Risk is a fundamental calculation in commercial banking. A large literature explores banks’ contrasting incentives for risk-taking. On the one hand, safety-net subsidies such as mispriced deposit insurance give banks the incentive to take extra risk while, on the other hand, the potential for costly episodes of financial distress involving liquidity crises, regulatory interventions into bank operations, and the possible forfeiture of a valuable charter gives banks the incentive to reduce risk. While this literature explores the effect of these contrasting incentives on banks’ risk-taking, it generally ignores the microeconomics of bank production. An equally large literature uses dual cost and profit functions to investigate the microeconomics of bank production—to measure scale and scope economies and to gauge managerial efficiency. While this literature models production decisions, its reliance on the assumptions of cost minimization and profit maximization leaves it without an analytical framework to incorporate risk-taking and such risk-related phenomena as diversification and moral hazard.
This paper presents a model and empirical results that bridge the gap between these two literatures. We have used this model in other studies that focused on different aspects of bank production, but this paper presents a unified discussion of the theoretical framework, its application to efficiency measurement, and the necessary empirical tools (in Appendix 2 we delineate the steps a researcher would take to estimate our model). In addition, we estimate the model for a sample of commercial banks and present results that focus on how risk affects production decisions, in particular, the levels of capitalization and volatile funding. This application illustrates how our framework bridges the gap between the risk-incentives literature and the microeconomics-of-production literature.
