Is Bank Efficiency Cyclical? The Relationship Between Economic and Financial Market Conditions and Bank Performance”, Drexel University working paper

A major concern of bank capital regulation arises from procyclicality: worsening bank conditions result in more stringent capital regulations that force banks to tighten credit and further constrict economic growth, further worsening bank conditions. Hence, if bank conditions are highly correlated with fundamental macroeconomic performance (beyond idiosyncratic portfolio difficulties) bank regulation may promote economic downturns through the credit channel. The present manuscript sheds light on the magnitude of the correlation between bank performance and economic growth by estimating translog flexible function specifications of bank cost and profit efficiency during the period 1988-1997, yielding a panel data set of nearly 300,000 bank/quarter observations, and then using the results to test how local and national business and national financial market conditions affect bank efficiency. A model that controls for idiosyncratic bank characteristics and major bank deregulatory events shows that typical measures of business conditions are procyclically related to bank performance, whereas financial market conditions appear countercyclical