Academic journal article Economic Perspectives

Assessing the Impact of Regulation on Bank Cost Efficiency

Academic journal article Economic Perspectives

Assessing the Impact of Regulation on Bank Cost Efficiency

Article excerpt

Introduction and summary

The purpose of financial regulation is to improve upon the performance of financial markets relative to how they would perform driven solely by the forces of the private marketplace. For example, in the 1930s it was decided that, left unchecked, competition in the pricing of U.S. banking services could become so intense that it would actually be harmful to the functioning of the markets. This resulted in the introduction of interest rate and price restrictions to provide banks with an inexpensive source of funds. In addition, to insure that local market participants were not forced from the market as a result of "excessive" competition, entry barriers and branching restrictions were introduced.

Such regulation, however, frequently results in unintended behavior and market inefficiencies. The price restrictions aimed at providing an inexpensive source of bank funding resulted in disintermediation and significant bank expenditures to circumvent the restrictions. The entry barriers resulted in inferior service levels and the generation of local market power by incumbent institutions as competing service providers were unable to use an efficient entry mechanism. These unintended effects often prompt re-regulation to realize the original intent of the regulation, but without the resulting inefficiencies. However, re-regulation typically results in additional responses by bankers aimed at avoiding the effect of the regulation.

In responding to regulation, banks are altering the production process. The theoretical foundation for most bank cost studies is based on the maintained assumption of cost minimization with respect to market input prices in competitive markets.(1) However, extensive evidence suggests that this is not the behavior practiced by regulated firms. Regulated firms frequently alter the production process from what it would be absent the regulation. Banking firms are subject to extensive regulation in nearly all facets of operations, raising the possibility that the assumption of cost-minimizing behavior in response to market input prices may be particularly inappropriate for this industry.

Our objective is to evaluate whether industry regulations distort firm behavior and, as a result, generate productive inefficiency in the mix of inputs used by banks (for example, physical capital to labor ratios). We estimate this allocative inefficiency using a generalized cost function that allows for cost-minimization behavior, taking into account the above-mentioned distortions resulting from regulation. From a theoretical viewpoint, the generalized model is superior to the standard model. We test to see if there is also a statistical difference. We evaluate the impact of accounting for the regulatory distortions on various cost characteristics.(2) In addition to generating a measure of inefficiency resulting from banks using a suboptimal mix of inputs, we obtain a measure of the level of inefficiency resulting from the underutilization or mismanagement of inputs, that is, technical inefficiency. Finally, we analyze the effect of relaxing the regulatory constraints.

For a sample of large U.S. banks, we find statistically significant input price distortions, and resulting allocative inefficiency, which we attribute to regulation. We reject the standard cost model in favor of a more general one, which allows for cost minimization subject to effective input prices that can differ from market prices as a result of regulation. Findings from our analysis of the 1972-87 period suggest that for our sample of banks, scope economies and minor scale economies existed. Scope economies exist if the cost of joint production is less than the cost resulting from independent production processes; scale economies exist if, over a given range of output, per unit costs decline as output increases. In addition, technology played a significant role in reducing costs, and regulatory induced allocative inefficiency existed. …

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