Increasing returns to scale and financial fragility

Abstract

How do liquidity creation and financial fragility depend on increasing returns to scale? We study this question in a version of the Diamond and Dybvig (1983) model with limited commitment. We show that while a higher minimum scale generally lowers welfare since it makes the investment technology more restrictive, there exhibits a non-monotonic relationship between the degree of instability and size thresholds. In particular, to reap the benefits of scale economies, the bank facing somewhat higher scale cutoffs may issue liabilities prudently where such cautious behavior ameliorates depositors’ incentive to panic. Nevertheless, a relatively large minimum scale is not always associated with lower degrees of fragility in the sense that the bank facing medium size thresholds is most vulnerable to a crisis. Such findings indicate that failing to account for scale economies in banking activity leaves a significant void in policy debates regarding the stability of the financial system.