Do Large Banks have Lower Costs? New Estimates of Returns to Scale for U.S. Banks

The number of commercial banks in the United States has fallen by more than 50 percent since 1984. This consolidation of the U.S. banking industry and the accompanying large increase in average (and median) bank size have prompted concerns about the effects of consolidation and increasing bank size on market competition and on the number of banks that regulators deem “too–big–to–fail.” Agency problems and perverse incentives created by government policies are often cited as reasons why many banks have pursued acquisitions and growth, though bankers often point to economies of scale. This paper presents new estimates of ray-scale and expansion-path scale economies for U.S. banks based on non-parametric local-linear estimation of a model of bank costs. Unlike prior studies that use models with restrictive parametric assumptions or limited samples, our methodology is fully non-parametric and we estimate returns to scale for all U.S. banks over the period 1984–2006. Our estimates indicate that as recently as 2006, most U.S. banks faced increasing returns to scale, suggesting that scale economies are a plausible (but not necessarily only) reason for the growth in average bank size and that the tendency toward increasing scale is likely to continue unless checked by government intervention. ∗Wheelock: Research Department, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166–0442; [email protected]. Wilson: The John E. Walker Department of Economics, 222 Sirrine Hall, Clemson University, Clemson, South Carolina 29634–1309, USA; email [email protected]. This research was conducted while Wilson was a visiting scholar in the Research Department of the Federal Reserve Bank of St. Louis. We thank the Cyber Infrastructure Technology Integration group at Clemson University for operating the Palmetto cluster used for our computations; we are especially grateful to Barr von Oehsen for technical support and advice. We thank Craig Aubuchon, Heidi Beyer and David Lopez for research assistance, and we thank the editor, Bob DeYoung, and an anonymous referee for comments on a previous version of this paper. The views expressed in this paper do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System. JEL classification nos.: G21, L11, C12, C13, C14.