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Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling

Joseph P. Hughes and Loretta J. Mester
The Review of Economics and Statistics
Vol. 80, No. 2 (May, 1998), pp. 314-325
Published by: The MIT Press
Stable URL: http://www.jstor.org/stable/2646641
Page Count: 12
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Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling
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Abstract

We amend the standard cost model to account for the role of financial capital in banking. The cost function is conditioned on the level of capital, but we model the demand for financial capital so that it can serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. Scale economies are then computed without assuming that the bank chooses a level of capitalization that minimizes cost. We find evidence of substantial scale economies and that bank managers are risk averse and use the level of financial capital to signal the level of risk.

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