The objective of this paper is to investigate the potential implications of consolidation activities in the Hong Kong banking industry in recent years. While there are many cited implications of consolidation activities, this paper concentrates on the cost efficiency effects in order to limit the scope to manageable proportions....[ Read more ]

The objective of this paper is to investigate the potential implications of consolidation activities in the Hong Kong banking industry in recent years. While there are many cited implications of consolidation activities, this paper concentrates on the cost efficiency effects in order to limit the scope to manageable proportions.

To study the cost structure of banks in Hong Kong, we construct a multi-output cost function of bank operation. A panel of 28 local banks with six years, 1992-1997, of financial data is used to estimate a representative cost function for the Hong Kong banking industry. The cost function is then used to examine the existence of economies of scale and economies of scope in banking operation. In addition, simulations of artificial bank consolidations are performed to quantify potential cost efficiency change from prospective consolidation activities in Hong Kong.

Since consolidation may involve enlargement of production scale and change in output mix, both scale and scope economies are possible sources of cost efficiency change. The findings reveal that the small and medium-sized banks may achieve improvements in cost efficiency by enlarging their scale and/or scope of operations. Furthermore, the simulation results confirm that mergers between small and medium-sized banks would result in large cost efficiency improvements. In addition, it is found that smaller banks achieved a higher level of technical progress than large banks after the 1994-5 interest rate deregulation in Hong Kong. This indicates that smaller banks may better adapt to changes in the business environment. Thus, the consolidations that make the size of banks larger may result in a reduction of their abilities in adapting to changes in the business environment.