Federal Reserve System and the Conference of State Bank Supervisors

Community Banking in the 21st Century

October 2-3, 2013, Federal Reserve Bank of St. Louis

Session 1 | Role of Community Banks

Title: Do Community Banks Play a Role in New Firm Survival? (PDF)
Authors: Smith Williams, Yan Y. Lee
Abstract: In the United States, net job creation is largely a story of new and young firms (Neumark, Wall and Zhang 2008; Haltiwanger, Jarmin and Miranda 2010; and Kane 2010). New firms create more new jobs each year than any other firm age group. Kane (2010) estimates that new firms generate at least four times the average annual number of jobs created by any other age group. Start-up firms also have higher rates of employment growth in their early years than do older firms, conditional on survival (Haltiwanger Jarmin, and Miranda 2010). However, many new firms, and their associated jobs, do not survive more than a few years. Haltiwanger, Jarmin and Miranda estimate that firm deaths eliminate 40 percent of the jobs created by start-ups within the first five years. These authors interpret the high rates of job creation and destruction by new firms as evidence of an up-or-out dynamic—a new firm either grows or dies. This study explores whether community banks play a role in increasing a new firms’ access to capital and, consequently, start-ups’ chances of survival.

Title: Equipment Lease Financing: The Role of Community Banks (PDF)
Authors: Charles Kelly, Mohammed Khayum, Curtis Price
Abstract: Recent analyses of U.S. community banking indicate the existence of cross-sectional and time series variation in performance, business models and strategic directions among community banks (FDIC, 2012; Gilbert et al. 2013). While consolidation within the U.S. commercial banking sector over the last quarter century has resulted in a declining number of community banks, these banks continue to play a vital role in the national economy, particularly with respect to small businesses and rural communities. Community banks provide 46 percent of small loans to farms and businesses, 16.1 percent of residential mortgage lending, 65.8 percent of farm lending and 34.5 percent of commercial real estate loans, while accounting for 19.4 percent of all retail deposits at U.S. banks as of 2011 (FDIC, 2012). At the same time, evidence of sharp declines in the community banks’ share of mortgage and consumer loans, low profitability indicators, and the continued incidence of community bank failures raises concerns about the future viability of community banking.

Title: Bank Failure, Relationship Lending and Local Economic Performance (PDF)
Authors: John Kandrac
Abstract: Whether bank failures have adverse effects on local economies is an important question for which there is scarce and conflicting evidence. In this study, I use county-level data to examine the effect of bank failures and resolutions on local economies. Using quasi-experimental techniques, as well as cross-sectional variation in bank failures, I show that recent bank failures were followed by significantly lower income and compensation growth, higher poverty rates, and lower employment. Additionally, I find that the structure of bank resolution appears to be important. Resolutions that include loss-sharing agreements tend to be less deleterious to local economies, supporting the notion that the importance of bank failure to local economies stems from banking and credit relationships. Finally, I show that markets with more interbank competition are more strongly affected by bank failure.

Title: Small Business Lending and Social Capital: Are Rural Relationships Different? (PDF)
Authors: Robert DeYoung, Dennis Glennon, Peter Nigro, Kenneth Spong
Abstract: Rural communities often are described as places where “everyone knows each other’s business.” Such intracommunity information is likely to translate into a stock “social capital” that supports well-informed financial transactions (Guiso, Sapienza and Zingales 2004). We investigate whether and how the “ruralness” of small banks and small-business borrowers influences loan-default rates, using data on more than 18,000 U.S. Small Business Administration loans originated and held by rural and urban community banks between 1984 and 2001. These data provide a good test of the value of soft information and lending relationships because (a) these borrowers tend to be smaller, younger and more credit-challenged than other small businesses and (b) these loans were originated largely before the advent of small business credit scoring and securitization, hence they were held in portfolio and put some bank capital directly at risk. We have two main findings. First, loans originated by rural community banks and/or loans borrowed by rural businesses default substantially less often than loans made by urban banks and/or in urban areas. Second, loan-default rates are significantly higher when borrowers are located outside the geographic market of their lenders, even after accounting for the physical distance between the bank and the small business. Thus, we conclude that loan defaults are lower in communities arguably expected to have large amounts of inexpensive soft information and at banks likely to have a high level of personal knowledge about their customers. Our findings offer an explanation for why community banks—and in particular, rural banks—continue to exist despite operating at such a small scale; why small local banks play a critical role in lending to small, informationally opaque borrowers; and why small rural banks are less likely to use small business credit scoring than their small urban counterparts. Moreover, our findings are consistent with the idea that a high stock of social capital is conducive to financial activity and development.

Session 2 | Community Bank Performance

Title: Financial Derivatives at Community Banks (PDF)
Authors: Xuan (Shelly) Shen, Valentina Hartarska
Abstract: Community banks did not actively participate in the derivatives market until the enactment of the Gramm-Leach-Bliley Act of 1999. Call reports show that less than 1 percent of community banks used derivatives in 1999, but around 16 percent of community banks were active derivative users by 2012. Even though there were consolidations of community banks in last decade, these banks remain relatively small, and are therefore more vulnerable to inappropriate derivative activities. However, due to the relatively short history of derivative activities at these banks, not much is known about how financial derivatives affect the profitability of community banks. Meanwhile, recent regulation changes have brought many challenges to community banks. In particular, implementation of the Volcker Rule not only prohibits banks from proprietary trading in derivatives, but also has the potential to deter small banks from permissible risk-mitigating derivative activities because the increased regulatory costs are proportionally higher for these small banks. This study not only provides empirical evidence on how financial derivatives affect the profitability of community banks but also estimates the potential effects of the Volcker Rule on these small banks. Furthermore, specializing community banks have different exposure levels to various risks and their derivative activities tend to be heterogeneous. This work, in turn, studies the effects of derivative activities on profitability at community banks by lending specialties, such as mortgage specialists, commercial real estate loan specialists, commercial and industrial loan specialists, multiple specialists, and nonspecialty banks.

Title: Lessons from Community Banks that Recovered from Financial Distress (PDF)
Authors: R. Alton Gilbert, Andrew P. Meyer, James W. Fuchs
Abstract: This project is a follow-up to our recent report, “The Future of Community Banks: Lessons From Banks that Thrived During the Recent Financial Crisis,” which appeared in the March/April edition of the Federal Reserve Bank of St. Louis’ Review. In our previous work, we studied the attributes of banks that maintained a CAMELS rating of 1 throughout the financial crisis years of 2006 to 2011. We showed a variety of statistically significant balance-sheet ratios and other attributes that were different between these “thriving” banks and other banks that survived the financial crisis but did not maintain the highest supervisory rating. We followed up the statistical analysis with interview evidence from a sample of thriving bankers to determine what they considered to be the keys to their success. We are taking a similar path with the current project, but instead of studying the essential factors for maintaining health, we are identifying the essential factors for regaining health after suffering significant safety-and-soundness problems. To that end, we have identified a sample of 1,376 commercial banks under $10 billion in assets that were downgraded to a CAMELS rating of either 4 or 5 during the sample period of 2006 to 2011.

Title: The Effect of Distance on Community Bank Performance Following Acquisitions and Reorganizations (PDF)
Authors: Gary D. Ferrier, Timothy J. Yeager
Abstract: We analyze the efficiency and performance of more than 2,000 U.S. community bank acquisitions and reorganizations between 1988 and 2002. Post-acquisition bank performance deteriorates with the geographic distance between the target and the acquirer. In contrast, bank performance following reorganization (charter consolidation) of a given bank-holding company improves with the distance between affiliates. We argue that distance between the target and the acquirer harms performance because high information and monitoring costs overwhelm any diversification benefits. Conversely, reorganizations benefit geographically distant entities the most precisely because these firms have the most to gain from reducing information and monitoring costs.

Title: Performance of Community Banks in Good Times and Bad Times: Does Management Matter? (PDF)
Authors: Dean F. Amel, Robin A. Prager
Abstract: Community banks have long played an important role in the U.S. economy, providing loans and other financial services to households and small businesses within their local markets. In recent years, technological and legal developments, as well as changes in the business strategies of larger banks and nonbank financial service providers, have purportedly made it more difficult for community banks to attract and retain customers, and hence to survive. Indeed, the number of community banks and the shares of bank branches, deposits, banking assets and small business loans held by community banks in the U.S. have all declined substantially over the past two decades. Nonetheless, many community banks have successfully adapted to their changing environment and have continued to thrive. This paper uses data from 1992 through 2011 to examine the relationships between community bank profitability and various characteristics of the banks and the local markets in which they operate. Bank characteristics examined include size, age, ownership structure, management quality and portfolio composition; market characteristics include population, per capita income, unemployment rate and banking market structure. We find that community bank profitability is strongly positively related to bank size; that local economic conditions have significant effects on bank profitability; that the quality of bank management matters a great deal to profitability, especially during times of economic stress; and, that small banks that make major shifts to their lending portfolios tend to be less profitable than other small banks.

Session 3 | Supervision and Regulation of Community Banks

Title: Estimating Changes in Supervisory Standards and Their Economic Effects (PDF)
Authors: William F. Bassett, Seung Jung Lee, Thomas W. Spiller
Abstract: The disappointingly slow recovery in the United States from the recent recession and financial crisis has once again focused attention on the relationship between financial frictions and economic growth. With bank loans having only recently started growing and still remaining sluggish, some bankers and borrowers have suggested that unnecessarily tight supervisory policies have been a constraint on new lending that is hindering recovery. This paper explores one specific aspect of supervisory policy: whether the standards used to assign commercial bank CAMELS ratings have changed materially over time (1991-2011). We show that models incorporating time-varying parameters or economy-wide variables suggest that standards used in the assignment of CAMELS ratings in recent years generally have been in line with historical experience. Indeed, each of the models used in this analysis suggests that the variation in those standards has been relatively small in absolute terms over most of the sample period. However, we show that when this particular aspect of supervisory stringency becomes elevated, it has a noticeable dampening effect on lending activity in subsequent quarters.

Title: The Impact of Dodd-Frank on Community Banks (PDF)
Authors: Tanya D. Marsh, Joseph W. Norman
Abstract: The American system of banking regulation is a system of regulation by accretion–it is the result of legislative responses to particular crises, from the need to create a market for U.S. national bonds to help finance the Civil War (which led to the creation of national bank charters), to the creation of the Federal Reserve after the monetary panic of 1907, to the creation of the FDIC following the stock market crash of 1929, and, most recently, to the creation of Dodd-Frank after the 2007 financial crisis. Each of these legislative efforts was a well-meaning attempt to deal with the perceived problems that led to each crisis. However, the net result of these policies is a federal regulatory system for banking that is fundamentally flawed and has unintended consequences on community banks.

Title: Capital Regulation at Community Banks: Lessons from 400 Failures (PDF)
Authors: Robert R. Moore, Michael A. Seamans
Abstract: We draw on data from the recent financial crisis and its aftermath to examine factors underlying community bank performance, failure and regulation. In particular, we investigate the failure of some 400 community banks from 2008 to 2013, with a focus on the ability of two measures of capital, tier 1 capital to assets and tier 1 capital to risk-weighted assets, to explain and forecast these failures. Both measures of capital provide useful information for explaining failures in-sample. For predicting failures out-of-sample, we find that both measures have similar Type I error rates for given Type II error rates, particularly if variables beyond the capital ratios themselves are included in logistic failure models. Our results accord well with those of Estrella, Park and Peristiani (2002) who examined an earlier failure wave, and with Haldane and Madouros (2012) who brought a different approach to examining the recent failure wave. Consistent with this previous research, our results support keeping capital requirements for community banks simple.

Title: A Failure to Communicate: The Pathology of Too Big to Fail (PDF)
Authors: Harvey Rosenblum, Elizabeth Organ
Abstract: Guided by an examination of community banks and their relative stability during the recent financial crisis, we propose that lasting financial stability will rest on a level playing field that rewards sound judgment and integrity among profit-seeking financial firms, while penalizing excessive risk and complexity. To promote such an operating environment, government should retain its role as the financial system’s watchdog, but must (1) render no institution immune to market discipline and (2) tailor regulation and supervision to fit the distinct business models employed by different types and groups of financial firms.