Journal of Monetary Economics 31 (1993) 47-67.

North-Holland

Size and performance of banking firms

Testing the predictions 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. Theoret-
ically, 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, Federal Reserve Bank of Mmneapohs,
P 0. Box 291, Minneapohs, MN 55480-0291. USA.
*Thanks are due to V.V. Chari, Stan Graham, Raw Jagannathan. Jim O’Brien. 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 small-
bank failures, since the former are viewed as more likely to result in macroeco-
nomic 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 asym-
metrically 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 size-
related subsidies and distortions.
The empirical tests to be presented cannot clearly differentlate between
a competitive advantage due to technical efficiency (predicted by modern inter-
mediation 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. How-
ever. 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
Tobin’s 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 Tobin’s 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 repre-
sentative 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 con-
siders 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 straight-
forward 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

‘Flannery’s (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 don’t. This asym-
metric 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. O’Hara 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.

C’o?qecture. As a result of differential regulation, large banking firms will be

less likely to fail than smaller banking firms.

_.a.
7 7 Moderri intertmhltiorl 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 com-
puters). 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
environments with all agents risk-neutral. 3 Specifically, diversification is valu-
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 informa-
tion 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 cost-
efficient than small banking firms.

3Not surprtsingly, dtversification IS even more valuable when agents are risk-averse This issue is
explored in Diamond (1984).
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 litera-
ture 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 author-
ity 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 affili-
ates. 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 pur-
poses, 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
Tobin’s 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 Tobin’s 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)= i $(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
Tobin’s 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=, (2)

z = (k - p)/a, (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 probatnh-
ties 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 Tobin’s 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,- 1 + 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, Tobin’s q is
estimated by Am/(LB + EB), where EB is the accounting value of equity. Any
attempt to measure Tobin’s q is subject to measurement error because of
difficulties in evaluating both the total market value of the firm’s 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 attrib-
utable 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 short-
term 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. There-
fore, 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 Tobin’s 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, measure-
ment 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 Poor’s 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 COM-
PUSTAT 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.
 Table 1
Performance and risk characteristics of sample bank holding companies, sample means (medtans in parentheses).”
-___- -- _-. _. .._ -~
1971-90 1981-90
(full sample period) (second half)
-.. ~____
Size class (average total assets)
--___--- -... -..- __ _~ -_.___._____
All (I) $1 bil- (II) $2 5 bil- (III) $4 bil.- (IV) Over Sigmficance All
Variable firms $2.5 btl. $4 bil. $8 btl. $8 bil. 1eveP firms
___-. - -..--.-___
1. Number of firms 122 24 38 27 33 122
2. Assets ($ bk), A 9.73 1.98 3.16 5.61 26.3 13.93
(3.86) (1.991 (3.13) (5 37) (15.2) (5.31)
3. Tobm’s 9 I .ooz 1.004 1.006 0.995 1.003 0.014 1.005
11.QW (1.001) (1.003) (0.993) tt.OW (1,001)
4. Z-score, (R + K)/S 4.31 4.05 4.61 4.44 3.99 0.282 4.90
(3.99) (4.21) (4.19) (3.96) (3.78) (4.52)
5. Standard devtatton of R, S 0.017 0.019 0.019 0.015 0.016 0.054 0.016
(0.016) (0.017) (0.017) (0.015) (0.013) (0.015)
6 Equttyiassets, -K 0.061 0.066 0.07 1 0.053 0.052 O.OOO
(0.060) (0.063) (0.067) (0.052) (0.045) (~~~
7. Return on assets, R 0.0055 0.0056 0.0072 0.0037 0.0039 0.009 0.0065
(0.0047) (0.0057) (0.0059) (0.0039) (0.0030) (0.0064)
8. Return on equtty, R, 0.137 0.140 0.148 0.128 0.129 0.603 0.151
(0.139) (0.136) (0.149) (0.132) (0.132) (0.162)

“Cross-section averages (medians) of tndivldual firms’ statisttcs.

bSignificance level from xi test. Test is against null hypothesis of no significant difference in group means.
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. Cross-
section regressions employ a correction for conditional heteroskedasticity using
White’s (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 and risk measures regressed on BHC size. annual data, 1971-90, 122 firms.

Slope coefficient Sample Type of

Dependent variable of size. In(A) t-statistic” sizeb regression’

1. Tobin’s 4 - 0.0012 1.07 122 Cross-section

- 0.0004 0.36 2029 Panel
2. Z-score, (R + K)$ - 0.0904 0.77 122 Cross-section
n,‘a n/a n/a Panel
3. Standard deviation of R. S ~ 0.0022 4.02** 122 Cross-section
n/‘a n/a n/a Panel
4. Equity/assets, -K - 0.0082 5 40** 132 Cross-section
- 0.0075 5 21** 2029 Panel
5. Return on assets. R - 0.0011 3.63** 122 Cross-section
- 0.0007 1.39 1907 Panel
6. Return on equity, R, - 0.0111 2.47* 122 Cross-section
- 0.0073 1.06 1907 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
Tobm’s 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 coeffi-
cients 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 hetero-
skedasticity using White’s (1980) method.

The size group statistics are intended primarily as a check for the existence of
a specific cutoff size for the ‘too big . . .’ policy, which might be obscured in the
regressions. Generally speaking, however, the analysis of size groups in table 1 is
quite consistent with the regression results in table 2. In what follows, therefore,
we do not discuss the size group comparisons.12

There is also considerable uncertainty as to when this policy, mformal as it is. was first put into
effect. O’Hara and Shaw (1990) date the formal statement of the policy at the Comptroller’s 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 Comptroller’s 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 Tobin’s r~dependent Row 1 m table 2 suggests that
there is no meaningful relationship between size and Tobin’s 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 Tobin’s 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 that’s 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 Tobin’s q. In the case of Tobin’s 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 Tobin’s y whtch are almost tdenttcal in table 1.)
r3Keeley (1990) also reports findmg no stgmficant relattonship between size and Tobin’s 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.
 J.H. Boyd and D.E. Runkle, Si:e and performance of bankmgjrms 61

Table 3
Performance and risk measures regressed on BHC size, annual data, 1981-90, 121 firms.

Slope coefficient Sample Type of

Dependent variable of size, In(A) t-statisti? size regressionb

1. Tobin’s 4 - 0.0038 3.39** 122 Cross-section

- 0.0028 2.13* 1160 Panel

2. Z-score. (R + K)/S 0.03 16 0.17 122 Cross-section

nla n/a n/a Panel
3. Standard deviation of R, S - 0.0032 6.45** 122 Cross-section
n/a n/a n/a Panel
4. Equity/assets. -K - 0.0101 6.36** 122 Cross-section
- 0.0088 5.25** 1160 Panel
5. Return on assets, R - 0.0010 2.3-P 122 Cross-section
- 0.0013 2.14* 1142 Panel
6. Return on equity, R, - 0.0056 0 71 122 Cross-section
- 0.0130 1.38 1142 Panel

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 coeffi-
cients 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 hetero-
skedasticity usmg White’s (1980) method.

We shall discuss these findings in a moment. First, we examine some data on

actual failure rates.

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

l“A 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- C
62

Table 4
Bank failure rates by size class. 1971-91.”

Asset size of banksh 1971-80 1981-91 1971-91

Small (assets less than $1 bilhon) 0.56 9.9 I 1026

Large (assets of $1 btllton or more) 2 74 IO.45 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 Common-
wealth: 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, Seamen‘s 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 industry’s 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 (mvolv-
mg large banks) tends to understate the large-bank failure rate relative to the small-bank fatlure
rate
“Work by Kuester and O’Brien (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 O’Hara 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 share-
holders 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 Tobin’s q. In
our tests with data for the full 20”year 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 risk-
regulated 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 signifi-
cant relationship with size was revealed. (For brevity, these results are not
reproduced.) To summarize, the authorities may .SUJ’they’re especially con-
cerned about the risk of large BHCs, but if they’ve 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 diversifica-
tion, 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 Tobin’s 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 factor which could result in performance

differences across BHCs is variations 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 advan-
taged 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 Tobin’s 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, Tobin’s ~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, Tobin’s 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 3009’0 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 total assets)
~__
(I) Under (II) $1.5 bill (III) $2 bil.- (IV) Over
Variable $1.5 bd. $3 bd. $3.5 bd. $3 5 bll
--~ _ ~- ~___. -
Number of firms 27 35 21 28
Total assets. A 1.12 I .80 2.56 17.40
(1.13) (1.76) (3.34) (8.85)
Tobin’s q 0.99 1 0.990 0.997 1000
(0.987) (0.986) (0.996) (0 996)
Return on assets. R 0 0050 0.0020 0.0022 0.0025
(0.0041) (0.0022) (0.0020) (0.0030)

Second half (1981-90)

Size class (average total assets)

~~~__ ~_~
(I) $1 b1l.m (II) $3 bll- (III) $5 b& (IV) Over
Variable $3 bll $5. bd $15 bll $15 bll.
____ ~-~ ~__~__
1. Number of firms 27 29 35 30
2. Total assets. A 2 39 3.84 8.24 40.6
(2.47) (3 6.5) (7.57) (25.5)
3. Tobm’s q 1.010 1007 1001 1002
(1.008) (1.007) (0.999) (0 998)
4 Return on assets. R 0.0070 0.0070 0.0066 0.0049
(00061) (0.0072) (0.0066) (0.0038)
__ __ ~___~~~~_

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 of‘harking.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 interven-
tions such as deposit insurance need to be introduced and studied in equilib-
rium models in which banking firms exhibit meaningful technologies and thus
have a raison d’btre. 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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