Don’t diss economies of scale in finance. Well I do actually. There’s lots of evidence that, beyond a certain modest size, dis-economies of scale come to dominate economies of scale. And now it looks like those areas of finance that are not simple commodities that anyone can do, are best done by small firms. Why? Because they’ve got the local knowledge and they can learn – something larger organisations find harder.
In a very recent survey of the literature over the last fifteen years or so, Walter observes that while scale economies could be expected from the fixed costs of information and management systems the empirical evidence suggests that, at least with large firms, economies of scale do not outweigh diseconomies of scale such as “disproportionate increases in administrative overheads, management of complexity, agency problems and other cost factors”.
The studies are not conclusive owing to methodological difficulties but Walter (2009, p. 597-9) reports as follows:
Cost estimation has uniformly found that economies of scale are achieved with increases in size among small commercial banks (below $100 million in asset size), while a few studies have shown that they may also exist in banks in the $100 million to $5 billion range. However, there is limited evidence to date of scale economies in the case of banks larger than $5 billion, and although there has been some recent scattered evidence of scale-related cost gains for banks up to $25 billion in asset size, there is none such for very large banks (exceeding $25 billion). Some studies have found the relationship between size and average costs to be U-shaped, suggesting that small banks can benefit from economies of scale as they grow bigger, but that large banks seem to suffer from diseconomies of scale and higher average costs due to factors like complexity as they increase in size. The inability of empirical research to find significant economies of scale among large financial services firms is also true of the larger insurance companies and broker-dealers.
Walter goes on to observe (p. 599) that “like economies of scale, cost-related scope economies should be directly observable in costs of financial services suppliers and in aggregate performance measures. But empirical studies have generally failed to find significant cost-economies of scope in the banking, insurance or securities industries”.
The literature on mergers indicates that they are often a general response to a major economic shock, but that on average shareholders in the acquiring company do not receive improved share value. Transitional and transactional costs can often outweigh the expected real economic benefits, and further that the expected benefits are overstated in that management have different drivers to shareholders.
By contrast to the absence of cost based economies of scope being available to fund the diversification and growth of financial conglomerates, Walter (2009, p. 599-600) cites some evidence of revenue based economies of scope which arise from the advantages of being able to ‘cross-sell’ more than one financial product to the same customer. As he observes this is most likely to be at the retail level. But while this certainly lowers costs for the incumbent firm it is far from clear that the influence a financial firm will have on a customer in ‘cross-selling’ products to a client should be regarded as of wider benefit to the society. Indeed one would have greater confidence in the outcome of a customer’s choice if it were made in response to the advice of an expert fiduciary, which is directly at odds with cross-selling.
In the meantime, I great deal of finance is commoditised, which is to say it’s just based on routines that anyone can be trained to follow. By contrast the main area where some skill is required is business lending. And here’s a very recent paper which suggests that small is beautiful when it comes to small business lending.
A vast literature has emphasized that small banks are at a comparative advantage in small business lending. In this paper, we show that apart from size, which is negatively correlated with bank specialization in small business lending, organizational characteristics affect bank loan portfolio choices. By using a unique dataset based on a recent survey of Italian banks, we find that after having controlled for bank size, a branch loan officer’s authority has a key role in explaining bank specialization in small business lending. In particular, banks which delegate more decision-making power to their branch loan officers are more willing to lend to small firms than other banks. We approximate loan officers’ authority by controlling for several factors which shape their incentives: loan officer turnover, the amount of money up to which they are allowed to lend autonomously, their role in loan approval and in setting loan interest rates, the kind of information (soft versus hard information) used for screening and monitoring borrowers, and the structure of their compensation schemes.
Walter, Ingo, 2009. “Economic Drivers of Structural Change in the Global Financial Services Industry” Long Range Planning, 42, pp 588-613.