On the optimal scale of banks: a review

Alejandro E. Caceres H.
(Economics and History Master, Utrecht School of Economics - March 2009)

Introduction
In a survey of International Banking done by The Economist in 2006, warning lights were turned
on due to the increase in size that banks were experiencing amidst the consolidation of the sector,
based on the fact that they were testing the limits of manageability, given that size and
complexity complicated the understanding and control of operations. They argued that bigness
may be a competitive advantage, but only up to a point, and that banks would realize they had
crossed this hubris, especially in a market downturn or if troubled with certain asset classes.
These words could well be regarded as premonitory of the financial crisis of 2008, considered by
Beardsley, Enriquez and Nuttall (2008) of McKinsey as the demarcation between two regulatory
eras, from one in which free markets enjoyed a remarkable intellectual and political ascendancy,
praised as the best way to promote continuing growth and stability; to one in which some
problems seem to large and threatening to be solved by free-wheeling businesses. All of which
reveal the importance of establishing sound policies to regulate banking sector.

This review will address the studies that have been performed regarding optimal scale of banks,
relevant aspects in the topic, and the estimations in terms of total assets that banks should have in
their balance sheets in order to be within the optimal scale area in different areas of the world.

Economies of scale and scope

Goddard, Molyneux, Wilson, and Tavakoli (2007) address that early literature, was concerned
with identifying the potential for achieving cost savings in two ways: (1) selecting the optimal
firm size and product mix (exploiting economies of scale and scope); and (2) by maximizing
operational or productive efficiency. Operational efficiency considers technical or X-efficiency
(avoiding waste by achieving the maximum possible output from a given set of inputs); and
economic efficiency (selecting the most cost-effective combination of inputs given a prevailing
set of input prices).

Regarding the sources of scale and scope economies, Boot and Marinc (2008) identify the
following ones: (1) information technology-related economies, (2) reputation and
marketing/brand name-related benefits, (3) financial innovation-related economies, and (4)
diversification benefits.

Berger, De Young, Genay and Uddell (2000) address that the average cost curve has a relatively
flat U-shape, with medium-size banks being slightly more cost scale efficient than either large or
small banks. Similar U-shaped average cost curves or conflicting cost scale results are found for
securities firms and insurance companies. Nevertheless, Berger, Demsetz and Strahan (1999)
conclude that, in general, the empirical evidence cannot readily identify substantial economies of
scale or scope in the banking sector.
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In respect of cost productivity, evidence shows it worsened in the 1990s. Mester (2005) argues
that it might seem at odds with the technological changes that have occurred in banking, but
suggests that as cost productivity decreased, banks experienced an increase in profit productivity.

Issues of banking consolidation

Regarding the positive and negative aspects of consolidation, Mester (2005) considers that
consolidation is potentially positive given it will generate: (1) More efficient scale or product
(scope) mix. (2) Better diversification over product lines and/or across geographic markets, since
the price of risk-taking falls via diversification. (3) Higher X-efficiency. Consolidation can help
rid the industry of such X-inefficiency to the extent that more efficient firms take over less
efficient firms and are able to extend efficient operations to the target.
But, on the other hand, Mester argues, consolidation could also be a negative for the industry and
economy. (1) It could result in a less competitive banking system, concentrating market power in
a handful of very large institutions, or reduce the supply of funds to small firms by driving
community banks out of business. (2) Consolidation might be motivated by a desire to maximize
managers’ objectives and therefore not be socially optimal. Even if it were motivated by a desire
to maximize shareholder value, it would not be socially optimal, given that shareholder value can
be raised via more efficient production, but also via higher prices if banks’ market power rises by
consolidation. (3) Systemic risk problems might also increase as a result of consolidation. Finally
an additional negative element of consolidation related to performance is found Boots and
Marinc (2008): (4) Consolidation may undermine the incentives of banks to produce and utilize
soft information, since recent research reveals that large banks are less capable of using soft
information.

Methodological issues
Mester (2005) points the measurement issues associated with the estimation of optimal scale of
banks. Studies that have focused on smaller banks and those focused on larger banks have tended
to find the exhaustion of scale economies at different sizes. This implies that a single function
may not be able to incorporate both large and small bank technologies or that some important
factor that varies with bank size is excluded from the model. Evidence on this point gives mixed
signals. McAllister and McManus (1993) found that the translog function is not an adequate
global approximation to all sizes of banks. Berger and Mester (1997) identified that while the
coefficients on the Fourier terms in the Fourier-flexible functional form were jointly significantly
different from zero, the improvement in the goodness of fit of the Fourier over the translog was
small and not economically significant.
Another methodological issue is related to the modeling of bank production function, which as
Mester argues, has been enhanced by recognizing that the level of risk is an endogenous choice
of bank managers and that financial capital is an input into bank production. Thereby, developing
and estimating models that allow for managerial preferences that differ from cost minimization
and profit maximization and that allow managers to trade off risk versus return.

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Empirical evidence throughout the world
United States
Mester (2005) indicates that early studies based in data of United States banks from the 80s,
could find scale economies only for small banks, that is, USD100 million in assets. McAllister
and McManus (1993) using data of the same period but making econometric adjustments to the
methodology applied concluded that the optimal scale was in the order of USD500 million of
total assets.

Later on, research was done with data from the 1990s, and found economies of scale for
institutions with assets of up to USD10 billion. The studies performed by Berger and Mester
(1997); Hughes, Mester, Moon, (2001); Bossone and Lee, (2004), that took into account the risk
preferences and financial capital into bank production models were able to come up with
economies of scale, for banks that exhibited USD25 billion in assets. De Young (2007) illustrates
that for community banks the optimal bank scale can be found by growing up to USD500
million.

Van der Vennet (2002) argues that this shift in the optimal scale of banks in the United States
during the 90s in contrast with the 80s comes given by regulatory and technological changes, as
also should be considered as relevant the methodological changes and the incorporation of new
elements in the production function afore mentioned.

Boot and Marinc (2008) argue that studies done in the United States do not capture the dramatic
structural and technological changes in banking that have taken place, particularly in the 90s.
They consider that studies in the United States reflect the historic fragmentation of the banking
industry due to severe regulatory constraints on the type of banking (banks could engage in
commercial banking or investment banking, but not both) and the geographic reach of activities
(limits on interstate banking) that was present till the deregulation in the 90s.
Europe
Van Der Vennet (1996) using data from 1987-1992 found that the optimal scale in Europe was
found in banks with assets up to USD 3-10 billion. In the German case, Lang and Welzel (1996,
1998) using data of the year 1992 found scale economies among universal banks up to a size of
DEM5 billion (approximately 2.5 billion USD).
Schure and Wagenvoort (1999) performed a study on European banking industry in the period
1993-1997 for banks from the 15 EU countries and found that, consistent with the findings of the
studies in the United States, that increasing returns of scale only exist for firms up to a size of
EUR600 million. The average cost curve in this study revealed that was U-shaped for saving
institutions.
O’Brien and Wagenvoort (2000), extend Schure and Wagenvoort (1999) findings identifying that
for European commercial banks there appears to be increasing returns to scale for banks up to
total assets size of EUR5 billion, followed by constant returns to scale up to total assets size of

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EUR100 billion. As for the savings banks it was found that increased scale economies could be
realized up to total assets size of EUR10 billion and then constant returns to scale.
Turkey
Kasman (2002), using data of the Turkish banking system between 1988-1998 offers one of the
few studies on optimal bank scale beyond the United States and Western Europe, suggesting that
the optimal scale should be in the range of USD400 million and USD2 billion. Also it could be
argued that a U-shaped cost efficiency curve is present in the Turkish banking system since the
study identified that the less efficient banks are both the largest and small banks in Turkey.

Middle East
Al-Obaidan (2008) performed a study of the optimal scale of the banks operating in the countries
that are members of the Gulf Cooperation Council that includes Bahrain, Kuwait, Qatar, Oman,
Saudi Arabia, and The United Arab Emirates. The study used 2005 data, and identified that the
optimal scale for banks in the region amounted to up to USD5 billion in total assets. In the
Appendix a summarization of the estimations of the optimal scale of banks in the different
regions of the world is offered in Table 1.

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Appendix

Table 1: Estimations of Optimal Bank Scale in Total Assets across the world
Total Assets (in
Geographical
Data Set millions of USD, Relevant aspects of the study
Area
unless indicated)
100
1980s
500 Corrected for econometric adjustments
10,000
United States
1990s Included in the production function risk
25,000
preferences and bank capital
1980s-1990s 500 Only for community banks
1988-1992 3,000-1,0000
1993-1997 600* Savings banks
Europe Savings banks (methodological revisions
1993-1997 10,000*
and increased dataset)
1993-1997 5,000-100,000* Commercial Banks
Germany 1992 2,500 Universal banks
Turkey 1988-1998 400-2,000
Middle East 2005 5,000 Gulf Cooperation Council Countries
(*) In millions of Euros

Sources:
United States: Mester (2005), McAllister and McManus (1993), Berger and Mester (1997);
Hughes, Mester, Moon, (2001); Bossone and Lee, (2004), De Young (2007)
Europe: Van Der Vennet (1996), O’Brien and Wagenvoort (2000), Schure and Wagenvoort
(1999)
Germany: Lang and Welzel (1996, 1998)
Turkey: Kasman (2002)
Middle East: Al-Obaidan (2008)