View full paper here.

In her literature review of economies of scale in banking, Loretta Mester, the President of the Federal Reserve Bank Of Cleveland, concluded, “The literature on scale economies in banking, including my own studies, suggests that imposing a strict size limit would have unintended consequences and work against market forces…” Mester concluded that better solution to legislative limits on bank size included a credible resolution mechanism and other regulations to improve bank safety.

Last April, Mester and Rutgers’ Joseph Hughes updated their paper on scale economies and explored the consequences of a break up. Their analysis concluded that since scale economies increase with size, the break-up of the largest financial instructions would have significant consequences in the global market.  Below are key highlights:

After Controlling For A Potential Funding Advantage For Large Banks, Mester And Hughes Still Find Economies Of Scale At Large Banks. “To investigate this possibility, we calculated what the scale economies for the TBTF banks would have been had the cost of the three inputs representing funding costs, namely, w3 = uninsured deposit rate, w4 = insured deposit rate, and w5 = other borrowed funds rate, been the median values for the banks with assets ≤ $100 billion… Again, we find significant scale economies that also increase with size… Thus, while there may be a funding cost advantage among the largest banks (perhaps because they are considered TBTF), our production model controls for this funding advantage in its computation of scale economies, and there is no evidence that a funding cost advantage influences scale economies.” (Joseph Hughes And Loretta Mester. “Who Said Large Banks Don’t Experience Scale Economies? Evidence From A Risk-Return-Driven Cost Function,” Wharton Finance, 4/13)

Mester And Hughes Find That Breaking Up Large Banks Significantly Raises Cost And “Could Seriously Affect Their Competitiveness In Global Financial Markets.” “If these 17 banks were broken into smaller banks with $100 billion in assets but with no change in their output mix, costs would increase from $410 billion to $1.48 trillion. This scale effect means the average cost per dollar of assets would increase from 4.5 percent to 16.3 percent, an increase of 11.8 percentage points. This increase in average cost per dollar of assets suggests that restricting the size of financial institutions in a manner consistent with this exercise could seriously affect their competitiveness in global financial markets if institutions in other countries were not similarly constrained in size.” (Joseph Hughes And Loretta Mester. “Who Said Large Banks Don’t Experience Scale Economies? Evidence From A Risk-Return-Driven Cost Function,” Wharton Finance, 4/13)

Mester And Hughes Find That Broken Up Banks Would Likely Offer Different Financial Services At Lower Costs, But Point Out That While Costs Are Reduced, Products Offered By Large Banks Would Be Gone. The higher total cost of the increased number of smaller banks required to replace the output of the larger banks would likely undermine the global competitiveness of U.S. banks. On the other hand, if the broken-up banks produce the mix of financial products and services of smaller institutions, their total costs would be slightly lower. Whether this is socially beneficial, however, depends on whether the product mix offered by the largest banks was beneficial – a question that is beyond the scope of the current paper.” (Joseph Hughes And Loretta Mester. “Who Said Large Banks Don’t Experience Scale Economies? Evidence From A Risk-Return-Driven Cost Function,” Wharton Finance, 4/13)

Because Banks Benefit From Scale Economies, Size Limits Will Have Unintended Consequences As Small Banks Seek Ways Around Policy, According To Mester And Hughes. “Our results suggest that the product mix offered by the largest institutions cannot be produced economically by smaller institutions that must compete with larger banks in global markets. Nevertheless, should a break-up policy be enacted, the scale economies that exist will give the smaller banks an economic incentive to seek ways around the policy, perhaps using alternative organizational structures.” (Joseph Hughes And Loretta Mester. “Who Said Large Banks Don’t Experience Scale Economies? Evidence From A Risk-Return-Driven Cost Function,” Wharton Finance, 4/13)