Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function

Forthcoming in the Journal of Financial Intermediation       

FRB of Philadelphia Working Paper No. 13-13

50 Pages Posted: 26 Apr 2013 Last revised: 25 Mar 2016

See all articles by Joseph P. Hughes

Joseph P. Hughes

Rutgers, The State University of New Jersey - Department of Economics

Loretta J. Mester

Federal Reserve Banks - Federal Reserve Bank of Cleveland; University of Pennsylvania - The Wharton School

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2013

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.

Keywords: Banking, Production, Risk, Scale economies, Too big to fail

JEL Classification: D20, D21, G21, L23

Suggested Citation

Hughes, Joseph P. and Mester, Loretta J., Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function (April 1, 2013). Forthcoming in the Journal of Financial Intermediation       ; FRB of Philadelphia Working Paper No. 13-13. Available at SSRN: https://ssrn.com/abstract=2256059 or http://dx.doi.org/10.2139/ssrn.2256059

Joseph P. Hughes (Contact Author)

Rutgers, The State University of New Jersey - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

Loretta J. Mester

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

University of Pennsylvania - The Wharton School

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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