Academic journal article Academy of Banking Studies Journal

The Determinates of a Community Bank's Profitability

Academic journal article Academy of Banking Studies Journal

The Determinates of a Community Bank's Profitability

Article excerpt

INTRODUCTION

The past decade has witnessed a disturbing trend regarding commercial bank failures. As can be seen in Table 1, the number of commercial bank failures in the United States has escalated dramatically in recent years (FDIC: Failed Banks, 2013). This fact indicates an increasing pressure on bankers and regulators to understand commercial bank profitability and its components so that the determinants of commercial bank profitability can be properly managed. However, bankers and regulators face tremendous complexity when it comes to determining the proper "mix" of loans and investments held by a commercial bank. Further, there is little in the literature that provides a valid framework to assist bankers in using readily accessible data to understand the factors that determine bank profitability or to analyze those factors for a specific bank. Thus, the purpose of this paper is to present a methodology that commercial banks may use to determine the factors influencing their net profit fluctuations and to demonstrate the use of that methodology for a specific community bank.

Community banks have had a continuous series of challenges and changes during the past decade. Including major regulatory pressures, technological improvements in processing and service delivery, and extreme economic swings in several of the customer segments (DeYoung & Duffy, 2004). The impact of these issues has resulted in Federal Reserve interest rate adjustments, purchase of various asset classes in order to stimulate economic growth and the TARP program to assist in supporting the capital levels in nearly 700 financial institutions according to a Board of Governors of the Federal Reserve System International Finance discussion (2012). The result is a series of internal challenges and a changing paradigm in profitability do to pressures on management and boards, Capital, asset valuation and liquidity (McTaggart & Callaghan, 2011). Community bank CFOs are faced with increasing efforts to support decisions to regulatory bodies, deal with the changing values of asset in loans and investments, and the pressure on actual profitability (Cochero, 2006).

The external environmental dynamics are further driving the need for the study of accurate metrics and understanding of profitability. A group of elite academics met and formulated a number of recommendations for the financial industry at Squam Lake in 2008 (French et al. 2009). Attention to the "too big to fail" segment of the industry drove many of the recommendations but the level of impact on the smaller community banks was for the most part overlooked. The closing of 406 banks since 2008 has included primarily community banks that could not respond to the dramatic turbulence in the industry (Federal Deposit Insurance Corporation, 2013). The opportunities for the smaller bank segment has been focused on responding to the external issues with lesser amounts of attention paid to the possible shifts in internal financial ratios and determinants of profitability (Cocheo, 2011).

Motivation for the study was the pressure experienced by community banks as the result of economic pressures and more specifically mortgage and residential development loan failures. Community banks have well developed internal loan policies and procedures for loan evaluation. The recent loan failures have indicated many banks do not account for the external risk in determining loan approval. Consequently, if appraisal values are increasing quickly collateral of the loan and the financial net worth of the borrowers can be inflated. The increasing values could affect the loan policy calculations. This study considers additional external variables that may affect bank net income.

METHOD

The community bank selected for this study is a full service $230 million asset institution. The scope of the organization includes five branch locations and approximately 56 fulltime employees. …

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