1. 5 th Annual Banking Research Conference - FDIC Competition, efficiency and agency costs in European banking An analysis of charter values Olivier De Jonghe Rudi Vander Vennet Ghent University

2. Motivation Deregulation Second banking directive Mergers & acquisitions Banks versus financial markets Economic and monetary integration Capital adequacy rules Market structure Competition Efficiency Capital Profitability Risk

3. Motivation

4. Market structure Competition Efficiency Capital Profitability / Risk Effect on bank charter value  charter value = the present value of the stream of profits that a firm is expected to earn as a going concern  franchise or charter value: return and risk in the long run  construction of a market-based performance measure: Tobin’s Q, noise adjusted

5. Performance measure: Q NA Concept: Q NA (based on Market Value Efficiency)  Definition: Market value inefficiency measures the shortfall of a bank’s market value from its highest potential market value as a proportion of the bank’s book-value investment in its assets Parametric (Stochastic Frontier Analysis), translog (Hughes, Lang, Mester, Moon and Pagano, 2003 and 2004)

6. Some summary statistics

7. Hypotheses: Competition and Efficiency 1. Structure-Conduct-Performance: concentration 2. Relative Market Power: market share 3. X-Efficiency: management skills or production technologies 4. Scale-Efficiency: scale-related cost/revenue advantages Implications for merger and antitrust policy Hypotheses are interrelated Solution: reduced form (Berger,1995) Stigler (1964), Demsetz (1973), Berger (1995), Vander Vennet (2002)

8. Hypotheses: Competition and Efficiency Bank profitability  Accounting profits (ROA, ROE)  Subject to noise (tax distortions, accounting practices,earnings management)  Short-run performance (versus long-run equilibrium)  Backward looking >< sustainable rents Solution: use market value of a listed bank  Q NA Test Structure-Conduct-Performance, Relative Market Power, Efficiency paradigms simultaneously in a coherent forward- looking framework based on stock market values

9. The role of capital Bank capital serves different purposes 1) Capital structure is regulated to reduce risk-taking 2) Capital may reduce funding costs (depositor discipline) 3) Capital as a signal of private information about future cash flows =>Capital affects bank charter value positively 4) Capital is inversely related to Leverage  Separation of ownership and control (principal-agent problem)  Value maximization  Utility maximization  Choice of capital structure may mitigate agency costs, due to alignment of interests (Berger and Bonaccorsi di Patti, 2003) =>Leverage affects bank charter value positively

10. The Dataset 255 listed banks  Large and medium-sized  All types: retail banks, commercial banks, savings banks, financial conglomerates EU15 + Norway+ Switzerland 1995-2003 (unbalanced) Balance Sheet and Income Statement  Bankscope Stock market data  Datastream

11. Baseline equation: results  Market share is a long-term generator of superior future profits  Concentration plays no significant role  Operational efficiency is strongly valued by stock market investors  Diseconomies of scale  Leverage plays an important role in mitigating agency costs

12. Robustness Competition  Interaction between Market Share and HHI negative and significant  Contestability: Foreign presence and importance negative and insignificant  Concentration Ratio 5 in stead of HHI  Size classes Leverage  Tier 1 Capital ratio  Charter value and capital ratio: endogeneity issue  Capital ratio classes  All conclusions remain valid: RMP X-Efficiency Leverage

13. Robustness: Control variables Diversification  Diversification benefit Profitability  Accounting -and market-based variables  Positive effect Risk  Accounting -and market-based variables  Negative effect Regulation and supervision  Worldbank, KKZ, Heritage data  Low variation in sample  Not significant Macro-environment  GDP, Inflation, LT-Interest rate, Stock Market index  Significant (if no time dummies) All conclusions from baseline remain valid Bank-level Country-level

14. Conclusions Using a market-based forward looking measure of bank performance, we find that:  Market share is a long-term generator of superior future profits  Concentration has no significant effect  Relative market power dominates structure!  Operational efficiency in banking is strongly valued by stock market investors  Market value diseconomies of scale  X-Efficiency is far more important than Scale-Efficiency  Capital plays a role in mitigating agency costs  Leverage/Creditworthiness trade-off Basel 2, Pillar 3: use market mechanisms for prudential supervision  Q NA (market values) are a useful indicator Insight into building blocks of charter value  financial stability Lack of bank market integration in EU even among the largest (listed) banks