Joseph P. Hughes is Professor of Economics. He is also a Fellow of the Wharton Financial Institutions Center and has been a Visiting Scholar at the Office of the Comptroller of the Currency, the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Philadelphia, and the Federal Reserve Bank of New York. His research has been published in such journals as the American Economic Review, the Journal of Banking and Finance, the Journal of Economic Theory, the Journal of Financial Services Research, the Journal of Money, Credit, and Banking, and the Review of Economics and Statistics. He received his Ph.D. from the University of North Carolina at Chapel Hill.
Selected Publications
- "The Performance of Financial Institutions: Modeling, Evidence, and Some Policy Implications," with Loretta J. Mester, in The Oxford Handbook of Banking, third edition edited by Allen N. Berger, Philip Molyneux, and John Wilson, Oxford University Press, forthcoming.
- “Comments on the Evolving Complexity of Capital Regulation,” Journal of Financial Services Research, 2018, 53, 207-210.
- “Measuring Agency Costs and the Value of Investment Opportunities of U. S. Bank Holding Companies with Stochastic Frontier Estimation,” with Loretta J. Mester (Federal Reserve Bank of Cleveland) and Choon-Geol Moon (Hanyang University), Chapter 11, pp. 205-229, in Research Handbook on Competition in Banking and Finance, eds. Jacob A. Bikker and Laura Spierdijk, Edward Elgar Publishing, 2017.
- “The Future of Large, Internationally Active Banks: Does Scale Define the Winners?” with Loretta J. Mester (Federal Reserve Bank of Cleveland), Chapter 6, pp. 77-96, in The Future of Large, Internationally Active Banks, Douglas Evanoff, Editor, World Scientific Publishing Co., 2016.
- "Measuring the Performance of Banks: Theory, Practice, Evidence, and Some Policy Implications," with Loretta J. Mester, in The Oxford Handbook of Banking, second edition, edited by Allen N. Berger, Philip Molyneux, and John Wilson, Oxford University Press, 2015, 247-270.
- "The Elusive Scale Economies of the Largest Banks and Their Implications for Global Competitiveness," in Douglas Evanoff, Cornelia Holthausen, George Kaufman and Manfred Kremer, editors, The Role of Central Banks in Financial Stability: How Has It Changed? World Scientific Publishing Co. Pte. Ltd, New Jersey, 2013.
- "Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function," with Loretta J. Mester, Journal of Financial Intermediation, 2013, 22:4, 559-585.
- “A Primer on Market Discipline and Governance of Financial Institutions for Those in a State of Shocked Disbelief,” with Loretta J. Mester, for Efficiency and Productivity Growth in the Financial Services Industry, edited by Fotios Pasiouras, pp. 19-47, John Wiley and Sons, 2013.
- "A New Cost Efficiency Measure for Not-for-Profit Firms: Evidence of a Link between Inefficiency and Large Endowments," in memory of John Virgo, Editor, Atlantic Economic Journal, 2013, 41:3, 279-300.
Research Profile
My research has focused on incorporating endogenous risk-taking into the analysis of banking production, which uncovers evidence of large economies of scale across banks of all sizes with the largest economies at the largest financial institutions - a result that suggests proposed restrictions to limit the size of financial institutions, if effective, may put large banks at a competitive disadvantage in global markets where competitors are not similarly constrained. Moreover, size restrictions may not be effective since they work against market forces and create incentives for firms to avoid them. Avoiding the restrictions could thereby push risk-taking outside of the more regulated financial sector without necessarily reducing systemic risk. I have also examined the role of the too-big-to-fail policy in contributing to measured scale economies at the largest financial institutions.
Using stochastic frontier estimation, I have developed a novel technique to decompose banks' ratio of nonperforming loans to total loans into three components: first, a minimum ratio that represents best-practice lending given the volume and composition of a bank's loans, the average contractual interest rate charged on these loans, and market conditions such as the average GDP growth rate and market concentration; second, a ratio, the difference between the bank's observed ratio of nonperforming loans, adjusted for statistical noise, and the best-practice minimum ratio, that represents the bank's proficiency at loan making; third, a ratio that captures statistical noise. The best-practice ratio, the ratio a bank would experience if were fully efficient at credit-risk evaluation and loan monitoring, represents the inherent credit risk of the loan portfolio. For publicly traded banks, the proficiency of loan making is positively associated with market value for all banks; however, inherent credit is negatively associated with market value at smaller banks and positively associated with the market value at the largest banks. By rewarding higher credit risk at these large institutions, capital market discipline appears to undermine financial stability through credit risk-taking. (paper)
I have found similar dichotomous value-enhancing strategies for capital structure that differ by the charter value of banks. For banks with relatively valuable investment opportunities, a higher capital-to-assets ratio improves market value because it tends to protect these valuable opportunities from financial distress. On the other hand, a lower capital ratio improves market value for banks with less valuable investment opportunities because the higher risk capital strategy exploits the option value of explicit and implicit deposit insurance. Banks for which the higher risk capital strategy tends to improve market value tend to be the largest financial institutions. Thus, for these large banks, capital market discipline appears to erode financial stability through capital structure. (paper)
I have been a Fellow of the Wharton Financial Institutions Center, a Visiting Scholar at the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Philadelphia, the Federal Reserve Bank of New York, and the Office of the Comptroller of the Currency.
My research has been published in such journals as the American Economic Review, the Journal of Economic Theory, the Journal of Money, Credit, and Banking, and the Review of Economics and Statistics, the Journal of Financial Intermediation, the Journal of Banking and Finance, and the Journal of Financial Services Research.
Recent Papers
"The Performance of Financial Institutions: Modeling, Evidence, and Some Policy Implications," with Loretta J. Mester, in The Oxford Handbook of Banking, third edition, edited by Allen N. Berger, Philip Molyneux, and John Wilson, Oxford University Press, 2019, 229-261. (paper)
Abstract
The unique capital structure of commercial banking – funding production with demandable debt that participates in the economy’s payments system – affects various aspects of banking. It shapes commercial banks’ comparative advantage in providing financial products and services to informationally opaque customers, their ability to diversify credit and liquidity risk, and how they are regulated, including the need to obtain a charter to operate and explicit and implicit federal guarantees of bank liabilities to reduce the probability of bank runs. These aspects of banking affect a bank’s choice of risk versus expected return, which, in turn, affects bank performance. Banks have an incentive to reduce risk to protect their valuable charters from episodes of financial distress, and they also have an incentive to increase risk to exploit the cost-of-funds subsidy of mispriced deposit insurance. These are contrasting incentives tied to bank size. Measuring bank performance and its relationship to size requires untangling cost and profit from decisions about risk versus expected return because both cost and profit are functions of endogenous risk-taking. This chapter gives an overview of two general empirical approaches to measuring bank performance and discusses some of the applications of these approaches found in the literature. One application explains how better diversification available at a larger scale of operations generates scale economies that are obscured by higher levels of risk-taking. Studies of commercial banking cost that ignore endogenous risk-taking find little evidence of scale economies at the largest banks, while those that control for this risk-taking find large scale economies at the largest banks – evidence with important implications for regulation.
"How Bad Is a Bad Loan? Distinguishing Inherent Credit Risk from Inefficient Lending (Does the Capital Market Price This Difference?) with Choon-Geol Moon (Hanyang University), Journal of Economics and Business, May/June 2022
Abstract
We develop a novel technique to decompose banks' ratio of nonperforming loans to total loans into two components: first, a minimum ratio that represents best-practice lending given the volume and composition of a bank's loans, the average contractual interest rate charged on these loans, and market conditions such as the average GDP growth rate and market concentration; and, second, a ratio, the difference between the bank's observed ratio of nonperforming loans, adjusted for statistical noise, and the best-practice minimum ratio, that represents the bank's proficiency at loan making. The best-practice ratio of nonperforming loans, the ratio a bank would experience if it were fully efficient at credit-risk evaluation and loan monitoring, represents the inherent credit risk of the loan portfolio and is estimated by stochastic frontier techniques.
We apply the technique to 2013 data on top-tier U.S. bank holding companies. We divide them into five size groups. The largest banks with consolidated assets exceeding $250 billion experience the highest ratio of nonperformance among the five groups. Moreover, the inherent credit risk of their lending is the highest among the five groups. On the other hand, their inefficiency at lending is one of the lowest among the five. Thus, the high ratio of nonperformance of the largest financial institutions appears to result from lending to riskier borrowers, not inefficiency at lending. Small community banks under $1 billion also exhibit higher inherent credit risk than all other size groups except the largest banks. In contrast, their loan-making inefficiency is highest among the five size groups.
Restricting the sample to publicly traded bank holding companies and gauging financial performance by market value, we find the ratio of nonperforming loans to total loans is on average negatively related to financial performance except at the largest banks. When nonperformance is decomposed into inherent credit risk and lending inefficiency, taking more inherent credit risk enhances market value at many more large banks while lending inefficiency is negatively related to market value at all banks. Market discipline appears to reward riskier lending at large banks and discourage lending inefficiency at all banks. (paper)
"Consumer Lending Efficiency: Commercial Banks Versus a Fintech Lender" with Julapa Jagtiani (Federal Reserve Bank of Philadelphia) and Choon-Geol Moon (Hanyang University), Financial Innovation, April 2022. (paper)
Abstract
We compare the performance of unsecured personal installment loans made by traditional bank lenders with that of LendingClub by applying a novel technique developed by Hughes and Moon (2017) that relies on stochastic frontier estimation to decompose the observed rate of nonperforming loans into three components. The first is the best-practice minimum ratio that a lender could achieve if it were, relative to its peers, fully efficient at credit-risk evaluation and loan management. This is the inherent credit risk of the lender’s loan portfolio. The second is a ratio that reflects the difference between the observed ratio (adjusted for statistical noise) and the minimum ratio − nonperformance in excess of best practice. This difference gauges the lender’s relative proficiency at credit analysis and loan monitoring relative to its peers. We measure lending inefficiency as the proportion of the observed nonperforming loan ratio represented by the excess ratio. The third is statistical noise.
We apply this technique to compare the efficiency of small and large lenders. Ben Bernanke (2011) has hypothesized that community banks are more effective lenders: “. . . The largest banks typically rely heavily on statistical models to assess borrowers' capital, collateral, and capacity to repay, and those approaches can add value, but banks whose headquarters and key decision makers are hundreds or thousands of miles away inevitably lack the in-depth local knowledge that community banks use to assess character and conditions when making credit decisions. This advantage for community banks is fundamental to their effectiveness and cannot be matched by models or algorithms, no matter how sophisticated.”
We investigate a second important comparison of lenders that focuses on lenders who tend to use the same techniques of assessing credit risk and monitoring loans, notably, those lenders using statistical models and algorithms. Such lenders tend to have large volumes of consumer loans and include LendingClub as well as large traditional bank lenders.
The largest BHCs experienced the highest ratio of nonperforming consumer loans in the years 2016 and 2013 of our data. When loan performance is evaluated controlling for the lenders’ credit assessment techniques, we find that the largest lenders exhibited the highest inherent credit risk and the highest lending efficiency, indicating that their high ratio of nonperformance is driven by inherent credit risk, rather than by lending inefficiency. While smaller lenders exhibit relatively high lending inefficiency, the smallest lenders are more efficient than other small lenders. LendingClub’s performance was similar to small bank lenders as of 2013. As of 2016, LendingClub’s performance resembled the largest bank lenders − the highest ratio of nonperforming loans, inherent credit risk, and lending efficiency − although its loan volume was smaller.
We add the caveat that these conclusions may not be applicable to fintech lenders in general, and the results may not hold under different economic conditions such as a downturn.
"Market Discipline Working For and Against Financial Stability: The Two Faces of Equity Capital in U. S. Commercial Banking" with Loretta J. Mester (Federal Reserve Bank of Cleveland) and Choon-Geol Moon (Hanyang University), 2016 (paper)
Abstract
The second Basel Capital Accord points to market discipline as a tool to reinforce capital standards and supervision in promoting bank safety and soundness. The Bank for International Settlements contends that market discipline imposes strong incentives on banks to operate in a safe and efficient manner – in particular, to maintain an adequate capital base to absorb potential losses from their risk exposures.
Using 2007 and 2013 data on top-tier, publicly traded U.S. bank holding companies, we find that market discipline rewards risk-taking at some of the largest U.S. financial institutions. In particular, we find evidence of two faces of equity investment – dichotomous capital strategies for maximizing value. At banks with higher-valued investment opportunities, a marginal increase in their equity capital ratio is associated with better financial performance, while at banks with lower-valued investment opportunities, a marginal decrease in their equity capital ratio is associated with better financial performance. Because the largest U.S. financial institutions tend to have lower-valued investment opportunities, our results suggest that they may have a market-based incentive to reduce their capital ratio. To the extent that market discipline rewards reducing the capital ratio among the largest banks, it would tend to undermine financial stability. Our results support the need for regulatory capital requirements.
"Comments on the Evolving Complexity of Capital Regulation" presented at a conference on "The Interplay of Financial Regulations, Resilience, and Growth" sponsored by the Federal Reserve Bank of Philadelphia and the Wharton School, Journal of Financial Services Research, 2018, 53, 207-210. (paper)
Abstract
Capital regulation has become increasingly complex as the largest financial institutions arbitrage differences in requirements across financial products to increase expected return for any given amount of regulatory capital, as financial regulators amend regulations to reduce arbitrage opportunities, and as financial institutions innovate to escape revised regulations -- a regulatory dialectic. This increasing complexity makes monitoring bank risk-taking by markets and regulators more difficult and does not necessarily improve the risk sensitivity of measures of capital adequacy. Explaining the arbitrage incentive of some banks, several studies have found evidence of dichotomous capital strategies for maximizing value: a relatively low-risk strategy that minimizes the potential for financial distress to protect valuable investment opportunities and a relatively high-risk strategy that, in the absence distress costs due to valuable investment opportunities, "reaches for yield" to exploit the option value of implicit and explicit deposit insurance. In the latter case, market discipline rewards risk-taking and, in doing so, tends to undermine financial stability. The largest financial institutions, belonging to the latter category, maximize value by arbitraging capital regulations to "reach for yield." This incentive can be curtailed by imposing "pre-financial-distress" costs that make less risky capital strategies optimal for large institutions. Such potential costs can be created by requiring institutions to issue contingent convertible debt (COCOs) that converts to equity to recapitalize the institution well before insolvency. The conversion rate significantly dilutes existing shareholders and makes issuing new equity a better than than conversion. The trigger for conversion is a particular market-value capital ratio. Thus, the threat of conversion tends to reverse risk-taking incentives -- in particular, the incentive to increase financial leverage and to arbitrage differences in capital requirement across investments.
"Does Scale Matter in Community Bank Performance? Evidence Obtained by Applying Several New Measures of Performance" with Julapa Jagtiani (Federal Reserve Bank of Philadelphia), Loretta J. Mester (Federal Reserve Bank of Cleveland), and Choon-Geol Moon, Journal of Banking and Finance, 2019, 106, 471-499 (paper)
Abstract
We consider how size matters for banks in three size groups: small community banks with assets less than $1 billion, large community banks with assets between $1 billion and $10 billion, and midsize banks with assets between $10 billion and $50 billion. To illustrate the differences between these banks and larger banks whose business models are distinctly different, we examine large banks with assets between $50 billion and $250 billion and the largest banks with assets exceeding $250 billion. Community banks have potential advantages in relationship lending compared with large banks. However, increases in regulatory compliance and technological burdens may have disproportionately increased community banks’ costs, raising concerns about small businesses’ access to credit. Our evidence suggests several patterns: (1) while small community banks exhibit relatively more valuable investment opportunities, larger community banks, midsize banks, and larger banks exploit theirs more efficiently and achieve better financial performance; (2) average operating costs that include costs related to regulatory compliance and technology decrease with size; (3) unlike small community banks, large community banks have financial incentives to increase lending to small businesses; and (4) for business lending and commercial real estate lending, compared with small community banks, large community banks, midsize banks, and larger banks assume higher inherent credit risk and exhibit more efficient lending. Thus, concern that small business lending would be adversely affected if small community banks find it beneficial to increase their scale is not supported by our results.
"Measuring Agency Costs and the Value of Investment Opportunities of U. S. Bank Holding Companies with Stochastic Frontier Estimation," with Loretta J. Mester (Federal Reserve Bank of Cleveland) and Choon-Geol Moon (Hanyang University), 2017, in Research Handbook on Competition in Banking and Finance, eds. Jacob A. Bikker and Laura Spierdijk, Chapter 11, 205-229, Edward Elgar Publishing. (paper)
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 U. S. bank holding companies, we obtain evidence on market discipline: we 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, we 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. Our results suggest that higher-valued opportunities may reduce managers' performance pressure and provide a stronger incentive to consume agency goods.
"Measuring the Performance of Banks: Theory, Practice, Evidence, and Some Policy Implications," with Loretta J. Mester, in The Oxford Handbook of Banking, second edition, edited by Allen N. Berger, Philip Molyneux, and John Wilson, Oxford University Press, 2015, 247-270. (paper)
Abstract
The unique capital structure of commercial banking - funding production with demandable debt that participates in the economy's payments system - affects various aspects of banking. It shapes banks' comparative advantage in providing financial products and services to informationally opaque customers, their ability to diversify credit and liquidity risk, and how they are regulated, including the need to obtain a charter to operate and explicit and implicit federal guarantees of bank liabilities to reduce the probability of bank runs. These aspects of banking affect a bank's choice of risk vs. expected return, which, in turn, affects bank performance. Banks have an incentive to reduce risk to protect the valuable charter from episodes of financial distress and they also have an incentive to increase risk to exploit the cost-of-funds subsidy of mispriced deposit insurance. These are contrasting incentives tied to bank size. Measuring the performance of banks and its relationship to size requires untangling cost and profit from decisions about risk versus expected-return because both cost and profit are functions of endogenous risk-taking. This chapter gives an overview of two general empirical approaches to measuring bank performance and discusses some of the applications of these approaches found in the literature. One application explains how better diversification available at a larger scale of operations generates scale economies that are obscured by higher levels of risk-taking. Studies of banking cost that ignore endogenous risk-taking find little evidence of scale economies at the largest banks while those that control for this risk-taking find large scale economies at the largest banks - evidence with important implications for regulation.
"Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function," with Loretta J. Mester, Journal of Financial Intermediation, 2013, 22:4, 559-585. (paper)
Abstract
The Great Recession focused attention on large financial institutions and systemic risk. We investigate whether large size provides any cost advantages to the economy and, if so, whether these cost advantages are due to technological scale economies or too-big-to-fail subsidies. Estimating scale economies is made more complex by risk-taking. Better diversification resulting from larger scale generates scale economies but also incentives to take more risk. When this additional risk-taking adds to cost, it can obscure the underlying scale economies and engender misleading econometric estimates of them. Using data pre- and post-crisis, we estimate scale economies using two production models. The standard model ignores endogenous risk-taking and finds little evidence of scale economies. The model accounting for managerial risk preferences and endogenous risk-taking finds large scale economies, which are not driven by too-big-to-fail considerations. We evaluate the costs and competitive implications of breaking up the largest banks into smaller banks.
"A Primer on Market Discipline and Governance of Financial Institutions for Those in a State of Shocked Disbelief," with Loretta J. Mester, for Efficiency and Productivity Growth in the Financial Services Industry, edited by Fotios Pasiouras, pp. 19-47, John Wiley and Sons, 2013. (paper)
Abstract
Self regulation encouraged by market discipline constitutes a key component of the third pillar of Basel II. But high-risk investment strategies may maximize the expected value of some banks. In these cases, does market discipline encourage risk-taking that undermines bank stability in economic downturns? This paper reviews the literature on corporate control in banking. It reviews the techniques for assessing bank performance, interaction between regulation and the federal safety net with market discipline on risk-taking incentives and stability, and sources of market discipline, including ownership structure, capital market discipline, product market competition, labor market competition, boards of directors, and compensation.
