Nationally chartered banks will be allowed to branch across state lines beginning June 1, 1997. Whether they will depends on their assessment of the profitability of such a delivery system for their services and on their preferences regarding risk and return. We investigate the probable effect of interstate branching on banks' risk-return tradeoff, accounting for the endogeneity of deposit volatility. If interstate branching improves the risk-return tradeoff banks face, then banks that branch across state lines may choose a higher level of risk in return for higher profits. We find efficiency gains due to geographic diversity. EFFICIENT BANKING UNDER INTERSTATE BRANCHING The Interstate Banking Efficiency Act of 1994 allows nationally chartered banks to branch across state lines beginning June 1, 1997. Whether banks take advantage of this new ability to branch will depend on their assessment of the profitability of such a delivery system for their services. It will also depend on their preferences regarding risk and return. Interstate branching can lead to a reduction in the price of controlling liquidity risk because it allows the bank to more fully geographically diversify its deposit gathering. Similarly, geographical diversity may also lower the volatility of returns on a bank's loan portfolio. If these diversification effects exist, then geographic diversification improves the bank's risk-return opportunity set. This effectively lowers the cost, in terms of risk, of engaging in activities that generate higher profits. These profitable activities are likely to include the substitution of loans for securities in the bank's portfolio. Hence, on balance, it is not clear what the impact of geographic diversification will be on the riskiness (i.e., volatility of returns) of the bank. Interestingly, previous studies that have looked at bank risk have not found that it is lower for banks that are more fully geographically diversified. This seems perplexing until one accounts for the fact that risk is endogenous-the bank chooses its level of risk. Depending on the bank's risk preferences, interstate branching might lead to a higher level of risk-taking by banks, since it improves the risk-return tradeoff (i.e., lowers the price of risk), but also to a higher level of profitability. 1. GEOGRAPHIC DIVERSIFICATION AND BANK EFFICIENCY A. Geographic Diversification and the Price of Risk Deposit volatility contributes to liquidity risk and increases the cost of risk management. Liquid assets are the first line of defense against liquidity risk. Hence, a higher degree of liquidity risk requires that a higher proportion of assets be held in securities. The cost of managing this risk includes the interest differential between loans and securities that is sacrificed when the loan-to-asset ratio must be reduced to accommodate a higher degree of liquidity risk. In principle, liquidity risk can be reduced when the deposit base is diversified. Greater diversification can be achieved by increasing the number of deposit accounts, giv...

For nearly two decades banks in the United States have consolidated in record numbers &in terms of both frequency and the size of the merging institutions. Rhoades (1996) hypothesizes that the main motivators were increased potential for geographic expansion created by changes in state laws regulating branching and a more favorable antitrust climate. To look for evidence of economic incentives to exploit these improved opportunities for consolidation, we examine how consolidation affects expected profit, the riskiness of profit, profit efficiency, market value, market-value efficiencies, and the risk of insolvency. Our estimates of expected profit, profit risk, and profit efficiency are based on a structural model of leveraged portfolio production that was estimated for a sample of highest-level U.S. bank holding companies in Hughes, Lang, Mester, and Moon (1996). Here, we also estimate two additional measures that gauge efficiency in terms of the market values of assets and of equity. Our findings suggest that the economic benefits of consolidation are strongest for those banks engaged in interstate expansion and, in particular, interstate expansion that diversifies banks' macroeconomic risk. Not only do these banks experience clear gains in their financial performance, but society also benefits from the enhanced bank safety that follows from this type of consolidation.

For nearly two decades banks in the United States have consolidated in record numbers &in terms of both frequency and the size of the merging institutions. Rhoades (1996) hypothesizes that the main motivators were increased potential for geographic expansion created by changes in state laws regulating branching and a more favorable antitrust climate. To look for evidence of economic incentives to exploit these improved opportunities for consolidation, we examine how consolidation affects expected profit, the riskiness of profit, profit efficiency, market value, market-value efficiencies, and the risk of insolvency. Our estimates of expected profit, profit risk, and profit efficiency are based on a structural model of leveraged portfolio production that was estimated for a sample of highest-level U.S. bank holding companies in Hughes, Lang, Mester, and Moon (1996). Here, we also estimate two additional measures that gauge efficiency in terms of the market values of assets and of equity. Our findings suggest that the economic benefits of consolidation are strongest for those banks engaged in interstate expansion and, in particular, interstate expansion that diversifies banks' macroeconomic risk. Not only do these banks experience clear gains in their financial performance, but society also benefits from the enhanced bank safety that follows from this type of consolidation.

Nationally chartered banks will be allowed to branch across state lines beginning June 1, 1997. Whether they will depends on their assessment of the profitability of such a delivery system for their services and on their preferences regarding risk and return. We investigate the probable effect of interstate branching on banks' risk-return tradeoff, accounting for the endogeneity of deposit volatility. If interstate branching improves the risk-return tradeoff banks face, then banks that branch across state lines may choose a higher level of risk in return for higher profits. We find efficiency gains due to geographic diversity. EFFICIENT BANKING UNDER INTERSTATE BRANCHING The Interstate Banking Efficiency Act of 1994 allows nationally chartered banks to branch across state lines beginning June 1, 1997. Whether banks take advantage of this new ability to branch will depend on their assessment of the profitability of such a delivery system for their services. It will also depend on their preferences regarding risk and return. Interstate branching can lead to a reduction in the price of controlling liquidity risk because it allows the bank to more fully geographically diversify its deposit gathering. Similarly, geographical diversity may also lower the volatility of returns on a bank's loan portfolio. If these diversification effects exist, then geographic diversification improves the bank's risk-return opportunity set. This effectively lowers the cost, in terms of risk, of engaging in activities that generate higher profits. These profitable activities are likely to include the substitution of loans for securities in the bank's portfolio. Hence, on balance, it is not clear what the impact of geographic diversification will be on the riskiness (i.e., volatility of returns) of the bank. Interestingly, previous studies that have looked at bank risk have not found that it is lower for banks that are more fully geographically diversified. This seems perplexing until one accounts for the fact that risk is endogenous-the bank chooses its level of risk. Depending on the bank's risk preferences, interstate branching might lead to a higher level of risk-taking by banks, since it improves the risk-return tradeoff (i.e., lowers the price of risk), but also to a higher level of profitability. 1. GEOGRAPHIC DIVERSIFICATION AND BANK EFFICIENCY A. Geographic Diversification and the Price of Risk Deposit volatility contributes to liquidity risk and increases the cost of risk management. Liquid assets are the first line of defense against liquidity risk. Hence, a higher degree of liquidity risk requires that a higher proportion of assets be held in securities. The cost of managing this risk includes the interest differential between loans and securities that is sacrificed when the loan-to-asset ratio must be reduced to accommodate a higher degree of liquidity risk. In principle, liquidity risk can be reduced when the deposit base is diversified. Greater diversification can be achieved by increasing the number of deposit accounts, giv...

Bank consolidation is a global phenomenon that may enhance stakeholders' value if managers do not sacrifice value to build empires. We find strong evidence of managerial entrenchment at U.S. bank holding companies that have higher levels of managerial ownership, better growth opportunities, poorer financial performance, and smaller asset size. At banks without entrenched management, both asset acquisitions and sales are associated with improved performance. At banks with entrenched management, sales are related to smaller improvements while acquisitions are associated with worse performance. Consistent with scale economies, an increase in assets by internal growth is associated with better performance at most banks.