INCREASING RETURNS TO SCALE: Why banking is dominated by a few big and highly leveraged firms

The domination of the banking industry by a handful of ''too-big-to-fail'' and highly leveraged banks is driven by two forces at the heart of modern market economies: competition and ''increasing returns to scale''. In research published in the June 2015 issue of the Economic Journal, Tianxi Wang shows how these two forces shape the banking industry profoundly because of its two specialities.

The first is the banks'' expertise in screening profitable investment projects, an activity that is key to the real economy. The benefits to a bank from better screening expertise are restrained by its lending capacity, namely its size. By contrast, a small video-game firm can gain as much from the invention of a popular game as a big firm can. This speciality makes only bigger banks attain better screening expertise and therefore turns size into a competitive edge.

Banks'' second speciality is that the goods they supply, namely finance on the asset side and investment on the liability side, are among the most homogenous of all. This makes competition between banks extremely fierce. Even toilet paper can be made to look differently via packaging. But there is hardly any difference between one dollar funded or returned by Bank of America and one by Wells Fargo.

For a century, the banking industry has witnessed trends of increasing concentration and growing leverage. Some factors behind these trends may be remediable, such as the empire-building motives of banks'' senior executives and the tax benefits of debt. But the effects of competition and increasing returns to scale are harder to curb.

There are several sources of increasing returns to scale in the banking industry. The particular one identified by this author is connected with the expertise that banks have and the general public does not – screening profitable investment projects. After obtaining this screening expertise at some fixed costs, the greater the lending capacity a bank has (the bigger it is), the more it gains.

For example, suppose with this expertise a bank can identify an area of renewable energy that generates a 25% annual rate of return. If it has £100 million to invest, it annually earns £25 million; but if it invests £1 billion, it annually earns £250 million. The return to the same expertise is 10 times bigger if its lending capacity is multiplied by 10. This effect feeds back to induce bigger banks to attain better screening expertise.

This type of increasing returns to scale exists widely in the economy. For example, it explains why there are greater benefits from learning English as a second language than learning Swedish; and why top singers in English typically earn much more than top singers in Swedish.

Better screening expertise is a competitive edge on both sides of banks'' balance sheets. On the asset side, other things equal, a borrower firm prefers funding by a bank with better expertise, because it better certifies to the markets that someone that knows the business well (namely the bank) believes in the quality of this firm.

On the liability side, where banks compete for funding from the general public, bigger banks, with better expertise, know better where the risks are and are thus more trustworthy to investors. Moreover, bigger banks can better diversify and reduce the risks further.

Consequently, small banks, disadvantaged with a low level of expertise, are edged out in competition, either being absorbed into a big bank or leaving the business altogether. Moreover, to exploit the increasing returns to scale and to seek these competitive edges, banks are in an incessant race for expansion, continuously edging out those at the lower end.

Thus, the number of banks remaining in the business continuously shrinks, while those that remain in the business grow continuously bigger. As bigger banks are more leveraged, the industry-wide leverage continuously increases. Consequently, the industry is dominated by a few big and highly leveraged banks.

''Competition and Increasing Returns to Scale: A Model of Bank Size'' by Tianxi Wang is published in the June 2015 issue of the Economic Journal. Tianxi Wang is at the University of Essex.