RESOLVING THE SCALE EFFICIENCY PUZZLE IN BANKING

Most previous empirical research on scale efficiency in banking has found increasing returns to scale only among relatively small banks, and decreasing returns to scale among larger banks. The present study shows that these results were biased by problems in the statistical techniques used and by the fact that the models ignored an important input required for the intermediation process, financial capital. When the econometric problems are solved and the relationship among size, diversification. and risk is properly accounted for, there is strong evidence of increasing returns to scale for banks up to about $500 million in total assets and approximately constant returns for larger banks.