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Productivity and economies of scale in the production of bank service value added

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  • J. Christina Wang
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    Abstract

    This paper uses a new measure of bank service output to estimate various specifications of production and cost functions for Bank Holding Companies (BHCs) over the period 1986 to 1999. The new output series is a true flow measure of bank service value added, and it follows from a unified model of bank operation that integrates risk and the measurement of bank services. The model also establishes separability between the production function of bank services and the funds borrowed and lent-a special intermediate input for banks. The preferred specification of the cost function estimates a large dispersion in productivity levels across BHCs. This implies that one potential benefit of bank mergers is the acquisition by more productive banks of less productive banks, thereby improving the targets' productivity. The cost function also yields an estimate of increasing returns to scale in banking, contrasting with the typical finding in the existing literature of constant returns to scale. On the other hand, the production function estimates decreasing returns to scale. But these estimates are shown to be potentially biased downward, whereas the estimates from the cost function are likely to be biased upward because of measurement errors in the imputed output. The paper tentatively concludes that there is likely to be a modest degree of increasing returns to scale in the production of bank services. If confirmed, this tentative conclusion implies that the cost savings from increased scale of banking institutions should be taken into account in the analysis of mergers and antitrust policy.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 03-7.

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    Date of creation: 2003
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    Handle: RePEc:fip:fedbwp:03-7

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    Keywords: Bank holding companies ; Risk ; Banks and banking - Customer services ; Productivity;

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    References

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    1. J. Christina Wang, 2003. "Loanable funds, risk, and bank service output," Working Papers 03-4, Federal Reserve Bank of Boston.
    2. Joseph P. Hughes & William W. Lang & Loretta J. Mester & Choon-Geol Moon, 1996. "Efficient banking under interstate branching," Working Papers 96-9, Federal Reserve Bank of Philadelphia.
    3. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," Center for Financial Institutions Working Papers 96-28, Wharton School Center for Financial Institutions, University of Pennsylvania.
    4. Allen N. Berger & David B. Humphrey, 1997. "Efficiency of financial institutions: international survey and directions for future research," Finance and Economics Discussion Series 1997-11, Board of Governors of the Federal Reserve System (U.S.).
    5. Allen N. Berger & Gerald A. Hanweck & David B. Humphrey, 1986. "Competitive viability in banking: scale, scope, and product mix economies," Research Papers in Banking and Financial Economics 82, Board of Governors of the Federal Reserve System (U.S.).
    6. Susanto Basu & John Fernald & Miles Kimball, 2004. "Are technology improvements contractionary?," Working Paper Series WP-04-20, Federal Reserve Bank of Chicago.
    7. Allen N. Berger & Loretta J. Mester, 1997. "Inside the black box: what explains differences in the efficiencies of financial institutions?," Finance and Economics Discussion Series 1997-10, Board of Governors of the Federal Reserve System (U.S.).
    8. Klette, T.J., 1992. "The Inconsistency of Common Scale Estimators when Output Prices are unobserved and Endogenous," Harvard Institute of Economic Research Working Papers 1586, Harvard - Institute of Economic Research.
    9. Joseph P. Hughes & Loretta J. Mester, 1998. "Bank Capitalization And Cost: Evidence Of Scale Economies In Risk Management And Signaling," The Review of Economics and Statistics, MIT Press, vol. 80(2), pages 314-325, May.
    10. Joseph P. Hughes & Loretta J. Mester, 1991. "A quality and risk-adjusted cost function for banks: evidence on the " too-big-to-fail" doctrine," Working Papers 91-21, Federal Reserve Bank of Philadelphia.
    11. Dixon, Bruce L & Garcia, Philip & Anderson, Margot, 1987. "Usefulness of Pretests for Estimating Underlying Technologies Using Dual Profit Functions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 623-33, October.
    12. Clark, Jeffrey A, 1996. "Economic Cost, Scale Efficiency, and Competitive Viability in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(3), pages 342-64, August.
    13. Bhargava, A & Franzini, L & Narendranathan, W, 1982. "Serial Correlation and the Fixed Effects Model," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 533-49, October.
    14. Mitchell, Karlyn & Onvural, Nur M, 1996. "Economies of Scale and Scope at Large Commercial Banks: Evidence from the Fourier Flexible Functional Form," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(2), pages 178-99, May.
    15. Griliches, Zvi & Hausman, Jerry A., 1986. "Errors in variables in panel data," Journal of Econometrics, Elsevier, vol. 31(1), pages 93-118, February.
    16. Rogers, Kevin E., 1998. "Nontraditional activities and the efficiency of US commercial banks," Journal of Banking & Finance, Elsevier, vol. 22(4), pages 467-482, May.
    17. Arellano, M, 1987. "Computing Robust Standard Errors for Within-Groups Estimators," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 49(4), pages 431-34, November.
    18. Argia M. Sbordone, 1994. "Interpreting the procyclical productivity of manufacturing sectors: external effects or labor hoarding?," Working Paper Series, Macroeconomic Issues 94-9, Federal Reserve Bank of Chicago.
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    Cited by:
    1. J. Christina Wang, 2003. "Merger-related cost savings in the production of bank services," Working Papers 03-8, Federal Reserve Bank of Boston.
    2. Scott J. Dressler, 2011. "Economies Of Scale In Banking, Indeterminacy, And Monetary Policy," Economic Inquiry, Western Economic Association International, vol. 49(1), pages 185-193, 01.

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