Academic journal article Economic Perspectives

Birth, Growth, and Life or Death of Newly Chartered Banks

Academic journal article Economic Perspectives

Birth, Growth, and Life or Death of Newly Chartered Banks

Article excerpt

Introduction and summary

Thousands of new commercial banks have been chartered in the U.S. over the past two decades. As the U.S. banking industry continues to consolidate, these de novo banks are potentially important for preserving competition and providing credit in local markets. However, like other new business ventures, newly chartered banks initially struggle to earn profits, and this financial fragility makes them especially prone to failure. In this article, I document the financial evolution of the typical de novo bank and develop and test a simple theory of why and when new banks fail.

Recent decades have seen an upsurge in the number of mergers and failures among new banks. Figure 1, panel A shows the annual change in the number of commercial bank charters in the U.S. since 1966. Prior to 1980, the reduction in bank charters due to mergers and failures was relatively stable at about 100 charters per year, or about 1 percent of the industry total ([ILLUSTRATION FOR FIGURE 1 OMITTED], panel B). The pace accelerated greatly after 1980, and since 1986 about 600 charters, or 5 percent to 6 percent of the industry total, have disappeared each year due to mergers and failures.

To a large extent, this tremendous consolidation can be explained by the repeal of federal and state laws that restricted branch banking and interstate banking. As these restrictions gradually were relaxed, banking companies expanded their geographic reach by acquiring thousands of other banks, and reduced their overhead expenses by converting thousands of affiliate banks into branch offices. This geographic expansion, combined with newly deregulated deposit rates, increased competition between commercial banks just when new information technology was allowing mutual funds, insurance companies, and the commercial paper market to compete for banks' traditional loan and deposit businesses. Under these new competitive conditions, many commercial banks became more vulnerable to economic downturns, and thousands of banks failed during the 1980s and early 1990s. Over the past two decades, the combined effect of these mergers and failures has reduced the number of commercial banks in the U.S. by nearly 40 percent.

This consolidation has been partially offset by a recurring wave of new bank charters. As shown in figure 1, panel A, over 3,000 de novo commercial banks have been chartered by state and federal banking authorities since 1980. It is generally believed that these newly chartered banks can help restore competition in local markets that have experienced a large amount of consolidation. It is also commonly believed that these newly chartered banks can help replace credit relationships for small businesses whose banks failed or were acquired or reorganized. However, before a newly chartered bank can provide strong competition for established banks and before it can be a dependable source of credit for small businesses, it must survive long enough to become financially viable.

I begin by examining the conditions under which investors are likely to start up new banks, including the influence of business cycles, merger activity in local banking markets, and the policies of federal and state chartering authorities. Next, I track the evolution of profits, growth rates, capital levels, asset quality, overhead costs, and funding mix at more than 1,500 commercial banks chartered between 1980 and 1994. These data suggest that newly chartered banks pass through a period of financial fragility during which they are more vulnerable to failure than established banks. Specifically, new bank capital ratios quickly decline to established bank levels, but new bank profits improve more slowly over time before attaining established bank levels.

Based on these empirical observations, I develop a simple life-cycle theory of de novo bank failure, in which the probability of failure at first rises, and then declines with the age of the new bank. …

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