Are European banks too big? Evidence on economies of scale

Abstract

In light of the policy debate on too-big-to-fail we investigate evidence of economies of scale for 103 European listed banks over 2000–2011. Using the Stochastic Frontier Approach, the results show that economies of scale are widespread across different size classes of banks and are especially large for the biggest banks. At the country level, banks operating in the smallest financial systems and the countries most affected by the financial crises realize the lowest scale economies (including diseconomies) due to the reduction in production capacity. As for the determinants of scale economies, these mainly emanate from banks oriented toward investment banking, with higher liquidity, lower Tier 1 capital, those that contributed less to systemic risk during the crises, and those with too-big-to-fail status.

Introduction

Post-crises, the costs associated with ‘too-big-to-fail’ bailouts have heightened the policy debate concerning the role and benefits of bank size and the influence of public safety net subsidies that accrue with both size and complexity (Schmid and Walter, 2009, Stern and Feldman, 2009, Veronesi and Zingales, 2010, Wilson et al., 2010, Inanoglu et al., 2012, DeYoung, 2013; and DeYoung and Jiang, 2013).³ Safety net subsidies are centered on the view that governments provide implicit support because the failure of a large institution could have major systemic implications for the economy.⁴ State financed bank bailouts that occurred in the second half of 2008 illustrated evidence of such safety nets (Molyneux et al., 2014). As a response, regulators in the US (under the Dodd Frank Act of 2010) and in the EU (as in recommendations by the Liikanen Report 2012 being implemented into EC law as well as by the Vickers Report 2011 implemented into UK law) have sought to impose restrictions on banks by asking for more capital and liquidity (in-line with Basel 3 requirements)⁵ and also to restrict riskier areas of activity⁶ – all of which constrains bank’s size.

The motivation for these policy actions has been to reduce the negative consequences associated with the failure of systemically important banks, but as DeYoung and Jiang (2013) have argued, the policy debate has largely ignored the fact that large banks can also create positive externalities. Limiting the size of big banks could result in a net social loss if the restrictions inhibit bank’s ability to realize potential scale economies that can be passed onto bank customers in the form of more efficient intermediation and therefore lower prices. Social spillover costs associated with troubled banks are tangible, observable, and happen in conjunction over relatively short timeframes; whereas the benefits associated with more efficient intermediation tend to occur over time, are less tangible, and therefore are not completely observable – as such, these benefits tend to be overlooked.

The aim of this paper is to investigate evidence of scale economies for Europe’s listed banks and to examine whether different business models and risk-taking features influence the realization of scale economies as this will inform contemporary policy debate on proposed regulatory reforms that are likely to inhibit bank size/growth. Using a sample of 103 European listed banks from the Stoxx 600 Banks index over 2000–2011 we find that scale economies are widespread across different size classes of banks and especially for the largest (with total assets exceeding €550 billion). Furthermore, the realization of scale economies are less prevalent in smallest financial systems (Belgium, Finland, and Iceland) and in countries most affected by financial crises (Belgium, Greece, Iceland, Ireland, Portugal and Spain). Banks more oriented toward investment banking appear to realize greater scale economies as do those with: higher liquidity (but only up to a liquidity ratio of about 7.5%; a convex curve); greater leverage (with lower Tier 1 capital); for those banks that contribute less to systemic risk, and those with too-big-to-fail status. (Granger causality tests suggest the existence of unidirectional causality for liquidity, Tier 1 capital, and systemic risk).

Scale economies, therefore, appear prevalent at big banks and particularly for those involved in investment banking. As such, the EU plans to limit the activities of EU institutions (through, among other things, the proposed ban on proprietary trading) may limit bank’s ability to realize such scale economies. Tougher capital regulations appear likely to reduce cost economies in banking although the requirement to boost liquidity (up to a certain level) may have the opposite effects. While theory suggests that bank average costs curves are U-shaped and therefore exhausted at some point, empirical estimates of bank cost economies rarely finds such cost features. Traditionally the early European literature finds evidence of somewhat flattish cost curves (see Goddard et al., 2001) whereas more recent studies show positive economies of scale for all asset levels in Europe (Dijkstra, 2013) and for small and especially large asset levels in the US.⁷ Our findings on scale economies in European banking echo findings from the US that suggest that the round of regulatory reform aimed at curtailing bank size may yield second-best policy solutions (DeYoung and Jiang, 2013).

The paper is organized as follows: in Section 2, we present the motivation for this study in light of the literature on economies of scale. Section 3 offers a description of the methodology and the sample, and we discuss the empirical results and some robustness tests in Section 4. Section 5 concludes.