A theory of optimal bank size

48 Pages·1992·2.8 MB·English

by  Krasa, Stefan

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Theory of Optimal Bank Size
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Stefan Krasa Anne P. ViUamil
Department ofEconomics Department ofEconomics
University ofIllinois University ofIllinois
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Bureau of Economic and Business Research
College ofCommerce and Business Administration
University ofIllinois at Urbana-Champaign

BEBR
FACULTY WORKING PAPER NO. 92-0100
College of Commerce and Business Administration
University of Illinois at Urbana-Champaign
January 1992
A Theory of Optimal Bank Size
Stefan Krasa
Anne P. Villamil
Department of Economics

A Theory of Optimal Bank Size
Stefan Krasa Anne P. Villamil*
First Draft: May 1991 This Draft: December 1991
Abstract
This paper provides a theory of optimal bank size determination
with implications for the size distribution of banks in a model with
asymmetric information and costly state verification. Production is
subject to minimum scale requirements and two types of risk: diver-
sifiable idiosyncratic project risk, and imperfectly diversifiable aggre-
gate "macroeconomic" risk. We first show that delegated monitoring
with two-sided simple debt contracts dominates direct investment if
the cost of monitoring the intermediary is bounded and if the variance
of the non-diversifiable macroeconomic risk is sufficiently small. We
next show that: (i) banks are offinite size; (ii) bank size is inversely re-
lated to the bank's exposure to macroeconomic risk, and (iii) multiple
banks co-exist with the same size within a locale but with (possibly)
different sizes across locales.
'Address of the authors: Department of Economics, University of Illinois, 1206 South
Sixth Street, Champaign, IL 61820.
We gratefully acknowledge useful comments from Anthony Courakis and financial sup-
port from the National Science Foundation (SES 89-09242).