Whither the Community Bank? Relationship Finance in the Information Age

By DeYoung, Robert; Udell, Gregory F. | Chicago Fed Letter, June 2002 | Go to article overview

Whither the Community Bank? Relationship Finance in the Information Age


DeYoung, Robert, Udell, Gregory F., Chicago Fed Letter


Technological progress has eroded one of community banks' traditional advantages-- the information edge from being located close to their customers. Is the community bank business model still viable in a world where financial relationships do not depend on face-to-face contact? The authors review some of the existing evidence and look forward to a research conference where participants will offer new evidence.

Megamergers between large banks have received lots of attention, but nine out of every ten bank mergers have eliminated a community bank.

There are more banks per capita in the United States than in any other developed economy. The vast majority of these banks are so-called "community banks," identifiable by their small size, their limited geographic reach, and their traditional array of banking services. The central principle of community banking is "relationship finance," the idea that personal interaction between bankers, small borrowers, and small depositors creates informational efficiencies that allow credit to flow more efficiently and commerce to grow more quickly.

Community banking is consistent with traditional American beliefs that small business and local control of resources are intrinsically good, while concentrated financial, economic, and political power is intrinsically bad. For decades, state and federal banking regulations based on these ideals locked the U.S. banking industry into a system of small, local banks by restricting banks from doing business across state and county borders. As a byproduct, these regulations helped preserve thousands of poorly run community banks by shielding them from outside competitors.

In recent years, advances in communications technology, financial markets, and banking production techniques have reduced the comparative advantages of community banks in collecting local information. In a world with these new technologies, the arguments for protecting local banks from outside competition became much weaker. State and federal legislatures rolled back and eventually eliminated banking and branching restrictions, and the result has been a dramatic restructuring of the U.S. banking system.1 Thousands of community banks have been merged out of existence, and although thousands of community banks still remain, the surviving banks tend to be the larger ones.

There are two distinctly different-- though not necessarily mutually exclusive-explanations for the declining number of community banks. One explanation contends that the decline in numbers is a long overdue culling of inefficient, poorly managed community banks unable to survive in highly competitive, post-deregulation banking markets. If this is the case, then thousands of well-managed community banks are likely to survive. A second explanation contends that the local banking model is no longer economically viable due to technological change. If this is the case, then the number of traditional community banks is likely to dwindle even further in the future.

This Chica Fed Letter explores the causes and consequences of the shrinking community banking sector and considers the sector's future. This article also serves as an introduction to a conference to be held in March 2003, jointly sponsored by the Federal Reserve Bank of Chicago and the Journal of Financial Services Research, at which academic and regulatory economists will present new research on the future of community banking.

Fewer community banks: Deregulation and mergers

The declining presence of community banks in the U.S. banking system is illustrated in figure 1. The top panel shows that the number of "small" community banks (banks with assets less than $100 million) has fallen from around 11,000 banks in 1980 to less than 5,000 banks today. The number of "large" community banks (assets between $100 million and $1 billion) has declined only slightly since 1980, while the number of "large banks" (assets greater than $1 billion) has held relatively steady. …

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