Do Economies of Scale Exist in the Banking Industry?

Economies of scale implies that "bigger is cheaper." In other words, firms that produce large amounts of output have lower average costs. Firms with high start-up costs--automobile producers, for example--typically have significant economies of scale because they spread those costs over more units as production increases. A firm with an output level that is lower than the level that minimizes average costs suffers a cost disadvantage, which threatens its long-term viability if it does not expand production.

Numerous economists have studied the cost structure of the banking industry. Because various statistical techniques are used in measuring economies of scale, researchers have produced conflicting results. To the extent that there is agreement, however, the consensus is that economies of scale exist for the smallest banks; average costs are minimized in an asset range somewhere between $75 million and $300 million.1

Nobel laureate George Stigler argued that economies of scale are best measured by an extremely simple tool called the survivor technique.2 This technique differs from other approaches because the results are not sensitive to the researchers' choices of statistical modeling. Instead, economies of scale are measured over the long run by observing the evolution of the surviving firms. If surviving firms grow over time while small firms decline, then economies of scale must be present. The survivor technique requires classifying firms by industry size and then calculating the share of industry output coming from each class over time.

A necessary assumption of this technique is that there are no growth restrictions on the firms in the industry--an assumption that did not hold for U.S. banks before the 1980s. Branching restrictions prevented banks from fully exploiting economies of scale; therefore, small firms that otherwise would have been driven from the market were able to survive. Since the 1980s, however, restrictions have gradually been lifted, paving the way for even more rapid consolidation as firms attempt to exploit economies of scale that have been present, but unexploitable, for some time.

Between 1983 and 1998, large banks grabbed significant market share from their smaller counterparts. As the accompanying table shows, between 1983 and 1998, market share for banks with less than $100 million in assets declined by 60 percent, while market share for banks with between $100 million and $300 million in assets declined by 39 percent.3 In 1983, community banks held one-fourth of the market share; by 1998, the fraction was just one-eighth. In contrast, banks with more than $1 billion in assets held 65 percent of the market in 1983 and 81 percent in 1998. These statistics support the belief that significant economies of scale exist in the banking industry.

The change in the number of banks also supports the assertion that economies of scale exist at small banks. As the chart illustrates, the total number of banks with assets less than $300 million decreased by 43 percent between 1983 and 1998, while the number of all other banks declined by just 1 percent.

Because the survivor technique is a long-run approach to measuring economies of scale, it is too early to draw definite conclusions. So far, though, evidence from the cost-structure literature and the survivor technique indicates that economies of scale are available at low asset levels. This means that banks with assets of $300 million or more appear to have a cost advantage over smaller banks, calling into question the long-run viability of small banks.

Large Banks Grow at Small Banks' Expense
Distribution of Bank Assets by Bank Size 1983-1998
(Constant 1992 dollars)

Percent of Total Commercial Bank Assets
Number of Banks

Total Assets 1983 1988 1993 1998 1983 1988 1993 1998

Less than $100 million 13.7% 11.0% 9.4% 5.5% 11,241 9,719 7,790 5,711

$100 - $300 million 11.4% 10.0% 9.5% 7.0% 2,232 2,161 2,060 1,989

$300 - $1 billion 9.8% 9.1% 8.7% 6.5% 604 633 595 591

$1 billion - $15 billion 30.4% 35.9% 34.9% 18.7% 305 357 324 273

Greater than $15 billion 34.7% 34.0% 37.5% 62.4% 21 30 33 53

NOTE: Data are as of Dec. 31 for each year and include all U.S. commericial banks, except for special status banks.
SOURCE: FFIEC Reports of Condition and Income for Insured U.S. Commercial Banks

See Berger and Humphrey (1994).

See Stigler (1958).

Output is measured by bank assets. However, bank assets understate output growth because they exclude off-balance-sheet items (unused funding commitments by banks), which have grown significantly in recent years. Because larger banks have increased their off-balance-sheet items more than small banks have, the bias reduces the chances of uncovering significant economies of scale.