For release: March 14, 2001
Contact: Charles B. Henderson, (314) 444-8311

Are Small Rural Banks Vulnerable to Local Economic Downturns?

ST. LOUIS -- As economic markets continue to integrate and erode geographical borders, small rural banks have become less vulnerable to local economic downturns, based on a study by two economists at the Federal Reserve Bank of St. Louis.

The economists, Andrew P. Meyer and Timothy J. Yeager, wrote the study for the March/April issue of Review, the St. Louis Fed's bimonthly journal of business and economic issues.

"Banks -- especially small banks -- tend to make loans to the people and businesses that are geographically close because monitoring costs increase as the distance between lender and borrower increases," said Meyer and Yeager. "If a bank's operations are concentrated in a limited geographical area, and many firms or people in the area become financially distressed at the same time, the small bank's credit quality will likely suffer more than the credit quality of a more geographically diversified bank. In addition, if local economic activity affects a bank's performance, this association is more likely to be evident in the data for small banks in rural areas than for small banks in urban areas, because banks in rural areas lend to a higher portion of the businesses and residents in their communities."

Meyer and Yeager studied data covering an eight-year span for more than 850 banks per year with $300 million or less in assets (a commonly used benchmark to define a small bank) in the Fed's Eighth District: Arkansas, eastern Missouri, southern Illinois, southern Indiana, western Kentucky, western Tennessee and northern Mississippi. They limited their scope to the Eighth District to keep the volume of county-level economic data more manageable.

The county-level economic data came from the Bureau of Labor Statistics and the Bureau of Economic Analysis, and included unemployment rates, employment growth, personal income growth, and per capita personal income growth.

To measure bank performance, Meyer and Yeager used three asset quality ratios and one earnings ratio commonly used in bank supervision to monitor a bank's condition. The asset quality ratios chosen were nonperforming loans to total loans, net loan losses to total loans, and other real estate owned (OREO) to total assets. The earnings ratio was adjusted return on assets (ROA) or net income plus provision expense, divided by assets.

"Other things being equal, we expected asset quality and earnings to improve with employment and income growth to worsen with a rise in the unemployment rate," they said.

Employing a regression model, Meyer and Yeager found that economic activity at the county level did not, by and large, have as big an influence on bank performance as a state's economic activity did. They concluded that the results of their study have two policy implications for bank supervisors:

1. County economic data are not systematically useful in the risk-focused supervision process because the data are weakly correlated with bank performance.
2. Little justification exists for imposing more stringent regulatory requirements on banks with geographically concentrated offices than on other banks. "For example, all else equal, higher capital standards on geographically concentrated banks are not warranted," Meyer and Yeager wrote.

"Despite liberalized branching laws, thousands of small rural banks are still in existence and are likely to be around for some time. While our study is not necessarily definitive for the rest of the country, we did not find anything that would suggest our results would be dramatically different for other regions," Meyer and Yeager concluded.

Subscriptions to Review are available by calling (314) 444-8809.

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern

Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. In addition to serving as a bank for depository institutions and the U.S. government, each Reserve Bank monitors economic conditions in the District, participates in formulating monetary policy, and supervises state-chartered member banks and bank holding companies to foster safety and soundness of the District's banking and financial institutions and protect the credit rights of consumers.

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