Are big banks too-big-to-fail? An investigation into the size premium and scale economies for European banks

We investigate a “size anomaly” in European banking—namely, whether very large banks earn significantly lower risk-adjusted stock returns than smaller peers, even when those peers are systemically important. To better understand this phenomenon, we construct a bank-specific size factor using principal component analysis on residual stock returns and introduce a new measure of economies of scale, based on Data Envelopment Analysis (DEA) and proximity to the Most Productive Scale Size (MPSS). A key innovation of our study is the double-sorting of banks by size and scale elasticity. We find that excess return differentials are primarily concentrated among large banks operating under increasing returns to scale, and that accounting for scale elasticity reconciles the size anomaly. These results suggest that investors may attribute lower required returns to operational efficiencies rather than solely to implicit too-big-to-fail (TBTF) guarantees. Our findings challenge the view that size alone is a reliable proxy for systemic risk and underscore the importance of distinguishing scale-driven efficiency from TBTF moral hazard. The evidence has direct implications for regulatory policy, particularly in the context of post-crisis debates on size restrictions and systemic risk oversight.