Journal of Monetary Economics 31 (1993) 229-249. North-Holland Economies of diversification in the banking industry A frontier approach* Gary D. Ferrier zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGF University of Arkansas, Fayetteville. AR 72701, USA Shawna Grosskopf Sourhem Illinois University. Carbondale, IL 62901, USA Kathy J. Hayes Southern M ethodis University, Dallas, TX 75275, USA Suthathip Yaisawarng Union College, Schenectady, NY 12308. USA Received November 1991, final version received December 1992 This paper defines a new measure, economies of diversification, to examine the cost effect of product line expansion. This measure is a special case of expansion path subadditivity and contains economies of scope as a special case. A nonparametric frontier technique which isolates the effects of inefficiency and scale is used to measure economies of diversification. Applied to a set of 468 U.S. depository institutions operating in 1984, we find slight diseconomies of diversification. Dis- economies of diversification and inefficiency due to the overutilization of resources are found to be more important determinants of bank costs than is the failure to operate at optimal scale. Keywords: Economies of diversification; Nonparametric frontier; Banking zyxwvutsrqponmlkjihgfedcbaZ 1. Introduction Recent changes in banking laws and regulations have allowed commercial banks to expand their services into new product lines and geographic areas. Correspondence to: Kathy J. Hayes, Department of Economics, Southern Methodist University, Dallas, TX 75275, USA. *The authors thank, without implicating, Allen N. Berger, Rolf Fire, David B. Humphrey, C.A. Knox Lovell, and an anonymous referee for their valuable comments on earlier drafts of this paper. 0304-3932/93/%06.00 0 1993-Elsevier Science Publishers B.V. All rights reserved