Community Banks: Descriptions, Characteristics, and Outcomes

Executive Summary

Community bankers manage a small share of the banking system; nevertheless, they provide valuable services to farmers, consumers, and small business owners (Hoenig 5).  Joe Ricketts, the founder of TD Ameritrade, thinks that community banks prosper with less regulation. They will provide entrepreneurial capital--leading to more jobs, improving the economy (Ricketts A-15).  Since well-run community banks provide unique products and services,   continuation appears certain with probable help coming soon in the form of relief from regulatory overkill by Dodd-Frank regulations of capital requirements and mortgages.  The following sections will review research findings under the general themes of descriptions, characteristics, and outcomes.  The final section concludes.

Descriptions

Characteristics

Bank managers constitute the linchpin for increasing profitability by recognizing the available factors which lead to profitability for their banks (Amel and Prager 179).  Looking at positive factors the authors find “that bank size is significantly positively related to profitability” (168).  Other determinants are selection of S-corporations for taxation, less reliance on brokered deposits, wise composition of loan portfolios, and fewer shifts in the types of loans within portfolios (Amel and Prager 168-171).  Local board members of community banks approve loans based upon their personal knowledge of customers, and they are “part of the rich ethos of community banking” (Lux and Greene 3).  Community bank officers and directors support local charities and often lead these charities by serving as officers and on the boards (Wilmarth 289-290).  In short, the Gilbert, Meyer, and Fuchs aver: “thriving banks benefit from strong communities and community relationships, conservative underwriting, and good product structure” (125, 128-131).

Outcomes

The different researchers highlight reasons for safeguarding the survival of community banks in the United States.  Fogel, Kali, and Yeager find “an inverse relationship between community bank presence in a given county and home foreclosure rates” (2509).  The authors regard their study as proof that community banks make prudent home loans, with fewer foreclosures as the evidence (Fogel, Kali, and Yeager 2500).  Hein, Koch, and MacDonald believe community bankers “process information differently than managers of larger banks” giving them tools to overcome negative factors such as concentration of loans, regulatory authoritarianism, and technological shortcomings (16-18).  Amel and Prager find “that community bank profitability is affected by a number of factors such as “local economic conditions” (151) that are “outside of the control of banks’ management”; for examples, “per capita income, the unemployment rate, and the share of deposits that are held by other community banks” (168).  

Hoenig, former senior officer with the Federal Reserve Bank of Kansas City who served there for thirty-eight years, believes “community banks that are well-managed, equipped with appropriate technologies, and located in viable communities should be able to hold their own against other financial services providers” (9).  Backup and Brown declare that on average community banks exhibit stability, survive despite their usually lower economies of scale, and continue as they have after “more than 30 years of industry consolidation” to provide vital bank services to small businesses and the “communities that might not be served by noncommunity banks” (37, 42-43). Lux and Greene warn policymakers about the “acceleration of banking sector consolidation,” and the negative effects upon the positive services community banks perform for the economy (27).  So the authors promote these actions: (1) “reform the regulatory process to mitigate unintended consequences”; (2) “improve existing regulations”; and (3) expand community banks’ regulatory exemptions” (Lux and Greene 27-31).

Conclusions

I. The Banking System

Hein, Scott E., Timothy W. Koch, and S. Scott MacDonald. “On the Uniqueness of Community Banks.”  Economic Review, Federal Reserve Bank of Atlanta, First Quarter, 2005, pp. 15-36.

Hein, Koch, and MacDonald “explore differences between community banks” and their larger brethren (17).  They point out that community banks are relationship oriented and “focus their activities on local communities” (16) while larger banks are transaction oriented (20).  Sometimes community banks enjoy almost monopolistic relationship advantages--especially in rural areas (20).  Therefore, community bankers conduct more business via “human interaction at higher unit cost” (20).  However, community bank managers often make savvy lending decisions “because they have an information advantage relative to the larger banks” (28).   Small banks enjoy a niche (19), and primarily make loans to small and medium size businesses, consumers, and agricultural customers, being more reliant on net interest margins and stable core deposits (25).  The authors believe community banks can flourish by placing emphasis on long-term relationships, accessing funding from Federal Home Loan Banks, receiving government guarantees on agricultural loans, and using S corporation elections for income taxation (17).  Yet community banks face impediments to success: “excessive concentration of risk in lending,” competition pressure from nonbanks due to deregulation, new expensive technology upgrades, “limitations on market power and brand recognition” (16).  Indeed, critics argue that community banks typically have greater credit risk because of limited geographic diversification (32). However, during the credit crisis debacle of 2008 these banks with less than one billion dollars in total assets (16) fared better on average than large banks (35). The authors point out that generally community banks that have strived to increase noninterest income--generating fees--have encountered a “poor risk-return trade-off in developing many of these lines of business” (21-22) with slim transaction margins.  The authors predict more consolidation as large banks endeavor to expand their economies of scale and scope as these strategies ultimately reduce operating expenses in a transaction orientation (20).

DeYoung, Robert, William C. Hunter, and Gregory F. Udell.  “The Past, Present, and Probable Future for Community Banks.”  Journal of Financial Services Research, vol. 25, issue 2-3, 2004, pp. 85-133.

DeYoung, Hunter, and Udell examine some vital statistics, characteristics, and laws affecting the nation’s community banks. They contend that the “number and market share of community banks have approximately halved since 1980” (85).  After the passage of the Riegle-Neal Interstate Banking and Branching Act in 1994 most mergers involved two community banks (96).   After mergers they “occupy the same strategic ground” (110) which involve lending to small businesses subject to their “legal lending limits” imposed by their capital levels (91).  The Glass-Steagall Act of 1933 separated commercial banking as a highly regulated industry from investment banks, insurance companies, and brokerage firms (88). Congress passed the “Graham-Leach-Bliley Act in 1999 which effectively repealed the Glass-Steagall Act” (96).  Furthermore, the Garn-St. Germain Depository Institutions Act of 1982 allowed thrift institutions to make commercial loans even though these savings and loan firms lacked the expertise (93).  These changes in banking laws removed any “comfort zone” heretofore existing for community banks (91-92). The authors find support in the literature showing community banks possess expertise in “processing soft information and extending relationship loans” (106).  Thus, these small firms are “differentiated by their “high value-added strategy’” (110). Nevertheless, empirical evidence does not show such relational strategies as giving community banks an advantage over larger banks in private banking services to high net worth individuals and family offices (110 at footnote 40).  The authors state that developing a local focus depends on “local media and word of mouth, but ironically, large banks spend more money to get noticed” (116).  Founding control groups continue to believe in the community bank model since over “4,000 de novo banks” have been chartered in the last twenty years (119).  The authors believe the data indicates that the “smallest community banks (less than $100 million in assets) have to be extremely well-run to earn returns comparable to larger community banks” (122).

Wright, Robert E.  “Community, Mega, and Goldilocks Banks in U.S. History.”  Augustana College-Division of Social Sciences.  Available at ssrn.com/abstract=362640, March 18, 2015, pp. 1-37.

Wright describes how community banks have survived economic calamities beginning with the Great Depression (1).  He aptly points out how urbanized most Americans are and what it takes for larger banks to prosper in smaller communities: he believes, “can still behave as if they were community banks if they retain a community banking ethos based on fairness” (11-12).   Researchers pronounce the largest banks as the ones that sought required government assistance during the financial crisis of 2008-2009.  Accordingly, the author states, “the biggest bank holding companies [ . . . ] were also those most in need of government assistance during he panicked months at the end of 2008” (15).  Wright wonders about why mega banks with their immense size and complexity caused so much “bad (meaning both ‘evil’ and ‘poor’) banking behavior” (15).  He blames some of this malfeasance on governance which he denotes as inadequate supervision of and incentives for line managers working for the largest banks (16).  In short, and arguably too simple an explanation,  Wright thinks the senior managers at the largest banks during the crisis were too far removed while in the community banks the directors and officers knew what their employees did and furthermore, knew how to appropriately reward their work ethic.  “The more complex an organization is, the more likely it is to attract the attention of shysters and those bent on self-aggrandizement at all costs,” asserts the author (17).  The author believes that rogue banks should be fined based upon a “multiple of profits gained by the illicit activities” (32).  He also does not think the largest banks are warranted on account of their “efficiency grounds alone” (30) which oftentimes do not exceed those of community banks.  In his summary, he eschews the status quo which he describes as “goldilocks banks” [large, complex financial institutions] that do not function fairly as community banks do; and regulators should break up the “worst offenders” (32).

Cole, Rebel A., Lawrence G. Goldberg, and Lawrence J. White.  “Cookie Cutter vs. Character: The Micro Structure of Small Business Lending by Large and Small Banks.”  Journal of Financial and Quantitative Analysis, vol. 39, no. 2, June 2004, pp. 227-251.

Cole, Goldberg and White contend that relationships are more important for small banks than large banks because large banks rely more on “organizational and operational differences” (229).  The authors say large banks use a “cookie-cutter approach” wherein their loan officers base loan decisions upon “standardized quantitative criteria” (228), also called “formal numbers-based criteria” (249).  But their results do not show that loan applicants necessarily believe that small banks use mostly character evidence when approving loans (240) which means these bankers use a “more discretionary approach” (249). The research results imply that “small banks, but not large banks, are more likely to extend credit to firms with which they had pre-existing deposit relationships and are less likely to extend credit to firms with which they had pre-existing loan relationships” (249).  Therefore, rural loan applicants are inclined to make their loan applications at small rural banks because the applicants do not want their decisions made in a regional bank office (241).  “Large banks employ a cookie-cutter approach to small business lending to control for agency problems and to maintain consistent loan standards,” the researchers’ evidence proves (249).  On the other hand, the authors state that small banks encounter “less severe agency problems and are likely to have superior knowledge about their customers” (249).  Additional finding are: “small banks are less likely to extend credit to firms asking for larger loan amounts,” and both large and small banks appear to favor loan applications from firms in different lines of business . [ . . . ]” (249).

Gilbert, R. Alton, Andrew P. Meyer, and James W. Fuchs.  “The Future of Community Banks: Lessons from Banks That Thrived During the Recent Financial Crisis.”  Federal Reserve Bank of St. Louis Review, March/April 2013, pp. 115-143.

Gilbert, Meyer, and Fuchs report on a survey by the Federal Reserve bank in St. Louis that differentiated community banks, finding why some thrived while others languished (116).  The bank managers of “thriving banks” held fast to conservative lending principles, receiving excellent ratings  for the “M” portion of the CAMELS protocol, used by regulators (116-117).  The authors find that managers of thriving banks adapt readily to the market conditions in their trade areas (116).  These authors used an asset size for community banks of under $10 billion in assets (116).  “The secret to operating a thriving community bank does not necessarily involve keeping total assets within a certain size range,” acknowledge the authors (118).  They also note from the surveys that “surviving” banks and thriving banks treat potential customers with equanimity (122). In their Tables 6 and 7 (123-124) the authors present ratios comparing thriving banks to surviving banks.  Obviously, as the writers emphasize, the successes by thriving banks results in significant measures from local economic conditions coupled with the quality of management and directors (125).  From analyses of Tables 6 and 7, thriving banks maintain high levels of “core deposits to total deposits and relatively low ratios of loans to assets” (125, 130).  The survey did not indicate “a relatively high ratio of interest income to total assets” as a characteristic of thriving banks (132).  The thriving banks realize low operating expenses (136).  These successful bankers were “able to successfully manage the risks inherent in CRE lending” (136).  Successful bankers acknowledge a vital link to responsive, good customer service (126). In short, the authors aver: “thriving banks benefit from strong communities and community relationships, conservative underwriting, and good product structure” (125).  The authors in this paper offer proof from interviews with bank officers that the community banking model is not dead, and continues as a viable financial institution.  

II. Regulatory Structure of the Banking Sector

Wilmarth, Arthur E., Jr. “A Two-tiered System of Regulation is Needed to Preserve the Viability of Community Banks and Reduce the Risks of Megabanks.”  Michigan State Law Review, vol. 249, 2015, pp. 249-370.

Wilmarth, a law professor, in this expansive law review article reports on bank mergers after the financial crisis, the government’s response to the crisis, passage of the Dodd-Frank Act, and the post-crisis viability of community banks without ameliorative regulatory changes.  Federal regulators as a result of the crisis treated community banks and mega banks differently (274); for example, “federal regulators guaranteed the survival of the nineteen largest banks but stood by while more than 450 community banks failed between 2008 and 2012” (275).  During the crisis the U.S. Treasury was more stringent in its evaluation of capital requests by community banks (269).  The author insists that the “Fed’s monetary policy since 2008 has benefited big banks while hurting community banks” (257).  “The Dodd-Frank and Basel III capital accords have imposed costly compliance requirements on community banks,” notes the author (277).  Traditionally, community banks do not securitize home and commercial real estate mortgages so they incurred large losses to these assets which remained on their balance sheets during the crisis (278).  Dodd-Frank requires “higher capital charges” and “new mortgage rules” causing some community banks to curtail or abandon their booking of real estate loans (287).  Wilmarth thinks community banks are a national priority: small businesses account for one-half of private sector jobs and output (288) and community banks “provide about half of all bank credit extended to small businesses, even though community banks hold less than one-fifth of the banking industry’s assets” (289); bank managers and directors support local charitable organizations and hold key leadership positions in the organizations (289-290); and “more than one-third of U.S. counties  [. . . ] have very limited physical access to mainstream banking services without the presence of community banks” (290).  Therefore, the author argues “a two-tiered system of regulation is needed to maintain a healthy community banking sector and eliminate the TBTF [too-big-to-fail] subsidy for megabanks” (340).  He predicts that “without changes, Dodd-Frank will further weaken the community bank sector, accelerate the ongoing consolidation of our banking industry, and enable megabanks to exercise even greater influence over our political and regulatory systems” (368).

Marsh, Tanya D. and Joseph W. Norman.  “The Impact of Dodd-Frank on Community Banks.” American Enterprise Institute, Available at ssrn.com/abstract=2302392, May 2013, pp. 1-51.

March and Norman opine that community banks “barely resemble their too-big-to-fail [TBTF] cousins” (4).  Arguably, community banking practices have not changed drastically in the last one hundred years.  During the last credit crisis of 2008-2009 community banks barely participated in the securitization of subprime residential mortgages (5, 25).  “A mere 7.6 percent of banks currently hold about 86 percent of all banking assets in the United States,” (7) and “community banks constituted 92.4 percent of chartered banking organizations in the United States,” (9) report the authors.  The authors emphasize: “half of U.S. GDP comes from small businesses and half of small businesses have loans outstanding to community banks” (12).  Community banks provide financing for commercial real estate projects and farmland in outlying areas where their TBTF competitors prefer to abstain (15-17).  The federal regulators have wide discretion in their oversight under the Dodd-Frank Act of 2010 (28-29).  “The approach of Dodd-Frank in identifying these ‘systemically important’ companies has led to concern that the act inadvertently grants a competitive advantage to those institutions, claim Marsh and Norman (29).  Additionally, Basel III standards on capital requirements apply to banks of all sizes (24).  Community banks endure higher compliance costs as they grapple with the vagaries of Dodd-Frank with its sweeping mandates (33).  Dodd-Frank created the Consumer Financial Protection Bureau to protect consumers with its czar subject to control by the Federal Reserve rather than Congress (33-35).  These laws and regulations lessen profits and returns on equity for community banks because they are hampered by mortgage lending reforms, increased data accumulations, and reporting requirements (36).  Large bank holding companies reflect these compliance costs down to subsidiaries, incrementally representing small increases to their operating expenses; whereas community banks incur compliance costs for “staff, technology, lawyers, and consultants” which clearly impact their balance sheets (38).  The authors insist these regulations promote standardization (39); the community bank model based upon “personal knowledge of a customer’s financial situation and local business conditions” flounders (11).  Also, small banks do not have the economies of scale to absorb added regulatory costs (39).  Customers in marginal areas may lose access to credit because they do not fit into the standardization mold (40).  Therefore, the authors believe a two-tiered system of regulation will help safeguard the viability of community banks, providing small businesses with capital they need for providing jobs in towns and rural communities (40).

Lux, Marshall and Robert Greene.  “The State and Fate of Community Banking.”  Harvard-Kennedy School, Mossavar-Rahami Center for Business and Government, M-RCBG Associate Working Paper Series,  No. 37, February 2015, pp. 1-31.

Lux and Greene say community banks have lost market share at twice the rate that they lost it during the financial crisis (31). They raise questions about this loss of market share because “community banks provide 77 percent of agricultural loans and over 50 percent of small business loans” (2). “Overall, community banks also make up a disproportionately large share 46%-of commercial real estate lending market,” report the authors (11). Alarmingly, for community banks, since 1994 their share of the U.S. lending market has fallen “approximately half-from 41 percent to 22 percent-while the top five banks’ share has more than doubled from 17 percent to 41 percent” (14).  They quote a small North Carolina banker who told the Wall Street Journal, “When it created ‘too big to fail,’ they also created ‘too small to succeed.’” (3)  The writers reference a picket of regulatory laws- a flawed playing field for different sizes of banks (3).  Larger banks may deploy more sophisticated technology, but this does not necessarily “substitute for the skills, knowledge, and interpersonal competencies of many traditional community banks” (5).  The Dodd-Frank Act was headlined as legislation that would dismantle the too-big-to-fail moral hazard dilemma for the mega banks (21). Larger banks can handle the costs and navigate the broader regulatory burdens better when compared to smaller banks (21).  The authors note the Mercatus Center survey at George Mason University which “reported that 83% of small banks believe compliance costs have increased at least 5 percent since the passage of Dodd-Frank” (24).  The authors warn policymakers about the “acceleration of banking sector consolidation,” and the negative effects upon the positive services community banks perform for the economy (27).  So the authors promote these actions:   (1) “reform the regulatory process to mitigate unintended consequences”;       (2) “improve existing regulations”; and (3) expand community banks’ regulatory exemptions” (27-31). And policymakers, they argue, should review capital rules as these rules apply to community banks, and consider possible exemptions for community banks to some of the capital rules (31).        

III. Characteristics Based Upon Bank Size

Berger, Allen N. and Lamont K. Black.  “Bank Size, Lending Technologies, and Small Business Finance.”  Journal of Banking & Finance, vol. 35, 2011, pp. 724-735.

Berger and Black delineate the comparative advantages of small and large banks.  They follow customary results finding that large banks are best at “transactions-based lending” and small banks excel at “soft-information technologies” (725).  The large banks vary in their hard lending technologies without set trends as the size of bank assets increases (725). Large banks appear to have different comparative advantages in each of the fixed-asset lending technologies [. . .], they report (725).  With respect to small banks, the authors believe their relationship advantage “seems to be strongest for lending to the largest firms” (725).  “Our results suggest that large banks have a clear superiority in leasing relative to other fixed-asset lending technologies” state the researchers (735). Their empirical results do not support the paradigm that large banks always excel over small banks regarding “hard-information technologies” (735).  They believe “credit-scoring” has reduced the value of relationships between small bank managers and their smallest customers (735).  Their results suggest that “large banks may have a comparative advantage in lending to smaller firms using certain hard-information technologies such as fixed-asset lending” (735).  These results therefore imply that smaller firms will have their loan requests addressed even after small banks continue to disappear due to industry consolidation (735).  Importantly, the authors find “that banks over $1 billion in assets make about 60% of all small business loans” (724).

Berger, Allen N., William Goulding, and Tara Rice.  “Do Small Businesses Still Prefer Community Banks?”  FRB International Finance Discussion Paper No. 1096. Available at ssrn.com/abstract=249812, December 2013,   pp. 1-25.

Berger, Goulding, and Rice claim this paper is the “first to use these data [2003 Survey of Small Business Finance] to test role of bank type-small versus large, single-market versus multimarket, and local versus nonlocal banks-in banking relationships” (10). The authors test as follows: “the type of bank serving as the main relationship bank identified by small business,” (3) and the strength and longevity of the relationship based upon the “main bank type and its financial fragility, as well as firm, owner, and market characteristics,” (4).  They claim the literature suggests that “small banks are better able to form strong relationships with informationally opaque firms” because it is more difficult to “quantify and transmit through the communication channels and layers of management of large organizations” (1).  The authors expect “large, multimarket, nonlocal institutions would tend to serve more transparent firms” (1).  The authors also acknowledge previous research that maintains that large banks can sometime serve opaque small businesses using credit scoring and other “hard-information techniques” (2). However, large banks with many branches have been able to attract core deposits from small businesses which can be used to make loans to these customers (2).  Further empirical studies “find benefits to borrowers from strong relationships,” note the authors (5).  Yet, the authors claim that exclusive banking relationships may “give the bank market power over the firm, yielding a hold up problem and extraction of rents from the firm.” (6). The authors state that consolidation of banks will shift the roles traditionally performed by small banks to large banks (8-9). “Mergers and acquisitions (M&As) within markets likely reduces competitiveness and M&As across markets likely increase competitiveness,” assert the authors (9). Small businesses may incur costs when required to use multiple banks to satisfy their needs (6).  However, the large banks are more likely to close branches and “cut off credit than small, single-market, and local institutions” (7).  They find that “opaque small businesses are not more likely to have a community bank as their main bank” and “the evidence is clearer that strength [of relationship] does not depend on the type of bank” (17).

Jagtiani, Julapa and Catharine Lemieux.  “Small Business Lending: Challenges and Opportunities for Community Banks.”  Research Department, Reserve Bank of Philadelphia, Working Paper 16-08. Available at ssrn.com/abstract=2752863, March 2016, pp. 1-53.

Jagtiani and Lemieux report that large banks have increased “their share of small business lending [SBL] over the past decade” (6).  After the crisis large banks aided by more technology than smaller rival banks, and even some nonbank competitors, frequently called upon “smaller commercial borrowers,” hoping to earn larger credit spreads during a low interest rate environment after 2008 (2).  Small businesses had used equities in owned real estate to “fund their business, exposing them to the eventual mortgage crisis” (6).  “Regardless of whether the data are unadjusted, inflation adjusted, or adjusted for asset size, the decline in SBL by smaller banks is evident,” the authors state (9).  Many nonbank lenders favor credit approaches such as a “faster application process, use of alternative data, and reduced collateral requirements” (14).  In fact, the authors point out, “the number of counties where small banks made more than 80% of all the SBL [. . .] fell by more than 70% between 1997 and 2013” (10).  Some community banks partner with nonbanks especially when nonbanks offer services which they cannot provide (20).  The authors believe the larger banks and nonbanks provide credit when community banks cannot because these competitors use technology to obtain “alternative information sources to judge creditworthiness” (20-21).  These alternative lenders may give credit decisions quicker than community banks by using automated, online credit applications, with less financial documentation (21-22).  Therefore, large banks and nonbanks exemplify strong competition to community banks as the smaller banks try to retain their market shares (21).  Some community bankers recognize the inevitability of nonbank and larger bank competitors so they form “formal partnerships and alliances” (22).  

IV. Other Attributes of Community Banks

Tomy, Rimmy E.  “Competition and the Use of Discretion in Financial Reporting Evidence from Community Banks.”  The University of Chicago Booth School of Business.  Available at ssrn.com/abstract=2903918, January 25, 2017, pp. 1-57.

Tomy explores some differences between publicly-owned and privately-held community banks as well as aspects applicable to both types. He states that over “80% of the revenue of a community bank consists of net interest income” (3).  Interestingly, his research indicates that some community banks may increase their loan loss reserves in order to discourage competitors from entering their trade areas (4).  In fact, “publicly-listed banks increase their provisions to a greater extent in the face of an increased threat of competition,” Tomy asserts (5).  He also found that bank managers increase loan loss provisions more when they are “located nearer to the regulators’ offices” (6).  The deregulation of branch banking increased the threat of outside competition from an array of financial institutions (8).  The author finds that competitors prefer to enter a trade area with profitable banks, gleaning information from public financial statements (9).  Therefore, some bank owners use discretion over loan loss reserves to bias their results downward; and “in more dispersed markets, the financial statement of each incumbent bank conveys less information about the underlying market conditions” (10) making such efforts more opaque.  The author finds that “loan growth is positively and significantly associated with loan loss provisions” and “change in state level per capital GDP is negatively associated with loss provisions” (16).  Additionally, bank managers set their loan loss provisions partly by accounting for what neighboring managers are doing (23).  Accordingly, bank managers evaluate all these reasons when setting reserves for loan losses in addition to the basic reason of unfortunately owing non-performing loans (25).

Backup, Benjamin R. and Richard A. Brown.  “Community Banks Remain Resilient Amid Industry Consolidation.”  FDIC Quarterly, vol. 8, no. 2, 2014, pp. 33-43.

Backup and Brown specify their key finding to be “that institutions with assets between $100 million and $10 billion-most of which can be considered community banks-have increased in both number and in total assets since 1985” (33).  They relate that the “consolidation of charters with banking companies” (34) left at “year-end 2013, some 68 percent of community bank charters” (37) with the above range of assets.  Notably, these authors have defined community banks as having assets up to 10 billion so they are comfortable in saying, “economies of scale do not appear to be working against the majority of community banks” (37).  These banks are less likely “to rely on the models-based underwriting used by larger banks” (38).  The authors state a common understanding that community banks serve as relationship lenders to small businesses in locations “that are overlooked by larger noncommunity institutions” (33).  Nevertheless, they point out: “While community banks held 37 percent of industry assets in 1985, their share declined to just 14 percent by 2013” (39).  Their data shows that “their rate of total attrition over the last decade was less than half that of noncommunity banks” (40).  They argue that on average the community banks are larger now, and continue to serve “essential banking services to a limited geographic market” (42).  In fact, these banks serve “600 U.S. counties (almost one-fifth of all U.S. counties) that would not have had any physical banking offices [. . .] if not operated by community banks” (42).  Their message emphasizes the continued prosperity of banks with assets between $100 million and $10 billion even after acknowledging full interstate banking and branch banking against a backdrop of “30 years of industry consolidation” (43).

Jacewitz, Stefan and Paul Kupiec. “Community Bank Efficiency and Economics of Scale.”  FDIC Community Banking Study, December 2012, pp.1-26.

Jacewitz and Kupiec show in their analysis that the “asset concentration in the largest noncommunity banks does affect the efficiency performance comparison between community banks and noncommunity banks” (1).  They define a bank’s efficiency as “the ratio of a bank’s non-interest expense to revenues” (1).  Based upon the FDIC Community Banking Study, the authors announce that “community bank efficiency ratios have increased relative to noncommunity banks over the 1974-2011 time period” (1).  With respect to economies of scale the authors did not find “significant scale benefits beyond $500 million in asset size for most lending specializations” (1).  They point out that of the community banks surviving that last twenty-five years “60 percent remain under $200 million and many remain under $100 million in asset size” (1). Few community banks own assets over $1 billion, about “85 percent (4,419 banks) that survived have less than $500 million in assets at year-end 2011” (24).  Here are some more of their findings: (a) “community banks now earn less on their loan portfolios and pay slightly more that noncommunity banks for funding”; (4) (b) community banks also experienced a sizable decline in the ratio of their non-interest income to non-interest expense”; (4) (c) community banks have experienced slower productivity gains (in terms of assets per employee) compared to noncommunity banks”; (6) and (d) community banks still earn a greater average net interest income on loans but the spread advantage has been decreasing over the years (11).  The authors conclude that size and economies of scale apparently do not determine survivability since 60 percent of community banks [. . .] have less than $200 million in assets” (25).

Fogel, Kathy, Raja Kali, and Tim Yeager.  “Have Community Banks Reduced Home Foreclosure Rates?”  Journal of Banking & Finance, vol. 35, 2011, pp. 2498-2509.

Fogel, Kali, and Yeager find “an inverse relationship between community bank presence in a given county and home foreclosure rates” (2509). In their analysis the authors use the traditional definition of community banks as those banks with “less than $1 billion in assets” (2500). Their findings are after “controlling for a host of economic and demographic factors that affect foreclosures” (2499). Factors include “housing market variables, demographic variables, social capital, and bank deregulation,” note the authors (2503).  Thus, community banks originate affordable loans by knowing their customers.  Historically, community banks made residential real estate loans, exhibiting the expertise bolstered by their community associations (2498).  Typically, community banks create the loans, do not securitize, and continue interactions with the borrowers who usually add other bank services (2500).  The authors regard their study as proof that community banks make prudent home loans, with fewer foreclosures as the evidence (2500).  “Assuming the average number of housing units of 40,733 per county, this amounts to approximately 15 fewer foreclosures per county in 2008,” confirm the authors (2505).  They also report “a 31 percentage point increase in the share of deposits held by community banks reduces average foreclosures in a given county by approximately 11 in 2008” (2507). Community bankers are highly regulated and they are “relatively easy to monitor.” (2509). Although the banks typically sell these loans to government sponsored agencies, the sales are customarily made on a recourse basis (2509).  These bankers know their customers-lower foreclosure rates incentivize them-the bankers increase profits by reducing loan loss reserves (2509).

Jagtiani, Julapa.  “The Evolving Role of U.S. Community Banks and Its Impact on Small Business Lending.”  Federal Reserve Bank of Philadelphia, Working Paper No. 14-16, March 13, 2014, pp. 1-35.

Jagtiani explains some of the unique characteristics of community banks that differentiate them from large banks. (6)  She argues that small banks improve local economies when large banks fail to ascertain “the true value” of “borrowers’ projects” (3).  She devotes her paper to the ramifications of mergers on community banks, and she finds as follows: (a) acquisition of small banks may “disrupt relationship lending” (8); community banks usually acquire other community banks via “in-state mergers” (8-9); “based upon the average supervisory ratings [. . .] targets are clearly weaker than the acquirers” and “have resulted in combined banking firms that are healthier financially and more efficient in their operations” (10, 23); the ratings of the consolidated entity usually improve (10); mergers during the financial crisis actually improved the strength of the community banking industry (10); acquiring banks typically had a greater proportion of their loans to small businesses (16); acquiring banks were almost as active as target banks in making small business loans during the “2008-2011 financial downturn” (16); “merger premiums are smaller when the acquiring banks are very large banks (with total assets greater than $10 billion)” (20);  apparently stock market assessment of these mergers revolved around the “deal premiums” (21); fundamentally, the acquired often were rated negatively under “CAMELS” criteria because they were performing poorly (22-23); and small business lending does not appear to be hurt by the mergers, the “larger bank acquirers have tended to step in and play a large role” (23-24).  In summary, the mergers have led to stronger community banks within state lines in that most mergers were closed by community banks acquiring weaker peers (9).  Admittedly, the “number of large banks (with more than $100 billion in total assets) has doubled from six banks in 2001 to 18 banks in 2012” (7); however, these mega banks search for larger target banks than community banks with assets under $1 billion.  Somewhat surprising was her finding about “the share of SBL [small business lending] to U.S. banking assets has become significantly smaller now than over a decade ago (17).

Berger, Allen N., Adrian M. Cowan, and W. Scott Frame.  “The Surprising Use of Credit Scoring in Small Business Lending by Community Banks and the Attendant Effects on Credit Availability, Risk, and Profitability.”  Journal of Financial Services Research, vol. 39, issue 1-2, April 2011,   pp. 1-33.

These writers claim their paper based upon the “2005 survey sponsored by the U.S. Small Business Administration” (3) makes four main contributions to the literature: (a) uses a new survey to assess credit scoring for small business lending by banks with under $1 billion in assets; (b) examines bankers’ call reports to ascertain the effects of credit scoring on loans made to small businesses; (c) analyzes for the first time commercial and industrial loans (C&I) on non-accrual to total C&I loans after credit-scoring the loans; and (d) identifies any effect on profitability from credit-scoring the loans (4-5).  The authors describe credit scoring as “combining personal financial data about the owner of the business with the relatively limited information about the firm using statistical methods to predict future credit performance” (2).  They suggest that “banks that use credit scoring tend to have no more loan performance problems than other banks” (5).  Scoring technology “increases credit availability” for the average bank of the 330 institutions in the 2005 survey (3).  They use survey data on consumer credit scoring and small business credit scoring in conjunction with call reports about nonperforming loans (4).  They find (91% of banks surveyed) that community banks widely use credit scoring (6), and the loan officers rely more on the consumer credit scores when approving loans (12, 18). Community banks use credit scoring to increase their loans to small businesses, and suffer slightly more loan losses at first, but over time the quality of their loan portfolio survives untainted (27).

DeYoung, Robert, W. Scott Frame, Dennis Glennon, and Peter Nigro. “The Information Revolution and Small Business Lending: The Missing Evidence” Federal Reserve Bank of Atlanta, Working Paper Series No. 2010-7. Available at ssrn.com/abstract=1577911, March 1, 2010,        pp. 1-18.

DeYoung et al. using a Small Business Administration sample of 31,880 loans originated from 1984-2001 discover a “strong empirical link between small business credit scoring and borrower-lender distance” (1).  They make three important findings: (a) “borrower-lender distances ere increasing during the 1980s and early 1990s,” and small businesses were usually located within a few miles of their lenders; (b in comparison to an earlier study they find “the annual increases in small business borrower-lender distances have in recent years accelerated substantially”; and (c) they link these most recent increases to a “specific, hard information-based innovation in information technology” now commonly referred to as credit-scoring (12-13).  After controlling for “borrower characteristics, lender characteristics, market conditions, regulatory constraints, moral hazard incentives (lender exploitation of government guarantees), and principal-agent incentive (borrower exploitation of corporate limited liability),” they authors assign “at least half of the post-1993 [ . . .] acceleration in borrower-lender distances to the adoption of small business credit scoring technologies by the lending banks” (1-2).  They find that credit-scoring banks reach out further to make loans, i.e. “the average loan made by a scoring bank was 52.5 miles more distant than the average loan made by a non-scoring bank, ceteris paribus” (8).  The authors additionally find “lending to opaque business borrowers based on soft information and bank-borrower relationships are made more efficient by advances in information, communication, and other technologies” (13).  From the standpoint of moral hazard “larger government loan guarantees make lenders more willing to lend to especially information-poor borrowers,” assert the authors (13).    Besides the majority effect of credit scoring on increased lender distances from borrowers, the authors find empirically that “cross-sectional differences in borrower, lender, and market characteristics are important determinants of small business borrower-lender distances” (13).

McKee, Gregory and Albert Kagan.  “Community Bank Structure an X-efficiency Approach.”  Review of Quantitative Finance and Accounting, Available at https://doi.org/10.1007/s11156-017-0662-9, 28 August 2017, pp.1-23.

McKee and Kagan investigate the effects of asset sizes of community banks to “macroeconomic and regulatory changes” and well as the implications “with respect to the ability of community banks to preserve market viability” (6).  The authors find unsurprisingly that the quality of managers to assess macroeconomic and internal attributes will determine how well their banks perform (3).  The authors seek answers to what appears on the horizon for community banks, considering their dwindling number, declining revenues and profits, growth of loans to deposits, and lower deposits (7-9).  The authors opine that bank size “preserves the conceptual rationale of the relationship bank” (9).  They find “x-efficiency” decreases with an increase in the asset size of a community bank (13), depends on local macroeconomic factors (13-14), and vacillates from changes to “credit risk” (14).  “An effective way to increase a firm’s x-efficiency is to lend a portion of deposit funds as loans,” state the authors (15).  Managers must do more than increase assets: they must market products based upon their cost structures, seeking to achieve economies of scale (15-16).  The authors argue “variables that had the most pronounced impact on community banks’ x-efficiency were assets held as capital reserves, overall firm liquidity risk and credit risk exposure of the bank” (19).  Capable bank managers after receiving more deposits successfully convert deposits into assets which improve their x-efficiency results.  In a final point, the authors believe the “foundations of relationship banking” are at risk, and viability of the community banking model must be considered anew in light of myriad changes to financial institutional structures (20).

Amel, Dean F. and Robin A. Prager.  “Community Bank Performance: How Important are Managers?”  Review of Industrial Organization, vol. 48,   2016, pp. 149-180.

Amel and Prager use a sample from “1992 through 2011 restricted to community banks” (156).  Community banks in rural areas consistently earn more in their returns on assets than urban ones (156,160).  During the financial crisis of “2007-2011, profit declines were more severe for urban banks than for rural banks” (161).  Although deposits have been steadily declining at community banks, the rural banks on average hold more deposits (161).  Real estate loans continue to predominate in overall loan portfolios, and “rural community banks’ average portfolio shares of real estate-backed loans are consistently lower than those of urban community banks” (162). Rural banks also hold a higher percentage of consumer loans, and “both types of banks saw these shares decline over time” (162).  The authors find “that community bank profitability is affected by a number of factors [“local economic conditions” (151)] that are outside of the control of banks management”; for examples, per capita income, the unemployment rate, and the share of deposits that are held by other community banks” (168).  Looking at positive vectors the authors find “that bank size is significantly positively related to profitability” (168).  Other determinants are selection of S-corporations for taxation, less reliance on brokered deposits, wise composition of loan portfolios, and fewer shifts in the types of loans within portfolios (168-171).  Bank managers constitute the linchpin for increasing profitability by recognizing the available factors which lead to profitability for their banks (179).  They find evidence “that the quality of bank management matters a great deal to profitability, especially during time of economic stress” (151).

References

Ackerman, Andrew, Ryan Tracy, and Christina Rexrode.  “Senators Support Rollback of Bank Oversight.”  The Wall Street Journal, 14 November 2017, pp. A-1, A-6.

Amel, Dean F. and Robin A. Prager.  “Community Bank Performance: How Important are Managers?”  Review of Industrial Organization, vol. 48,   2016, pp. 149-180.

Andriotis, AnnaMaria, Christina Rexrode, and Eli Stokols. “Consumer Czar Ends Stormy Term.”  The Wall Street Journal, 16 November 2017, pp. B1-B2.

Back, Aaron.  “Smaller Banks May Now Dream Big.”  The Wall Street Journal, 15 November 2017, p. B-20.

Backup, Benjamin R. and Richard A. Brown.  “Community Banks Remain Resilient Amid Industry Consolidation.”  FDIC Quarterly, vol. 8, no. 2, 2014, pp. 33-43.

Biery, Mary Ellen.  “Stress-testing for community banks.”  Forbes, 24 October 2012.  Web. 15 September 2017.

Berger, Allen N. and Lamont K. Black.  “Bank Size, Lending Technologies, and Small Business Finance.”  Journal of Banking & Finance, vol. 35, 2011, pp. 724-735.

Berger, Allen N., Adrian M. Cowan, and W. Scott Frame.  “The Surprising Use of Credit Scoring in Small Business Lending by Community Banks and the Attendant Effects on Credit Availability, Risk, and Profitability.”  Journal of Financial Services Research, vol. 39, issue 1-2, April 2011,   pp. 1-33.

Berger, Allen N., William Goulding, and Tara Rice.  “Do Small Businesses Still Prefer Community Banks?”  FRB International Finance Discussion Paper No. 1096.  Available at ssrn.com/abstract=249812, December 2013,   pp. 1-25.

Cole, Rebel A., Lawrence G. Goldberg, and Lawrence J. White.  “Cookie Cutter vs. Character: The Micro Structure of Small Business Lending by Large and Small Banks.”  Journal of Financial and Quantitative Analysis, vol. 39, no. 2, June 2004, pp. 227-251.

DeYoung, Robert, W. Scott Frame, Dennis Glennon, and Peter Nigro. “The Information Revolution and Small Business Lending: The Missing Evidence” Federal Reserve Bank of Atlanta, Working Paper Series No. 2010-7. Available at ssrn.com/abstract=1577911, March 1, 2010,        pp. 1-18.

DeYoung, Robert, William C. Hunter, and Gregory F. Udell.  “The Past, Present, and Probable Future for Community Banks.”  Journal of Financial Services Research, vol. 25, issue 2-3, 2004, pp. 85-133.

Economist (The).  “Relief Rally: America’s Community Banks Hope for Lighter Regulation.”  Available at https://www.economist.com/news/finance-and-economics/21722893, June 1, 2017.

Finkle, Victoria.  “Is Dodd-Frank Really Killing Community Banks?”  Financial Planning, 19 August 2015.  Web. 15 September 2017.

Fogel, Kathy, Raja Kali, and Tim Yeager.  “Have Community Banks Reduced Home Foreclosure Rates?”  Journal of Banking & Finance, vol. 35, 2011, pp. 2498-2509.

Gilbert, R. Alton, Andrew P. Meyer, and James W. Fuchs.  “The Future of Community Banks: Lessons from Banks That Thrived During the Recent Financial Crisis.”  Federal Reserve Bank of St. Louis Review, March/April 2013, pp. 115-143.

Hein, Scott E., Timothy W. Koch, and S. Scott MacDonald.  “On the Uniqueness of Community Banks.”  Economic Review, Federal Reserve Bank of Atlanta, First Quarter, 2005, pp. 15-36.

Hoenig, Thomas M.  “Community Banks and the Federal Reserve.”  Economic Review, Federal Reserve Bank of Kansas City, vol. 88, no.2, Third Quarter, 2003, pp. 5-14.

Jacewitz, Stefan and Paul Kupiec.  “Community Bank Efficiency and Economics of Scale.”  FDIC Community Banking Study, December 2012, pp.1-26.

Jagtiani, Julapa.  “The Evolving Role of U.S. Community Banks and Its Impact on Small Business Lending.”  Federal Reserve Bank of Philadelphia, Working Paper No. 14-16, March 13, 2014, pp. 1-35.

Jagtiani, Julapa and Catharine Lemieux.  “Small Business Lending: Challenges and Opportunities for Community Banks.”  Research Department, Reserve Bank of Philadelphia, Working Paper 16-08. Available at ssrn.com/abstract=2752863, March 2016, pp. 1-53.

Koch, Timothy W. and S. Scott MacDonald.  Bank Management.  7th ed.  Mason, OH: South-Western Cengage Learning.  2010

Lux, Marshall and Robert Greene.  “The State and Fate of Community Banking.”  Harvard-Kennedy School, Mossavar-Rahami Center for Business and Government, M-RCBG Associate Working Paper Series,  No. 37, February 2015, pp. 1-31.

Marsh, Tanya D. and Joseph W. Norman.  “The Impact of Dodd-Frank on Community Banks.”  American Enterprise Institute, Available at ssrn.com/abstract=2302392, May 2013, pp. 1-51.

McKee, Gregory and Albert Kagan.  “Community Bank Structure an X-efficiency Approach.”  Review of Quantitative Finance and Accounting, Available at https://doi.org/10.1007/s11156-017-0662-9, 28 August 2017, pp.1-23.

Ricketts, Joe.  “Some Banks Are Too Small to Succeed.”  The Wall Street Journal, 30 October 2017, A-15.  

Sparks, Evan.  “Small Business: A Competitive Edge for Community Banks.”  ABA Banking Journal, 29 April 2016.  Web. 15 September 2017.

Tomy, Rimmy E.  “Competition and the Use of Discretion in Financial Reporting Evidence from Community Banks.”  The University of Chicago Booth School of Business.  Available at ssrn.com/abstract=2903918, January 25, 2017, pp. 1-57.

Torry, Harriet.  “Yellen Affirms Some Bank-Rule Flexibility.” The Wall Street Journal, 05 October 2017, p. A2.

Wilmarth, Arthur E., Jr. “A Two-tiered System of Regulation is Needed to Preserve the Viability of Community Banks and Reduce the Risks of Megabanks.”  Michigan State Law Review, vol. 249, 2015, pp. 249-370.

Wright, Robert E.  “Community, Mega, and Goldilocks Banks in U.S. History.”  Augustana College-Division of Social Sciences.  Available at ssrn.com/abstract=362640, March 18, 2015, pp. 1-37.

1 “The typical community bank has less than $1 billion in total assets,” state Koch and MacDonald in their textbook (7).

2 “As of December 31, 2010, community banks constituted 92.4 percent of chartered banking organizations in the United States,” state Marsh and Norman (9).

3 McKee and Kagan write about “x-efficiency [degree of efficiency under conditions of imperfect competition] of community banks, and believe x-efficiency “tend[s] to be reduced as the asset size of the community bank increases” (19).

4 Lux and Greene report that since 1994 the “top five banks’ share [U.S. lending market] has more than doubled from 17 percent to 41 percent” (14).

5 And Berger and Black find that banks over $1 billion in assets make about 60% of all small business loans (724).  Marsh and Norman note that “community banks provide $2 out of every $5 of credit used to finance agricultural production or purchase farmland” (15).

6 In certain markets technologies are not adequate to substitute for the “skills, knowledge, and interpersonal competencies of many traditional community banks,” claim Lux and Greene (5).

7 Berger, Goulding, and Rice find that “the evidence is clearer that strength [of relationship] does not depend on the type of bank” (17).

8 Wright points out how “monitoring employees and incentivizing them” enables community banks to reward employees more easily than in megabanks (16).

9 The authors contend that large banks have a “comparative advantage in lending to smaller firms using certain hard-information technologies such as fixed-asset lending” (Berger and Black 735).

10 Community bankers typically “originate their mortgage loans in-house” (Fogel, Kali, and Yeager 2500).

11 They say the large bank focus on transactional banking will lead to more consolidation of the banking industry (20).

12 “Economies of scale measure the relationship between the cost of producing a unit of output and the level of output,” report Jacewitz and Kupiec (6)

13 However, these authors note that strong banking relationships create private information which gives the bankers market power over the borrowers (6).

14 These researchers separated out scoring and non-scoring determinants of distances, discovering “bank-borrower relationships-are made more efficient by advances in information, communication, and other technologies” (13).

15 Some community banks align themselves with nonbanks “as evidenced by new partnerships between banks and alternative lenders,” claim Jagtiani and Lemieux (19).

16 With respect to economies of scale Jacewitz and Kupiec did not find “significant scale benefits beyond $500 million in asset size for most lending specializations” (1).

17 The Garn-St. Germain Depository Institutions Act allowed thrift institutions to make commercial loans (DeYoung, Hunter, and Udell 93).

18 The Glass-Steagall Act passed in 1933 separated investment banks, insurance companies, and brokerage firms from commercial banks (DeYoung, Hunter, and Udell 88).  

19 Jagtiani adds that the mergers were largely in-state, and “strengthen the banks’ comparative advantage in relationship lending” (9).  Jagtiani and Lemieux find small banks have their greatest comparative advantage in lending to their largest customers (725).

20 March and Norman opine that community banks “barely resemble their too-big-to-fail [TBTF] cousins” (4).

21 Wright claims “the more complex an organization is, the more likely it is to attract the attention of shysters and those bent on self-aggrandizement at all costs” (17).

22 Wilmarth thinks community banks are a national priority: small businesses account for one-half of private sector jobs and output (288) and community banks “provide about half of all bank credit extended to small businesses, even though community banks hold less than one-fifth of the banking industry’s assets” (289); bank managers and directors support local charitable organizations and hold key leadership positions in the organizations (289-290); and “more than one-third of U.S. counties  [. . . ] have very limited physical access to mainstream banking services without the presence of community banks” (290).  

23  Dr. Timothy B. Michael expresses this axiom to his commercial banking students.