Sunday, October 17, 2010

The Economy of Scale Myth: Go Big or Go Home

I wrote a post a couple of months ago regarding diseconomies of scale under the premise that at some asset size-point, getting larger does not impact your efficiency and expense ratios in a material way (see link to that post below). Yet in spite of my efforts, bankers and industry experts continue to bang the drum for economies of scale. I decided to take a second look at the data to see if I was wrong in my premise.

I have been wrong in the past, and readily admit to my errors. I do not possess the personality that requires me to be right, especially in the face of evidence to the contrary. My wife and daughters tell me I'm wrong all of the time. So if my investigations into financial institutions' (FIs) economies of scale indicated that size does matter, I will say so.

Clearly size matters to some point. Banking has a step-variable cost structure that requires a certain amount of fixed expense investments that demonstrates excess capacity until an FI grows to some asset size. The devil is in the details of "some" asset size. Empire builders and investment bankers tend to argue for Mega-Bank, which supports many M&A transactions and higher executive compensation. However, as I searched my database for the top 100 return on average assets (ROAA) FIs for the 2nd quarter 2010, only six percent were over $1 billion in assets. Yet strategy sessions, competitor discussions, and CNBC focus primarily on the Mega Banks.

A note on my data collection. I searched for FIs that had greater than an 1.8% ROAA in EACH of the last four quarters. This tended to eliminate those FIs that benefited from one time gains and focused on those with consistent financial performance. I then manually went through the list to eliminate all of the special purpose institutions and subs of much larger institutions to get a more accurate list. Of the top 100, six were greater than $1 billion in assets, 55 were between $100 million and $1 billion, and 39 were less than $100 million in total assets. The table below shows the medians in selected financial ratios.

Countless strategy sessions I have been privileged to attend speak of what Bank of America and Wells Fargo are doing (not in the top 100). Very few speak of WestAmerica Bank in San Rafael, California (2.05% ROAA, $4.7 billion in assets). WestAmerica is primarily a business bank. Greater than 77% of their deposits were in core deposits (non-CDs) and their cost of funds was 28 basis points. So many banks are trying to reduce their dependence on commercial real estate and construction transactions by becoming more of a commercial bank, yet so few look to WestAmerica to see what they are doing to succeed. Instead, we focus on what Jamie Dimon is saying. We should focus more on what David Payne (WestAmerica's CEO) is doing.

If you are a senior executive of an FI smaller than WestAmerica and I am privileged to have your readership, are there smaller success stories? Must you be over $4 billion to be successful?... Yes to the first question and no to the second. Ninety four of the top 100 ROAA FIs were less than $1 billion in assets.

I have spoken and written about niche banking in the past. I offer an example of an FI that is currently succeeding at it: Live Oak Banking Company in Wilmington, North Carolina. Live Oak opened its doors a little over two years ago and yet it has met the four-quarter criteria of having an ROAA greater than 1.8% over the past four quarters. Live Oak opened to provide capital and other services to the veterinary, dental, and independent pharmacy businesses (see its About Us link below). The bank sells a high percentage of the loans it originates but keeps servicing rights to maintain relationships. At June 30, 2010 it had $209 million in assets and a 2.82% ROAA.

Extreme niche banking like Live Oak's may not be in the cards for your FI. But that doesn't preclude you from having a line of business or product set that you are known for, excel at, that delivers superior profits. After all, who wants to be known as "just another bank"?

Let's not be absolutists, claiming that economies of scale are needed, or that being highly specialized is critical. But the evidence clearly shows that there are financial institutions generating superior returns that are not Wells Fargo, PNC, et al. Let's not limit our universe of business models to study to a select few that have rolled the dice with the scale game.

What FIs do you admire that may not be the biggest kid on the block?

~ Jeff

jeff for banks blogpost: Diseconomies of Scale

Live Oak Banking Company - About Us


  1. I would agree that you don't need to be a mega bank to be profitable; our bank, State Bank of De Kalb, has been quite profitable for many years and we've been able to do that through the interest margin. If we start paying interst on business deposits, however, all of this will change in a hurry. Do you think that'll cause another big wave of failures?

    Dan Schmitt
    State Bank of De Kalb

  2. Hi Dan,

    My thoughts are that we in community financial institutions will be "price-takers" in new Commercial Checking pricing/fee schemes to the very large banks. But we may have opportunities to put forth a more attractive product because we don't have the large numbers that they do in terms of re-pricing those accounts.

    For example, Wells has ~ $181 billion of non-interest bearing deposits. What percent is commercial I don't know, but if they repriced at an average interest expense of 25 bps, that would be ~ $453 million pretax, or about 3% of their after-tax earnings. Because the numbers are so large, my hope is the big banks will come out conservatively.

    Nearly all bank failures are as a result of credit problems. Some fail because of liquidity, but the liquidity problem typically stems from credit. If community FI's margins shrink as a result of paying interest on commercial accounts, they may seek partners to grow the balance sheet and reduce expense ratios to make up for the shortfall.

    My guess is the margin contraction will be somewhat small because of the smaller commercial DDA balances, so a review of operating expenses (such as reviewing your core-processor invoices for non value added services) may make up the difference.

    Thanks for reading and your thoughtful comment.

    ~ Jeff

  3. And readers should note that Dan's bank is less than $1 billion in assets and has a year-to-date ROAA of 1.79%. Conversely, Wells Fargo YTD ROAA was 1%.

    ~ Jeff

  4. Jeff -

    Although this post is now almost 12 months old, the topic is still very much in debate. I wanted to share a bit of information that we published on our blog and get your assessment. See and

    We find that while there always a few exceptions Economics 101 does not have to be re-written for banking. The law of Economies of Scale holds for Banks.

  5. Serge,

    I refer you to my top 5 total return to shareholder post. The asset size of those banks are from $1-$13B in assets. If the economies of scale argument held water, why wouldn't the largest banks own the list? They're not even on the list.

    ~ Jeff