The cost of producing any good or service is a key determinant of the value that it provides to consumers. A business that can produce the same good at lower cost will be able to sell the good at lower prices, which allows consumers to purchase more of the good and to save more or spend more of their money on other goods and services. This is true as well in the context of producing banking services – such as business loans, auto loans, and checking accounts. While most people may not think of banking services as being “produced” in the same way that they think of, say, cars being produced, banking services are indeed produced from a combination of several key inputs such as physical capital, human capital, technology, and borrowed funds. Banks that can produce these services at lower cost can pass some of these savings onto businesses and households while using less of the economy’s valuable resources.
Banks that can produce these services at lower cost can pass some of these savings onto businesses and households while using less of the economy’s valuable resources.”
A fundamental economic concept that relates the size of a firm to the cost of production is the concept of scale economies. Firms exhibit increasing returns to scale when an increase in the size of the firm results in a decrease in the per unit cost of production. As a specific example, a bank that can make 1,000 loans at a cost of $100 per loan and also is able to scale up its business and make 1,100 loans at a cost of $95 per loan exhibits increasing returns to scale. Put differently, the bank can increase its loan output by 10 percent (100 loans) while only sustaining a 4.5 percent ($4,500) increase in costs. In addition to increasing returns to scale, a firm may also exhibit constant returns to scale in which per unit costs neither rise nor fall as the firm grows or decreasing returns to scale in which per unit costs rise as the firm grows.
There is good reason to think that the banking industry may exhibit increasing returns to scale. Information technology is a key input into the production of banking services. Loans and other banking services are increasingly produced by organizing, cataloging, and analyzing data with information technology. The past thirty years have seen enormous improvements in our ability to process, manage, and analyze large amounts of data while at the same time technology costs have plummeted. As shown in Figure 1, between December of 1997 and August of 2015, the price index for personal computers decreased by 96 percent while the price index for software declined by 64 percent. As managing more data becomes less costly, holding other expenses constant, a bank can increase the scale of its lending activities significantly without incurring a large increase in costs. The potential presence of returns to scale in the banking industry is important because it has important implications for policies that would limit the size of banks. Accordingly, it is important to understand the nature of scale returns in the banking industry.
A number of recent research papers have explored the empirical evidence for increasing returns to scale in the banking industry and find significant economies of scale. Mester and Hughes (2013) analyze a sample of several thousand U.S. bank holding companies (BHCs) in 2003, 2007, and 2010. These authors find that, overall, a 10 percent increase in banking sector output only results in an 8 percent increase in costs. What’s more, these authors examine the case for increasing returns to scale across banks of varying size and find that the largest banks exhibit the largest returns to scale. Using data from 2010, they find that banks with total assets in excess of $100 billion experience only a 7 percent increase in cost in response to a 10 percent increase in output.
A more recent paper by Wheelock and Wilson (2017) also examines the evidence for scale economies in banking using more recent data from 2015. They also find significant evidence in favor of increasing returns to scale in the banking sector. Also, like Mester and Hughes (2013), these authors find that the evidence in favor of increasing returns to scale is most compelling for the largest banks in their sample. Taken together, these studies suggest that increasing returns to scale is a consistent and robust feature of the banking industry and that these effects are largest among larger banks.
Finally, a related research paper by Kovner, Vickery, and Zhu (2014) examines how certain banking costs change with the size of U.S. BHCs over the 2003-2012 period. More specifically, they examine noninterest expenses, which includes all bank costs except the cost of borrowed funds. These costs include but are not limited to the costs of compensation, information technology, and legal services.
These authors also find that costs relative to bank size decline as bank size increases. According to the authors’ estimates, for an average-sized bank in 2017, increasing its total assets by an additional 10 percent would reduce noninterest expenses by roughly $6 million per year relative to a base case in which there is no relationship between bank size and expenses. These authors also document how increasing size would affect various components of noninterest expense. Table 1 displays the estimated annual reduction in cost relative to a base case in which cost and size are unrelated, for total noninterest expense and five other cost categories resulting from a 10 percent increase in the size of the average BHC in 2017 (i.e., $30 billion). As shown in the table, a 10 percent increase in the size of the average BHC would reduce compensation costs by roughly $3.4 million per year and information technology costs by roughly $300,000 per year relative to the base case. These authors also find some evidence that the identified scale economies are even larger for the largest banks.
Table 1: Economies of Scale in Banking
|Noninterest Expense Category||Annual Cost Decline Due to 10% Increase in Size of Average Bank Holding Company ($)|
|Total Noninterest Expense||5,871,954|
|Premises and Fixed Assets||516,325|
Source: Kovner, Vickery and Zhu (2014), staff calculations
While recent research does suggest that larger firms operate more efficiently with lower per-unit costs than smaller banks, some have argued that these results may be indicative of a too-big-to-fail (TBTF) subsidy. Those advancing this view argue that banks perceived as being TBTF can borrow money from depositors and creditors more cheaply than smaller banks, which lowers the cost structure for these banks. The research of both Hughes and Mester (2013) and Kovner, Vickery, and Zhu (2014), however, present evidence contrary to this argument. Hughes and Mester (2013) directly consider the TBTF issue and estimate scale economies for larger banks assuming they face the same borrowing costs as smaller banks and still find significant scale economies. Also, Kovner, Vickery, and Zhu (2014) examine those components of a bank’s cost structure other than borrowing costs and also find scale economies. While it is conceivable that larger banks could benefit from a TBTF perception that lowers borrowing costs, it is unclear how such perceptions would influence the costs of legal services, technology costs, or the costs of other expenses, such as real estate and office furniture costs.
While these recent research findings are good news for bank customers, these findings also bear on an important policy debate. Specifically, those considering proposals that seek to limit the size of banks should be aware of the costs that would be borne by households and businesses in the form of more costly banking services given the evidence of increasing returns to scale. While some argue that bank size does have certain financial stability implications, as stressed recently by Bernanke (2016), those implications should be weighed against the cost implications of limiting bank size.
Sean Campbell is the Executive Vice President, Director of Policy Research, at the Financial Services Forum.