Recovering Risky Technologies Using the Almost Ideal Demand System: An Application to U.S. Banking

Byline: Joseph P. Hughes (1), William Lang (2), Loretta J. Mester (3), Choon-Geol Moon (4) Keywords: banking; production; risk; efficiency; agency problems. Abstract: We present and estimate a model that shifts the focus of modeling production from the traditional assumptions of profit maximization and cost minimization to a more general assumption of managerial utility maximization that can incorporate risk incentives into the analysis of production and recover value-maximizing technologies. We implement the model using the almost ideal demand system. In addition, we use the model to measure efficiency in a more general way that can incorporate a concern for the market value of firms' assets and equity and identify value-maximizing firms. This shift in focus bridges the gap between the risk incentives literature in banking that ignores the microeconomics of production and the production literature that ignores the relationship between production decisions and risk. Our estimation of the model for a sample of U.S. commercial banks illustrates that results obtained from our generalized model can differ significantly from those obtained from the standard profit-maximization model, which ignores risk. Author Affiliation: (1) Rutgers University, USA (2) Office of the Comptroller of the Currency, USA (3) Federal Reserve Bank of Philadelphia and The Wharton School, University of Pennsylvania, USA (4) College of Business and Economics, Hanyang University, USA Article History: Registration Date: 09/10/2004