Academic journal article Economic Perspectives

The Challenges Facing Community Banks: In Their Own Words

Academic journal article Economic Perspectives

The Challenges Facing Community Banks: In Their Own Words

Article excerpt

Introduction and summary

When economists analyze an industry, they typically do so at arms length, using a combination of theoretical models and large amounts of statistical data. The theoretical models describe the interplay between the structure of the industry and the competitive behavior of the firms that populate the industry. The statistical data--which may include financial ratios, industry trends, and peer group comparisons--serve to personalize the sterile, one-size-fits-all nature of the theoretical models. But most industry studies never get especially close to the people most responsible for the industry data: the managers and owners who make long-run strategic plans that shape the data, who make short-run competitive decisions in response to the data, and whose careers and companies are ultimately defined by the data.

In this article, we analyze the U.S. community banking sector--a sector populated by small firms that hold a shrinking share of an increasingly competitive and technology-based financial services industry--but we rely on an atypical approach to perform the analysis. We use numerous first-hand observations made by individual community bankers, collected during a Federal Reserve survey in August 2001 (Federal Reserve System, 2002), to complement the usual data-intensive industry analysis. Although the survey itself was an effort to learn about the evolving payments services needs of community banks, the surveyed bankers also made wide-ranging observations on a variety of other topics, including the fundamental mission of community banks; the threats and opportunities posed by large banks; perceptions that the playing field is not always level; and the growing tension between traditional high-touch relationship banking and potentially more efficient high-tech banking.

Augmenting systematic industry data with bankers' anecdotal observations humanizes our analysis. The bankers tended to be more optimistic about the future viability of the community banking business model than many industry observers and, not surprisingly, they tended to be less sanguine about the regulatory and technological changes that have increased the competitive pressures on community banks. But aside from these and a few other differences, the assessments of the two groups were quite consistent--despite being stated from different perspectives and arrived at using different (and, in the case of the bankers, implicit) analytic frameworks. The consensus view is that industry consolidation and technological change are providing opportunities as well as posing threats for community banks; that community banks can profitably coexist with large multi-state banks in the future; but, to do so, community banks must be efficiently operated, well-managed, and must continue to innovate.

Forces of change

The past decade has witnessed tremendous changes in how banks are regulated, how they use technology to produce financial services, and how they compete with each other. These transformations have important consequences for the typical community bank, for the community banking sector as a whole, and by extension for the households and small businesses that purchase financial services from community banks.

Geographic deregulation

The McFadden Act of 1927 restricted U.S. commercial banks from branching across state borders. In addition, most state governments have historically restricted bank branching within state borders. These restrictions reduced the efficiency of the U.S. banking system by artificially limiting the size of commercial banks. But state governments began to gradually relax their geographic branching restrictions beginning in the mid-1970s, and by 1994 the federal government had passed the Riegle--Neal Act which eliminated virtually all prohibitions against interstate banking in the U.S. Both large and small banking companies have taken advantage of geographic deregulation by acquiring banks in other counties, states, or regions. …

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