A Quality and Risk-Adjusted Cost Function for Banks: Evidence on the "Too-Big-To-Fail" Doctrine

We estimate a multiproduct cost function model that incorporates measures for the quality of bank output and the probability of failure, which can influence a bank’s costs in a variety of ways. We model a bank’s price of uninsured deposits as an endogenous variable depending on the bank’s output level, output quality, financial capital level, and risk measures. Incorporating these aspects into the cost function has a significant effect on measures scale and scope economies when compared with results of previous studies that did not take quality and risk into account. We find constant returns to scale at the mean-sized bank and at banks in four different size categories. We also find evidence of diseconomies of scope at the larger banks. Finally, there is evidence that the "too-big-to fail" doctrine has a significant impact on the price a bank pays for its uninsured deposits. For banks in the largest size category, an increase in size, holding default risk and asset quality constant, significantly lowers the uninsured deposit price.