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

  • J. Christina Wang
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    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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    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
    Date of revision:
    Handle: RePEc:fip:fedbwp:03-7
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    1. Allen N. Berger & Loretta J. Mester, 1997. "Inside the black box: what explains differences in the efficiencies of financial institutions?," Working Papers 97-1, Federal Reserve Bank of Philadelphia.
    2. Tor Jakob Klette & Zvi Griliches, 1994. "The Inconsistency of Common Scales Estimators when Output Prices are Unobserved and Endogenous," Discussion Papers 127, Statistics Norway, Research Department.
    3. Joseph P. Hughes, 1997. "Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling," Departmental Working Papers 199601, Rutgers University, Department of Economics.
    4. 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.
    5. Berger, Allen N. & Hanweck, Gerald A. & Humphrey, David B., 1987. "Competitive viability in banking : Scale, scope, and product mix economies," Journal of Monetary Economics, Elsevier, vol. 20(3), pages 501-520, December.
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    9. Sbordone, Argia M, 1997. "Interpreting the Procyclical Productivity of Manufacturing Sectors: External Effects or Labor Hoarding?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(1), pages 26-45, February.
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    12. 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.
    13. 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.
    14. 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.
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    17. repec:oup:restud:v:49:y:1982:i:4:p:533-49 is not listed on IDEAS
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