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James Wahlen
Kelley School of Business

George Vlahakis
IU Media Relations

Last modified: Tuesday, July 18, 2006

Public vs. private

Private banks tend to be more profitable than similar-sized public banks, research suggests

July 18, 2006

James Wahlen image


BLOOMINGTON, Ind. -- Being privately-owned may help a company avoid onerous Sarbanes-Oxley requirements, as well as shareholders myopically focused on quarterly earnings, but it also results in greater profitability, if recent Indiana University research examining public and private banks is any indicator.

Private banks are more profitable than their same-sized publicly-traded peers, according to the first study to empirically compare profitability across private and publicly traded banks -- as well as three other dimensions of performance: risk, growth and accounting conservatism.

In most industry sectors, private companies are not required to file detailed financial statements with any public agencies. Not so in the banking sector, where federal deposit insurance regulations require that data from both types of companies.

That requirement gave James Wahlen, an accounting professor at IU's Kelley School of Business, a rare porthole into a question that has long vexed economists -- are private companies, unburdened by short-term pressures to report quarterly earnings to shareholders, more profitable?

The answer to that question: it depends, Wahlen says.

"For banks of equal size, public banks are less profitable than private banks," Wahlen says. "Compared to privately-held banks, publicly-traded banks face potentially greater agency costs as a consequence of greater separation of ownership and control. This makes them less profitable, all else equal. But the tradeoff is that public banks enjoy potentially greater benefits from access to the capital market and lower costs of equity capital.

"Public banks can more easily and cheaply issue equity capital, which fuels growth and helps them attain valuable economies of scale and they ultimately become larger and therefore more profitable because of their access to capital markets," he adds. "These results in general imply that public banks are motivated to acquire small privates. They're already pretty profitable and the consolidation trend and acquisition wave may also reflect these findings."

In the study, Wahlen, along with two co-authors who were Wahlen's PhD students at the Kelley School of Business, D. Craig Nichols, now of Cornell University, and Matthew M. Wieland, now of the University of Georgia's Terry College of Business, also hypothesize that agency costs change as a company increases in size.

To put it more simply, in private banks, owners work together, trust, manage and monitor each other, while in public banks, there's greater separation between those who own and those who manage the company, Wahlen says.

"Compensation schemes are created to align the manager's interests with the shareholders, but those incentives don't always work that well in public companies, including public banks," he observes. "In a private bank, if you make a bad loan as a bank owner, that money comes out of your pocket. In a public bank, loan losses accrue to the shareholders, and managers usually don't have a majority equity stake. So, managers at public banks might be more inclined to make a risky loan, because they may not bear the majority of the loss if the loan goes bad."

On the other hand, public banks can issue stock and raise more capital and grow faster, becoming more efficient and profitable in the process.

"That's the tradeoff between going public or private, and it's one that exists in all industries, not just banking," Wahlen says.

In the study, Wahlen and his co-authors examined 1,652 private banks and 608 public banks during 1992 to 2002, with assets that fell within the range between the smallest public bank and the largest private bank.

"Public banks generate less profitability per unit of risk and per dollar of invested capital than private banks of equivalent size. However, relaxing the control for size, public banks enjoy faster growth, become larger, achieve greater economies of scale, and therefore generate greater profitability than private banks," the authors write.

"These results imply that the costs associated with agency problems dominate the benefits of capital market access for public banks relative to private banks of equal size, but capital market access enables public banks to become larger and capture greater profitability from economies of scale."

"These implications may be partial explanations for why we observe that the majority of banks that seemingly meet U.S. stock exchange listing requirements choose to remain privately-held, but the largest and most profitable banks in the U.S. are publicly-traded," they conclude.

Among the private banks in the study sample, the median size in terms of total assets was $106 million, whereas the median size public bank was $408 million. Within the private bank sample, the size of the 25th percentile bank was only $38 million and the 75th percentile bank was $253 million. Within the public bank sample, the size of the 25th percentile bank was $247 million and the 75th percentile bank was $833 million. Within banking, this sample range includes what would be considered small banks. To benchmark this, consider that Bank of America currently has assets of roughly $1.3 trillion.