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Who said large banks don't experience scale economies? Evidence from a risk-return-driven cost function

  • Joseph P. Hughes
  • Loretta J. Mester

Earlier studies found little evidence of scale economies at large banks; later studies using data from the 1990s uncovered such evidence, providing a rationale for very large banks seen worldwide. Using more recent data, the authors estimate scale economies using two production models. The standard risk-neutral model finds little evidence of scale economies. The model using more general risk preferences and endogenous risk-taking finds large scale economies. The authors show that these economies are not driven by too-big-to-fail considerations. They evaluate the cost implications of breaking up the largest banks into banks of smaller size.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 11-27.

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Date of creation: 2011
Date of revision:
Handle: RePEc:fip:fedpwp:11-27
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  1. Demsetz, Rebecca S & Strahan, Philip E, 1997. "Diversification, Size, and Risk at Bank Holding Companies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 300-313, August.
  2. Braeutigam, Ronald R. & Daughety, Andrew F., 1983. "On the estimation of returns to scale using variable cost functions," Economics Letters, Elsevier, vol. 11(1-2), pages 25-31.
  3. Feng, Guohua & Serletis, Apostolos, 2010. "Efficiency, technical change, and returns to scale in large US banks: Panel data evidence from an output distance function satisfying theoretical regularity," Journal of Banking & Finance, Elsevier, vol. 34(1), pages 127-138, January.
  4. Joseph P. Hughes & William W. Lang & Choon-Geol Moon & Michael S. Pagano, 1998. "Measuring the efficiency of capital allocation in commercial banking," Working Papers 98-2, Federal Reserve Bank of Philadelphia.
  5. David C. Wheelock & Paul W. Wilson, 2012. "Do Large Banks Have Lower Costs? New Estimates of Returns to Scale for U.S. Banks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(1), pages 171-199, 02.
  6. Joseph P. Hughes & Loretta J. Mester, 2008. "Efficiency in banking: theory, practice, and evidence," Working Papers 08-1, Federal Reserve Bank of Philadelphia.
  7. Joseph Hughes & William Lang & Loretta Mester & Choon-Geol Moon, 2000. "Recovering Risky Technologies Using the Almost Ideal Demand System: An Application to U.S. Banking," Journal of Financial Services Research, Springer, vol. 18(1), pages 5-27, October.
  8. 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.
  9. Isil Erel & Taylor D. Nadauld & René M. Stulz, 2011. "Why Did U.S. Banks Invest in Highly-Rated Securitization Tranches?," NBER Working Papers 17269, National Bureau of Economic Research, Inc.
  10. Elijah Brewer & Julapa Jagtiani, 2011. "How much did banks pay to become too-big-to-fail and to become systematically important?," Working Papers 11-37, Federal Reserve Bank of Philadelphia.
  11. Michel A. Habib & Alexander Ljungqvist, 2005. "Firm Value and Managerial Incentives: A Stochastic Frontier Approach," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2053-2094, November.
  12. Alan Greenspan, 2010. "La crisis," Revista de Economía Institucional, Universidad Externado de Colombia - Facultad de Economía, vol. 12(22), pages 15-60, January-J.
  13. Allen N. Berger & Robert DeYoung & Mark J. Flannery & David Lee & Ozde Oztekin, 2008. "How do large banking organizations manage their capital ratio?," Research Working Paper RWP 08-01, Federal Reserve Bank of Kansas City.
  14. 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.
  15. 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.
  16. Loretta J. Mester, 1990. "Traditional and nontraditional banking: an information-theoretic approach," Working Papers 90-3, Federal Reserve Bank of Philadelphia.
  17. Oecd, 2010. "Labour markets and the crisis," OECD Economics Department Working Papers 756, OECD Publishing.
  18. Deaton, Angus S & Muellbauer, John, 1980. "An Almost Ideal Demand System," American Economic Review, American Economic Association, vol. 70(3), pages 312-26, June.
  19. 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.
  20. 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.
  21. Joseph P. Hughes & Loretta J. Mester & Choon-Geol Moon, 2000. "Are scale economies in banking elusive or illusive? evidence obtained by incorporating capital structure and risk-taking into models of bank production," Proceedings 700, Federal Reserve Bank of Chicago.
  22. Alan Greenspan, 2010. "The Crisis," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 41(1 (Spring), pages 201-261.
  23. Jagannathan Ravi & Boyd John, 2009. "Avoiding the Next Crisis," The Economists' Voice, De Gruyter, vol. 6(7), pages 1-5, July.
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