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The Elusive Scale Economies of the Largest Banks and their Implications for Global Competitiveness

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  • Joseph P. Hughes

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    (Rutgers University)

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    Abstract

    In the wake of the financial crisis that began in 2007, policy makers have focused again on the largest financial firms to consider the association of their size with systemic risk. An equally important question examines whether their size benefits the economy. In particular, is the size of our largest financial institutions the result of technological cost advantages that improve the efficiency of their capital allocation and liquidity and enhance their international competitiveness? Or is it the result, not of technological cost advantages, but of safety-net subsidies that confer too-big-to-fail cost advantages and foster moral hazard in investment decisions. This paper reviews the evidence of large scale economies that increase with size and considers the credibility of this evidence by examining details of how scale economies are measured and why evidence of scale economies eludes many investigations. A method of estimating scale economies developed by Hughes, Lang, Mester, and Moon (1996) distinguishes the underlying scale effects on cost from the effects on costs of size-related changes in risk-taking, which can obscure technological cost advantages, such as those due to better diversification. It reviews evidence that technology, not too-big-to-fail subsidies, accounts for the cost advantage of the largest financial institutions. Finally, it considers the implications of scale economies for scaling back the operations of the largest financial institutions and for the global competitiveness of smaller institutions.

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    Bibliographic Info

    Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 201134.

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    Length: 20 pages
    Date of creation: 07 Dec 2011
    Date of revision:
    Handle: RePEc:rut:rutres:201134

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    Keywords: banking; production; risk; scale economies; too big to fail;

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Joseph P. Hughes & Choon-Geol Moon, 1997. "Efficient Banking Under Interstate Branching," Departmental Working Papers 199609, Rutgers University, Department of Economics.
    2. Berger, Allen N. & Mester, Loretta J., 1997. "Inside the black box: What explains differences in the efficiencies of financial institutions?," Journal of Banking & Finance, Elsevier, vol. 21(7), pages 895-947, July.
    3. Guohua Feng & Apostolos Serletis, 2009. "Efficiency, Technical Change, and Returns to Scale in Large U.S. Banks: Panel Data Evidence from an Output Distance Function Satisfying Theoretical Regularity," Monash Econometrics and Business Statistics Working Papers 5/09, Monash University, Department of Econometrics and Business Statistics.
    4. Joseph P. Hughes & William W. Lang & Loretta J. Mester & Choon-Geol Moon, 1997. "Recovering risky technologies using the almost ideal demand system: an application to U.S. banking," Working Papers 97-8, Federal Reserve Bank of Philadelphia.
    5. Joseph Hughes, 1999. "Incorporating risk into the analysis of production," Atlantic Economic Journal, International Atlantic Economic Society, vol. 27(1), pages 1-23, March.
    6. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
    7. Grossman, Richard S, 1992. "Deposit Insurance, Regulation, and Moral Hazard in the Thrift Industry: Evidence from the 1930's," American Economic Review, American Economic Association, vol. 82(4), pages 800-821, September.
    8. Hughes, Joseph P. & Mester, Loretta J. & Moon, Choon-Geol, 2001. "Are scale economies in banking elusive or illusive?: Evidence obtained by incorporating capital structure and risk-taking into models of bank production," Journal of Banking & Finance, Elsevier, vol. 25(12), pages 2169-2208, December.
    9. Joseph P. Hughes & Choon-Geol Moon & Robert DeYoung, 2000. "Efficient Risk-Taking and Regulatory Covenant Enforcement in a Deregulated Banking Industry," Departmental Working Papers 200007, Rutgers University, Department of Economics.
    10. 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.
    11. Tufano, Peter, 1996. " Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry," Journal of Finance, American Finance Association, vol. 51(4), pages 1097-1137, September.
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