Edgeworth (1888) Initiated the Idea that Economies from RESERVE HOLDINGS Could Lead to a NATURAL MONOPOLY in Banking

A perennial issue in the banking literature is whether banking is a natural monopoly—are there economies of scale in banking such that only one firm can survive in the competitive equilibrium? In one way or another natural monopoly issues underlie many discussions of banking, and it is important to clarify them, because many people still believe, not only that banking is a natural monopoly, but that the monopolization of the currency supply and other aspects of present-day central banking can be justified on natural monopoly grounds. An industry can be said to be a natural monopoly if the average production cost is lower for one firm than it would be for two or more firms, and this condition requires that the production technology exhibits increasing returns to scale, to the point where all market demand is satisfied. There is nothing to prevent a second firm entering an industry characterized by natural monopoly, but average costs would be higher while both firms continued to supply the market, and these higher costs would presumably indicate scope for one firm to ‘eliminate’ the other in a mutually profitable way—bribing it to leave the market, for instance, or taking it over and then closing down its production facilities. It follows that while we might observe more than one firm in the industry over some short period, we would not expect that state of affairs to persist in the long run.

There are several reasons why banks might face increasing returns to scale that could conceivably lead to natural monopoly. One factor is economies from reserve holdings. The underlying idea goes back to Edgeworth (1888) and it has been developed since in a number of places (e.g., Porter 1961; Niehans 1978:182-4; Baltensperger 1980:4-9; Sprenkle 1985, 1987; Selgin 1989b:6-12; Glasner 1989a). These economies are based on a well known result that subject to certain plausible conditions a bank’s optimal reserves rise with the square root of its liabilities, implying that the bank’s optimal reserve ratio falls as the bank gets bigger. Given that reserves are costly to hold, a larger bank therefore faces lower average reserve costs.

—Kevin Dowd, “Is Banking a Natural Monopoly?” Laissez-faire Banking, Foundations of the Market Economy (London: Taylor & Francis e-Library, 2003), 76-77.