Efficiency and Risk-Taking in Pre-Crisis Investment Banks

Abstract

Efficiency and risktaking in precrisis investment banks Original CitationRadic, Nemanja, Fiordelisi, Franco and Girardone, Claudia (2011) Efficiency and risktaking in pre crisis investment banks. Working Paper. London Metropolitan University, London, UK.This version is available at http://eprints.hud.ac.uk/id/eprint/16670/ The University Repository is a digital collection of the research output of the University, available on Open Access. Copyright and Moral Rights for the items on this site are retained by the individual author and/or other copyright owners. Users may access full items free of charge; copies of full text items generally can be reproduced, displayed or performed and given to third parties in any format or medium for personal research or study, educational or notforprofit purposes without prior permission or charge, provided:• The authors, title and full bibliographic details is credited in any copy;• A hyperlink and/or URL is included for the original metadata page; and • The content is not changed in any way.For more information, including our policy and submission procedure, please contact the Repository AbstractInvestment banks' core functions expose them to a wide array of risks. This paper analyses cost and profit efficiency for a sample of investment banks for the G7 countries (Canada, France, Germany, Italy, Japan, UK and US) and Switzerland prior to the recent financial crisis. We follow Coelli et al. (1999)'s methodology to adjust the estimated cost and profit efficiency scores for environmental influences including key banks' risks, bank-and industry specific factors and macroeconomic conditions. Our evidence suggests that failing to account for environmental factors can considerably bias the efficiency scores for investment banks. Specifically, bank-risk taking factors (including liquidity and capital risk exposures) are found particularly important to accurately assess profit efficiency: i.e. profit efficiency estimates are consistently underestimated without accounting for bank risktaking. Interestingly, our evidence suggests that size matters for both cost and profit efficiency, however this does not imply that more concentrated markets are more efficient.JEL classification: D2, G24, G32, L25

Capital regulation and bank risk‐taking – new global evidence

“…Thus, the negative relationship between efficiency and z‐score implies that banks that have a lower level of efficiency have lower stability, indicating higher risk‐taking. This result is also consistent with Radić et al (2012) who argue that lower levels of efficiency with respect to costs and income causes banks to take higher risks, thus confirming the ‘bad management’ hypothesis identified in this article.…”

The influence of risk-taking on bank efficiency: Evidence from Colombia

“…In the banking literature, Bos et al (2009) identify these effects on efficiency levels and rankings when observed heterogeneity is omitted. In particular, in the case of risk exposure, Radić et al (2012) evaluate a sample of 800 investment banks of G-7 countries during the period 2001-2007 and find that omitting bank risk-taking from efficiency estimations leads to underestimating profit efficiency. The authors also find liquidity and capital risk exposures to be the most relevant factors determining cost and profit inefficiency.…”

“…Another widely used approach in the literature is to incorporate risk measures into frontier efficiency methods such as stochastic frontier analysis (SFA). Under this approach, Radić et al (2012) find capital and liquidity risk to have relevant effects on cost and profit efficiency of investment banks in G-7 countries. Also, Pessarossi and Weill (2014) find that increases of capital ratios during 2004-2009 had a positive influence on cost efficiency of Chinese banks, suggesting that capital requirements may improve cost efficiency.…”

The risk of financial intermediaries

“…The main distinctive element of their modeling framework is that accounting measures of risk and/or capital like the ones discussed above are incorporated into the production technology of banks to form the demand system for banking products. Many other empirical papers have followed this modeling choice henceforth (e.g., Radic et al, 2012). In our setting we borrow a number of elements from these studies, but we do not use specific variables to measure risk.…”