DP1950 | Expansion of Banking Scale and Scope: Don't Banks Know the Value of Focus

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This paper provides an explanation for the urge of banks to merge and expand scope. We build a model where bank activities evolve over time. Due to deregulation and technological advances, new opportunities become available, but the skill needed to exploit them effectively may be unknown. Early entry into these scope-expanding activities may have learning benefits that are manifested in discovery of the skill needed to operate effectively. This discovery permits more efficient production decisions and thus has value that is increasing in the strategic uncertainty about future skill that exists in the scope-expanding activity. Scope expansion may not always be optimal, however. The reason is that scope expansion requires irreversible investments before actual demand is known. This demand uncertainty means that losses are incurred when demand does not materialize and the irreversible investment is forsaken. To offset these losses, two conditions must be met. First, sufficiently high strategic uncertainty about future skills is necessary. Second, the existing commercial banking operations must be sufficiently profitable to give the bank the necessary ?deep pockets? to absorb these losses. The latter suggests that banking may not be too competitive, and could point to a benefit of merging insofar as mergers reduce competition and deepen the banks? pockets. Moreover, a merged entity may acquire the necessary skill for the future opportunity with higher probability than either of the merging partners on their own. This may elevate the benefits of merging further.