For release: April 2, 2002
Contact: Charles B. Henderson, (314) 444-8311

Does "Relationship Lending" Protect Small Banks from Economic Downturns

ST. LOUIS -- Even though most U.S. community banks do most of their business in their own regions, a new analysis from the Federal Reserve Bank of St. Louis suggests that those banks are able to withstand local economic downturns.

The analysis comes from John Hall, an assistant professor of finance at the University of Arkansas-Little Rock, and Timothy J. Yeager, an economist at the Federal Reserve Bank of St. Louis. Their comments appear in the April issue of The Regional Economist, the St. Louis Fed's quarterly journal of business and economic issues.

Despite the trend toward mergers and ever-larger banks, the vast majority of U.S. banks remain community banks, which provide important access to credit for small businesses. "Loans to small businesses require more costly evaluation and monitoring than do loans to larger firms because access to information on the borrowing firms is limited," wrote Hall and Yeager. "This so-called relationship lending is less costly at community banks because of the bankers' ability to assess credit quality through intangibles, such as the borrower's reputation in the community."

Hall and Yeager noted, however, that banks heavily involved in relationship lending may incur a potential for increased risk. Geographically concentrated banks that lend and draw deposits in their local markets may be vulnerable to local economic slowdowns. Such concentrated banks are prevalent throughout the United States. For example, in June of 2001, 61 percent of U.S. banks derived all of their deposits from offices in a single county and 97 percent of banks derived all of their deposits from offices in a single state.

"If geographic concentration leaves banks vulnerable to local economic swings, then bank managers may need to take steps to diversify their banks' exposure," said Hall and Yeager. "Similarly, regulators may need to direct supervisory resources to focus more on concentrated banks, and supervisors may also wish to focus on local economic data to help identify which banks are in trouble--or headed for trouble."

As part of their analysis, Hall and Yeager drew on a previous study by Yeager and Andy Meyer, another economist at the St. Louis Fed. The Meyer/Yeager study found that a one percentage point increase in the state unemployment rate increased non-performing loans by 17 basis points, whereas a one percentage point increase in a county unemployment rate had no effect on non-performing loans. "These results suggest that small, rural banks are not particularly vulnerable to local economic downturns," said Hall and Yeager.

Subsequently, Yeager studied the performance of a national sample of geographically concentrated banks in counties that experienced large, negative, local economic shocks. The preliminary results of his study suggest that the performance of those banks is no different from the performance of geographically concentrated banks not exposed to such shocks.

Hall and Yeager offered three possible reasons why community banks are less vulnerable to local economic shocks today, compared with previous decades:

• Advances in financial diversification. "Improved efficiency in credit markets means that almost any bank can engage in loan participation and sales," said Hall and Yeager. "In addition, collateralized mortgage obligations--securities backed by a pool of mortgages--offer banks opportunities to diversify credit risk without altering the markets they serve. Community banks have certainly become more active in this type of diversification."
• The broadening geographical scope of bank lending. "When banks lend to borrowers outside their counties," said Hall and Yeager, "the banks are less vulnerable to county economic shocks." They cited a study that showed that the distance between small firms and their banks grew from an average of 16 miles in the 1970s to 68 miles in the early '90s.
• The increased diversification of county economies. "Even if some of the firms in a county suffer financial distress, the local community bank may have enough other customers in strong financial condition such that the exposure to the distressed firm is small," they said.
  

Hall and Yeager concluded that one thing will not change, however: "Successful community banks will continue to be those that make sound lending decisions regardless of where their loan customers are located." Subscriptions to The Regional Economist are free and can be obtained 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 to protect the credit rights of consumers.

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