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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
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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
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Motivation
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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
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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)
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Some summary statistics
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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)
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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
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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
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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
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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
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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
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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
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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
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