There are various theoretical reasons why economies of scale should occur in the banking industry:
1 Specialization of labour. There is considerable scope for this as cashiers, loan officers,
2 Indivisibilities. Banks make use of much computer and telecommunications technology. Larger institutions are able to use better equipment and spread fixed costs more easily.
3 Marketing. Much of this involves fixed costs, in terms of reaching a given size of market; large institutions can again spread these costs more easily.
4 Financial. Banks have to raise finance, mainly from depositors. Larger banks can do this more easily and at lower cost, meaning that they can afford to offer their depositors lower interest rates.
There are also reasons why banks should gain from economies of scope; many of their products are related and banks have increasingly tried to cross-sell them. Examples are different types of customer account, accounts and credit cards, accounts and mortgages or consumer loans, and even banking services and insurance. There has also been a spate of bank mergers and acquisitions in recent years, often involving related institutions like building societies, investment banks and insurance companies. Many of these institutions
have been very large in size, with assets in excess of $100 billion. Examples are Citibank and Travellers Insurance (now Citigroup), Bank of America and NationsBank, Chase Manhattan and J. P. Morgan, HSBC and Midland; both NatWest Bank and Abbey National Bank in the UK have been the object of recent takeover bids. This would tend to support the hypothesis that ‘bigger is better’. The empirical evidence, however, is not supportive of the ‘bigger is better’ policy that many banks seem to be following. A number of empirical studies have been carried out regarding commercial banking and related activities, in both Europe and the United States. Some US studies in the early 1980s found diseconomies for banks larger than $25 million or $50 million in assets, a very small size compared with the current norm (the largest banks now have assets in excess of $500 billion). More recently a greater availability of data has enabled research to be carried out on much bigger banks, as deregulation in 1980 led to interstate banking in the United States. Shaffer and David examined economies of scale in ‘superscale’ banks, that is banks with assets ranging from $2.5 billion to $120 billion in 1984. They
estimated that the minimum efficient scale of these banks was between $15 billion and $37 billion in assets, and that these larger banks enjoyed lower average costs than smaller banks. Many of the studies have been summarized by Clark in the USA. In particular, Clark’s conclusions were that there are only significant economies of scale at low levels of output (less than $100 million in deposits). Furthermore, it appeared that economies of scope were limited to certain specific product categories, for example consumer loans and mortgages, rather than being generally applicable.
Question
1) What mathematical form of cost function would be most appropriate to use to test the existence of economies of scale in banking?
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