Economies or diseconomies of scope in the EU banking industry?

• Published date: 01 November 2020
• Author: Elena Beccalli,Ludovico Rossi
• Date: 01 November 2020
• DOI: http://doi.org/10.1111/eufm.12261

Eur Financ Manag. 2020;26:1261–1293. wileyonlinelibrary.com/journal/eufm © 2020 John Wiley & Sons Ltd.

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DOI: 10.1111/eufm.12261

ORIGINAL ARTICLE

Economies or diseconomies of scope in the EU

banking industry?

Elena Beccalli

1

|Ludovico Rossi

2

1

School of Banking, Finance and Insurance,

Università Cattolica del Sacro Cuore,

Milan, Italy

2

Department of Economics, CUNEF

(Colegio Universitario de Estudios

Financieros), Madrid, Spain

Correspondence

Elena Beccalli, School of Banking, Finance

and Insurance, Università Cattolica del

Sacro Cuore, Largo Gemelli, 20123 Milan,

Italy.

Email: elena.beccalli@unicatt.it

Abstract

Banks’business models are assumed to affect effi-

ciency, as documented in the banking supervisory

priorities of the European Union (EU) for 2016–2018

and the 2014 structural reform proposal for the EU

banking sector. We investigate evidence of economies

and diseconomies of scope for the EU. We find cost

economies of scope and revenue diseconomies of

scope, resulting in profit diseconomies of scope.

Separating commercial from investment activities

generates economic inefficiencies on costs but

efficiencies on revenues and profits. Economies of

scope are affected by bank size, liquidity, competition

in the banking industry, and the European sovereign

debt crisis.

KEYWORDS

bank business model, banking regulation, economies of scale,

economies of scope, European banking industry, stochastic frontier

analysis

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We thank John Doukas (editor) and an anonymous referee for valuable suggestions. We are grateful to Nikolaos

Antypas, Mirco Balatti, Daniele Bianchin, Dimitris Chronopoulos, Ettore Croci, Robert De Young, Francisco Rodríguez

Fernández, Francesca Daniela Lenoci, Philip Molyneux, Federica Poli, Francesco Rocciolo, Alessandro Sbuelz, and

Simone Varotto and all the participants at the British Accounting and Finance Association Annual Conference in

Edinburgh, the European Financial Management Association Annual Meeting in Athens, the Higher School of Eco-

nomics PhD Workshop Financial Markets, and Corporate Strategies: Comparative Studies in Moscow, the Money,

Macro and Finance PhD Workshop in Portsmouth, the Santander Financial Institute (SANFI) workshop New Per-

spectives on Regulating Banks after the Crisis (Santander), and the seminar of the Directorate General of Macro-

prudential Policy and Financial Stability of the European Central Bank for useful comments and suggestions.

1|INTRODUCTION

After crises, the costs associated with the riskier areas of banking activity have heightened the

policy debate concerning the role and benefits of bank business models (namely, whether banks

need to be restricted in traditional lending activities or whether they should diversify into other,

riskier activities). In response, US regulators have imposed restrictions on banks’riskier areas of

activity by signing into law the Dodd–Frank Act of 2010, while European Union (EU) regulators

have long discussed a structural reform proposal in the EU banking sector that has not been

implemented.

1

Furthermore, for three consecutive years (2016–2018), the first priority of the

single supervisory mechanism has been business models

2

and profitability drivers (European

Central Bank, 2016,2017,2018). These regulations, together with the Basel III regulations, have

heavily impacted banks’regulatory requirements and business models. Therefore, the academic

literature has focused a great deal of attention on the effects of regulation on the banking sector

(e.g. Baker & Wurgler, 2015; Bouwman, Hu, & Johnson, 2018; Lundtofte & Nielsen, 2019;

Thakor, 2018).

Given that banks’business models are assumed to affect efficiency, economies and

diseconomies of scope matter for banking authorities and bank managers and empirical

evidence of their presence is required. Therefore, we investigate economies and dis-

economies of scope (and their drivers) in the European banking industry. Bankers have

long advocated for production synergies and presumed advantages associated with pro-

viding joint products and services; however, to date, research efforts have focused solely

on cost production (cost economies of scope), while only Berger, Humphrey, and Pulley

(1996) have investigated the revenue side (revenue economies of scope). No study analyses

scopeeconomiesontheprofitside(combiningtherevenueandcostsides);previous

studies have not investigated whether bankers can achieve greater profits by jointly pro-

ducing investment and lending outputs.

Regarding the bank business model (in terms of joint or separate production of invest-

ment and lending outputs), if there are cost economies of scope, diversifying the output mix

by jointly producing different outputs decreases banks’total costs and therefore increases

efficiency in the banking industry. When cost diseconomies of scope exist, total costs in-

crease if banks produce a more diversified output mix. Similarly, in the case of revenue

economies of scope, diversifying the output mix increases banks’total revenues. In the case

1

To address this concern, the US Congress approved the Volcker rule (contained in the Dodd–Frank Act), which was

revised in October 2019 (Board of Governors of the Federal Reserve System Joint Press Release, October 8, 2019). The

UK Parliament passed the 2013 Financial Services (Banking Reform) Act. The Swiss Federal Assembly passed the 2011

TBTF Banking Act (for a detailed list of structural banking reforms and their cross‐border implications, see the

Financial Stability Board, 2014). At the EU level, in alignment with the recommendations outlined in the Liikanen

report of 2012 (European Commission, 2012), the European Commission made a proposal for structural reform in

January 2014 that aimed to minimize the risky activities of the EU's 30 systemically important banks (European

Commission, 2014). The proposal was designed to ban proprietary trading for banks labeled by international regulators

as “too big to fail”in the global economy or whose activities exceed certain financial thresholds. The EU reform was

withdrawn in October 2017.

2

As highlighted by the Liikanen Report (European Commission, 2012), there is significant diversity in bank business

models across the EU. Banks and their business models can be classified using various dimensions, such as size;

activities, as revealed by a bank's customer base; asset structure and income model; capital and funding structure;

ownership and governance; corporate and legal structure; and geographic scope, including the ways cross‐border

operations are legally and operationally structured. Typically, as stated in the Liikanen Report, labels focus on just one

or two of the numerous dimensions distinguishing different bank business models. In this paper, in accordance with the

European proposal for structural reform, we focus on activities and asset structure by investigating the separation

between commercial and investment banking.

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BECCALLI AND ROSSI

of profit economies of scope, diversifying the output mix increases banks’profits, whereas,

in the case of profit diseconomies of scope, profits decrease if banks produce a more di-

versified output mix.

The aim of this paper is to investigate whether there are cost, revenue, and profit

economies of scope in the European banking industry, their magnitude and economic

significance, and how they vary across different bank sizes, years, and countries. We are also

interested in understanding the interaction between economies of scope and economies of

scale. Moreover, we aim to investigate the impact on the scope economies of other bank and

industry characteristics, such as size, liquidity, competitiveness of the banking industry, and

freedom of investment. We estimate the within SCOPE measure (WSCOPE), which is a

measure of economies of scope that substitutes in‐sample minimum outputs for null values,

as proposed by Mester (1993), for a sample of 760 banks from all 28 EU countries between

2005 and 2018. The measure is calculated by employing a stochastic frontier analysis ap-

proach with translog cost, revenue, and profit functions. Overall, the results provide evi-

dence of cost scope economies and revenue scope diseconomies, resulting in profit scope

diseconomies in all European countries. Although diversification could decrease banks’

total costs, it could also induce a decrease in revenues, resulting in anoveralldeclinein

profits. Cost scope economies are found to have a lower absolute value than revenue scope

diseconomies, meaning that diversification could hurt banks’profit economies of scope.

When identifying the drivers of scope economies, we find that economies of scope are

affected by bank size, liquidity, competition in the banking industry, and the European

sovereign debt crisis. Moreover, profit economies of scope have an impact on the scale

economies of EU banks.

Our empirical findings demonstrate that the European banking structural reform, which

aimed to ban proprietary trading for banks labeled by international regulators as too big to

fail, would not have given rise to inefficiencies, meaning that limiting banks’activities

would not have decreased their profits. Thus, our results do not support the withdrawal of

the proposal in 2017. Moreover, our findings contribute to the European banking super-

visory examination regarding 2016–2018 supervisory priorities. The findings provide evi-

dence for the single supervisory mechanism that can be used to construct an assessment of

the key risks faced by supervised banks related to business models and profitability drivers,

especially in view of protracted ultra‐low/negative interest rates. Furthermore, our results

support theoretical models suggesting that engaging in different activities can exacerbate

conflicts of interest (Saunders, 1994) and moral hazard problems (Boyd, Chang, &

Smith, 1998). Finally, our results help to explain why Laeven and Levine (2007)andSchmid

and Walter (2009) find a diversification discount in the market values of financial

conglomerates. Their explanation is that agency costs are higher than the diversification

premiums originating from economies of scope. We add to their explanation by demon-

strating that large financial conglomerates present diseconomies of scope, at least regarding

revenues and profits, which can lead to diversification discounts.

The remainder of this paper is organized as follows. Section 2presents the motivation

for this study and reviews the literature on economies of scope. Section 3describes the

methodology, sample, and data sources. Section 4provides our estimates of scope econo-

mies and regression results. Section 5summarizes the robustness checks. Section 6

concludes.

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