Handbook of Competition in Banking and Finance
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Handbook of Competition in Banking and Finance

Edited by Jacob A. Bikker and Laura Spierdijk

For academics, regulators and policymaker alike, it is crucial to measure financial sector competition by means of reliable, well-established methods. However, this is easier said than done. The goal of this Handbook is to provide a collection of state-of-the-art chapters to address this issue. The book consists of four parts, the first of which discusses the characteristics of various measures of financial sector competition. The second part includes several empirical studies on the level of, and trends in, competition across countries. The third part deals with the spillovers of market power to other sectors and the economy as a whole. Finally, the fourth part considers competition in banking submarkets and subsectors.
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Chapter 11: Measuring agency costs and the value of investment opportunities of US bank holding companies with stochastic frontier estimation

Joseph P. Hughes, Loretta J. Mester and Choon-Geol Moon

Abstract

By eliminating the influence of statistical noise, stochastic frontier techniques permit the estimation of the best-practice value of a firm’s investment opportunities and the magnitude of a firm’s systematic failure to achieve its best-practice market value – a gauge of the magnitude of agency costs. These frontiers are estimated from the performance of all firms in the industry and, thus, capture best-practice performance that is, unlike Tobin’s q ratio, independent of the managerial decisions of any particular firm. Using the frontier measure of performance applied to 2007 data on top-tier, publicly traded US bank holding companies, the authors obtain evidence on market discipline: they find that higher managerial ownership at most banks tends to align the interests of insiders with those of outside owners and to be associated with improved financial performance; at most banks, higher blockholder ownership is associated with improved financial performance obtained from blockholders’ monitoring; and, at most banks, higher product-market concentration is associated with poorer financial performance and the so-called managerial quiet life. Using the frontier measure of investment opportunities, the authors find evidence that banks with relatively higher-valued investment opportunities achieve less of their potential market value, while banks with lower-valued opportunities achieve more of their potential value. In spite of their lower-valued opportunities, these banks, on average, achieve the same Tobin’s q ratio and, thus, appear better able to exploit their less valuable investment opportunities. The authors’ results suggest that higher-valued opportunities may reduce managers’ performance pressure and provide a stronger incentive to consume agency goods.

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