Academic journal article Federal Reserve Bank of St. Louis Review

Are Small Rural Banks Vulnerable to Local Economic Downturns?

Academic journal article Federal Reserve Bank of St. Louis Review

Are Small Rural Banks Vulnerable to Local Economic Downturns?

Article excerpt


In recent years, supervisory agencies have streamlined the bank examination process to focus attention on identified risk areas rather than the full scope of bank operations (Board of Governors, 1997). If supervisors can identify the potential risks, they can recommend preventive measures and respond more quickly to actual banking problems when they arise. Because of this shift to risk-focused supervision, off-site surveillance of banks has become much more important. Supervisory economists and staff who gather and interpret bank and economic data must direct examiners to areas of heightened risks.

Historical experience in the financial services industry demonstrates that institutions exposed to serious risk can run into trouble quickly. Many commercial banks were exposed to fluctuations in commercial real estate markets in the latter half of the 1980s. A sharp decline in real estate prices caused several hundred banks to fail (FDIC, 1997). In addition, agricultural bank failures represented a large share of the banks that failed from 1984 to 1987. These failures occurred within a few years after the peak in farmland prices, reflecting the inability of agricultural banks to absorb the losses accruing from falling farm incomes (Kliesen and Gilbert, 1996). Because these banks were not diversified in terms of geography or industry, the losses eventually overwhelmed the equity accumulated during the prosperous years. If exposure to these risks had been targeted as potential problems earlier, they might have been addressed sooner and their negative impacts dampened.

Because of the way that U.S. banking laws evolved, many U.S. banks have geographically concentrated offices and operations. Historically, national and state banking laws prevented banks from branching into other counties and states. Justification for such legislation was to promote sound and stable banking markets by limiting competitive pressures on existing banks and to prevent an excessive concentration of financial power (Spong, 2000, p. 146, and Jayaratne and Strahan, 1997). As we have noted, however, such laws left banks vulnerable to local economic downturns.

Over the last few decades, branching restrictions gradually have been lifted. By 1990, most states had granted banks permission to branch within state boundaries, and most states permitted some form of interstate banking (Berger et al., 1995, pp. 188-89). The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 removed most remaining barriers to interstate branching. Bank holding companies (BHGs) were allowed to acquire a bank in any state and--as of June 1, 1997--merge it with an existing bank. [1] Hence, most of the legal barriers to geographical expansion have been removed.

Despite liberalized branching laws, thousands of small banks with geographically concentrated offices remain and are likely to exist for some [2] time. Some argue that small banks have a comparative advantage over large banks in small-business lending for which little public information about the borrower's creditworthiness is available. This advantage (and thus incentive to remain small) arises because small banks can originate and monitor relationship loans at a lower cost [3] than larger banks. Relationship lending requires that loan officers have autonomy to set underwriting standards and discretion to monitor and evaluate borrowers. Management at small banks can more easily monitor loan officers; consequently, small banks are better able to develop the community relationships necessary to underwrite small business loans. In addition, anecdotal evidence suggests that branch managers of large banks are rotated more often into and out of communities as they progress in their organizations; therefore, they do not develop the same personal relationships with customers that long-time community bankers develop. To contain loan origination and monitoring costs, larger banks often prefer to lend to customers for which credit information is more readily available. …

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