The Region

Investigating the Banking Consolidating Trend

John H. Boyd
Stanley L. Graham | Economist

Published September 1, 1991  | September 1991 issue

Lately, the U.S. commercial banking industry has been consolidating. Although some firms have left the industry, many more have simply combined with other firms, resulting in fewer, bigger banks. Many legislators, regulators, bankers and economists have roundly applauded this consolidation trend. In their view, consolidation is a laudable market response to industry changes that will bring significant benefits such as greater efficiency and a lower rate of bank failures. They also see consolidation as an effective way to shift resources out of banking, an industry they think is plagued with excess capacity.

We take exception to this widely held positive view of consolidation. After examining the available evidence, we do not think consolidation will deliver any of the benefits its proponents expect from it. That's because consolidation in banking does not appear to be primarily due to market forces. Although we cannot definitely explain why this trend is occurring, the data suggest that a major cause is incentives created by government policy. In fact, our investigation raises serious questions about the wisdom of certain bank regulatory practices.

The consolidation trend

We begin by defining more precisely what we mean by consolidation and documenting that it is actually occurring. Consolidation by our definition, means a decrease in the number of firms in the industry combined with an increase in their average size. Between 1976 and 1990 the number of U.S. banking firms declined by 24 percent. While the number of banks has been shrinking, their average size has been growing. Between 1976 and 1987, the number of small banking firms, total assets less than $50 million, dropped from 85 percent to 62 percent of all banking firms, and their share of total assets dropped from 17 percent to 6 percent. Among the largest firms, total assets of $5 billion or more, the number rose from 0.2 percent to 0.9 percent of all banking firms, and their share of total assets rose from 30 percent to 59 percent.

Thus, the evidence reveals a recent, rapid consolidation trend in the U.S. banking industry. Why is this trend occurring? The popular belief is that market forces are causing banking consolidation; the industry is adjusting to take advantage of economies of scale, to eliminate excess capacity and to reduce the risk of bank failure. The available evidence, however, does not generally support this popular belief.

Consolidation not due to market forces

The popular view about economies of scale appears to be largely incorrect. A firm is said to exhibit economies of scale when its average cost of production declines as the quantity of its output increases. In theory, such economies could extend indefinitely. In fact, however, the evidence shows something different for commercial banking: After banks reach a fairly modest size, there is no cost advantage to further expansion. Most studies of scale economies among banking firms find significant scale economies in the industry, but they also suggest that these are exhausted below the relatively modest size of $100 million in deposits. Moreover, several studies have actually found diseconomies of scale for banks in the multibillion dollar range. Our own analysis, based on bank profits over the past two decades, is fully consistent with the main conclusions of the literature. Thus, the evidence does not support the popular belief that a quest for economies of scale is behind the banking industry's consolidation.

The notion that the banking industry is sodden with excess capacity is another popular market explanation for the current consolidation trend. This explanation, like the first, does not stand up well to scrutiny. The principal evidence used by proponents of consolidation is the banking industry's share of financial intermediation which has declined substantially over the last 15 years. Such seemingly irrefutable evidence suggests to some that resources need to be moved from banking to other industries. The answer is far from obvious. The data used by proponents of consolidation are misleading, in part because of recent changes banks have made from asset-based to off-balance sheet activities. However, even if proponents are right and banking is a declining industry, that apparently cannot explain the recent wave of mergers. For that explanation to make sense, there would have to be economies of scale for large banks, which there are not; or consolidation would have had to primarily involve small banks, which it has not. Both theory and evidence from other industries suggest that in industries with excess capacity and constant returns-to- scale, it is the larger firms that exit first.

A third popular market explanation for bank consolidation is that an increase in bank size will reduce the probability of bank failure. This explanation also fails the evidence test. Support for this view is based on the theory that very large banks can better diversify their investments and so better reduce their risk. However, this describes what large banks can do, not what they necessarily do do. That's an important distinction because distortions caused by deposit insurance result in moral hazard, which reduces or eliminates banks' aversion to risk. In fact, the data show that since 1970, the rate of big-bank failures, including banks that required government assistance, has been twice as large as small-bank failures.

The consolidation trend is real, but it is not (easily) explained by any market forces of which we are aware. What, then, can explain it? Why are large and medium-sized banks so eager to combine? If the explanation is not in market forces, the natural place to look is in public policies. Three policies appear particularly relevant.

Public policy encourages consolidation

First, the government's too-big-to-fail policy may produce an incentive for banks to increase their size. If a bank is so large that its failure might have consequences for the national economy, then the government considers it too big to fail. If a bank gets big enough to be considered too big to fail, it gets implicit guarantees for all its liabilities, whether they are insured deposits or not. So, attaining a certain size provides a bank with some free insurance and more complete coverage than it would get otherwise. The empirical evidence on this issue is mixed. Common sense suggests, however, that this policy encourages large size.

Second, government policy may be encouraging increases in bank size because of the (unintended) regulatory protection from hostile takeovers that bank managers often enjoy. This protected position could be related to the banking consolidation trend because bank managers do seem to have an incentive to create bigger banks—an incentive that is unrelated to increased efficiency. The data suggest that, regardless of bank profitability, the bigger the bank, the bigger the pay its top managers receive. More work needs to be done on this topic. Still, the data suggest that bank managers have a financial incentive to expand their firms, at least partly, because of the way their industry is regulated.

Third, government policy allows—or even encourages—banks in the same market to merge. These sorts of mergers increase market share of merged banks and could increase their ability to earn monopoly rents. Data indicate that bank concentration in urban markets has risen steadily since 1982 when the government adopted a more liberalized attitude toward within- market mergers. Research in concentration in banking suggests that, in more concentrated markets, on average, loan rates are higher and deposit rates are lower. If these findings are correct, they suggest an obvious incentive for banks to get bigger by merging with other banks in the same market, regardless of cost or risk incentives.


Consolidation in banking is not all it seems, and those who have enthusiastically applauded it are likely to be badly disappointed by its results. Contrary to popular belief, large banks are not more profitable than middle-sized ones, nor are they less likely to fail. And, it is not even clear that banking is a declining industry.

If competitive market forces are not behind this consolidation trend, another likely candidate is government intervention. We have identified aspects of public policy which arguably do produce
non-market incentives for consolidation, especially larger average bank size. Admittedly, our argument is not conclusive, and we may have overlooked some other significant factors. Nevertheless, our findings raise questions about current public policy toward banks.

Particularly serious is this one: Are competitive forces and policy forces pushing the banking industry in opposite directions? By this we mean, is the market slowly eliminating large banks, while government systematically resuscitates some of them and encourages the formation of others? These questions are beyond the scope of this analysis. But, we see scant evidence that further banking consolidation will benefit either the U.S. banking industry or the U.S. economy.

(This is a shortened version of the paper by the same title that appears in the Federal Reserve Bank of Minneapolis Quarterly Review, Spring 1991.)