When Do Economies Of Scale Stop Being Economical?

LAKE FOREST, Ill—Is there a point at which the efficiencies gained as an institution grows and gains scale where it hits a plateau or even sees those gains reversed? Yes, suggests one new analysis.

economy of scalew moebs

Achieving maximum operating efficiencies has long been an area of much study and analysis across a breadth of industries, including financial services and especially at credit unions, which have merged for many reasons but a chief reason cited is often the need to scale. It’s a question that’s become more relevant as more than 300 credit unions are now north of $1 billion in assets, and Navy Federal Credit Union recently became the first to sail past $100 billion.

Now, a new Moebs $ervices Economy of Scale (EOS) study finds (see graph), not surprisingly, expenses do fall as financial institutions become larger, but there is also a point at which big is just too big, said Michael Moebs, economist and CEO with the company.

“Our EOS study shows that total assets between $30 billion and $100 billion is the optimal level of operating a financial institution, or the optimal level of EOS,” said Moebs. “Economy of scale is a very difficult algorithm to derive and process. While we have precisely devised how to do an EOS, it is best for executives to first learn how expenses flow as volume and size increase.”

Moebs said the EOS report indicates a financial institution begins to see real economies of scale at around $500 million in assets.

“Up to this point, expense control and growth in assets need to be equal goals,” Moebs said.

Diseconomy of Scale

Moebs $ervices has identified 18 depositories over $100 billion in assets that are beyond their economy of scale, and now experience diseconomy of scale (DOS).

“The bigger these depositories become, the more expensive they are to operate, is a good summation of DOS,” said Moebs. “By EOS standards, these institutions are too big. So, when Maxine Waters, chair of the House Committee on Financial Services, labeled some banks ‘too big’ during a recent hearing with CEOs of large Wall Street banks, she was correct. Each of the depositories present at the hearing are in DOS.”

Eventually, an institution reaches a point where growth needs to take second place to efficiency or controlling expenses, said Moebs.

“It’s a process when management says, is one more person, one more branch, or new software really needed?” Moebs said.

A Difficult Function

Growth is the most difficult function for an FI to manage, according to the Moebs $ervices EOS study.

“Navy Federal Credit Union is an example. Navy Federal is the newest member of the diseconomy of scale group, or those over $100 billion in assets,” said Moebs. “The average non-interest expense to assets for the DOS group is 2.62%, while Navy Federal is 3%. Navy Federal’s expense to assets ratio is 14.5% more than its peers in the DOS group, and 38.2% higher than the most efficient in the EOS group. There simply is a point in the depository business were bigger is not better.”

Moebs

Michael Moebs

A strong measure of EOS, said Moebs, is to identify extremely efficient FIs that have an understanding of controlling expense, and know how to execute it.

“Fintechs are tough competitors because they have new technology with open architecture, and they are shirking regulatory expense due to their charters, or lack thereof. Lending fintechs are a good example of this,” said Moebs. “In any case, the fintechs demonstrate low expenses keep a depository at EOS optimality.”

Key Question

Questioning whether all financial institutions understand whether they are driving toward economies of scale or just simply growing, Moebs said many know what’s needed to drive profitable business.

“Star One Credit Union, in Sunnyvale, California, is one example of a depository that understands EOS and the significance of controlling expenses,” said Moebs. “Even if Star One CU was taxed, their total expenses would be half of banks its size. Understanding the economy of scale and knowing how to implement it is essential for leadership at any bank, credit union or thrift today.” 

EDITOR’S NOTE: Moebs $ervices excludes from its count of FIs above $100 billion the following institution types: corporate credit unions, territorial credit unions, “banker’s banks,” industrial banks, trust companies, credit card banks, payment system banks, international banks, investment banks, banks owned by foreign banks, banks with large international deposits, banks owned by private sector companies, such as security firms, insurance companies, etc., and business only financial institutions.

Section: Standard
Word Count: 953
Copyright Holder: CUToday.info
Copyright Year: 2019
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URL: http://www.cutoday.info/THE-feature/When-Do-Economies-Of-Scale-Stop-Being-Economical