Journal

of Monetary

Economics

31 (1993) 47-67.

Size and performance

Testing the predictions

North-Holland

of banking

firms

of theory

John H. Boyd and David E. Runkle

In recent years, two important

hteratures
on the theory of bankmg firms have developed. One
exammes the economic functtons of banks m environments
m which agents are asymmetrically
mformed Another considers the mcenttve effects (moral hazard) resultmg from deposit msurance
Both theortes make predtcttons about the relation between bankmg firm stze and performance.
An
emptrtcal analysis of large bank holdmg companies investigates measures of market valuation and
rusk of fadure. Limited support is provided for either set of theoretical predictions.

1. Introduction

In recent years, two important literatures on the theory of the banking firm
have developed. Both predict relationships
between the size of banking firms
and their performance. This study tests predictions of the theories.
One substantial
literature deals with deposit insurance and the effect that it
has on bank decisions. A fundamental
finding is that the U.S. system of deposit
insurance produces an incentive for insured banking firms to take risk. Theoretically, in fact, this distortion pushes them to corner solutions taking as much risk
as they can (for example, through the use of financial leverage). With this
approach
banks are viewed. essentially, as portfolios of risky claims. Their
production technologies are unimportant,
and size plays no role in the theory. If
regulatory treatment were the same for insured banks of all sizes, this theory
would predict no relationship
between size and performance.

Correspondencr
to. John H. Boyd. Research Department,
P 0. Box 291, Minneapohs,
MN 55480-0291. USA.

Federal

Reserve Bank of Mmneapohs,

*Thanks are due to V.V. Chari, Stan Graham,

Raw Jagannathan.
Jim OBrien. and Arthur
Rolmck for help with earlier drafts The vtews expressed herein are those of the authors and not
necessarily those of the Federal Reserve Bank of Mmneapolis
or the Federal Reserve System.

0304-3932~93,$05.00

m(_1993-Elsevter

Sctence Pubhshers

B.V. All rtghts reserved

In practice, though, regulatory

treatment
of banking firms has not been
symmetric by size. Large-bank failures are supposedly more feared than smallbank failures, since the former are viewed as more likely to result in macroeconomic externalities. Under the policy of too big to fail. all liabilities of very large
banks ~ whether formally insured or not - have been de,fucto guaranteed. They
have not been permitted to fail in the sense of defaulting on debt, because all
creditors were made well by the government.
As a result, the total package of
government insurance. formal and informal. should have been more valuable for
large banking firms than for the rest of the industry, cetrris parihus. More
precisely. accordmg to the theory. either large banking firms receive a greater
net subsidy from government
insurance than do others. or they are less risky, or
both.
Another recent literature
deals with the economic
role of banking
firms
(generally, financial intermediaries)
in environments
in which agents are asymmetrically
informed. This modern intermediation
theory predicts that large
intermediary
firms will be less likely to fail than small ones, and because of that
fact, more cost-efficient.
Importantly,
modern intermediation
theory predicts
efficiency gains related to size, whereas deposit insurance theory predicts sizerelated subsidies and distortions.
The empirical
tests to be presented
cannot clearly differentlate
between
a competitive advantage due to technical efficiency (predicted by modern intermediation
theory) and one due to a high subsidy rate (predicted by deposit
insurance theory). Thus, the two sets of theoretical predictions
intersect and
there is not a clean test of the one theory against the other. However, we can and
do test the joint predictions
of both theories, as will be made precise in what
follows.
As it turns out, the data provide only limited support for either theory. Our
results do suggest an inverse relationship
between size and the volatility of asset
returns. consistent with the predictions of modern intermediation
theory. However. we find no evidence that large banking firms are less likely to fail than
smaller ones. In fact. es posf evidence shows that in recent years the large
banking firms have failed somewhat more often. How can that be, if size confers
a diversification
advantage?
The apparent
answer is that there is an inverse
relationship
between size and two other variables: the rate of return on assets
and the ratio of equity to assets. In other words, larger banking firms are
systematically
less profitable in terms of asset returns and systematically
more

The Federal Deposit Insurance

Corporation
Improvement
Act of 1991 Includes prowsIons
Intended to hmlt the pohcy of too big to fad to only sltuatlons m which the stabihty of the bankmg
system IS truly threatened
To mtoke this pohcy now ~111 reqtnre a two-thirds
vote by both the
Federal Reserve and the FDIC boards and the agreement of the Treasury Secretary. It is too soon to
say what the effect of this change wll be In any case. the law was passed well after the end of the
sample period employed m this study and could not affect our findings. (See also footnote Il.)

highly levered. Their greater use of leverage is consistent with one prediction of
deposit insurance theory, a nonmarket distortion. Finally, we find no evidence
of a positive relationship between size and market valuation as represented by
Tobins 4. Such a relationship is predicted by both theories, due to either cost
efficiencies (modern intermediation theory) or a size-related subsidy (deposit
insurance theory). In fact, during the second half of the sample period, 1981-90,
size and Tobins y are significantly inversely correlated.
The empirical tests employ data for 122 banking holding companies over the
period 1971.-90. The sample is restricted to firms that are large by industry
standards, those whose shares are listed and actively traded. This is not a representative sample, and admittedly our findings could be different for small
banking firms.
The rest of the study proceeds as follows. Section 2 discusses the two theory
literatures. Section 3 examines the relation between this study and the literature
on economies of scale in banking. Section 4 considers issues in measurement,
explains the performance and risk indicators used, and describes a conjectured
industry equilibrium. Section 5 presents the empirical results. Section 6 considers whether our results may be influenced by systematic differences in market
power among sample firms. Section 7 concludes.

2. Theory

There is a large literature examining the incentive effects of fixed premium

deposit insurance, the kind offered by the FDIC. Studies on this topic, which we
call ~~~~~s~~
iil~~~un~~theor): include, for example, Merton ( 19771,Kareken and
Wallace (19781, Sharpe (19781, Flannery (1989). and Ghan, Greenbaum, and
Thakor (1992). A basic conclusion of deposit insurance theory is that as an
insured bank increases its risk of failure without limit, there is an ever-larger
expected-value wealth transfer from the FDIC to bank owners. A straightforward implication is that regulation of banks risk-taking, including their
leverage ratios, is essential, so as to bound the expected losses of the FDIC2
It is also easy to show that under the too big to fail policy, the net deposit
insurance subsidy per dollar of assets is greater for too big . . . banking firms

Flannerys (1989) model exhtbtts decreasmg returns to rusk-takmg, due to regulatory feedback m
the form of capital reqmrements. ln thts particular model, the incentive to mcrease the risk of farlure
may be hmtted. depending on parameter values There IS also some evidence that banks with high
charter values (for example. because of then ability to earn monopoly rents) may be relatively less
willing to take risks so as to exploit the deposit insurance subsrdy [Keeley (199O)J Benveniste, Boyd,
and Greenbaum
(1989) argue that thts constramt
on moral hazard may have been what kept the
FDIC intact unttl the late 1970s. when mcreased competitton
substanttally
reduced charter values.

than it is for others. For brevity, we do not include a formal proof, but the logic
is simple: too big . . . banking firms receive free insurance on their (technically)
uninsured deposits and other liabilities. Other banking firms dont. This asymmetric treatment is defended on the grounds that banking authorities fear the
possible macroeconomic
consequences
of permitting
a large banking firm to
default on its liabilities. OHara and Shaw (1990) find that public announcement
of commitment
to such a policy has had a favorable effect on the share prices of
the too big .
banks.
Ceteris might not be pwibus with respect to regulation of very large banking
firms. The authorities have repeatedly stated that they are especially concerned
about disruptions
of the largest banks, since these may result in systemic effects
(negative externalities). In fact, such concerns are the rrrison d&re of the too big
to fail policy. Based on these statements, one might logically expect regulators
to be more conservative
in setting risk constraints
on large banking firms ~ for
example, by requiring less risky asset holdings and less financial leverage. Then
if the true equilibrium
were one in which all firms are at regulatory
corner
solutions as predicted by the deposit insurance theory, empirical tests would
reveal an inverse relationship
between size and failure risk. Such regulatory risk
constraints
would also reduce the subsidy component
in deposit insurance so
that the net effect of differential treatment by size would be unclear. Even so,
deposit insurance theory does make a testable prediction:
Prediction 1. Either large (too big to fail) banking firms are less likely to fail
than small ones, or they are more highly subsidized per dollar of assets by
government
insurance, or both.
Obviously,
Prediction
1 does not preclude the possibility that large banking
firms will be less likely to fail than small ones urrd less subsidized. The conjecture
about regulatory risk constraints
is also testable.
Co?qecture. As a result of differential
less likely to fail than smaller banking

_.a.
7 7 Moderri intertmhltiorl

regulation,
firms.

large banking

firms will be

theor!.

Another large literature

has examined the economic role of banks (more
generally, financial intermediaries)
in environments
in which borrowers and
lenders are asymmetrically
informed.
This literature
includes
studi:s
by
Diamond (1984) Ramakrishnan
and Thakor (1984), Boyd and Prescott (1986).
Williamson
( 1986). and Allen (1990), to name a few. We shall refer to it as
modern intermediation theory. Prior to the development
of such theory, there
was no satisfactory
explanation
for the existence of banks; in the widely
studied Arrow-Debreu
paradigm. for example. there is no reason for them.

J.H. Boyd and D.E. Runkle. Size and performance of banking firms

51

This body of theory predicts economies of scale in intermediation,

quite apart
from any production
efficiency gains (such as those due to large-scale computers). Here the advantage of size is that it means an intermediary
can contract
with a large number of borrowers and lenders. Large numbers are assumed to
result in diversification,
and that has been shown to be valuable even in
is valuenvironments
with all agents risk-neutral. 3 Specifically, diversification
able because it reduces the cost of contracting
among asymmetrically
informed
agents. In many of these models it is assumed that borrowers, but not lenders,
costlessly observe investment
return realizations.
Uncertainty
about return
realizations is undesirable, and bad (failure) realizations trigger costly information production.
However, if a large number of investments is made by a single
intermediary,
pooled risk is reduced or eliminated, and so is the frequency of
costly failure states. What is predicted, then, is an inverse relationship
between
size and the probability
of failure.4
In addition, diversification
reduces the ex ante expected cost of overcoming
information
asymmetries. This results in cost savings which are realized whether
or not failure actually occurs. The precise link between diversification
and
intermediation
costs is to some extent model-specific.
In Diamond (1984), for
example, contracting with many agents reduces the ex ante expected cost of state
verification. In Boyd and Prescott (1986) intermediaries
produce information
about the return distributions
of investment projects before funding (some of)
them. In that environment,
large scale not only reduces contracting
costs, it
also permits intermediaries
to fund the most profitable investments.
However,
the finding that large intermediaries
are more efficient than small ones - even
abstracting
from risk aversion - is quite general. At least one textbook now
discusses this relationship in some detail [Greenbaum
and Thakor (1991, ch. 3)].
To summarize, modern intermediation
theory makes two related predictions
about scale effects in banking firms:

Prediction 2. Large banking firms will be less likely to fail and more costefficient than small banking firms.

3Not surprtsingly, dtversification

explored in Diamond (1984).

IS even more valuable

when agents are risk-averse

This issue is

40ne deficiency of modern intermediatton

theory will become apparent
when our empirtcal
results are presented. The theory has not yet paid adequate attention to a choice variable which
partially determines the probability
of failure: the ratio of equity to assets. In Boyd and Prescott
(1986), for example, the efficient arrangement
is one in which both debt and equity claims are issued
by intermedtartes.
While a umque equity/asset
is required for effictency in that environment,
it is
exogenously
determined.
A study by Bernanke and Gertler (1989) treats the financial leverage
decision of financial Intermediaries
in a more serrous way. There, however, it is optimal to go to
corner solutions at which intermediary
owners invest their entire endowment in the intermediary.
There are no outside eqmty investors.

52

J.H. Boyd and D.E. Runkle, Sm and performance of bankmg firtm

3. The relation of our work to the economies

of scale literature

There have been a number of studies using econometric

methods to test for
the existence of economies of scale in banks. The consensus seems to be that
there are significant scale economies up to a rather modest size, say $100 million
in total deposits. For larger-size banking firms, there is some disagreement:
some researchers find evidence of (slight) economies, others find evidence of
(slight) diseconomies5
Our study is different than most of the existing literature,
however, in
several fundamental
ways. The performance
measures employed in the literature are generally
based on accounting
costs or profitability.
Here market
(stock price) data will be used to indicate performance.
Moreover, based on the
predictions
of theory, we investigate the relationship
between scale and risk of
failure. This link has received little attention
previously. With few exceptions,
existing studies have investigated
banks, whereas this one investigates
bank
holding companies (BHCs). The holding company is a common organizational
form in U.S. banking, and virtually all large firms in the industry employ it.
Many small ones do too. In a bank holding company, a parent corporation
controls
one or more banking
subsidiaries
and often nonbank
financial
subsidiaries
as well. This structure provides opportunities
for diversification
not available to an individual
bank. When risk measures are investigated
as
they are here, the BHC is clearly the appropriate
organizational
entity to
consider.6
The trend in empirical investigations
of economies of scale in banking seems
to be to more and more complex econometrics.
Our work, on the other hand,
relies on rather straightforward
univariate
procedures,
but is related directly
to the predictions
of theory. Our approach has the obvious advantage
of ease
of interpretation,
and it avoids a myriad of measurement
problems
with
accounting
data. As we see it, if the scale effects predicted by theory are large
enough to be of much interest. they should be clearly reflected in market
valuation.

See Clark (1988) or Humphrey

(1990) for useful revtews of thts hterature.

bA bank holdmg company

is defined as an orgamzatton
(parent company)
whtch holds a
controlling
share of equity in one or more commercial
banks. Often multiple banks are held as
well as nonbank financial subsidiartes.
Each firm in a bank holding company is a separate legal
enttty. However, the enttre orgamzatton
ts regulated by the Federal Reserve System under authority of the Bank Holdmg Company Act of 1956 and subsequent amendments.
A ttme-honored
Fed
position is that holding companies should provide valuable diverstfication.
and that the nonbank
affiliates and the parent company should be a source of strength to commercial
bankmg affiliates. With that objective. there are a number of regulations
which make tt caster for funds to
flow from nonbank
affiliates to banks than in the other directton. However, funds do flow in
both directions and, of course, all affiliates take their orders from the same parent. For our purposes, tt seems reasonable
and approprtate
to treat bank holding companies
as consolidated
organizattons.

J.H. Bo_vdand D.E. Runkle, See and pe$ormance

of bankmgjrtns

53

4. Measuring performance: Market valuation and risk of failure

Let it = profits, A = assets, E = equity, k = - E/A, and i = 5/A, where
a tilde denotes a random variable. The performance of BHC i, relative to other
BHCs, is reflected in its return distribution
b(?)[. In our empirical tests, 4(f) is
represented
by sample estimates of its first and second moments, R and S,
respectively. For purposes of comparison across firms, these two statistics must
be combined into a single performance
indicator. That is done here by using
Tobins q, the ratio of the market value of assets to their replacement
cost.
Market investors have preferences not just toward mean returns but also toward
risk, and Tobins q will reflect the assessment of all relevant moments of #J(?).
with market weights.
Define failure as a realization
of it in which losses exceed equity. The
probability
of failure is then

p(E<

-E)=p(r<k)=

$(r)dr.

(1)

Note that under this definition unq banking firm, whether or not it is too big to
fail, has failed when f < k. That is what we shall mean by failed from here
onward. The risk indicator is an estimate of the probability of failure which, like
Tobins q, depends on the 4(Y) distribution.
If Y is normally distributed, eq. (1)
may be rewritten as

p(r<k)=

5 N(O,l)d=,

z = (k - p)/a,

(2)

(3)

where p is the true mean of the r distribution,

c is the true standard deviation,
and z is the number of standard deviations below the mean by which r would
have to fall in order to eliminate equity. In this sense, z is an indicator of the
probability
of failure. Note that by the Bienayme-Tchebycheff
inequality, even
when r is not normally distributed,
z is the lower bound on the probability
of failure as long as p and (T exist. Here we use sample estimates of p, 0, and
k (R, S, K) to compute a Z-score, the estimated value of - z (since z is always
negative).

For several reasons. the Z-score statlstlc almost surely underestlmates

the true failure probatnhties of sample firms. Its definition of failure is a single-period
loss so large that it wipes out equity.
However, bankmg firms can also fall by experiencing
a sequence of smaller losses over several
periods. As a practical matter. they may also experience credItor runs and other hquidity problems
which force their closure even when eqmty is positive but close to zero.

54

J.H

Boyd und D.E Runkle. SIZ and performunce of bankmg firms

In summary, the empirical performance

indicator is Tobins 4 and the risk
indicator is the Z-score. We also examine sample estimates of R, S, and K, the
underlying
parameters which determine q and z.
4.1. A corljecturecl

inhstry

equilihriw?l

Eq. (4) indicates the dependence

of q on 4(3, and sets out the arguments
which determine @(?) in a conjectured
industry equilibrium,

T(A) is included to represent scale effects, and modern intermediation

theory
predicts T > 0, for all A. S(A) is included to reflect the net rate of subsidy in
government
insurance. With the policy of too big to fail, the deposit insurance
theory predicts S 2 0, for all A. with strict inequality over some size range as
a BHC approaches too big . . status. For small BHCs and for very large ones
which already receive the maximum subsidy, S = 0.
If T and S were the only arguments in (4), the unique equilibrium
would be
one with a single large BHC. What we actually observe, however, is great
variation in BHC size. One possible explanation
is, simply, that both theories
are wrong and that T = S = 0, for many levels of A. Yet, other explanations
are possible. Besides great variation
in size, the data suggest a consistent
relationship
between population
concentration
and BHC size. For example,
virtually all large BHCs are located in major population
centers such as New
York and Chicago. Small towns and cities have small BHCs. In other words, we
observe limited geographic markets. In the U.S.. that is largely attributable
to
the fact that interstate banking has been prohibited or at least greatly restricted
by legislation and regulation.
Intrastate
branching
is also restricted in many
states. The argument A4 is included in (4) to stylistically represent the effect of
market size, and C, is the number of potential customers in the market of BHC i.
Over some range of A. M > 0 as assets are expanded to meet the intermediation
needs of agents in that market. Eventually, given a fixed market size, however,
the cost of further asset expansion exceeds the benefit and M < 0. Note that
this structure results in a distribution
of BHC sizes even if T = S = 0, for
all A.
Finally, .R is included in (4) to represent market power, the ability to earn
rents. .3 depends on a number of arguments, for example the size distribution
of
BHCs in the market. Our empirical tests will not attempt to directly control for
differences in 3 across BHCs. However, we recognize A as an argument
in (4) and defer this issue. If BHCs maximize
shareholder
wealth, as we
assume, each will choose A so as to maximize q. The distribution
of Cs will
induce a distribution
on A, and if T > 0 or S > 0, there will be a positive
cross-section
relationship
between A and q in equilibrium.
Of course, if neither

J.H. Boyd and D.E

Runkle. Size and performance sf banking firms

55

theory is correct and T = S = 0, for all A, then A and q will be unrelated

(assuming, further, that size and & are unrelated).

4.2. Market

data estinutes

With banking firms, accounting

profitability
measures are notoriously
poor
since gains and losses need not be realized in a timely manner. Loan losses, in
particular, may not show up in the accounting data for years. For that reason,
we use market-based
estimates of rates of return. In so doing. we take advantage
of the fact that most measurement
error in bank accounting data is in the assets.
Bank liabilities are relatively homogeneous
and short-term.
except for small
amounts
of subordinated
debt. Thus, for liabilities, book values should be
reasonable proxies for replacement
cost. Our estimate of the market value of
total assets A is
Am = Em + LB,

where Em = market value of equity (average price per share times average
number of shares outstanding)
and LB = accounting
(book) value of total
liabilities. Profits are estimated as

7rrn= NV, - P,-

D,)/P,-

1)

where P = price per share of common stock, D = dividends per share, t = time
period, and N = average number of shares outstanding.
Our estimate of the rate
of return on assets is simply R = nm/Am.
The Z-score estimates depend critically upon the volatility of returns. For
these estimates, market return measures are also employed, since it seems sure
that BHCs accounting
profits are highly smoothed.
Finally, Tobins q is
estimated by Am/(LB + EB), where EB is the accounting
value of equity. Any
attempt to measure Tobins q is subject to measurement
error because of
difficulties in evaluating both the total market value of the firms assets and the

The assumed mdustry structure IS obvtously very sample. But It is consistent with some stylized
facts m that tt results m an equthbrmm distrtbutton
of BHC stzes. depending on srze of market. Of
course, if T > 0 and S > 0, thts structure predtcts there will be one BHC per geographrc market,
which is inconsistent
with the facts. However. the observed structure
of the Industry may be
significantly influenced by anti-trust policies.
For each firm m the sample we computed the standard deviation of the rate of return on equtty
with both accounting and market data. The mean (median) standard deviation of the rate of return
on equity for all firms was 0.051 (0.035) wtth accountmg data and 0.289 (0.278) wtth market data.
Clearly, market returns are much more volattle than accounting returns. Z-scores estimated with the
accounting
data are implausible, predicting farlure rates of essenttally zero. This is entirely attributable to the low standard deviations with the accounting
data. Simtlar evtdence of smoothing
accounting
profits has been reported elsewhere [e g.. Greenawalt
and Sinkey (1988)].

replacement cost of those assets. However, these problems are likely to be less
severe for banks than for manufacturing
firms for two reasons. First, banks issue
little long-term debt. The overwhelming
majority of their liabilities are shortterm deposits. For such deposits, book value is a close approximation
to market
value. Therefore, for banks, the sum of the market value of equity and the book
value of liabilities is likely to be a good approximation
to the market value of
total assets. Second, relatively few bank assets are plant and equipment. Therefore, the major deviation of asset book value from replacement cost is likely to
occur in the loan and bond portfolios. To the extent that asset values (especially
loan values) are inaccurate at any date, this will be reflected in sample estimates
of Tobins q. Note, however, that generally accepted accounting procedures can
only drfer capital gains and losses; they cannot make them vanish. Eventually,
these must be realized. and when that occurs, accounting
asset values are
adjusted accordingly.
Here we investigate
relative values of q over a long
(20-year) period. This surely helps to reduce, if not totally eliminate, measurement error from this source. Measurement
errors are potentially
much more
severe in estimating
the risk indicators
S and Z-score. Estimates
of those
statistics, however, rely strictly on market data.
4.3. Sample bank lzolditzy companies
The annual data in this study include the years 1971-90 and come from
Standard
and Poors COMPUSTAT.
This source provides both accounting
data and stock prices for publicly traded firms. We do not include all the BHCs
that are in the COMPUSTAT
data base. For one thing, not all BHCs have data
in all sample periods, and we require that sample firms have a minimum
of
five consecutive years. In addition, we exclude the smallest BHCs in the COMPUSTAT data base. those with average total assets below $1 billion. BHCs in
this size range typically are not publicly traded, and the COMPUSTAT
BHCs
in this size range are too few to provide reliable statistics. Finally, for those
BHCs that would have failed except for government assistance, we eliminated all
data from the first year of such assistance and thereafter. We justify this action
on the grounds that we are interested in market behavior. There are nine such
firms in the sample, including some very large ones. These are too big to fail
BHCs which actually did fail in the sense of eq. (1)

The so-called survivor bias is a widely recogmzed problem with the COMPUSTAT
data set.
Firms which are acquired. fail, or have their securities dehsted are dropped from COMPUSTAT.
At
any pomt m time. therefore. the firms mcluded m this data set are not necessarily representative
of
their Industry, but are the survtvors. Admittedly, that is true of our sample, but the special regulatory
treatment afforded to bankmg firms helps to attenuate the problem The FDIC has almost never
liquidated banks or BHCs as large as those in our sample. Instead, it infuses them wtth new capital
and reorgamzes
them. When the reorgamration
mvolves an acqutsition
by a stronger firm. the
failing bank loses its identity and will subsequently
be removed from COMPUSTAT.
Often.

0.137
(0.139)

on equtty, R,

8. Return
0.140
(0.136)

0.0056
(0.0057)

0.066
(0.063)

0.019
(0.017)

4.05
(4.21)

0.148
(0.149)

0.0072
(0.0059)

0.07 1
(0.067)

0.019
(0.017)

4.61
(4.19)

1.006
(1.003)

3.16
(3.13)

38

(II) $2 5 bil$4 bil.

Cross-section
averages (medians) of tndivldual firms statisttcs.
bSignificance level from xi test. Test is against null hypothesis of no significant

0.0055
(0.0047)

on assets, R

0.061
(0.060)

0.017
(0.016)

4.31
(3.99)

7. Return

-K

devtatton of R, S

5. Standard

6 Equttyiassets,

(R + K)/S

4. Z-score,

1.004
(1.001)

I .ooz
11.QW

3. Tobms 9

24
1.98
(1.991

9.73
(3.86)

2. Assets ($ bk), A

(I) $1 bil$2.5 btl.

_. .._

companies,

1971-90
(full sample period)
-..

_-.

1
sample means (medtans

difference

0.128
(0.132)

in group

0.0037
(0.0039)

0.053
(0.052)

0.015
(0.015)

4.44
(3.96)

0.995
(0.993)

5.61
(5 37)

27

(III) $4 bil.$8 btl.

means.

0.129
(0.132)

0.0039
(0.0030)

0.052
(0.045)

0.016
(0.013)

3.99
(3.78)

1.003
tt.OW

26.3
(15.2)

33

(IV) Over
$8 bil.

Size class (average total assets)

--___---... -..- __ _~
-_.___._____

--

Table
of sample bank holding

122

All
firms
___-.

and risk characteristics

of firms

1. Number

Variable

-___-

Performance

0.603

0.009

O.OOO

0.054

0.282

0.014

Sigmficance
1eveP

in parentheses).

0.151
(0.162)

0.0065
(0.0064)

(~~~

0.016
(0.015)

4.90
(4.52)

(1,001)

1.005

13.93
(5.31)

122

All
firms
-..--.-___

1981-90
(second half)
~____

-~

58

J.H. Boyd and D.E. Runkle.

Si:e and performance qf hankmgjirms

After deletions, 122 BHCs remain. This is a small sample for an industry that
includes thousands of firms, and it does not include any firms with total assets of
less than $1 billion. Admittedly, findings could be different if these smaller firms
were included. Fortunately
there are still great differences in the sizes of firms
included: the largest sample BHC has total assets about 100 times greater than
the smallest. Table 1 shows the distribution
of sample firms, grouped into four
size classes. The largest size category (IV) includes 33 firms with average assets of
$26.3 billion. These are some of the largest BHCs in the United States, and
presumably most of them have been viewed as too big to fail by the authorities.
At the other extreme, the smallest size category (I) includes 24 firms with average
assets of about $2 billion. Based on official statements, these BHCs are not in the
too big to fail category.
Also shown in table 1 are performance and risk statistics for the sample firms,
grouped in several ways. The first column shows sample means and medians for
all firms in the entire 20-year period, 1971-90, followed by a breakdown by size
class. The last column shows sample statistics for all firms in the second half,
1981-90.

5. Size and performance,

size and risk

Table 2 shows the results of tests in which the performance and risk indicators
are regressed on BHC size, represented by In(A), the natural logarithm of total
assets. Both cross-section and panel results are displayed. However, the statistics
S and Z-score can only be obtained intertemporarily.
This is done once for each
firm, using the full sample period or whatever smaller number of observations
is
available.
Then the individual
firm statistics are regressed against In(A) in
cross-section. Panel data tests include dummy variables for time periods, but for
brevity those coefficients and t-statistics are not reported. In the panel data tests,
t-statistics
are adjusted to account for random firm-specific
effects. Crosssection regressions employ a correction for conditional
heteroskedasticity
using
Whites (1980) method.

however, the restructured

firm maintams its identity, wrth new owners and managers. In fact, nine
such BHCs are included m the sample employed here. As dtscussed above, we drop all data points
for these firms from the date of government
assistance onward (smce we are Interested in market
behavior). This regulatory treatment of large BHCs is extraordmary.
and it reduces the survivor btas
compared with almost any other Industry
It ts not enttrely clear how large a BHC must be before it ts constdered too big to fall by the
authorities, Since the pohcy has been Implemented by admnustrative
deciston, no formal guidelines
are avatlable. In September 1984. the Comptroller
of the Currency dtd testify before Congress that
11BHCs (roughly the 11largest) were too big to fad. However, banking firms considerably smaller
than that have recetved government
assistance, and tt seems clear that the policy may apply to
smaller firms under some circumstances.

J.H. Boyd and D.E. Runkle, Size and performance qf banking firms

59

Table 2
Performance

Dependent

and risk measures

Slope coefficient
of size. In(A)

variable

1. Tobins 4
2. Z-score,

(R + K)$

3. Standard

deviation

4. Equity/assets,

regressed

of R. S

-K

5. Return

on assets. R

6. Return

on equity,

R,

on BHC size. annual

data,

1971-90,

122 firms.

t-statistic

Sample
sizeb

Type of
regression

- 0.0012
- 0.0004

1.07
0.36

122
2029

Cross-section
Panel

- 0.0904
n,a

0.77
n/a

122
n/a

Cross-section
Panel

~ 0.0022
n/a

4.02**
n/a

122
n/a

Cross-section
Panel

- 0.0082
- 0.0075

5 40**
5 21**

132
2029

Cross-section
Panel

- 0.0011
- 0.0007

3.63**
1.39

122
1907

Cross-section
Panel

- 0.0111
- 0.0073

2.47*
1.06

122
1907

Cross-section
Panel

t-statistics
are against the null hypothesis
that the slope coefficient is zero. **(*) indicates
significantly different than zero at 99% (95%) confidence.
bin panel data tests, sample size is smaller with R or R, the dependent variable than it is with
Tobms 4 dependent. Computation
of returns requires differencing, and that results in the loss of the
first sample date.
Panel data regressions include dummy variables for the time period. For brevity, these coefficients and t-statistics are not reported. In these regressions, r-statistics are also adjusted to account
for random firm-specific effects. Cross-section
tests employ a correction
for conditional
heteroskedasticity
using Whites (1980) method.

The size group statistics are intended primarily as a check

a specific cutoff size for the too big . . . policy, which might
regressions. Generally speaking, however, the analysis of size
quite consistent with the regression results in table 2. In what
we do not discuss the size group comparisons.12

for the existence of

be obscured in the
groups in table 1 is
follows, therefore,

There is also considerable

uncertainty
as to when this policy, mformal as it is. was first put into
effect. OHara and Shaw (1990) date the formal statement of the policy at the Comptrollers
1984
testimony. Yet that testimony itself dealt with the bailout of a large banking firm, Continental
Ilhnois, that had occurred earher the same year It is clear. therefore, that the pohcy was operative
prior to the Comptrollers
statement. Ten years earlier in 1974, the Franklin National Bank, then
20th largest, was bailed out of financial difficulty by the government.
Subsequent testimony and
analyses clearly suggest that the pohcy existed even then. [For example, see Federal Reserve Bank of
New York (1974) Annual Report.] Arguments
for such a pohcy can be found earlier still, most
notably m Friedman and Schwartz (1963. pp 309-311).
*One significant exception IS the results with Tobins r~dependent
Row 1 m table 2 suggests that
there is no meaningful relationship
between size and Tobins 4. The grouped data in table 1 do
display a difference in group means that is statistically
significant
at about the 1% level.

60

J. H. Boyd and D. E. Runkle. Sm and performance of bankmg firms

Row 1 in table 2 shows a negative relationship between size and Tobins q. not
significantly different than zero at even 90% confidence.13 Row 2 suggests that
there is no meaningful
relationship
between size and Z-score. However, row
3 displays an inverse relationship
between size and S, the standard deviation of
the rate of return on assets, which is significantly different than zero at a high
confidence level. The ratio of equity to assets, -K, is negatively related to size at
a high significance level, and that result is obtained in both cross-section
and
panel data tests (row 4). The rate of return on assets, R, is also negatively related
to size, and significance levels are high in the cross-section regression, but not in
the panel regression (row 5). However, the cross-section results may be spurious
because, on average, the smaller banks have fewer observations
from the first
half of the sample, during which R was lower, on average, for all banks. Finally,
the rate of return on equity, R,, appears to be weakly negatively related to size
(row 6).
Table 3 shows the results of the same regressions as in table 2, but estimated
with data from the last half of the sample period, 198 l-90. There are two reasons
to look at the subperiod.
First, a considerable
number of firms entered the
sample well after 1971. Thus, the second subperiod has many more firms (20
more) and less missing data than the first. Therefore, inference with this sample
is more robust. In addition, it is worth investigating
whether the regression
results are sensitive to choice of time period. In general, comparison
of the
regressions in table 2 and table 3 suggests thats not so. Results in both tables are
very similar when the dependent
variable is the Z-score (row 2), equity/assets
( - K) (row 4), and rate of return on assets (R) (row 5). As previously mentioned,
the probable cause for these differences is that small banks have many missing
observations
in the first half of the sample, when the average value of several of
the dependent variables was substantially
different from the average value in the
second half of the sample.
Both tests also suggest a negative relationship between size and S, the standard
deviation of R (row 3). However, it appears that this relationship got stronger over
time, in terms of both the regression coefficient and the r-statistic. The same is true
of the negative relationship between size and Tobins q. In the case of Tobins q,
the change is quite marked. The fact that the results generally differ little between
the two time periods shows that the results are robust with respect to sampling
difference. These sampling differences also explain why size does not explain
return on equity in the cross-section during the second half of the sample.

However. this IS entirely due to the difference between intertor size group III and the other groups,
and can be dtsmtssed as economtcally
unimportant.
(The other stze groups dtsplay mean and medtan
values of Tobins y whtch are almost tdenttcal in table 1.)
r3Keeley (1990) also reports findmg no stgmficant relattonship between size and Tobins q in tests
conducted with a stmrlar sample of large BHCs. However, his regresstons include several addttional
explanatory
vartables bestdes ttme pertod and firm stze.

61

J.H. Boyd and D.E. Runkle, Si:e and performance of bankmgjrms

Table 3
Performance

Dependent

and risk measures

regressed

Slope coefficient
of size, In(A)

variable

1. Tobins 4
(R + K)/S

3. Standard

deviation

4. Equity/assets.

-K

5. Return

on assets, R

6. Return

on equity,

R,

1981-90,

121 firms.

Sample
size

Type of
regressionb

3.39**
2.13*

122
1160

Cross-section
Panel

0.17
n/a

122
n/a

Cross-section
Panel

- 0.0032
n/a

6.45**
n/a

122
n/a

Cross-section
Panel

- 0.0101
- 0.0088

6.36**
5.25**

122
1160

Cross-section
Panel

- 0.0010
- 0.0013

2.3-P
2.14*

122
1142

Cross-section
Panel

- 0.0056
- 0.0130

0 71
1.38

122
1142

Cross-section
Panel

0.03 16
nla
of R, S

data,

t-statisti?

- 0.0038
- 0.0028

2. Z-score.

on BHC size, annual

at-statistics
are against the null hypothesis
that the slope coefficient is zero. **(*) Indicates
sigmficantly different than zero at 99% (95%) confidence.
Panel data regressions mclude dummy variables for the time period. For brevity, these coefficients and t-statistics are not reported. In these regressions, f-statistics are also adlusted to account
for random firm-specific effects. Cross-section
tests employ a correction
for conditional
heteroskedasticity usmg Whites (1980) method.

We shall discuss these findings

actual failure rates.

in a moment.

First, we examine

some data on

5.1. Actual rates of bank failure

Table 4 shows actual rates of failure of commercial banks for two size classes:
total assets of less than $1 billion (small) and total assets of $1 billion or more
(large). These data are for all (FDIC-insured)
banks and are quite different than
our sample of large BHCs. It would be nice to have more than two classes in the
size range examined in our other tests. However, the number of banks with total
average assets of $1 billion or more is small (about 200), and the failure rates are
relatively low. As a result, there are not enough data points to partition more
finely. As it is, we refrain from presenting significance tests.i4

lA failed bank is defined as an FDIC-insured

bank, includmg an FDIC-insured
savings bank,
that was closed because of financial difficulties or that required financial assistance from the FDIC.
Failure data apply to banks, not BHCs. Thus, to determine BHC failures would require counting
multiple bank-affiliate
failures within one BHC as a single failure. The available data do not permit

JMon-

62

Table 4
Bank failure rates by size class. 1971-91.
Asset size of banksh
Small (assets less than $1 bilhon)
Large (assets of $1 btllton or more)

1971-80
0.56
2 74

1981-91

1971-91

9.9 I
IO.45

1026
16.15

Source: Federal Deposit Insurance

Corporation.
This table is an updated
version of one
appearmg m Boyd and Graham (1991)
For each size class. percentages are based on the cumulative number of failures and the average
annual number of banks of that size over the time period specified. Over this 21-year period. the
average number ofsmall banhs was 14.031 and the average number of large banks was 260. Failures
ofsmall banks averaged 52 per year and large banks averaged 2. Data reported by the FDIC Include
federally Insured savmgs banks.
hThe 41 commercial and aavmgs banks with assets of $1 billton or more that failed or required
FDIC assistance are hsted here grouped by the year of failure (assistance)
1972. Bank of Commonwealth: 1973. Umted States NB: 1974, Frankhn NB: 1980, First Pennsylvama
NB; 1981. Greenwich
SB. Umon Dime SB. 1981. Western NY SB. NY Bank for Savmgs, Western Savmgs Fund Society of
Philadelphia.
1983. Dry Dock SB. First NB Midland, Texas: 1984, Contmental
Illinois: 1985.
Bowery SB: 1986, First NB&T, Oklahoma
City, BankOklahoma:
1987, Syracuse SB: 1988, First
City Bancorp.. Texas (one bank). Ftrst Repubhc Texas (four banks), Umted Bank Alaska: 1989,
M Corp., Texas (four banks). Texas-American
Bankshares (one bank), NBC, Texas (one bank), First
American B&T. Palm Beach, Florida
1990, Seamens Bank for Savmgs. NB of Washington.
DC.
1991. Bank of New England (three banks). Mame SB. First NB ofToms River, New Jersey, Goldome
SB. First Mutual Bank for Savmgs, Boston. Citytrust. Bridgeport. Corm., Mechamcs & Farmers SB.
Bridgeport.
Corm., New Hampshire
SB, Connecticut
SB

Table 4 shows that the large-bank failure rate was consistently higher than the
small-bank
failure rate. That is true over the full period 1971-91 and over both
subintervals.
For both size classes, failure rates were much higher in the 1980s
than in the 1970s; this is not surprising since the banking industrys problems in
the 1980s have been widely documented. ls

identification
of BHC afhhation of failed banks Where atlihation is obvious. we treat multiple bank
failures as a smgle fatlure This 15 done m Just two cases, both m Texas. This adJuatment (mvolvmg large banks) tends to understate
the large-bank
failure rate relative to the small-bank
fatlure
rate
Work by Kuester and OBrien (1990) supports some of the results reported here Uamg data for
225 BHCa, they find that the standard deviation ofasset returns is negatively related to size. at a high
significance
level They also directly estimate the value of government
msurance.
usmg the
BlackScholes
put-pricmg equation, In their tests, the option value of government
msurance is not
related to size at any reasonable sigmficance level. A study by OHara and Shaw (1990). however,
suggests that equitv mvestors may value too big to fail status. They examme the announcement
of
the too big to fali pohcy by the Comptroller
of the Currency m 1984 Usmg an event testmg
approach, they find that the announcement
resulted m positive short-run wealth effects for shareholders of some large BHCs

J.H. Boyd and D.E. Runkle, See and performance of bankrngjirms

63

5.2. Discussion qf results

The data provide no support for ~~ed~crio~ 1 from the deposit insurance
theory: that large banking firms will either be less likely to fail than small ones,
or be more heavily subsidized, or both. In all our tests, the Z-score risk measure
is unrelated to size. And data on actual failure rates suggest that over the last 20
years large banking firms have failed more frequently than small ones. As argued
earlier, the predicted size-linked subsidies ought to be reflected in Tobins q. In
our tests with data for the full 20year period, the relationship between size and
q is of the wrong sign (negative), but confidence
levels are low. In tests using
198 l-90 data, that relationship is also negative, but with reasonable confidence
that the true coefficient of the size term is negative (the opposite of what is
predicted). Again, in sum, there is no support for Prediction I from deposit
insurance theory.
Obviously, our C~~~~cr~~e, that large banking firms are more tightly riskregulated than small ones, is not supported either. Arguably the simplest risk
measure for regulators to monitor and control is financial leverage. Yet, the data
suggest an inverse relationship
between size and -K, the ratio of equity to
assets - the opposite of that conjectured.
Guessing that bank supervisors pay
more attention
to accounting
than to market data, we repeated these tests
employing an accounting measure of -K. Again, an inverse and highly significant relationship
with size was revealed. (For brevity, these results are not
reproduced.)
To summarize,
the authorities
may .SUJtheyre especially concerned about the risk of large BHCs, but if theyve been doing anything about it,
these efforts do not show up in the data.
Modern intermediation
theory is supported by our results in one important
respect. That theory assumes that scale confers a diversification
advantage via
contracting
with more agents. Our finding of a consistent
and significant
negative relationship
between size and S. the standard deviation of rates of
return, is consistent with the theory. However, it appears that better diversification, as reflected in S, does not result in lower risk of failure (reflected in Z-scores
or actual failure rates.) The data strongly suggest that. whereas the larger BHCs
may be better diversified, they employ more financial leverage and earn lower
rates of return on assets. These factors (at least) offset the diversification
advantage. Finally, if there are contracting cost efficiencies of scale as suggested
by the theory, these do not show up in the Tobins q performance measure. In
sum, the data provide only limited support for Prediction 2 from modern
intermediation
theory.

6. Are these results affected by differences in market power?

As indicated in eq. (4), an additional
differences across BHCs is variations

factor which could result in performance

in market structure, 8, or the ability to

64

J.H

Boyd und D. E. Runkie. See und prrfornmce

qf barking firm

earn rents. Some believe it is possible to statistically

separate performance
differences due to technology from those due to market power using variables
which represent the size distribution
of firms in an industry [Smirlock, Gilligan,
and Marshall (1984)]. Others argue this is not possible, or at least very difficult
[Stevens (1990)]. Here no attempt has been made to directly control for
differences in market power across firms. Therefore, it is possible that actual
scale efficiencies (or size-linked subsidies) are obscured in our tests ~ offset by
systematic differences in market power according to banking firm size. This
would necessitate an inverse relation between size and market power, which may
seem intuitively unlikely to some.
Additional evidence can be brought to bear on this issue. The sample period
1971-90 was a time of very significant deregulation
in banking, including the
Banking Acts of 1980 and 1982. A priori. one would expect deregulation
to
reduce rents. If the smaller sample BHCs were the ones systematically
advantaged in terms of market power, one would expect to see that advantage
diminishing
over time with deregulation.
But, as shown in table 5, that is not
what happened.
Table 5 shows the mean (median) value of Tobins q for four different
size classes of BHC, for the first half of the sample period (1971-80) and for
the second (1981-90). To obtain roughly equal cell sizes, different asset-size
groupings must be employed in the two subperiods.
However, the results are
clear. In the first subperiod,
Tobins ~1 is, if anything,
positively
related
to size. In the second subperiod.
the relationship
is negative.
Table 5
also displays
the rate of return
on assets (R) by size class. Although
the cell-by-cell
comparisons
look somewhat
different, it is clear that R is
negatively related to size in both subperiods. In sum, there is no evidence that
smaller BHCs did relatrt!e/y better than large ones in the 1970s compared to
the 1980s. Indeed, Tobins q comparisons
suggest the exact opposite. Thus, it
seems most unlikely that economies of scale or size-related subsidies are being
obscured in our tests by an inverse association
between BHC size and market
power. b

lhBy no means are we argumg that deregulation

has had no effect on banking firms abtlity to
earn rents. However, one would expect such effects to be greatest for the thousands of commumty
and agrrcultural
bankmg firms whtch operate m very restrtcted geographtc markets These are not
pubhcly traded and are not m our sample of BHCs Table 4 provides some evidence on thts tssue
whtch IS at least suggesttve. All the sample BHCs have average assets of $1 bullion or more, and their
affihated banks are generally Included m the large-size category m table 4. For banks m thts stze
category, the cumulattve fatlure rate over 1971-80 was about 1.74. whtle over the 1981-91 pertod tt
was about 10.45. roughly a 30090 Increase. Commumty and agrtcultural banks are all Included m the
small-stze category Durmg the same submtervals. their cumulattve fatlure rate mcreased from about
0.6 to about 9.9
an mcrease of more than 1.600~ Of course. these fatlure stattsttcs have been
mfluenced by many factors bestdes deregulatton.

J.H. Boyd and D.E

Runkle. Sre and performance of bankingjirms

65

Table 5
Size class comparisons.

first and second half, group

means (medians

m parentheses)

First half (1971MO)

___~
Size class (average

Variable

--~

~-

Number

of firms

(I) Under
$1.5 bd.

(II) $1.5 bill

$3 bd.

total assets)
~__
(III) $2 bil.$3.5 bd.

~___.

(IV) Over
$3 5 bll
-

27

35

21

1.12
(1.13)

I .80
(1.76)

2.56
(3.34)

Tobins q

0.99 1
(0.987)

0.990
(0.986)

0.997
(0.996)

1000
(0 996)

Return

0 0050
(0.0041)

0.0020
(0.0022)

0.0022
(0.0020)

0.0025
(0.0030)

Total assets. A

on assets. R

Second half
Size class (average

Variable
____
1. Number

~-~

(I) $1 b1l.m
$3 bll

of firms

27

(II) $3 bll$5. bd
29

28
17.40
(8.85)

(1981-90)
total assets)
(III) $5 b&
$15 bll
35

~~~__

~_~
(IV) Over
$15 bll.
~__~__
30

2. Total assets. A

2 39
(2.47)

3.84
(3 6.5)

3. Tobms q

1.010
(1.008)

(1.007)

(0.999)

1002
(0 998)

0.0070
(0.0072)

0.0066
(0.0066)

0.0049
(0.0038)

4 Return

on assets. R
__

0.0070
(00061)

__

1007

~___~~~~_

8.24
(7.57)

1001

40.6
(25.5)

7. Conclusion

Our main conclusion, unfortunately.

is that the two banking firm theories are
not yet sufficiently advanced to take to the data. Significant predictions of these
theories are not supported,
and interesting
regularities
in the data are not
predicted. Anecdotal explanations
abound, but we know of no theoretical model
of the banking firm with equilibria in which financial leverage is positively
related to size. Nor are we aware of theory which predicts an inverse relationship
between size and rates of return on assets in equilibrium. Unfortunately,
it is not
difficult to find policy studies which treat one prediction of theory as a stylized
fact - the prediction that large banking firms will be less likely to fail than small
ones. Obviously, our findings suggest that this is counterfactual,
and we refrain
from citing specific references.

66

J H. Boyd und D.E

Rut~kie. SIX and performance

ofharking.firms

In our view, there are two directions

in which theory could be profitably
extended, and some work is already being done in each. First, policy interventions such as deposit insurance need to be introduced
and studied in equilibrium models in which banking firms exhibit meaningful
technologies
and thus
have a raison dbtre. An example of recent work along these lines is Chart,
Greenbaum,
and Thakor
(1992). In addition,
more detailed study of the
optimal mix of claims against banking
firms is warranted.
Bernanke
and
Gertler (1989) have done very interesting
work in this area, but further
extensions
would be useful, perhaps allowing for the existence of outside as
well as inside equity.

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Journal
of Fmancial Intermediation
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Benveniste, Larry. John H Boyd, and Stuart I. Greenbaum,
1989. Bank capital regulatton (ASSOCIatton of Reserve City Bankers, Washington,
DC).
Bernanhe. Ben S and Mark Gertler, 1989. Agency costs, net worth, and busmess fluctuations,
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Boyd, John H. and Stanley Graham.
1991. Investigating
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Reserve Bank of Minneapolis
Quarterly
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Boyd, John H and Edward C Prescott, 1986. Fmancial intermediary-coalitions.
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Clark, Jeffrey A, 1988. Economies of scale and scope at depository financtal mstitutions: A review of
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Diamond. Douglas W., 1984. Fmancial Intermediation
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Greenawalt.
M.B. and J.F. Smkey. Jr. 1988. Bank loan-loss pro&tons
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Stuart and Anjan Thakor, 1991, Contemporary
financtal intermedtatton,
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