Analyzing Bank Efficiency: Are “Too-Big-to-Fail” Banks Efficient?

Abstract

The recent financial crisis has given rise to a re-examination by regulators and academics of the conventional wisdom regarding the implications of the spectacular growth of the financial sector of the economy. In the pre-crisis era, there was a widespread common wisdom that “bigger is better.” The arguments underpinning this view ranged from potential economies of scale and scope, to a better competitive stance at the international level. However, in the post-crisis world the common wisdom has been altered somewhat as large banks have come to be viewed as problematic for policy makers and regulators, for various reasons. One reason often given is that economic agents who are insured have the incentive to take on too much ex ante risk; also known as the moral hazard problem. Second, there is the “too-big-to-fail” problem: the fear that large and interconnected financial institutions may become a source of systemic risk if allowed to go out of business, especially in a “disorderly” fashion (Bernanke (2009)). Support for or against large banking institutions turns on the central issue of whether or not efficiencies of scale and scope are economically and statistically significant and are positively associated with bank size. If they are positively associated with bank size then the expected benefits of the cost savings generated by increased efficiencies passed on to consumers in terms of better services or reduced banking service fees are traded off with the expected costs implicit in the moral hazard and systemic risk arguments.