The economic performance of small banks, 1985-2000 - Statistical Data Included

Federal Reserve Bulletin, Nov, 2001 by William F. Bassett, Thomas F. Brady, James E. Cypert, Jr., Mark J. Gibson

Several trends in the financial industry over the past decade and a half have potentially threatened the competitiveness of small banks. Among these developments are the numerous mergers that increased the size and scope of large banks and greater competition from mutual funds and other nonbank financial institutions. In this article, we examine the economic performance of small banks during the 1985-2000 period by focusing on their ability to attract and profitably intermediate insured and uninsured deposits. (1)

We find that the expansion of deposits and assets at small banks, when adjusted to account for the effects of mergers on measured growth, has consistently exceeded the growth at large banks. Moreover, the profitability of small banks has risen to high levels over the period. These indications of strength among small banks as a whole also hold true for subgroups within the small bank sector. The key reasons for the generally good performance of small banks in recent years appear to be their ability to earn relatively high rates of return on their loans and an increase in the share of their portfolios devoted to loans.

RECENT TRENDS AFFECTING SMALL BANKS

Among the challenges that have confronted small banks since the mid-1980s have been a wave of bank mergers and acquisitions, the continued rise in nonbank competition for customers, and a decline in the real value of deposit insurance. Mergers reduced the number of banks in the United States from more than 14,000 in 1985 to about 8,300 at the end of 2000 (chart 1, top panel). Although many mergers since the mid-1990s liberalization of banking laws have involved reorganizations within existing bank holding companies, the number of such banking organizations also has fallen over the 1985-2000 period, from about 11,000 to less than 7,000. Mostly as a result of mergers, the share of domestic banking assets held by the largest 100 banks (hereafter, large banks) rose from about 50 percent to more than 70 percent during the period (chart 1, bottom panel). The bulk of the gain came at the expense of small banks--those not among the 1,000 largest; their share of assets fell from about 25 percent to just over 10 percent.

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A merger would tend to improve the competitive position of the surviving institution by adding to the scope of its activities, thus allowing it to offer a larger variety of services and products to customers, and by increasing the diversity of its assets. All else equal, the greater diversification would act to stabilize earnings, thereby reducing the riskiness of the surviving bank and increasing its attractiveness to depositors. Alternatively, the now-larger bank could exploit the greater diversification to maintain the riskiness of the institution around pre-merger levels while adjusting its portfolio toward higher-yielding assets, thus boosting profitability. (2)

The competitiveness of the largest banks would also be improved if depositors believe that the government will treat these banks as "too big to fail," and the perceived advantage would be greater still in the context of declining real levels of deposit insurance. (3) However, the Federal Deposit Insurance Corporation Improvement Act of 1991 substantially circumscribed the ability of regulators to use too-big-to-fail by requiring that the Federal Deposit Insurance Corporation (FDIC) pursue the resolution method that minimizes the cost to its insurance fund. In addition, exceptions to the "least cost" method are allowed only with the approval of at least two-thirds of both the Federal Reserve Board and FDIC board of directors and the approval of the Secretary of the Treasury in consultation with the President. Moreover, bank regulatory agencies maintain that no bank is too large for shareholders and holders of the bank's nondeposit liabilities to face complete loss, should the decline in bank asset values be large enough, and for uninsured depositors to be subject to less than 100 percent reimbursement. (4)

Besides the effects of consolidation and a decline in the real value of deposit insurance, increasing competition from a "parallel banking system" may have weakened the competitive position of small banks since the mid-1980s. (5) On the liability side of the balance sheet, banks compete with stock, bond, and money market mutual funds for deposits. Although mutual funds compete with banks of all sizes, they likely pose a greater competitive challenge to small banks, which are more dependent on deposits than are large banks. Given their high liquidity and their record of preserving the par value of their investors' assets, money market mutual funds represent a particularly attractive alternative to bank deposits. (6) About one-third of money fund assets consist of commercial paper issued by finance companies, which, in turn, compete in markets for consumer loans and business equipment financing, markets that may be more important for small banks than for large banks.

Nonetheless, consolidation in the banking industry may have had some beneficial aspects for small banks. For example, some large banks may find that they lack the knowledge and experience necessary to compete effectively in the local loan markets of the smaller banks they have acquired. Similarly, on the funding side, bank depositors may react adversely to acquisitions of their banks by out-of-area institutions and move their deposits to a locally headquartered small bank. (7)