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

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  • Joseph P. Hughes
  • Loretta J. Mester

Abstract

The Great Recession focused attention on large financial institutions and systemic risk. We investigate whether large size provides any cost advantages to the economy and, if so, whether these cost advantages are due to technological scale economies or too-big-to-fail subsidies. Estimating scale economies is made more complex by risk-taking. Better diversification resulting from larger scale generates scale economies but also incentives to take more risk. When this additional risk-taking adds to cost, it can obscure the underlying scale economies and engender misleading econometric estimates of them. Using data pre- and post-crisis, we estimate scale economies using two production models. The standard model ignores endogenous risk-taking and finds little evidence of scale economies. The model accounting for managerial risk preferences and endogenous risk-taking finds large scale economies, which are not driven by too-big-to-fail considerations. We evaluate the costs and competitive implications of breaking up the largest banks into smaller banks. ; This paper supersedes Federal Reserve Bank of Philadelphia Working Paper No. 11-27

Suggested Citation

  • Joseph P. Hughes & Loretta J. Mester, 2013. "Who said large banks don’t experience scale economies? Evidence from a risk-return-driven cost function," Working Papers 13-13, Federal Reserve Bank of Philadelphia.
  • Handle: RePEc:fip:fedpwp:13-13
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    References listed on IDEAS

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    1. Mester, Loretta J., 1992. "Traditional and nontraditional banking: An information-theoretic approach," Journal of Banking & Finance, Elsevier, vol. 16(3), pages 545-566, June.
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    9. 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;Western Finance Association, vol. 18(1), pages 5-27, October.
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    More about this item

    Keywords

    Banks and banking; Risk; Economies of scale;
    All these keywords.

    JEL classification:

    • D20 - Microeconomics - - Production and Organizations - - - General
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • L23 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Organization of Production

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