Evidence on the Objectives of Bank Managers

94-15

Posted: 15 Jul 1998

See all articles by Joseph P. Hughes

Joseph P. Hughes

Rutgers, The State University of New Jersey - Department of Economics

Loretta J. Mester

Federal Reserve Bank of Cleveland; University of Pennsylvania - The Wharton School

Date Written: January 1994

Abstract

We present evidence on the objective function of bank management--that is, are they risk neutral and maximize expected profits, or are they risk averse and trade off profit for risk reduction? We extend the model of Hughes and Mester (1993) to allow a bank's choice of its financial capital level to reflect its preference for return versus risk. A multiproduct cost function, which incorporates asset quality and the risk faced by a bank's uninsured depositors, is derived from a model of utility maximization. The utility function represents the bank management's preferences defined over asset levels, asset quality, capital level and profit. Endogenizing the bank's choice of capital level in this way permits the demand for financial capital to deviate from its cost-minimizing level. The model consists of the cost function, share equations and demand for financial capital equation, which are estimated jointly. We then are able to explicitly test whether bank managers are acting in shareholders' interest and maximizing expected profits, or whether they are maximizing a utility function that exhibits risk aversion. We believe this is the first such test.

JEL Classification: G2, D2

Suggested Citation

Hughes, Joseph P. and Mester, Loretta J., Evidence on the Objectives of Bank Managers (January 1994). 94-15, Available at SSRN: https://ssrn.com/abstract=7038

Joseph P. Hughes

Rutgers, The State University of New Jersey - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

Loretta J. Mester (Contact Author)

Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

University of Pennsylvania - The Wharton School

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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