Productive Efficiency in Commercial Banking: The Effects of Size and Legal Form of Organization On the Cost of Producing Demand Deposit Services

Abstract

A three-component measure of output is more responsive to complex production-cost relationships in multi-plant firms producing several nonhomogeneous products than the customary single measure of output. The parameters of these three components in the statistical cost function indicate the effects of changes in the scale of operations caused by changes in plant size, firm structure, and type of customer on direct operating costs. Knowledge about the magnitudes of each of these three scale effects is important for regulators in guiding changes in the structure of the banking industry which will protect the viability of the banking system, preserve competition, and promote productive efficiency. This information is also useful to bankers in planning for expansion.Only one of the major productive activities-demand deposit services-in the commercial banking industry was analyzed in this study. Therefore, although the demand deposit results have implications for regulatory policy, these implications may be tempered by the results for other banking activities which were not analyzed in this study.Analysis of the results led to the conclusion that the number of offices operated by a branch bank has little effect on average operating costs per dollar of demand deposits. However, when average office size, as measured by the number of demand deposit accounts, increases, average costs decline in all banks except unit banks which are not affiliated with holding companies. An increase in average account size results in a substantial decline in average costs in banks belonging to all forms of organization. This evidence led to the conclusion that a specification of the statistical cost function which does not restrict the parameters of the three components of total demand deposits-number of accounts, average account size, and number of offices-to be equal is superior to a specification in which these parameters are restricted. The results also suggested that unit and branch nonaffiliated banks with a small average account size and a below average number of demand deposit accounts per office have lower operating costs per dollar of demand deposits than unit and branch affiliated banks. The reverse conclusion holds when average account balance and the number of accounts per office are large.