Bank size, returns to scale, and cost efficiency

Abstract

Since the Great Recession, government regulators have become more interested than ever in the significant increase of bank size in the US financial sector. We contribute to the literature by studying the dynamic and bidirectional interactions between size, cost efficiency, and returns to scale using a newly constructed bank-level dataset. We first estimate scale economies for 198 US commercial bank holding companies using Fourier flexible form. We find that all banks except the too-big-to-fail banks exhibit increasing returns to scale. Proving the bidirectional relationship, we find that bank size Granger-causes both returns to scale and cost efficiency. On the other hand, cost efficiency also Granger-causes bank size. Taking this endogeneity into account, PVAR and Bayesian PVAR analyses demonstrate that banks enjoy cost efficiency as they grow, but lose scale economies gains even after controlling for bank-level characteristics, macroeconomic factors, and the regulatory environment. Our findings further suggest that regulations help decrease the costs of most banks, potentially encouraging them to grow further.