Abstract
While many studies found no evidence of scale economies at large commercial banks, more recent studies have uncovered such evidence and, thus, have provided a rationale for the very large scale of banks worldwide. Most of these studies used data from the 1990s or earlier. Since then, the largest banks have grown even larger, off-balance-sheet activities have increased in importance, and the too-big-to-fail doctrine has reemerged as a focus of public policy and as one rationale for the increasing scale of the largest banks. Using data leading up to and during the current financial crisis, this paper estimates scale economies with two fundamentally different models of bank production – one that assumes risk-neutral cost minimization and another that allows for more general risk preferences and for endogenous risk diversification and risk taking. The traditional model finds no evidence of scale economies at large banks; the latter, large scale economies. The paper explains the source of these differences and evaluates the extent to which advantages bestowed on banks considered too-big-to-fail by investors and creditors may affect measures of scale economies.