Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Role of Community Banks in the U.S. Economy

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Role of Community Banks in the U.S. Economy

Article excerpt

The Role of Community Banks in the U.S. Economy

The U.S. banking system is unusual in consisting not only of some very large banks but also a large number of relatively small community banks. This bifurcated banking structure resulted largely from a legal framework that, in the past, restricted banks' abilities to diversify geographically. This institutional structure, in turn, reflected a long-standing concern in the United States about the concentration of banking power in a few very large institutions located far away from many of the customers they serve.

The bifurcated banking system in the United States has served the economy well. Over time, with regulatory change and financial innovation, large banks have become complex organizations engaged in a wide range of activities. They provide a variety of services to their customers, but often rely on hard financial information, computer models, and centralized decision-making as the basis for conducting business. In contrast, small banks have focused more on "relationship banking," basing decisions on personal knowledge of customers' creditworthiness and a keen understanding of business conditions in the communities they serve. In this way, the bifurcated banking system has served the needs of a diverse U.S. economy composed of businesses of all shapes and sizes and consumers with diverse needs and preferences.

While community banks have a clear place in the U.S. banking system, some analysts have questioned whether they play a sufficiently important role in the economy to warrant public interest and oversight. With increased merger activity over the last 20 years, the number of community banks-while still quite large-has declined. In addition, small banks pose little systemic risk to the nation's financial system. And, if community banks were not there, other financial services providers might readily step in to take their place.

This article examines the role of community banks in the U.S. economy. The first section of the article argues that, while community banks hold only a small share of the nation's banking assets, they provide important financial services-for which there are few, if any, substitutes-to some key sectors of the economy. The second section argues that community banks will continue to play an important role in the banking industry, even as technology and market conditions change. The paper concludes that the Federal Reserve therefore has a strong interest in understanding issues facing community banks.

I. THE CURRENT ROLE OF COMMUNITY BANKS

The banking system in the United States has always been unique in the sense of containing large numbers of small banks closely tied to their local communities. But the banking system in this country has also undergone tremendous change during the last 20 years due to deregulation and mergers. While community banks still comprise the vast majority of banks, the question arises whether their role in the banking system has declined to the point of insignificance. This section shows that community banks account for a much smaller share of total banking activity than they did 20 years ago, but that they still play a key role serving certain types of communities and providing certain types of banking services.

Definition of a community bank

There is no single definition of a community bank. However, most people think of community banks as having two key characteristics-they are small in size, and they do most of their business in the community in which they are located. Because these two characteristics tend to go together and because size is easy to measure, common practice is to define community banks as those below a certain size threshold.

This article also adopts this approach, defining community banks solely in terms of their size. It is important to note, however, that such a definition can lead to anomalies. Some highly specialized banks may be classified as community banks because of their small size but still do business over a broad geographic area. …

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