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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

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

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 13-13.

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Date of creation: 2013
Date of revision: 04 Feb 2014
Handle: RePEc:fip:fedpwp:13-13
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  1. 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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  3. 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.
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  7. Joseph P. Hughes & William Lang & Loretta J. Mester & Choon-Geol Moon, 2000. "Recovering Risky Technologies Using the Almost Ideal Demand System: An Application to U.S. Banking," Center for Financial Institutions Working Papers 97-47, Wharton School Center for Financial Institutions, University of Pennsylvania.
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