Consolidation in the Banking Industry and the Viability of Small Commercial Banks: X-Efficiency and Bank Size

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ABSTRACT

The relaxation of geographic restrictions on the branching activities of U. S. commercial banks has resulted in numerous predictions about the future composition of the industry. Most predict some degree of consolidation, reducing the total number of commercial banks. As a result, the future of small banks is unclear. In this paper, stochastic cost and profit frontiers are constructed to estimate X-efficiency for small banks and their future competitors. Small bank X-efficiency is estimated relative to a frontier shaped to fit their prospective competitors, efficient, larger banks. The results imply that small banks are more cost efficient but less profit efficient.

INTRODUCTION

The advent of the Riegle-Neal Interstate Banking and Branching Efficiency Act has relaxed historical geographic restrictions on banks, contributing to the trend of consolidation in the U. S. commercial banking industry. The prospect for such extensive change has led researchers to speculate about the future composition of the banking industry. Forecasts predict that a small number of large banks will control most financial assets in the industry, but many small banks will still survive (Berger, Kashyap & Scalise, 1995; Moore, 1995). The asset size composition of the industry has received much attention recently due to the concern that small business lending might decline if banks consolidate (Berger et al., 1998; Peek & Rosengren, 1998; Strahan & Weston, 1998). In fact, these studies have found that small business lending may not decline. They find evidence against the hypothesis that small business lending will decline as banks become larger. If small banks' presence in credit markets is reduced, then there may be an impact on the availability of credit to small borrowers. Petersen and Rajan (1994) find that the availability of credit is increased when a firm has close ties with its lender. If consolidation results in the disappearance of these lenders, then some loans may cease to have positive net present values and not be made.

One area of research that is relevant to the viability of small banks in a consolidating industry is that of efficiency. When new geographic markets are opened to allow more competition, inefficient banks will be forced to improve or be driven out of the industry by relatively more efficient, larger banks. Previously protected small banks could also be acquired by expanding banks, especially if de novo branching is not permitted. Hence, comparisons of X-efficiency in different bank size classes should reveal some information on the ability of small banks to compete with larger banks. Given standard approaches of X-efficiency estimation used with banks, such a comparison is not that meaningful. As noted by Berger (1993), because of the preponderance of small banks in any nationwide data sample of banks, the estimated frontier tends to fit small banks better, resulting in higher efficiency scores compared to larger banks. For this reason, comparing small banks with larger institutions is problematic. As a result of consolidation, small, medium, and large banks will in some cases share the same market even though they do not share the same technology. Hence, to provide a useful comparison between small banks and their future competitors, X-efficiency needs to be measured relative to efficient banks in larger size classes. Under this framework, more meaningful comparisons can be made between small banks and their potential competitors as the banking industry consolidates.

This paper attempts to make such comparisons. Following the procedure introduced in Mester (1997), frontiers for different size classes are estimated separately. Using the distribution free approach of Berger (1993), cost and profit X-efficiency of small banks are compared to medium and large banks. The results suggest that even after adjusting the frontiers for size classes, small banks still tend to be more cost efficient than large banks, but less profit efficient than some medium-sized banks. …