Who said large banks don't experience scale economies? Evidence from a risk-return-driven cost function

Joseph P. Hughes, Loretta J. Mester

Research output: Contribution to journalArticle

78 Citations (Scopus)

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.

Original languageEnglish (US)
Pages (from-to)559-585
Number of pages27
JournalJournal of Financial Intermediation
Volume22
Issue number4
DOIs
StatePublished - Oct 1 2013

Fingerprint

Cost function
Scale economies
Risk-return
Costs
Risk taking
Too big to fail
Endogenous risk
Risk preferences
Diversification
Great Recession
Economies of scale
Econometrics
Incentives
Systemic risk
Subsidies
Financial institutions

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics
  • Finance

Keywords

  • Banking
  • Production
  • Risk
  • Scale economies
  • Too big to fail

Cite this

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Who said large banks don't experience scale economies? Evidence from a risk-return-driven cost function. / Hughes, Joseph P.; Mester, Loretta J.

In: Journal of Financial Intermediation, Vol. 22, No. 4, 01.10.2013, p. 559-585.

Research output: Contribution to journalArticle

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