2004 Annual Report

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Community Banks At Their Best: Serving Local Financial Needs

As the population of community banks continues to decline, some worry that this most traditional of U.S. financial institutions might no longer be viable. But a careful look at the data doesn't square with a path to extinction. Instead, the evidence suggests a process of natural selection in which well-run community banks will thrive.

By Robert DeYoung
Senior Economist and Economic Advisor

Large banks are everywhere. You've paid them more attention lately, especially since they set up shop in your town by buying local banks and changing the signs. They advertise during all the football games you watch on television, and some of the arenas are even named after them. And they always seem to be opening new branches — near your office, in your supermarket, and next to your shopping mall. In fact, following the lead of several tony Chicago suburbs, your town council is considering an ordinance that would ban any new bank branches from opening on Main Street.

But there are still small banks in your town. One community bank has been there as long as you can remember. You don't need a TV commercial to remind you, because you've driven or walked past it nearly every day of your life. It's where your parents took you to open your first savings account, and where you received the mortgage to buy your first home.

It finances your neighbor's business and your brother's farm, and it manages your parents' retirement investments. No one would dream of banning this bank from Main Street.

What is a Community Bank?
The word "community" infers a smallness and a connectedness — but a separateness as well. From Webster's Dictionary, a community is "a group of people with a common characteristic or interest living together within a larger society." Community banks serve the financial needs of community residents - local businesses and households - so that they can make their own unique contributions to the larger economy.

A community bank is a nexus of financial, human, and social capital not easily described in purely quantitative terms. Chiefly important is its local focus. Its owners and its managers have a personal economic stake in the local economy. Its competitive advantage derives directly from its first-hand knowledge of the people, businesses, and institutions driving the local economy.

To some, the community bank is a manifestation of the Jeffersonian ideal of local economic power, self-employment, and reinvesting local savings in local businesses. In less grand terms, community banks meet the financial needs of local business people, greet their depositors by name, and carry a more-than-fair share of civic responsibilities.

The customers served by community banks typically share a common geography - a suburban town, a rural county, or an urban neighborhood. Because these communities tend to be small in economic terms, so too are the community banks that serve them. But although the households and businesses in these communities share a number of common characteristics, their financial needs can differ from each other in subtle ways. A community bank prospers by focusing on the differences of customers within these towns, suburbs, and neighborhoods.

On a dollar-for-dollar basis, community banks make nearly three times as many small business loans as the typical large banking company, and they rely more than twice as much on small deposit accounts for funding. These are long-run economic relationships - community banks do not sell-off the loans they make to local businesses, and they consider their depositors to be permanent customers, not just sources of funds. To make this banking approach work, community bankers invest in a portfolio of local information - gathered by living in these neighborhoods, frequenting the local businesses, and participating in community events and institutions - and this information allows them to better understand the idiosyncratic financial needs of their customers.

By contrast, large retail banking companies are high-volume operations that focus on the similarities of customers across towns, suburbs, and neighborhoods. Economies of scale allow large banks to efficiently market, produce, and distribute standardized financial services - such as credit cards, securitized home mortgages, retail stock brokerage, and widespread ATM access - to banking customers across multiple towns, cities, and states.

Even after adjusting for bank size, the typical large banking company holds twice as many consumer loans as community banks - and unlike community banks, it uses these assets to generate fee income (origination fees, servicing fees) rather than interest income, eventually selling off these loans rather than holding them as investments. Compared with community banks, large banks are four times as likely to finance their investments with overnight funds, are more than twice as reliant on fee income, and spend three times more on advertising and marketing.

This mass retail strategy - similar to that used for decades by non-financial consumer product companies - has only recently become accessible to banking companies, due to deregulation and innovations in financial markets and information processing. It is a remarkably efficient approach to providing financial services, but it can grind to a halt if it tries to account for the differences among individual customers.

A Shrinking Population of Community Banks
A general rule of thumb defines community banks as those with less than $1 billion in assets. There are approximately 7,000 such community commercial banks in the U.S. today, and they account for about 95% of the total number of U.S. commercial banks.

This is a substantial number of banks: approximately one community bank for every 40,000 U.S. citizens, a much higher multiple than in most other western economies. But compared with our recent past, this is a very small number of community banks: The population of U.S. community banks has been cut in half since 1985, when they numbered nearly 14,000. This huge decline would be a small issue if community banks' market share had held steady, but it has not. The share of U.S. banking assets held by community banks has declined in near lockstep with their dropping numbers, from slightly more than 30% in the mid-1980s to only about 15% today.

Here in the upper Midwest, economic and regulatory conditions have traditionally been very hospitable for community banks. For instance, the Seventh Federal Reserve District (all of Iowa and most of Illinois, Indiana, Wisconsin and Michigan) is one of 12 Federal Reserve Districts, but it is currently home to about one in every six community banks. But the trend of reduction here has been just as strong - the number of community banks in the Seventh District has fallen from about 2,600 in 1985 to only about 1,300 today.

Why has the number of community banks plummeted? And are these trends likely to continue? More directly, what do these numbers imply for the financial viability of the community bank business model? The most illuminating way to approach these questions, perhaps, is not to ask why so many community banks disappeared in recent years - but rather, why were there so many community banks in the U.S. in the first place?

A Less Hospitable Landscape
The U.S. is a vast nation, with clusters of economic activity separated by wide geographic spaces. And America has a long history of local political and economic control - as evidenced by the powers held by the 50 state governments to grant local banking charters. In such a world - especially before advances in information and communications technologies allowed financial information to travel instantly across these wide spaces - it is not surprising that the economic infrastructures in the U.S. would in many ways be local ones, and would feature large numbers of community banks.

Federal and state regulations traditionally protected these local financial institutions from competition. The McFadden Act of 1927 prohibited rival banking companies from crossing state borders to compete with one another, and in many states banks were prohibited from crossing even county borders. The Federal Reserve's Regulation Q limited the rates that banks could pay to attract depositors, further reducing competition. And the Glass-Steagall Act of 1933 prohibited commercial banks from engaging in the activities of investment banks, securities firms, and insurance companies (and vice versa), further insulating commercial banks from competition.

This was a fabulous world for community bankers. Protected from competition, they could earn strong profits. Or alternatively, they could choose to earn satisfactory profits and simply lead a quiet life.

This environment kept the price of financial services artificially high, reduced banks' incentives to innovate, and bred a population of community bankers largely inexperienced with competitive rivalry. When state and federal regulatory protections were dismantled in the 1980s and 1990s, community banks began to disappear. Aggressive banking companies starved for growth began to move across state borders, and the fastest channel for growth was to acquire existing community banks.

Inefficient and poorly run community banks made especially attractive acquisition candidates. If a community bank could not flourish under the new competitive conditions, it could be purchased for a relatively low price. As an economist would say, these banks had a low opportunity cost for their capital. Consistent with this, about 95% of the nearly 1,500 commercial banks that failed during the 1980s and 1990s have been community banks, further testimony to the inefficiencies bred by years of regulatory protection.

Viewed in this historical context, the recent decline in the number and market share of community banks isn't necessarily a sign that community banks can't be competitive in the future - instead, these changes may simply mark a transformation to a new industry equilibrium. Artificial regulatory barriers had supported an over-populated and inefficient community banking sector, and removing those barriers is allowing the industry to move toward a more 'normal' and efficient structure.

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