The Future of Community Banks

The June issue of the Chicago Fed Letter examines the outlook for community banks in the U.S. The authors of the study are Robert DeYoung, William C. Hunter, and Gregory F. Udell. At the outset, the authors observe: "There are more banks per capita in the United States than in any other developed economy." This statistic reflects our large number of "community banks." Community banks became prevalent in the U.S. because they offered relationship finance; that is, "the idea that personal interaction between bankers, small borrowers, and small depositors allow credit to flow more efficiently and commerce to grow more quickly." This belief was consistent with the generally held belief that big business, big government and big financial institutions were bad. This concern fostered laws that prevented banks from doing business across state lines. Locking out competition had the predictable effect. The regulations "helped preserve thousands of poorly run community banks." Initially, community banks could dominate the local financial market because they "knew" the community. However, with the development of communication technology, community banks lost their semi-monopoly position. In addition, new state and federal legislation eliminated the restrictions on branching and crossing state lines that had protected local banks from competition. As a result of these changes, mergers and acquisitions greatly reduced the number of banks in the U.S.

There are two explanations for these trends. Although they are not mutually exclusive, they lead to very different forecasts for the future of banking. One possibility is that the banks that were inefficient were the most likely to be acquired by larger, efficient banks. In that case, the small banks that survive were likely to be well managed and fully capable of providing profitable services to their communities. The second possibility is that "the local banking model is no longer economically viable due to technological changes."

While community banks that are poorly managed could have become more efficient, they were hard-pressed to overcome the dramatic changes in technology that offset their previous local monopoly of financial services. No longer do consumers need to leave their funds on deposit at a local bank. Instead, they can invest online in money market funds. Rather than rely on local banks to meet their credit needs, they can finance their mortgages and obtain credit cards and automobile loans through the mail or on the web. The lenders need not have an office in the towns where their clients live in order to gather local knowledge about credit applicants. Extensive and current data are available in their credit reports, and credit scores replace local opinions about credit applicants. Finally, in managing their relationships with borrowers and lenders, large banks have economies of scale that are not available to small, local banks. The authors conclude that the large banks will specialize in high-volume, low-margin financial services, while the smaller banks will sell low-volume, high-margin services. For example, they will offer financing to local small businesses and personalized investment services. This market specialization will lead to fewer, but more profitable banks. Nonetheless, as a result of these pressures, about 15 percent of the industry's total assets have shifted from community banks to large banks over the past two decades.

Will the number of community banks continue to decline? The authors cite a recent study by Douglas Robertson of the Office of the Comptroller of Currency. Using a complicated statistical analysis of 40 years of data, he concludes that by 2007 "there will be only 2,500 banks with assets less than $100 million (down from about 4,000 today), only about 1,750 with assets $100 million and $900 million (compared with about 2,500 today), and about 500 banks with assets between $900 million and $2.7 billion (about the same as today)."

Such predictions must, of course, be taken with the proverbial "grain of salt." If the large banks should ignore the credit needs of small businesses, community banks will be organized to meet those needs. For example, a recent study has shown that the average return on equity of the most profitable half of community banks exceeded the rate of return on equity of large commercial banks with assets above $10 billion.

As an interesting footnote to this study, we note that the May 6 issue of Business Week carried an article titled "For Small Banks, It's a Wonderful Life." The article reported that small banks are gaining market share by serving the "scorned customers" of large banks angered by the "megabanks" that "raised account minimums, and slapped on ATM fees.