CLEMSON — As calls for shrinking the size of the nation’s largest banks continue following the 2007-08 economic meltdown, research by a Clemson University economics professor and a Federal Reserve Bank expert suggests doing so may result in more harm than good.
Findings by Paul W. Wilson, Clemson professor of economics; and David C. Wheelock, vice president/deputy director for research, Federal Reserve Bank of St. Louis, indicates while there may be some good reasons to limit the size of banks, regulators and policymakers need to recognize there may be significant costs associated with doing so.
In their research paper, “The Evolution of Scale Economies in U.S. Banking,” Wilson and Wheelock attempted to determine how costs, revenue and profit might be related to the size of banks.
Since the financial crisis, academics, politicians and regulators have called for the nation’s banking giants to be shrunk. The Dodd-Frank Act of 2010, in part, attempted to prevent banks from becoming too big to fail so that if they did become insolvent their assets could be liquidated.
But the research by Wilson and Wheelock suggests limiting the size of banks would also raise the cost of providing banking services by preventing them from exploiting economies of scale.
“Banks, like other businesses, benefit from certain economies of scale as they grow larger and produce more output,” Wilson said. “Larger banks are able to cut costs by spreading infrastructure and technology costs over a larger customer base.”
Wilson added that if policymakers initiated efforts to limit the asset size of the nation’s largest banks, their costs would rise and services would likely diminish or become more expensive.
“Ultimately, the real losers in capping a bank’s size would be consumers and the U.S. economy,” he said.
The reason consumers would be impacted by downsizing banks is that smaller banks would be picking up the loans the large banks would no longer provide because their loan portfolios would shrink. Subsequently, the interest rates and fees would likely become higher.
Federal officials have proposed capping banks’ assets at $1 trillion. Today, four banks would be affected: J.P. Morgan Chase, Bank of America, Citibank and Wells Fargo.
Using a sophisticated estimation methodology, Wilson and Wheelock found that if a bank increases its size by 1 percent, its cost for doing so would be less than 1 percent.
“Economists call that increasing returns to scale,” Wilson said. “It’s good for banks and society. It means costs are lessened with more output and that’s good for the business and the consumer.”
Wilson said financial crises occur perhaps at most every 20 years or so, but the costs incurred by limiting a bank’s size would continue quarter after quarter. Over time, the costs would be substantial.
The researchers approximated those costs by capping the four largest banks at $1 trillion each at their 2006 levels, before the downturn. By spreading the costs of those assets across more banks, the price tag would be in the neighborhood of $80 billion a year, a cost that would repeat year after year.
“To put that in perspective, at end of 2006 the combined net income of the four largest banks was roughly $70 billion,” Wilson said. “Indications are the total cost of providing their output would exceed their combined profits.”
The research also examined how bank size would affect revenue. Though the impact on revenue is less clear than it is on cost, the research suggests if a bank’s revenue were to grow by 1 percent, revenue would increase by less than 1 percent, but it still increases.
Wilson and Wheelock also made comparisons on costs before the economic downturn and after, in 2006 and 2012.
“The results are not inconsistent before and after the crisis. We still see strong evidence on their being a cost to limiting banks’ sizes,” Wilson said. “Banking is a highly competitive market and resources are efficiently allocated when they maximize their profits. If banks increase their profits it benefits the consumer and the economy. Moreover, size does not necessarily equate with risk.”
