The Evolution of Scale Economies in U.S. Banking

Abstract

Continued consolidation of the U.S. banking industry and a general increase in the size of banks has prompted some policymakers to consider policies that discourage banks from getting larger, including explicit caps on bank size. However, limits on the size of banks could entail economic costs if they prevent banks from achieving economies of scale. This paper presents new estimates of returns to scale for U.S. banks based on nonparametric, local-linear estimation of bank cost, revenue and profit functions. We report estimates for both 2006 and 2015 to compare returns to scale some seven years after the financial crisis and five years after enactment of the Dodd-Frank Act with returns to scale before the crisis. We find that a high percentage of banks faced increasing returns to scale in cost in both years, including most of the 10 largest bank holding companies. And, while returns to scale in revenue and profit vary more across banks, we find evidence that the largest four banks operate under increasing returns to scale.

Why Are Big Banks Getting Bigger?

“…Wilson (2012) and Wheelock and Wilson (2015). Finally, to the extent that the underlying size distribution of business firms is determined by the distribution of managerial talent, it is possible that these changes in the bank size distribution are being driven by a change in managerial talent (Lucas, 1978).…”

Bank runs without sequential service

“…The wave of redemptions ceased only after the U.S. government announced it would insure deposits in money market funds, essentially rendering them panic-free. 20 Even though at that time prime investment funds allowed their depositors to withdraw their funds on demand with impunity at a …xed par exchange rate, our model suggests that if these funds were priced using a net-assetvaluation (NAV) method, there might still have been a run. In our model, promised rates of return are made contingent on market conditions, i.e., aggregate redemption demand, and this can be interpreted as a form of NAV pricing of liabilities.…”

“…The liquidity ratio requires that banks be able to withstand a signi…cant liquidity out ‡ow for a period of 30 days. A bank is better able to survive such a 20 See Kacperczyk and Schnabl (2010). Recall that run-proof banking is not necessarily optimal in our framework.…”

“…Inspecting conditions (20) and (21), leads us to the following result, Lemma 1 For r arbitrarily close to (but less than) unity,ĉ…”

“…It has, in fact, been documented for the retail banking sector and it appears to be relevant for wholesale banking. At the retail level, Mester (2008), Wheelock and Wilson (2017), and Corbae and D'Erasmo (2018) provide empirical support for increasing returns to scale in the banking industry. Our analysis, along with the empirical evidence, suggests that factors other than sequential service can lead to retail bank instability.…”