The New England banking industry experienced serious problems between
1989 and 1992. As the region's economy deteriorated, banks failed at a
n unprecedented rate and many others barely survived. Banking problems
were widespread, but they were not uniform. The ratio of nonperformin
g loans to total loans was in excess of 10 percent for some New Englan
d banks, below 1 percent for others, even though all faced the externa
l shock of the collapse in the region's real estate market. This study
attempts to determine whether a 'skills' hypothesis or a 'policies' h
ypothesis better explains the differences among banks in the severity
of their loan problems. The 'skills' hypothesis posits that banks with
the greatest loan problems were those that employed managers with def
icient skills. The 'policies' hypothesis posits that banks with the gr
eatest loan problems were those that chose higher loan-to-asset ratios
, held a greater concentration of riskier types of loans, or accepted
riskier loan customers. The author uses an analysis of profit and cost
efficiency to help identify the hypothesis that better explains the d
isparity. He finds evidence in support of the 'policies' hypothesis. C
onscious decisions by bank managers regarding the riskiness of their l
oan portfolios, as well as the level of capital to hold, help explain
why some New England banks were able to survive the real estate crisis
while others failed.