Bank Capitalization and Cost: Evidence of Scale Economies in Risk Management and Signaling

The cost function is conditioned on the level of capital, but the authors model the demand for financial capital so it can serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. Scale economies are then computed without assuming that the bank chooses a level of capitalization that minimizes cost. The authors find evidence of substantial scale economies and that bank managers are risk averse and use the level of financial capital to signal the level of risk.