Economies of scale

Although diseconomies of scale may appear with a high variance in different firms, there is a point for the firms beyond which diseconomies of scale would outweigh the economies of scale.

In other words, beyond that output level the long-run average total cost will rise and stifle the economies of scale. Therefore, depending on the industry, there is a point beyond which the economies of scale will turn into diseconomies of scale. According to this theory, there exist a maximum and minimum efficient size for any economic firm, the firms below the minimum efficient size have higher per unit costs and the firms larger than that efficient size cannot maximize their profits.¹²¹

If there are economies of scale in a certain industry, ‘one’ firm can produce any level of output in a lower cost than ‘many’ firms.¹²² In other words, “when the long-run average cost curve (given fixed input prices) is downward sloping, the least costly way to serve the market is to concentrate production in the hands of a single firm” which paves the way for the emergence of natural monopolies.

The same logic for economies of scale in the real economy can be applied to financial markets.

There are at least two major factors which give rise to economies of scale; huge start-up costs keeping potential competitors out of the market, and dramatic fall in the per unit production costs. Though there is almost no clear-cut empirical evidence for considerable economies of scale in the financial sector,¹²³ it seems that financial sector displays, to a certain extent, economies of scale and network economic effects through cross-selling. These two effects, hand in hand, might weaken the competition in markets and create natural monopolies or concentrated markets which can pose systemic risk by reinforcing the financial institutions tendency to become TBTF.

121 Taking advantage of the economies of scale is one of the characteristics of the oligopolistic markets in which in the supply side, there are few suppliers and they can meet the needs of the whole market. See J. Gwartney et al., Microeconomics: Private and Public Choice, 11th ed.Thompson/South western, 2006), pp. 241-242.

Regarding the economies of scale, it should also be noted that there are differences between the markets subject to study. Based on the industrial, agricultural, and service economies, the ideal firm size may vary. The industrial economies tend to be larger, while the two others tend to be smaller.

122 Cooter and Ulen, Law and Economics, p. 31.

123 See Admati and Hellwig, The Bankers' New Clothes: What's Wrong with Banking and What to Do about It.

As pre-1990s empirical studies suggest, smaller banks were more profitable than the larger ones.¹²⁴ However, with increasing use of the Internet, computer and communication technologies in the financial industry, a whole host of opportunities for huge economies of scale and scope emerged. The increasing use of financial software in risk management made calculations related to most sophisticated financial transactions and services increasingly easier.¹²⁵ It goes without saying that these advantages did spill over to the information-related services, such as servicing loans and other extensions of credit, investment and financial advising, providing book keeping or data processing services, and management and consulting for unaffiliated banks.

Another problem that can give rise to anti-competitive effects in financial markets is the existence of “natural monopolies” on information production. One of the basic functions of financial intermediaries is their screening and monitoring function of the borrowers. Since there are economies of scale in the production of information, this will lead to the reduction in the costs of production of information. On the other hand, since duplication of the already acquired information by another financial institution is socially wasteful, a case can be made for the monopolization of the production of such information which might result in natural monopolies.¹²⁶

Due to a need for innovation, expertise of highly qualified financial engineers, ever-changing technologies, and the need for more sophisticated facilities, the start-up investments in financial industry entail huge costs. Once established, the marginal cost of producing financial products and services nears zero. Thus, theoretically speaking, large financial institutions gain huge

124 These studies should be taken into account in light of the fact that they mostly failed to account for the role of innovations and technologies in the financial industry and the ensuing economies of scale. From the standpoint of technological advances, the banking era can be divided into pre and post-1990s. Before 90s, most banking profits were based on traditional banking activities such as relationship lending. The reliance on the traditional business lending made the retailers and local financial industries, those who were focused on providing local services in the banking and overall financial industry, be more profitable in their business activities. Furthermore, since the ratio of retail loans to total loans was higher in smaller banks’ portfolios, it contributed to the profitability of the smaller banks. These empirical studies also show that the large banks were neither more profitable nor more cost effective than smaller ones.

125 Back office operations processing, delivery of services, credit and market risk management, marketing and development of new services, and marketing for retail lending are among the ones mostly affected by these technological innovations.

126 Mathias Dewatripont and Jean Tirole, The Prudential Regulation of Banks (Cambridge, Massachusetts: MIT Press, 1994).

advantages over smaller ones.¹²⁷ Empirical evidence also shows substantial economies of scale in banking.¹²⁸ For example, because of the high start-up costs in the prime brokerage business,¹²⁹ the new entrants in this business need to improve their platforms and services compared to existing leading prime brokers to attract new hedge fund customers. Otherwise, hedge funds will select their prime brokers from among the few ‘elite’ prime brokers.¹³⁰

Although there exist economies of scale in the prime brokerage business, the hedge fund industry itself does not display such a phenomenon. Firstly, because there are almost no or negligible statutory or legal entry and exit barriers in the hedge fund industry. Secondly, hedge funds size and investor base are normally small because of the legal restrictions on the investor qualifications. Third, the size does not play a role in hedge fund success, i.e., investment strategies employed by hedge funds are not scalable.¹³¹ In other words, the crucial venues

127 Not only did the use of these technologies create opportunities for economies of scale in the domestic financial markets, but also they paved the way for converging global financial market and created new venues for economies of scale in financial institutions in a greater scale. Furthermore, these developments contributed to a greater extent to the concentration in the securities trading and foreign exchange markets. Therefore, concentration is no longer limited to banking sector and it can be seen in other financial institutions and intermediaries such as broker-dealers, mutual funds, pension funds, and hedge funds. These huge economies of scale made the financial markets prone to the emergence of huge monopolies which needed to be torn down by anti-trust laws.

128 Joseph P. Hughes and Loretta J. Mester, "Who Said Large Banks Don’t Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function," Journal of Financial Intermediation (4 July, 2013).

However, it is suggested that big banks’ profitability might not be attributable to efficiencies in scale, but it should be studied in light of the implicit guarantees offered to TBTF banks. The distortive effect of these guarantees is such that some mergers in the banking sector were motivated by achieving TBTF status and gaining access to implicit government guarantees. See Elijah III Brewer and Julapa Jagtiani, "How Much did Banks Pay to Become Too-Big-to-Fail and to Become Systemically Important?" Journal of Financial Services Research 43, no. 1 (2013), 1-35.

Furthermore, in the aftermath of the global financial crisis, another concern for the failure of competition emerged;

i.e., regulators and central bankers’ concerns about systemic risk and the failure of big financial institutions and spill-overs to the real economy pushed concerns about competition aside. One of the unintended consequences of bailing out the financial institutions was significant reduction in the competition, more concentration in the banking sector, and rising TBTF concerns. Some financial institutions arising from the post-crisis reorganizations, initially initiated to save the financial system from the dangers and risks of failure of TBTF banks, became so large that gave rise to concerns about the financial institutions becoming too-big-to-save. See Brunnermeier et al., The Fundamental Principles of Financial Regulation: Geneva Report on the World Economy, pp. 2-3.

129 Prime brokers as part of major investment banks are broker-dealers that clear and finance customer trades executed by one or more other broker-dealers, known as executing brokers. See President’s Working Group, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, 1999), p. B-4.

Prime brokerage services are the services offered by investment banks and securities firms to their prime clients such as hedge funds and other professional investors. These services include securities lending, repo financing, acting as custodian of customers’ securities, clearing of the customers’ transactions, capital raising for customers, and providing seed investment for their prime clients. Prime brokers also offer execution brokerage services, such as services related to trade execution, transition management, commission sharing arrangements, direct market access (DMA), and research. See Aikman, When Prime Brokers Fail: The Unheeded Risk to Hedge Funds, Banks, and the Financial Industry, p. 31, 125-126.

130 Ibid.

131 Lhabitant, Handbook of Hedge Funds, p. 34.

through which hedge funds can successfully operate and gain profits are managerial skills and available investment opportunities and these two factors are not scalable, meaning that they do not yield economies of scale.¹³²