Home | Business News | Browse by Publication | I | International Advances in Economic Research

Regulatory optimal bank size.

Article Excerpt
Abstract This paper presents a study of potential outcomes of bank growth. Banks grow by expanding market presence within the geographic region within which they are domiciled and by expanding presence into other regions via new implantations. Growth leads to improved diversification, but also results in an increase in the risk of catastrophe that a bank's failure may engender. The conclusion is that there will exist a threshold size of bank at which the rate of growth in its systemic risk exceeds the rate of decline in its risk of insolvency. An empirical study of US bank call report data provides results that are consistent with the theory presented in the first part of the paper.

Keywords Banks. Systemic risk. Diversification. Optimal size

JEL Classification D21. E50. G20 L10 R10

Introduction

This paper studies the heterogeneity present across bank structures, as well as the heterogeneity that exists in the interbank markets. Banks are observed to be spatially separated from heterogeneously allocated investment alternatives and to have investment costs that are partially dependent upon distance. Limitations to divisibility of investment alternatives, as well as distance costs, result in heterogeneous portfolios, and this creates heterogeneity in systemic risk.

In the presence of distance costs, spatial separation of investment alternatives requires a bank to grow geographically in order to reduce the distance between it and a new subset of alternative investments. Bank growth thereby leads to improved diversification and a reduction in the risk of insolvency. An additional outcome is that it also increases a bank's linkages to other banks. This increased exposure to other banks, in combination with its own greater weight in the money supply, results in an increasing systemic risk in the event of its failure.

Background

Allen and Saunders (1986) explain the heterogeneity found in the structure of the interbank market for Federal Funds in the U.S.A. as an outcome of a game theoretic ranking of banks in the competition for funding. However, distance costs explain the asymmetrical structure within this market quite handily and, moreover, provide a rationale for banks to grow larger. As demonstrated below, in the presence of distance costs, a heterogeneous, geographic dispersion of asset correlations will constrain banks to geographic expansion for the purposes of achieving better diversification.

The works of Pyle (1971), Hart and Jaffee (1974), and Kim and Santomero (1988) depict banks as portfolio managers. The studies of Rochet and Tirole (1996), Freixas et al. (2000) and Allen and Gale (2000) model risk present in the interlinkages between banks. While the research of Hotelling (1929), Coase (1937), Salop (1979), and Fujita et al. (2001), discuss different aspects of the problem of spatial separation and the strategic implications of growth through geographically separate emplacement. This paper builds upon the fundamentals discussed in this body of literature by demonstrating that the natural search for improved performance results in a regulatory optimal size of bank.

In the literature, game theoretic arguments are frequently used to describe the potential for systemic failure. However, one must not lose sight of the fact that an asset deflation event may cause a bank to become 'insolvent' in the sense that it no longer has a required level of capital. Indeed, system wide catastrophic outcomes can occur in the absence of rational runs on banks. The interbank market for funds serves as a conduit for the transmission of failure and exposure to the market creates conditions for systemic failure.

The Model

In order to simplify the approach it is assumed that banks issue capital and liabilities in the from of deposits and borrowings from other investors (including banks). Capital is set in the initial period and varies depending upon asset valuations and income. New capital injections are not possible and no dividends are paid. Furthermore, asset-liability composition of banks is assumed to be independent a la Klein (1971) and Monti (1972). Managers are constrained to maintaining a minimum, risk-weighted capital ratio, in default of which their bank may be declared insolvent by the regulatory authority and subject to reorganization or liquidation. The risk-return function associated with assets is assumed to be convex.

Distance Costs

Monitoring and other costs associated with the reduction of moral hazard are to some extent related to the relative distance of the asset from the monitor, where the concept of distance includes anything that reduces the bank's ability to monitor an asset (see also Coase 1937). Distance cost includes factors which are essentially geographic in nature (proximity relationships, language barriers, etc.), that engender expense that is associated with search and transactions (including monitoring). Distance costs reduce the expected return of a potential investment from what would otherwise have been obtained.

Justification for such costs is also found in the research of Hotelling (1929) and Salop (1979) who present models where, in the presence of transportation costs, ceteris paribus, clients prefer to deal with suppliers who have lower costs. (1) An outcome of such cost is that, in order to achieve greater diversification, a bank will eventually need to create branches or subsidiaries in locations that are characterized by substantial reduction in the geographical separation from investment...

View this article FREE - Now for a Limited Time, try Goliath Business News
Free for 3 Days!