Measuringtheefficiencyofcapitalallocationincommercialbanking.docVIP

Measuring the Efficiency of Capital Allocation in Commercial Banking Joseph P. Hughes Department of Economics Rutgers University New Brunswick, NJ 08903-5055 jphughes@rci.rutgers.edu 732-932-7517 William W. Lang Office of the Comptroller of the Currency 250 E Street SW Washington, DC 20219 william.lang@occ.treas.gov 202-874-5386 Choon-Geol Moon Department of Economics College of Business and Economics Hanyang University 17 Haengdang-Dong, Seongdong-Gu Seoul 133791 KOREA mooncg@unitel.co.kr 82-2-2290-1035 Michael S. Pagano Department of Finance Villanova University Villanova, PA 19085 Michael.Pagano@villanova.edu 610-519-4389 Revised, April 1999 The views expressed in this paper are those of the authors and do not necessarily represent those of the Office of the Comptroller of the Currency or the Department of the Treasury.  Abstract We propose a new technique for measuring the efficiency of banks’ capital allocation using the difference between their potential market value based on a stochastic frontier calculation and their observed market value. We find evidence of a dichotomous role of equity capital in promoting market-value efficiency that suggests less capitalized banks may be exploiting the subsidy of underpriced components of the federal safety net, while more capitalized banks may be signaling their safety to capital markets. In particular, inefficient banks that are less capitalized improve their market-value efficiency by reducing their capital ratio and their asset quality while inefficient banks that are more capitalized improve their market-value efficiency by increasing their capital ratio and their asset quality. This dichotomy in equity capital’s effect on efficiency suggests a separating equilibrium in which more and less capitalized banks have different incentives to employ capital.  Introduction Numerous