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Vins, Oliver; Bloch, Thomas
The effects of size on local banks' funding costs
Working paper series // Johann-Wolfgang-Goethe-Universität Frankfurt am Main,
Fachbereich Wirtschaftswissenschaften Finance & accounting, No. 189
Provided in Cooperation with:
Faculty of Economics and Business Administration, Goethe University
Suggested Citation: Vins, Oliver; Bloch, Thomas (2008) : The effects of size on local banks'
funding costs, Working paper series // Johann-Wolfgang-Goethe-Universität Frankfurt
am Main, Fachbereich Wirtschaftswissenschaften Finance & accounting, No. 189, http://
JOHANN WOLFGANG GOETHE-UNIVERSITÄT
FRANKFURT AM MAIN
WORKING PAPER SERIES: FINANCE & ACCOUNTING
Oliver Vins and Thomas Bloch
The Effects of Size on Local Banks’ Funding Costs
OLIVER VINS* & THOMAS BLOCH†
THE EFFECTS OF SIZE ON LOCAL BANKS’ FUNDING COSTS‡
* Johann-Wolfgang Goethe-Universität Frankfurt, Finance Department, Mertonstr. 17, 60325 Frankfurt a. M.,
Germany, Corresponding author: fon: +49 175 318 5202, E-Mail: firstname.lastname@example.org
† Johann-Wolfgang Goethe-Universität Frankfurt, Finance Department, Mertonstr. 17, 60325 Frankfurt a. M.,
Germany, Corresponding author: fon: +49 163 362 3822, E-Mail: email@example.com
‡ This paper is part of a project funded by the German Savings Banks Association (DSGV) and conducted in
cooperation with the Johann Wolfgang Goethe-University in Frankfurt am Main. The contribution of DSGV is
gratefully acknowledged. The expressed opinions are strictly those of the authors and do not necessarily reflect
those of the affiliated organizations. We thank René Fischer, Andreas Hackethal, Yassin Hankir, Sascha Steffen,
and Mark Wahrenburg for valuable comments and suggestions. All remaining errors are our own.
Paper accepted for presentation (among others): Australasian Finance & Banking Conference (Sydney, 2007),
Midwest Finance Association 57th Annual Meeting (San Antonio, 2008), Southwestern Finance Association
47th Annual Meeting (Houston, 2008), Midwest Economics Association Annual Meeting (Chicago, 2008),
Eastern Finance Association Annual Meeting (St. Pete Beach, 2008), HVB Doctoral Seminar (Eltville, 2007).
The working papers in the series Finance and Accounting are intended to make research findings available to other
researchers in preliminary form, to encourage discussion and suggestions for revision before final publication. Opinions are
solely those of the authors.
The E?ects of Size on Local Banks' Funding
O. Vinsa,∗T. Blocha,∗∗
aJohann Wolfgang Goethe-University Frankfurt, Finance Department, Mertonstr.
17, 60325 Frankfurt a. M., Germany
Motivated by the recent discussion of the declining importance of deposits as
banks' major source of funding we investigate which factors determine funding costs
at local banks. Using a panel data set of more than 800 German local savings and
cooperative banks for the period from 1998 to 2004 we show that funding costs
are not only driven by the relative share of comparatively cheap deposits of bank's
liabilities but among other factors especially by the size of the bank. In our empirical
analysis we ?nd strong and robust evidence that, ceteris paribus, smaller banks
exhibit lower funding costs than larger banks suggesting that small banks are able
to attract deposits more cheaply than their larger counterparts. We argue that this
is the case because smaller banks interact more personally with customers, operate
in customers' geographic proximity and have longer and stronger relationships than
larger banks and, hence, are able to charge higher prices for their services.
Our ?nding of a strong in?uence of bank size on funding costs is also in an in-
ternational context of great interest as mergers among small local banks - the key
driver of bank growth - are a recent phenomenon not only in European banking that
is expected to continue in the future. At the same time, net interest income remains
by far the most important source of revenue for most local banks, accounting for
approximately 70% of total operating revenues in the case of German local banks.
The in?uence of size on funding costs is of strong economic relevance: our results
suggest that an increase in size by 50%, for example, from EUR 500 million in total
assets to EUR 750 million (exemplary for M&A transactions among local banks) in-
creases funding costs, ceteris paribus, by approximately 18 basis points which relates
to approx. 7% of banks' average net interest margin.
Key words: Regional banks, bank funding, mergers & acquisitions
JEL: G21, G34, L25, C23
The future role of deposits as banks' major and at the same time cheapest
source of funding has recently attracted attention by both researchers and
practitioners. Both alike argue that the importance of deposits has been di-
minished because more and more money traditionally held as deposits is today
invested in alternative investment products o?ered by non-bank ?nancial in-
termediaries, a trend typically referred to as disintermediation (see Edwards
and Mishkin (1995) and Hackethal (2004)). Norden and Weber (2008) ?nd
that customer deposits lose ground in relative terms while inter-bank liabil-
ities increase as a source of banks' funding. Furthermore, the emergence of
securitization is regarded as another key trend responsible for the declining
importance of deposits in bank funding as it provides banks with an alterna-
tive way of ?nancing their lending activities and the opportunity to take their
loans (partially) o? balance sheet. Only the recent liquidity crisis in the sec-
ond half of 2007 caused by the subprime mortgage crisis in the US has again
highlighted the advantages of bank deposits providing banks with liquidity
and ?exibility when other sources of funding dry up.
Motivated by the recent discussion and market developments we examine the
importance of customer deposits for banks' funding by investigating the de-
terminants of funding costs. The role of deposits as part of banks' funding
mix is especially important in view of the German market because access to
customer deposits is regarded as key strength of local banks. In Germany,
customer deposits account for 70 to 80% of local banks' total liabilities and
in volume terms even outweigh banks' loan portfolios. Using a panel data set
comprising bank level ?nancials for over 800 German local savings and coop-
erative banks for the period from 1998 to 2004 we show that funding costs
are not only driven by the relative share of relatively cheap deposits in banks'
funding mix as suggested by Norden and Weber (2008) but among other fac-
tors especially by the size of the bank.1In our empirical analysis we ?nd
⋆This paper is part of a project funded by the German Savings Banks Association (DSGV) and conducted
in cooperation with the Johann Wolfgang Goethe-University in Frankfurt am Main. The expressed opinions
are strictly those of the authors and do not necessarily re?ect those of the a?liated organizations. We
thank René Fischer, Andreas Hackethal, Yassin Hankir, Sascha Ste?en, and Mark Wahrenburg for valuable
comments and suggestions. All remaining errors are our own.
Paper accepted for presentation (among others): Australasian Finance & Banking Conference (Sydney,
2007), Midwest Finance Association 57th Annual Meeting (San Antonio, 2008), Southwestern Finance As-
sociation 47th Annual Meeting (Houston, 2008), Midwest Economics Association Annual Meeting (Chicago,
2008), Eastern Finance Association Annual Meeting (St. Pete Beach, 2008), HVB Doctoral Seminar (Eltville,
∗Corresponding author: fon: +49 175 318 5202
∗∗Corresponding author: fon: +49 163 362 3822
Email addresses: firstname.lastname@example.org (O. Vins),
email@example.com (T. Bloch).
1We de?ne funding costs as the average interest rate paid on liabilities calculated
as a bank's interest expenses over average interest-bearing liabilities.
strong and robust evidence that, ceteris paribus, smaller banks exhibit lower
funding costs than larger banks suggesting that small banks are able to attract
deposits more cheaply than their larger counterparts. We propose that this is
the case because smaller banks interact more personally with customers, op-
erate in customers' geographic proximity and have longer and, thus, stronger
relationships than larger banks and, hence, are able to charge higher prices for
their services. In line with Berger et al. (2005) we argue that larger banks, in
contrast, operate at a greater distance, interact more impersonally with their
customers and have shorter and more transaction based relationships, i.e. they
compete on terms and conditions rather than on customized services. Bank
growth, especially in the course of mergers and acquisitions, is often accom-
panied by streamlining of bank networks, eliminating regional proximity to
customers and therefore the basis for close customer relationships.
Our ?nding of a strong positive relation between bank size and funding costs is
of great interest as mergers among small local banks are a recent phenomenon
in European banking that is expected to continue in the future. At the same
time, net interest income remains by far the most important source of revenue
for most local banks, accounting for approximately 70% of total operating
revenues. Furthermore, the size e?ect is of strong economic relevance: our
results suggest that a 50% increase in size from EUR 500 million in total assets
to EUR 750 million (exemplary for M&A transactions among local banks)
increases the funding costs and therefore simultaneously decreases the net
interest margin by approximately 18 basis points -this amounts to more than
7% of the average net interest margin of a German local bank in our sample,
which is less than 300 basis points. Especially the comparison to banks' average
net pro?t margin of 24 basis points in our sample highlights the economic
signi?cance of this e?ect.
While previous research has extensively investigated the determinants of banks'
net interest margins based on work by Ho and Saunders (1981), there is no
study that considers the determinants of interest income and interest expenses
(funding costs) separately. With this paper we contribute to closing this gap
and examine the determinants of banks' funding costs. We also go beyond the
national view on bank pro?tability and consider di?erences in market concen-
tration and the economic environment on the local market level.
The remaining paper is structured as follows: Section 2 provides a brief overview
of the literature closely related to our work. Section 3 lays out the empirical
framework for our analysis and derives key hypotheses. Section 4 discusses the
panel data set, the di?erent samples used for our analysis as well as empirical
speci?cations of the model. Section 5 summarizes the empirical results and
section 6 provides some robustness checks. Finally, Section 7 concludes.
The e?ects of size on bank's funding costs - di?erent time periods
This table presents coe?cient estimates from regressions relating funding costs to bank size. As dependent variable
we use Interest Expenses / Total Liabilities as measure of Banks' Funding Costs. Regression analyses include
observations from di?erent time periods: 1998-2000 (Column 1), 2001-2004 (Column 2), 1998-1999 (Column 3),
2000-2001 (Column 4) and 2002-2004 (Column 5). Analyses for di?erent time periods do not include the same
number of banks and observations due to the unbalanced nature of the dataset. All regressions include bank ?xed
e?ects dummy variables and year dummy variables (not reported). As estimation technique, we use ?xed e?ects
regression models (Least Square Dummy Variable Approach) with heteroskedasticity-robust standard errors. P-
values are reported in brackets.
Interest Expenses / Total Liabilities
Variables (1) (2) (3)(4) (5)
Bank speci?c characteristics
Operating Expenses / Total Assets0.389***0.499***0.298*** 0.666***0.496***
[0.000] [0.000][0.002] [0.000][0.000]
Implicit Interest Payments-0.084-0.137***-0.054-0.237***-0.169***
Equity / Total Assets-0.098***-0.0170.043 0.033-0.002
Deposits / Loans-0.002***-0.001-0.002-0.0020.000
Local market environment
Local HHI 0.000 0.000 0.000 0.000 0.000
[0.691] [0.639] [0.468][0.194][0.275]
***signi?cant at 0 to 1 percent level, **signi?cant at 1 to 5 percent level, *signi?cant at 5 to 10 percent level, others:
signi?cant at above 10 percent level; Note: Note: Interest rate variable has been dropped from regressions (3) and
(4) due to collinearity.
0.885 0.929 0.9410.933 0.933
The e?ects of size on bank's funding costs - the e?ects of M&A
This table presents coe?cient estimates from regressions relating changes in funding costs to
changes in bank size at merging banks. As dependent variable we use the ?rst di?erence of
our funding costs variable Interest Expenses / Total Liabilities. As explanatory variables we
include the ?rst di?erences of our bank size variable Total Assets and control variables. First
di?erences for the respective variables are calculated between the pre-merger year (t-1) and
the merger year (Column 1), the ?rst post-merger year (Column 2) and the second merger year
(Column 3). Regression analyses include observations of all banks that have been involved
in merger between 1998 and 2004 for the years before and after their respective mergers.
All regressions include bank ?xed e?ects dummy variables and year dummy variables (not
reported). As estimation technique, we use Ordinary Least Square (OLS) regression models
with heteroskedasticity-robust standard errors. P-values are reported in brackets.
∆ Interest Expenses / Total Liabilities
Bank speci?c characteristics
∆ Total Assets0.656***0.327***0.378***
∆ Operating Expenses / Total Assets0.495**0.380**-0.084
[0.047] [0.028] [0.647]
∆ Implicit Interest Payments0.088 -0.194 0.472*
∆ Equity / Total Assets0.032-0.061-0.077
∆ Deposits / Loans-0.009***-0.007***-0.003
Local market environment
∆ Local HHI-3.786**-0.125-1281
∆ Interest Rate-0.625**0.1140.253**
∆ Local GDP-0.044***-0.017*-0.033***
∆ Savings Rate0.257***0.172***0.170**
***signi?cant at 0 to 1 percent level, **signi?cant at 1 to 5 percent level, *signi?cant at 5
to 10 percent level, others: signi?cant at above 10 percent level; Note: Note: Interest rate
variable has been dropped from regressions (3) and (4) due to collinearity.
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