* Preliminary draft. Please do not quote without explicit written permission. We thank Bob DeYoung and Mark Vaughan for helpful comments. We also benefited from seminars at the Federal Reserve’s annual System Committee on Financial Structure and Regulation, the Federal Reserve Bank of St. Louis, the Financial Management Association Meetings in Toronto, and the University of Missouri, St. Louis. We thank Tim Bosch for helpful discussions. Finally, we benefited greatly from the empirical assistance of Gregory Sierra and Andy Meyer. The views expressed here are those of the authors, not necessarily those of the Federal Reserve Bank of St. Louis or the Federal Reserve System. Reducing the Risk at Community Banks: Is It Size or Geographic Diversification that Matters? Most community banks face relatively high levels of credit risk because they have relatively few loan customers (idiosyncratic risk) and are not geographically diversified (local market risk). We focus on merger strategies that community banks might pursue to improve their risk-return tradeoff, identifying in the process which type of risk is more important. We find that the greatest risk-reduction benefits are achieved by increasing a community bank’s size, regardless of where the merger partner is located. We interpret this result as evidence that idiosyncratic risk dominates local market risk, especially at rural banks. Community banks face enormous pressure to grow, yet the pressure to geographically diversify is limited. As a consequence, larger community banks are likely to replace smaller community banks, but their focus on relationship lending will not disappear. Banks will be able to serve the businesses and households in their communities without being forced to acquire and manage offices distant from their community roots.

him to the fallacy of large numbers over a decade ago but who bears no responsibility for the author’s subsequent application of that knowledge. Conventional wisdom states that large banks are safer than small banks because they can diversify more. This conventional wisdom, however, confuses risk with probability of failure. While the law of large numbers does imply that a large bank is less likely to fail than a small bank, equating this tendency with lower risk falls into what Samuelson [1963] termed the fallacy of large numbers. A $10 billion bank may be less likely to fail than a $10 million bank, but it may also saddle the investor with a $10 billion loss. In this article, I hope to clarify what this distinction means for banks. Banks diversify by growing—by adding risks—something distinctly different from the subdivision of risk behind standard portfolio theory. A simple meanvariance example will make the point that a risk-averse bank owner need not value diversification by addition. After that, I take a regulator’s perspective and consider how a bank guarantee fund, such as the deposit insurance agency, views bank growth and diversification. After a short review of why diversification by adding risks decreases the probability of bank failure, I look at how such diversification alters the expected value of deposit insurance agency payments, then turn to diversification’s impact on the deposit insurance agency’s expected utility, using recent results from the theory of standard risk aversion. To concentrate on the cleanest example, this article stays with the case of independent and identically distributed risks. This admittedly ignores the alleged ability of large banks to diversify regionally 1 or the possibly adverse incentives of deposit insurance (Boyd and

The views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Dallas or the Federal Reserve System. Please do not quote without permission of the authors. Competitive Viability in Banking: Looking Beyond the Balance Sheet Determining the cost and revenue efficiency of financial intermediaries is important in a world economy characterized by sudden change and rapid innovation. Changing laws and regulations (e.g., such as interstate banking and branching, the expansion of banking powers, and intensified competition from nonbank financial institutions) coupled with improved telecommunications and computer technologies have raised questions concerning the competitive viability of different sizes and types of banks. Further, an often cited rationale for the ongoing consolidation of the U.S. banking industry through mergers and acquisitions, is the need to improve cost and revenue efficiencies by achieving greater scale and product mix economies. As argued in Berger, Hunter, and Timme (1993), increased efficiencies might be expected to result in improved profitability, more intermediated funds, better prices and service quality for consumers. Increased efficiency may also improve safety and soundness if some of the efficiency savings are applied toward improved capital buffers to absorb risk. But, as these authors note, the opposite effects might be expected if the evolution of the industry results in less efficient institutions.

necessarily those of the Central Bank of Brazil.

Abstract not found

-< r o _ cFederal Reserve Bank of Minneapolis Quarterly Review vol.18.no. 3 ISSN 0271-5287 This publication primarily presents economic research aimed at improving policymaking by the Federal Reserve System and other governmental authorities. Any views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

Government support to banks through the provision of explicit or implicit guarantees can affect the willingness of banks to take on risk by reducing market discipline or by increasing charter value. We use an international sample of bank data and government support to banks for the periods 2003-2004 and 2009-2010. We find that more government support is associated with more risk-taking by banks, especially during the financial crisis (2009-10), even after controlling for several bank-specific and country-level factors. We use several measures of government support and bank risk-taking, and the results are robust to various possible misspecification issues. We also find that restricting banks ’ range of activities ameliorates the moral hazard problem. We conclude that policy measures to counteract this moral hazard problem should be geared towards strengthening market discipline in the banking sector.

We analyze incentive-efficient government bailouts within a canonical model of intra-firm moral hazard. Bailouts exacerbate the moral hazard of firms and managers in two ways. First, they make them less averse to failing. Second, the taxes to fund bailouts dampen their incentives. Nevertheless, if third-party externalities from keeping the firm alive are strong, bailouts can improve welfare. Our model suggests that governments should use bailouts sparingly, where social externalities are large and subsidies small; (often) eliminate incumbent owners and managers to improve a priori incentives; and finance bailouts through redistributive taxes on productive firms instead of forcing recipients to repay in the future.