Too Big to Be Efficient? The Impact of Implicit Subsidies on Estimates of Scale Economies for Banks

Abstract

We examine whether "too-big-to-fail" (TBTF) factors affect estimates of scale economies for large banks. From a standard model of bank production that does not control for any TBTF factors, we find evidence of scale economies for our sample of large banks. We then control for TBTF factors by using a measure of the "implicit subsidy" that emerges from a reduction in TBTF banks' funding costs due to investor expectations of government support. We do this in two ways: first, we estimate scale economies from an augmented model of bank production that employs a proxy for the counterfactual price of debt that banks would face in the absence of any TBTF funding cost advantage; second, we estimate scale economies from a model of bank production that is estimated only for a sample of banks considered unlikely to be TBTF. After controlling for TBTF factors using either method, we no longer find evidence of scale economies for our sample of large banks. These results suggest that estimated scale economies for large banks are affected by TBTF factors.JEL codes: G21, L11, L25

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“…The phrase "heads, I win, tails, the creditor or the taxpayer loses" captures the essence of a problem that has led to many banking crises of the past. 50 This problem, which is more likely if managers are compensated based on shareholders' returns, is more pronounced the 46 On debt as a device to mitigate diversion of company resources for the private benefits of management, see Jensen and Meckling (1976) and Hellwig (2009a). The notion that debt is informationally undemanding is discussed by Townsend (1979), Diamond (1984), Gale and Hellwig (1985), Gorton and Pennacchi (1990), and Dang, Gorton, and Holmström (2012).…”

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