Rural Banking and Information Technology: A Community Bank Perspective

RMA Journal, The, Feb, 2001 by Albert Kagan, Neilson Conklin

If technology is supposed to be the greater equalizer and rural financial markets are increasingly similar to urban/national markets, then it follows that rural community banks are jumping like mad onto the technology bandwagon. But they're not. Meantime, their larger brethren have used technology to extend their reach and, through the Internet, are knocking on the doors of even the most remote communities for deposit dollars and fee-based services. This paper reports the results of a survey of non metro banks in the North Central U.S., examining the Internet's impact on competition in their markets and the banks' use of the Internet to compete. The message to rural banks: Wake up.

Historically, rural markets have been less competitive for the financial services industry, if simply because lower population density and higher transportation costs have discouraged infiltration. That's changed, of course. By lowering transaction costs and allowing complex human interaction independent of distance, the information revolution offers the possibility to enhance competition in rural areas.

What are rural banks doing about it? A recent USDA report on rural credit markets noted: "The range of [rural] institutions involved is likely to be different, often narrower than that serving urban communities, and competition for rural loans is often not as keen as it is for urban loans." The structure of non metro financial service markets and the way in which they operate remain remarkably similar to the structure and processes in place half a century ago. But data suggests that rural America is not lagging behind more metropolitan areas in its adoption of PC and Internet use. Current market conditions suggest that the percentage of households and farmers "wired" and able to access financial services electronically is poised to grow rapidly.

The growth in Internet-based business activities is projected to increase rapidly. Jupiter estimates that 75% of all retail purchases will be Web influenced by 2005. This trend should result in $199 billion in online purchases and $632 billion in Web-influenced sales offline. This projection is based on 85 million online buyers being present by 2003. Forrester projects e-commerce revenues to exceed $6.8 trillion by 2004. This dramatic increase in electronic business participants will affect traditional community banking relationships as customers demand on line account access..

Non metro community banks have been the dominant providers of financial services in many rural markets. So it makes some sense to ask how the information revolution will affect these organizations. Will non metro community banks be displaced by large banks and other competitors making extensive use of the Internet or other delivery systems? Or will community banks adapt and use information technology to expand their markets and gain the efficiencies needed to compete in today's market? It's a matter of perception.

Technology Investment

U.S. banks invest $20-$30 billion dollars per year in information systems. The Royal Bank of Canada professes to be the largest commercial user of information technology in Canada. This bank spends $1 billion (Canadian) per year on IT services and employs 2,000 in the IT division. The Royal Bank indicates that this level of commitment is competitively driven and the bank has used these systems to create a new set of information products.

Traditional economic models focus on the mechanical aspects of financial transactions as the source of value in financial intermediation. However, by recognizing the importance of informational friction and the fact that no one has perfect information, current financial economic theory emphasizes the role of the financial intermediary as an information processor. A financial intermediary, whether it is a commercial bank or an insurance company, creates value by processing information to develop a financial contract or transaction.

For example, in the process of making a loan, a bank adds value by collecting and analyzing data about the borrower and using this information to establish loan terms and pricing that will generate a profit. It is important to make the distinction between raw data, sometimes referred to as digital information, and economically useful information. In the case of a farm operating loan, the raw data might include the borrower's balance sheet, current income statement, credit bureau history, and some additional demographic characteristics. The loan officer transforms this data into the information needed to make a loan decision through an analytical process, much of which is IT driven.

Financial intermediaries handle an array of financial contracts and transactions in different markets. Traditionally, financial intermediaries are placed into categories based on the type of contracts or financial assets they handle. Financial intermediaries can be classified into two broad classes--asset transformers and brokers.

Asset transformers carry financial risk on their balance sheet while brokers avoid carrying financial risk. Examples of asset transformers include banks, credit unions, and direct lending Farm Credit associations, while mortgage brokers, financial advisors, and stock brokers fall into the broker category. Brokers process information to identify profitable deals and put buyers and sellers together in a "public market." Asset transformers process information to identify the risks that can be profitably held in their investment portfolio. Although the two types of intermediaries differ in their handling of financial assets and risk, they share a common output--information. From the perspective of investors and borrowers, the activities of brokers and asset transformers are substitutes with respect to processing information. A new homeowner can get a mortgage loan from a mortgage broker selling to Fannie Mae or from a savings and loan that holds the loan in portfolio. Both types of intermediaries create value by processing information, and their common output or product is information.