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Scale Economies in Banking: Is Bigger Really Better?

Posted by Val Srinivas, Banking & Securities research leader, Deloitte Services LP, on April 23, 2014

"Where are the economies of scale we were promised?" demanded an article in a banking industry publication last year. The author further lamented the fact that in spite of the stupendous growth in the size of the largest banks in the United States, there were no meaningful cost advantages to size.1

So, are there scale economies in today's banking? And would limits on bank size negatively impact operational costs and lead to other adverse consequences?

Thanks in part to advances in data collection and econometric modeling, academic researchers have begun to shed more light on these questions in recent years.

The most recent research effort is from the Federal Reserve Bank of New York. As part of a series of papers on large and complex banks, their staff economists argue that there is a "robust negative relationship" between bank size and operating costs (i.e., noninterest expenses). To be specific, a $1 billion increase in assets, for an average bank holding company (BHC), is associated with a $1 million to $2 million decline in operating expenses per year, compared to a "base case where operating cost ratios are unrelated to size." This pattern is consistent across historical time periods and size bands.2

Curious to see if this would hold up in the current environment, I analyzed the ratio of noninterest expenses to total assets over the last five years for different sized banks. These data show that the largest banks (i.e., those over $500B in assets) have had the lowest average expense ratio, while banks with assets between the $10B and $100B have had the highest average expense ratio (Exhibit 1).3

Sources: SNL Financial and Deloitte Center for Financial Services

The research cited above from the NY Fed is only the latest to empirically illustrate that larger banks have operational cost advantages. In 2011, economists at the Federal Reserve Bank of Philadelphia determined that there are "large scale economies at small banks and even larger scale economies at large banks." 4

It appears this might be the case even outside the United States. In the European Union, for instance, significant scale economies were evident consistently through the 2002-2011 period and at all asset levels. This was particularly the case for banks that focused on traditional relationship banking versus transaction banking.5

Similarly, in Canada, analysis of the six largest banks over a twenty-year period (1983 to 2003) statistically confirmed that "bigger is better." 6

So what does all this research tell us?

Contrary to popular beliefs, there is increasing evidence that scale economies do exist in banking, not just in the USA but globally as well. And these efficiencies have likely benefited the economy through lower borrowing costs and banks' increased lending capacity.

Of course, the discussion about big banks is not complete without other issues such as systemic risk and TBTF (too big to fail) subsidies. Within these debates, limits on bank size have been widely argued. But in light of the scale economies research, it is important to remember that reducing a bank's size may result in higher operational costs. For instance, as the authors of the NY Fed paper illustrate, limiting the size of bank holding companies to four percent of GDP, as some suggest, could potentially increase operating costs at the largest banks by $8 billion to $16 billion per year (based on 2012 data).7

In the ongoing policy debates about bank size, the existence of scale economies and their benefits to the broader economy are important factors that should be fully considered.

1Harvard Winters, "Where Are the Economies of Scale We Were Promised?," American Banker, June 6, 2013.
2Anna Kovner, James Vickery, and Lily Zhou, "Do Big Banks Have Lower Operating Costs?," Federal Reserve Bank of New York Economic Policy Review, Volume 20, No. 2, forthcoming.
3Only institutions with data over the 2009-2013 period were included in this analysis.
4Joseph Hughes and Loretta J. Mester, "Who Said Large Banks Don't Enjoy Scale Economies: Evidence from a Risk-Return-Driven Cost Function," Working Paper No. 11-27, Federal Reserve Bank of Philadelphia, July 2011.
5Mark A. Dijkstra, "Economies of Scale and Scope in the European Banking Sector: 2002-2011," Working Paper, University of Amsterdam, August 16, 2013.
6Jason Allen and Ying Liu, "Efficiency and economies of scale of large Canadian banks," Canadian Journal of Economics/Revue, Volume 40, Issue 1, February 2007.
7Anna Kovner, James Vickery, and Lily Zhou, Appendix B, "Do Big Banks Have Lower Operating Costs?," Federal Reserve Bank of New York Economic Policy Review, Volume 20, No. 2, forthcoming.

As used in this document, "Deloitte" means Deloitte LLP and its subsidiaries. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

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