Efficiency and Risk-Taking in Pre-Crisis Investment Bank

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CENTRE FOR EMEA BANKING, FINANCE & ECONOMICS

Efficiency and Risk-taking in Pre-crisis Investment Banks Nemanja Radić, Franco Fiordelisi, Claudia Girardone

Working Paper Series No 08/11

Efficiency and risk-taking in pre-crisis investment banks

Nemanja Radić1, Franco Fiordelisi2, Claudia Girardone3

Abstract

Investment banks’ core functions expose them to a wide array of risks. This paper analyses cost and profit efficiency for a sample of investment banks for the G7 countries (Canada, France, Germany, Italy, Japan, UK and US) and Switzerland prior to the recent financial crisis. We follow Coelli et al. (1999)’s methodology to adjust the estimated cost and profit efficiency scores for environmental influences including key banks’ risks, bank- and industry specific factors and macroeconomic conditions. Our evidence suggests that failing to account for environmental factors can considerably bias the efficiency scores for investment banks. Specifically, bank-risk taking factors (including liquidity and capital risk exposures) are found particularly important to accurately assess profit efficiency: i.e. profit efficiency estimates are consistently underestimated without accounting for bank risktaking. Interestingly, our evidence suggests that size matters for both cost and profit efficiency, however this does not imply that more concentrated markets are more efficient.

JEL classification: D2, G24, G32, L25 Key words: Investment Banking;Stochastic Frontier Analysis; Efficiency; Environmental Conditions; Banking Risks.

1

Centre for EMEA Banking, Finance and Economics, London Metropolitan Business School, London Metropolitan University, 84 Moorgate, London EC2M 6SQ, UK; e-mail: n.radic@londonmet.ac.uk University of Rome III, Italy, Via S. D’Amico 77, 00145 Rome, Italy; e-mail: fiordeli@uniroma3.it University of Essex, Wivenhoe Park, Colchester, CO4…...

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