to be higher at banks with higher
asset quality increased their share of deposits
between December 1994 and December 1996.

Chart 4

Deposit Growth and Asset Quality in Argentina
Real Deposit Growth, December 1994-June 1995
Percent

Using the twenty largest banks in
Argentina creates a sample comparable
to that for Mexico in terms of the size of
both the sample and the banks. Moreover, as of December 1994, these banks
accounted for 64 percent of Argentina's
total banking assets, with the other 36
percent divided among the remaining
184 banks. If the remaining banks are
included in the regression, the asset
quality and capitalization variables are
no longer significant. Thus, while the
bulk of banking activity in Argentina
is characterized by a significant link

CONCLUSION: LETTING THE BANKING
MARKET WORK
The evidence presented above shows
Argentina and Mexico pursuing supervisory
policies that produce differing results. Because
Mexico supports its banks with extensive government guarantees, depositors behave as if the
safety of their deposits is independent of their
bank's condition. Although Argentina increased

Ratio of p a s t - d u e l o a n s to total a s s e t s
as of D e c e m b e r 1994, p e r c e n t
S O U R C E S : C e n t r a l B a n k of A r g e n t i n a ; a u t h o r ' s c a l c u l a t i o n s .

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

between bank financial condition and
deposit flows, the evidence does not
show that link extending to the entire
population of banks.
Conceptually, growth in deposits could
occur either through depositors choosing to move their funds into a bank or
from one bank acquiring another bank
and its deposits. The banks in the sample, however, did not acquire any banks
between December 1994 and June
1995, so the growth in deposits was
not due to acquisitions.

Barth, James R. (1991), The Great Savings and Loan

its support of its banks during the Mexican peso
crisis, depositors behave as if the safety of their
deposits is linked to the condition of their bank.
What is important about this distinction?
The quick answer is that depositors in
Mexico are in a more favorable position than
those in Argentina, because they are free from
worry about the safety of their deposits. Such
freedom has a cost, however. When depositors
view the safety of their deposits as unrelated to
the condition of their bank, they become willing
to fund weak and strong banks equally. When
this occurs, strong banks lose the funding advantage their strength would otherwise confer.
That funding advantage serves a useful
purpose because stronger banks are those with
a better record than their peers for sound lending decisions. If these banks continue making
good decisions, then directing funds to the
stronger banks will tend to result in the funds
being used well. Banks with lending policies
that result in repaid loans are directing capital to
borrowers that are passing the market test for
the worth of their projects.
When funds flow to weaker banks because
of government guarantees, the market mechanism that would otherwise limit the size of
those banks is subverted. Absent guarantees,
banks with lending policies that produce
unpaid loans and financial losses that erode the
capital-to-asset ratio tend to have difficulty
obtaining funding; if funding declines, so does
the size of the bank. Thus, strong banks would
tend to grow while weak banks would shrink,
thereby allowing the industry to evolve toward
strength. This process breaks down when guarantees allow weak and strong banks equal
access to funding.
The cost of guarantees may also emerge
more directly. If weak banks can grow by availing themselves of subsidized funding, they have
the potential to produce increasing losses. Such
losses would eventually result in a liability for
taxpayers. In anticipation of such problems, the
government can attempt to limit the losses by
regulating the behavior of the insured banks.
Attempting to limit the effects of extensive guarantees, however, may require an equally extens i v e — and expensive — regulatory system.

Debacle (Washington, D.C.: AEI Press).
Bernanke, Ben S., and Mark Gertler (1995), "Inside the
Black Box: The Credit Channel of Monetary Policy
Transmission," Journal of Economic

Perspectives,

Fall,

27-48.
Calomiris, Charles W. (1996), "Building an IncentiveCompatible Safety Net: Special Problems for Developing
Countries" (Paper presented at the conference "Policy
Rules and Tequila Lessons," Buenos Aires, August).
Caprio, Gerard, Michael Dooley, Danny Leipziger, and
Carl Walsh (1996), "The Lender of Last Resort Function
Under a Currency Board: The Case of Argentina," World
Bank Discussion Paper no. 1648 (Washington, D.C.:
World Bank, June).
Carrizosa, Mauricio, Danny M. Leipziger, and Hemant
Shah (1996), "The Tequila Effect and Argentina's Banking Reform," Finance and Development

33 (March):

22-25.
Gilbert, R. Alton (1990), "Market Discipline of Bank Risk:
Theory and Evidence," Federal Reserve Bank of St. Louis

Economic

Review, January/February, 3 - 1 8 .

Gould, David M. (1996), "Mexico's Financial Crisis:
Looking Back to Assess the Future," in

Changing

Structure of Mexico: Political, Social, and
Prospects,

Economic

ed. Laura Randall (Armonk, New York: M.E.

Sharpe), 1 5 - 3 9 .
Gruben, William, and John H. Welch (1996), "Distortions
and Resolutions in Mexico's Financial System," in

Changing

Structure of Mexico: Political, Social, and

Economic

Prospects,

ed. Laura Randall (Armonk, New

York: M.E. Sharpe), 6 3 - 8 1 .
Kane, Edward J. (1989), The S&L Insurance

Mess: How

Did It Happen? (Washington, D.C.: The Urban Institute
Press).
Kareken, John H. (1985), "Ensuring Financial Stability," in

The Search for Financial Stability: The Past Fifty Years,
(San Francisco: Federal Reserve Bank of San Francisco),
53-77.
Kaufman, George G. (1996), "Designing an Efficient and
Incentive Compatible Government-Provided Deposit

REFERENCES

Insurance Program for Developing and Transitional

Bank of Mexico (1996), The Mexican Economy

Economies" (Manuscript, Loyola University).

1996

(Mexico City: Bank of Mexico).
Mishkin, Frederic S. (1996), "Lessons from the Tequila
(1997), The Mexican Economy

Crisis" (Speech at the conference "Policy Rules and

1997 {Mexico City:

Tequila Lessons," Buenos Aires, August).

Bank of Mexico).

Peek, Joe, and Eric Rosengren (1995), "The Capital

Journal of Financial Services Research 6 (September):

Crunch: Neither a Borrower Nor a Lender Be," Journal of

279-80.

Money, Credit and Banking 27 (August): 6 2 5 - 3 8 .
Short, Genie D., and Jeffery W. Gunther (1988), "The
Republic of Argentina (1996), Economic

Report 1995

Texas Thrift Situation: Implications for the Texas Financial

(Buenos Aires: Ministerio de Economla y Obras y

Industry," Federal Reserve Bank of Dallas Financial

Servicios Publicos, Secretaria de Programacion

Industry Studies, September, 1-11.

Economlca).
Urbina-Nandayapa, Arturo (1995), iDebo
Rojas-Suarez, Liliana, and Steven R. Weisbrod (1996),

Firmar el ADE?

(Mexico City: SICCO).

"Towards an Effective Regulatory and Supervisory
Framework for Latin America," Inter-American

ment Bank Discussion

Develop-

Zarazaga, Carlos (1995), "Argentina, Mexico, and

Paper no. 336 (Washington, D.C.).

Currency Boards: Another Case of Rules Versus
Discretion," Federal Reserve Bank of Dallas

Shadow Financial Regulatory Committee (1992), "State-

Review, Fourth Quarter, 1 4 - 2 4 .

ment No. 76: The FDIC Improvement Act of 1991,"

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998

Economic

Full text of Financial Industry Studies : December 1997

FRASER