Knowledge that Transforms

The behavior of a risk neutral corporation in selection of a line of credit is modeled in a new framework where demand for credit lines by a firm arises from the stochastic arrival in continuous time of short-lived opportunities to capture investment projects. The firm needs speed and secrecy to capture projects before competitors. The firm chooses a credit line that balances its up-front commitment cost against the expected extra cost of borrowing in the spot market upon exhaustion of its credit line. The firm's demanded credit line depends upon both relative pricing within the contract and the nature of the firm's growth opportunities. Interestingly, while credit line demand is positively related to business growth prospects, it is potentially negatively related to uncertainty in those prospects.

In this article we have reviewed “Modern Portfolio Analysis” and outlined some important topics for further research. Issues discussed include the history and future of portfolio theory, the key inputs necessary to perform portfolio optimization, specific problems in applying portfolio theory to financial institutions, and the methods for evaluating how well portfolios are managed. Emphasis is placed on both the history of major concepts and where further research is needed in each of these areas.

Many regulations use private sector credit ratings to determine investment prohibitions and capital requirements for institutional portfolio investments. These regulations implicitly assume that different agencies have equivalent rating scales, despite the fact that some agencies assign systematically higher ratings than others. We assess the appropriateness of these regulatory practices by testing whether observed rating differences reflect different rating scales or simply result from sample selection bias. Our analysis reveals only limited evidence of selection bias. We also ask what types of firms of firms are most likely to seek ratings from the agencies with higher rating scales. Our analysis uncovers no evidence that firms seek ratings from these agencies to clear specific regulatory hurdles or to reduce ex ante uncertainty about default risk.

This paper examines the wealth effects of a decision by the Office of Thrift Supervision (OTS) to permit interstate branching for federally chartered savings and loan associations (SLAs). An event study of key OTS announcements in 1991 and 1992 is conducted based on samples of 38 federally chartered SLAs and 88 commercial banks. Large SLAs and commercial banks generally experienced significant positive wealth effects but little or no reaction was found for smaller depository institutions. These findings provide early evidence that interstate branching powers for depository institutions under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 will tend to benefit large institutions accelerating the trend toward consolidation, though without necessarily compromising the viability of smaller institutions.

Economies of scale and scope in Finnish non-life insurance are studied. The production process is separated into cost and portfolio management functions. Firms expand their branch network to either gain market power or informational advantages. There are diseconomies of scale at firm and economies of scale at branch level, and economies of scope in production. Large firms in the non-life insurance industry pay a substantial premium to gain market power via branch networks. The retained premiums-curve of portfolio management is U-shaped and a positive function of the number of branches.

This paper addresses a little examined intersection between the problem loan literature and the bank efficiency literature. We employ Granger-causality techniques to test four hypotheses regarding the relationships among loan quality, cost efficiency, and bank capital. The data suggest that problem loans precede reductions in measured cost efficiency; that measured cost efficiency precedes reductions in problem loans; and the reductions in capital at thinly capitalized banks precede increases in problem loans. Hence, cost efficiency may be an important indicator of future problem loans and problem banks. Our results are ambiguous concerning whether or not researchers should control for problem loans in efficiency estimation.

Research on bank efficiency has developed in two separate streams: econometric studies and Data Envelopment Analysis, a linear programming technique. These two branches of literature have developed quickly, but separately; in this paper these two approaches have been tested on a common panel of 270 Italian banks, and this has suggested the following: (i) econometric and linear programming results do not differ dramatically, when based on the same data and conceptual framework; (ii) when differences arise, they can be explained by going back to the intrinsic features of the models. Moreover, some findings on Italian banks may be of interest also to the international reader: (i) efficiency scores show a high variance; (ii) the banking system is split in two, between northern and southern banks; (iii) there is a direct (rather than inverse) relationship between productive efficiency and asset quality; (iv) the efficiency of Italian banks did not increase over the period 1988–1992.

This paper investigates the deterioration of the banking industry's risk-control system during the 1980s and the time-varying relation between a bank's ex-ante risk-taking incentives and its ex-post risk-taking behavior over the period 1977–1994. We document that banks with high charter value imposed self-discipline on risk-taking behavior at all times. In contrast, banks with low charter value assumed significantly more risk beginning around 1983, and this behavior continued into the early 1990s. These findings have several important policy implications.

In this paper, we examine the foreign exchange exposure of a sample of U.S. and Japanese banking firms. Using daily data, we construct estimates of the exchange rate sensitivity of the equity returns of the U.S. bank holding companies and compare them to those of the Japanese banks. We find that the stock returns of a significant fraction of the U.S. companies move with the exchange rate, while few of the Japanese returns that we observe do so. We next examine more closely the sensitivity of the U.S. firms by linking the U.S. estimates cross-sectionally to accounting-based measures of currency risk. We suggest that the sensitivity estimates can provide a benchmark for assessing the adequacy of existing accounting measures of currency risk. Benchmarked in this way, the reported measures that we examine appear to provide a significant, though only partial, picture of the exchange rate exposure of U.S. banking institutions. The cross-sectional evidence is also consistent with the use of foreign exchange contracts for the purpose of hedging.

Does approximating duration estimates by ignoring default risk lead to error in the two major duration applications — measuring interest — rate price elasticity and immunization? We derive a general expression for duration in the presence of default risk based on Jonkhart's term structure model (On the term structure of interest rates and the risk of default, Journal of Banking and Finance 3, 253–262, 1979) extended to encompass risk aversion. The model includes terms for default probabilities and default payoffs in each period as well as for a delay between the occurrence of default and the final default payoff. Our main conclusion is that practical duration applications involving bonds with default risk must employ duration measures adjusted for default risk.