The U.S. banking industry is unique among the world's industrialized nations as it consists of thousands of small banks in rural and urban communities. Due to the balance of power that exists between the federal and state governments, the dual banking system has remained in place despite numerous challenges to its existence over the years. Restrictive branching laws and the rural population base of many states fostered the creation of an extensive network of community banks in the more than 155 years of the dual banking system. In some ways, though, the shape of the banking industry today still reflects some legacy effect from an era where vigorous competition was restricted and bank charters swelled, attesting to the strength of the dual banking model.
The three-decade trend of industry consolidation, much involving community banks, has naturally drawn the attention of the industry and policymakers to the viability of the community bank business model. Today's community banks exist in an environment where competition is intense and financial innovation has stripped away much of a bank's cost advantages in acquiring funds and its revenue advantages on assets. Other contributing factors include the urbanization of population growth and the higher cost of regulation. As illustrated in Chart 1, over the past 30 years the number of bank and thrift charters has declined by 58 percent, a loss of more than 11,000 institutions. During this period (as in many others throughout history), the demise of the community bank business model has been prognosticated by many.
4Q 1979 - 1Q 2010
Indeed, over the last decade, some 4,000 community bank-sized organizations have merged, failed or outgrown their community bank status. However, during this same period about one-third have been replaced by a new (de novo) bank charter. Further, since the onset of the financial crisis in 2007, we've seen more than 276 banks fail; 220 of them (or 80 percent) were community banks. By most estimates, this episode of bank failures is not over, and it is expected that we will see an even further decline in the number of community banks in the U.S. in the next few years.
So, what do these numbers imply for the future of community banking? To begin answering this question, it's important to first define what is meant by the term "community bank." Typically a community bank conducts its business within a limited geographic area, is primarily retail-funded and has its decision makers locally based. A high level of personal service is another trait of a community bank. Commonly, banks under $1 billion in assets possess most of these characteristics; thus, for simplification, $1 billion or less in assets is considered our proxy of a community bank for the purpose of this analysis.
As a percentage of industry charters, community banks still represent 92 percent of all charters, but this is down from 96 percent a decade ago. And within our definition of a community bank, those with assets of $500 million or less outnumber banks with between $500 million and $1 billion in assets by a ratio of 10 to 1. As a portion of industry assets, the declining trend is more pronounced: Over the last ten years, community bank assets have grown rather modestly and lagged overall economic growth. By comparison, the nominal compound annual growth rate of aggregate community bank assets is 1.75 percent, compared with the nominal compound annual growth rate of the overall economy of 3.9 percent. While community banks hold a seemingly impressive $1.5 trillion of assets, this is only 10 percent of industry assets today, as highlighted in Chart 2. A decade ago, community banks represented 18 percent of industry assets.
Community banks have traditionally been an important provider of credit to small businesses. During the financial crisis, banks with less than $1 billion in total assets generally maintained their small-business loan volumes (as a percentage of total loans) compared with larger banks. For example, from June 30, 2009, to June 30, 2010, small banks on average saw virtually no change in their ratio of small-business loans to total loans (24.85 percent to 24.86 percent) while larger banks experienced a decline (7.02 percent to 6.63 percent). Small businesses arguably foster economic growth, and thus, their ability to find credit today and in the future is of consequence. Community banks have a comparative advantage in providing credit to small businesses, particularly in their ability to properly assess "informationally opaque" borrowers due to their knowledge of local conditions. Their focus on relationship-based lending prevents borrowers without histories suitable for credit-scored lending models from being completely cut out of the credit markets. This advantage is mutually beneficial.
An examination of Call Report data shows that the loss experience and yields on commercial and industrial (C&I) loans at community banks outperform those experienced at larger banks. For example, C&I yields for banks with less than $1 billion in total assets was 6.25 percent as of June 30, 2010, while yields at banks with more than $1 billion in total assets was 4.36 percent. While this is in line with what one would expect since community banks are dealing with more "opaque" borrowers (and should be able to achieve higher yields as a result), it is interesting that C&I loss rates for smaller banks were 1.32 percent as of June 30, 2010, while loss rates at the larger institutions were 1.96 percent. During the most recent recession, we've again seen how important relationship lending continues to be for many small businesses. For well-run and efficient small banks throughout the U.S., there will arguably always be a demand for their products and services as the need for credit cannot solely be allocated based on "hard credit data."
Despite continued demand for the products and services offered by community banks, technology and regulatory costs and standardized loan products have hurt their market share and profitability. Because community banks lack scale, technology and regulatory costs are spread across a smaller customer base. Also, standardized consumer, small-business and mortgage loans programs offered by larger market participants are less profitable in the low-scale community bank environment. Over the past decade, these factors have contributed to community banks seeking revenue in other more risky asset classes, such as commercial real estate loans. A look at the material loss reviews of failed banks (issued by their respective agency inspector general offices during this current episode of bank failures) suggests that CRE (commercial real estate) concentrations developed and proved disastrous for many community banks during the economic downturn.
So, how does the community bank model thrive? The most direct approach is to drive more efficiency into core business lines. This strategy has the advantage of staying within a community bank's proven areas of expertise. According to a 2007 study by St. Louis Fed, the most important driver of high earnings in small banks is control of operating expenses, followed by a high ratio of good quality and attractively yielding loans-to-assets. Of less importance is the percentage of core deposits.
A less proven strategy is to seek out new strategic businesses and sources of revenue. As with any new risk-taking endeavor, however, a risk management process should be in place to provide proper oversight. And finally, economic conditions matter. Stagnant local economic conditions and low population growth test the viability of the community bank business model. Under such conditions, community banks may experience returns, which are less than their cost of capital. In some instances, finding a merger partner may be the best alternative.
Financial innovation over the last 30 years has changed the complexion of banking. Made possible by advances in technology, innovations such as money market mutual funds, junk bonds, commercial paper, securitizations and the development of a shadow banking system, have provided a greater array of nonbank alternatives to consumers and the direct access to the capital markets for many commercial firms. Over time, this has changed the revenue and funding structure of all banks. However, for some community banks, the costs and risks to adapt to these changes were too high. Many found strategic partners.
Community banks that exist today have evolved in many ways—some by reducing operating costs, others by finding new sources of revenues. While opportunities will always exist for well-run and efficient community banks, many still need to evolve. As the banking industry continues to adjust from the fallout of the financial crisis, it seems likely that some of the consolidation currently taking place will continue for at least the next few years.
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