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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. 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.
  2. 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.
  3. Elijah Brewer & Julapa Jagtiani, 2013. "How Much Did Banks Pay to Become Too-Big-To-Fail and to Become Systemically Important?," Journal of Financial Services Research, Springer, vol. 43(1), pages 1-35, February.
  4. 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.
  5. Joseph P. Hughes & Loretta J. Mester, 1997. "Bank capitalization and cost: evidence of scale economies in risk management and signaling," Working Papers 96-2, Federal Reserve Bank of Philadelphia.
  6. Habib, Michel Antoine & Ljungqvist, Alexander P., 2000. "Firm Value and Managerial Incentives: A Stochastic Frontier Approach," CEPR Discussion Papers 2564, C.E.P.R. Discussion Papers.
  7. 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.
  8. 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.
  9. Allen Berger & Robert DeYoung & Mark Flannery & David Lee & Özde Öztekin, 2008. "How Do Large Banking Organizations Manage Their Capital Ratios?," Journal of Financial Services Research, Springer, vol. 34(2), pages 123-149, December.
  10. Joseph P. Hughes & Choon-Geol Moon, 1997. "Efficient Banking Under Interstate Branching," Departmental Working Papers 199609, Rutgers University, Department of Economics.
  11. Oecd, 2010. "Labour markets and the crisis," OECD Economics Department Working Papers 756, OECD Publishing.
  12. 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.
  13. Deaton, Angus S & Muellbauer, John, 1980. "An Almost Ideal Demand System," American Economic Review, American Economic Association, vol. 70(3), pages 312-26, June.
  14. Mester, Loretta J., 1992. "Traditional and nontraditional banking: An information-theoretic approach," Journal of Banking & Finance, Elsevier, vol. 16(3), pages 545-566, June.
  15. 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.
  16. Alan Greenspan, 2010. "La crisis," Revista de Economía Institucional, Universidad Externado de Colombia - Facultad de Economía, vol. 12(22), pages 15-60, January-J.
  17. Joseph P. Hughes & Loretta J. Mester, 2008. "Efficiency in banking: theory, practice, and evidence," Working Papers 08-1, Federal Reserve Bank of Philadelphia.
  18. 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.
  19. 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.
  20. Jagannathan Ravi & Boyd John, 2009. "Avoiding the Next Crisis," The Economists' Voice, De Gruyter, vol. 6(7), pages 1-5, July.
  21. 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.
  22. Joseph P. Hughes & William W. Lang & Choon-Geol Moon & Michael S. Pagano, 1999. "Measuring the efficiency of capital allocation in commercial banking," Proceedings 626, Federal Reserve Bank of Chicago.
  23. Alan Greenspan, 2010. "The Crisis," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 41(1 (Spring), pages 201-261.
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