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Cost dispersion and the measurement of economies in banking

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Cost Dispersion and the Measurement of Economies in Banking COST DISPERSION AND THE MEASUREMENT OF ECONOMIES IN BANKING David B. Humphrey Introduction and Summary The concept of scale economies in banking is im- portant because it implies that larger banks may have an inherent cost advantage over smaller ones.’ Such a competitive advantage could be increased if large banks found it easier to become even larger. This situation could occur if bank mergers were more freely permitted or nationwide banking became a reality. To properly gauge the effects of public policy in this area, it is necessary both to have accurate estimates of cost economies in banking and to deter- mine their potential contribution to differences in relative costs already observed among banks. Past studies generally have concluded that large banks possess scale economies. It is demonstrated below that these historical estimates of scale economies are small when compared with other in- fluences already operating on bank costs. That is, even if scale economies exist and are statistically significant, they are much less important in con- ferring competitive advantages than commonly thought. Put differently, the observed variation in cost among banks can be split into (a) scale or cost economies across different-sized banks and (b) cost differences between similarly-sized banks. The first type of variation has been extensively studied while the second is new. Using recent data on all commer- cial banks, it is shown that estimated cost economies (when they occur) pale in comparison with existing differences in average cost levels. This effect is easiest to see after all banks have been divided up into four equal groups or quartiles based on the level of their current average costs. The difference in average costs between the 25 percent of all banks with the lowest average costs and the * The opinions expressed are those of the author alone. Comments by Bob Avery, Allen Be

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