OCC: Economics: Recovering Technologies That Account for Generalized Managerial Preferences: An Application to Banks That Are Not Risk-Neutral

Site Map | Text Size: S M L

 

Home About the OCC News and Issuances Publications Tools and Forms Topics

Home > Publications > Economics Working Papers 

Alphabetical Listing

Publications by Topic

● Bank Management

● Bank Operations

● Capital Markets

● Capital Policy

● Community Affairs

● Compliance/BSA

● Consumer Protection

● Credit

● Dispute Resolution

● Economics

● Examinations

● International Banking

● Laws And Regulations

● Licensing

Publications by Type

● Comptroller's Handbook

● Licensing Manuals

● Annual Reports

● Economics Working Papers

● Survey of Credit Underwriting Practices Report

● Other Publications/Reports

BankNet

Recovering Technologies That Account for Generalized Managerial Preferences: 

An Application to Banks That Are Not Risk-Neutral

by Joseph P. Hughes, 

William W. Lang, 

Loretta J. Mester, 

and Choon-Geol Moon

OCC Working Paper 97-11, June 1997

Abstract

Large banks involved in recent mergers often cite scale economies as a principal motive. Yet despite this belief that 

bigger is more economical, most economic studies find either constant or decreasing returns to scale for large 

banks. What accounts for the disparity between the beliefs of bank managers and the results of these studies? This 

paper suggests that the answer may lie with the assumptions underlying estimations of standard cost and profit 

functions. Typically these estimations assume that banks are risk-neutral - that they ignore risk in their quest to 

maximize profits.

This paper develops an alternative model which is sufficiently general to allow for active risk management. The 

resulting empirical estimates indicate large economies of scale that increase with bank size.

We develop a maximization model that allows for (but does not impose) preferences of bank management that are 

not risk neutral. Our estimated equations are fully consistent with the theoretical model underlying the estimation 

procedure. The model considers a bank managerial utility function in which profit is one of many elements. Since we 

do not observe the probabilities that a bank assigns to various sets of outcomes, our model considers how banks 

rank production plans given their choices of the quantity and quality of outputs and inputs. Risk neutrality then 

implies that a bank's preferences will depend only on profit and that other variables in the utility function have no 

impact on bank preferences.

Our empirical model strongly rejects the hypothesis that banks are risk-neutral. Preferences over production plans 

are not invariant with respect to the tax rate on profits or on fixed revenues. Unlike previous studies, we find large 

increasing returns to scale even for the largest banks. This result is due to our allowance for behavior that is not riskneutral. When the empirical restrictions implied by risk neutrality are imposed, our estimates of returns to scale are 

similar to those found in previous studies - small returns to scale that decline with bank size.

Disclaimer

As with all OCC Working Papers, the opinions expressed in this paper are those of the author alone, and do not 

necessarily reflect the views of the Office of the Comptroller of the Currency or the Department of the Treasury.

Any whole or partial reproduction of material in this paper should include the following citation: by Hughes, Lang, 

Mester, and Moon, "Recovering Technologies That Account for Generalized Managerial Preferences: An Application 

to Banks That Are Not Risk-Neutral" Office of the Comptroller of the Currency, E&PA Working Paper 97-11, June 

1997.

Search for Economics Working 

Papers:

Search Publications:

Most Popular Publications

● Detecting Red Flags in Board Reports

● Activities Permissible by a National Bank

● Comptroller's Handbook

● Licensing Manuals

● Ombudsman's Report

Top Tasks

● Review list of available print publications

● Order OCC print publications

● Purchase the FFIEC BSA/AML Manual 

(4/20/2010)

● Search Office of Thrift Supervision (OTS) Archive

file:///C|/Documents%20and%20Settings/rpicariello/Desktop/working-paper-1997-11.html (1 of 2)10/11/2011 8:31:33 AM
OCC: Economics: Recovering Technologies That Account for Generalized Managerial Preferences: An Application to Banks That Are Not Risk-Neutral

More resources for national banks

HelpWithMyBank.gov 

Get answers to banking questions

Job Seekers

Join one of the best places to work

Accessibility | Web Site Privacy Policy | Privacy Impact Assessments | Contact Us | Department of the Treasury | USA.gov | No Fear Act | Freedom of Information Act | Contact Webmaster

file:///C|/Documents%20and%20Settings/rpicariello/Desktop/working-paper-1997-11.html (2 of 2)10/11/2011 8:31:33 AM