Community Banking Research and Policy Conference

Third Annual Community Banking Research and Policy Conference

Research Papers, Authors and Key Findings

Research Paper Session 1

Community Bank Discussant Presentation

The Changing Role of Small Banks in Small Business Lending

Authors: Lamont Black, Driehaus College of Business, DePaul University Chicago, Illinois; Michal Kowalik, Federal Reserve Bank of Boston

Abstract: This paper studies the effects of competition from large banks on small banks’ lending to small business borrowers. Small banks are better at monitoring their borrowers, but large banks have lower financing costs. This study looks at bank balance sheet data broken down by bank size. The study’s findings indicate that single-market banks increase their shares of small business loans in the intermediate size category ($250,000 to $1 million) following large bank entry into the market.

Small Business Lending Challenges and Opportunities for Community Banks

Authors: Catharine Lemieux, Federal Reserve Bank of Chicago; Julapa Jagtiani, Federal Reserve Bank of Philadelphia

Abstract: The ongoing evolution of the small business lending sector presents both challenges and opportunities to community banks. Many argue that the recent financial crisis and subsequent changes to the regulatory environment have resulted in declines in small business lending both directly and indirectly, by accelerating the effects of other contributing factors. Community banks face greater competition as large banks have increasingly leveraged technology to compete for smaller commercial borrowers. Competitive pressures on community banks are also rising as many borrowers become more comfortable turning to nonbank lenders. These alternative lenders have begun to introduce sophisticated technologies and new underwriting methods to issue small business loans quickly and electronically. Meanwhile, more established businesses are expecting more from small banks in terms of new products, technology and customer services. However, concurrent post-crisis regulations have made community banks less flexible, especially relative to unregulated nonbank lenders.

Despite these challenges, community banks are seeing new opportunities as well. Demand is higher for Small Business Administration loans, which are profitable products for many community banks. Growing interest in unconventional, higher-margin loan products may fit well with community banks. Historically, small banks have been strong in qualitative borrower analysis and relationship lending. There are recent examples of banks partnering with alternative lenders to purchase qualifying loans originated by online platforms.

Small Bank Comparative Advantage

Authors: Allen Berger, Darla Moore School of Business, University of South Carolina; Christa Bouwman, Texas A&M University; Dasol Kim,

Abstract: This paper uses novel survey data on U.S. small businesses ranging from 1993-2012 to evaluate whether small banks, compared to large banks, provided better financial support to small businesses. The analysis concludes that small banks have a stronger comparative advantage when local economic conditions are worse. It also finds that this advantage has not diminished over time.

During the recent financial crisis, both types of banks reduced lending to small businesses. However, following the Lehman Brother failure, small banks provided more support in regions dependent on asset-backed commercial paper markets. The paper asserts that small banks were able to achieve this by providing liquidity insurance to relationship borrowers. Large banks are more reliant on transactional lending technologies, like credit scoring models, which can be less effective during periods of economic stress.

Competition in Agricultural Lending Markets: The Effect of Including the Farm Credit System

Authors: Charles Morris, Federal Reserve Bank of Kansas City; James Wilkinson, Federal Reserve Bank of Kansas City; Eric Hogue, Federal Reserve Bank of Kansas City

Abstract: In recent years, bank consolidations have led to measurable increases in banking market concentration, according to traditional metrics. However, standard deposit-based measures for banking market concentration and competition fall short regarding capturing the impact of competitive pressures from non-bank institutions. In rural markets, agricultural lending is a principal business activity, and the Farm Credit System’s Agricultural Credit Associations (ACAs) play an important role.

This paper examines the lending structures and practices in rural banking markets, as well as the trends amongst traditional bank and ACA lending. Using this analysis, the paper puts forth a lending-based measure of banking market concentration that includes ACA activities. The final section calculates market shares of individual lenders and market concentration ratios with the new model and compares them to the deposit-based measurements.

Reaction to Small Business and Farm Lending Session

Small Business and Farm Lending- Moderated Question and Answer Session

Research Paper Session 2

Did the Financial Reforms of the Early 1990s Fail? A Comparison of Bank Failures and FDIC Losses in the 1986-92 and 2007-13 Periods

Authors: Eliana Balla, Federal Reserve Bank of Richmond; Edward Prescott, Federal Reserve Bank of Cleveland; John Walter, Federal Reserve Bank of Kansas City

Abstract: The banking problems in the late 1980s and early 1990s spurred two significant changes to banking supervision and regulation: the Basel 1 capital requirements and the prompt corrective actions (PCA) provisions of the FDIC Improvement Act (FDICIA). The PCA provisions, specifically, require regulators to shut down banks before book capital becomes negative.

To examine the impact of these reforms, this paper compares failures and FDIC losses on commercial banks in two different eras, the 1980-1990s, before the FDICIA and Basel 1 reforms, and then the recent financial crisis. The analysis uses a sample of community and mid-sized banks and shows that predictors of failure and high losses were matching across crises. The paper also finds that the failure rate in the recent period was driven more by severe economic conditions than by high concentrations in real estate lending.

While the PCA provisions and the increased capital requirements reduced the bank failure rate, they were less effective in mitigating FDIC losses. FDIC losses on commercial banks were 14 percent of failed bank assets in the first period, but rose to approximately 24 percent in the second period. The study found that neither variations in bank balance sheets, nor local economic conditions were able to explain variations in FDIC losses. However, “interest accrued, but not yet received”, a discretionary accounting variable, was predictive for both bank failure and higher FDIC losses.

Financial Performance and Management Structure of Small, Closely Held Banks

Authors: John Anderlik, Federal Deposit Insurance Corporation (FDIC); Richard Brown, Federal Deposit Insurance Corporation (FDIC); Kathryn Fritzdixon, Federal Deposit Insurance Corporation (FDIC)

Abstract: This paper examines the challenges and opportunities specific to closely held banks. It is based on a survey of bank examiners in three FDIC supervisory regions that is used to identify the ownership and management structure of over 1,400 institutions. Almost 75 percent of community banks in these regions can be regarded as closely held, typically on the basis of family or community ties. Closely held banks may face certain operational challenges in terms of raising external capital and recruiting future managers, especially in rural areas. At the same time, closely held banks may have certain operational advantages, including the ability to focus on long term goals and to minimize agency problems that may arise from the separation of ownership and operational control. The paper compares the performance of closely and widely held banks as identified in the survey and finds that closely held banks do not appear, on net, to have underperforming widely held banks in recent years. However, the results also point to the possibility that succession management may be a more difficult problem to them to resolve over the long term.

How Vulnerable Are Agriculturally Concentrated Banks to a Fall in Agricultural Land Values

Authors: Joseph "Jay" Smith, Federal Reserve Bank of Minneapolis; Ron Feldman, Federal Reserve Bank of Minneapolis

Abstract: Agricultural land values are currently at all-time highs, both in absolute terms and relative to the income they generate (e.g., price-to-rent ratio). This paper examines the determinants of performance of the agricultural sector and provides background on agricultural lending. Its focus is modeling the impact of a fall in land values on banks with large agricultural concentrations and exposure. Evidence indicates that the average agricultural bank would not suffer large loans losses. However, the subset of agricultural banks that are the most sensitive to land value declines would suffer substantial losses and reduced levels of capital.

An Historical Loss Approach to Community Bank Stress Testing

Author: Timothy Yeager, University of Arkansas

Abstract: This paper develops a stress testing model for community banks that uses an historical loss approach, subjecting banks to credit conditions from the 2008-2012 period. The model attempts to capture the resiliency of small banks to severe commercial real estate (CRE) downturns and/or recessions. The stress test utilizes the new loan categories that were added to the call reports in 2007.

The paper focuses its analysis on the performance of residential construction loans and owner-occupied CRE loans, which had perceived lower default risk ex-ante. In fact, default rates amongst these loan types were similar to rates for nonresidential and non-owner occupied loans during the sample period. Consequently, this provided fewer diversification benefits.

Reaction to Community Bank Performance session- Julapa Jagtiani

Community Bank Performance Moderated Question and Answer Session

Research Paper Session 3

The State and Fate of Community Banking

Authors: Marshall Lux, Harvard Kennedy School, Mossavar-Rahmani Center for Business and Government; Robert Greene, Harvard Kennedy School, Mossavar-Rahmani Center for Business and Government

Abstract: Community banks service a large number of key segments of the U.S. commercial bank lending market, including agriculture, real estate and small business loans. However, over the past 20 years, community banks’ market share of assets and lending has fallen from over 40 percent in 1994 to about 20 percent today. However, the passage of the Dodd-Frank Act seems to have accelerated this trend. Since its passage, around the second quarter of 2010, community banks’ share of U.S. commercial banking assets has fallen at a rate twice as quickly as compared to the previous four years. Community banks have also seen significant decreases in small business lending volume and incurred disproportionately large losses.

This paper aims to review the impact of regulation, consumer trends and other factors on community banks. It also examines the consequences of consolidation on U.S. lending markets and concludes with a discussion of policies to promote a more competitive and robust banking sector.

Accounting for the Decline in the Number of Community Banks since the Great Recession

Authors: Edward Prescott, Federal Reserve Bank of Cleveland; Roisin McCord, Federal Reserve Bank of Richmond

Abstract: Since the 2007-2009 financial crisis, there has been a significant change in the number of banks in the U.S. At the end of 2007, there were 6,153 commercial banks. By 2013, the number of banks had fallen to 5,317, a decrease of 13.6 percent. This article looks at the changes in the dynamics of entry and exit in the banking sector, as well as the fluctuations in market share of banks of differing sizes. According to the paper, measures of entrances by new banks have been inflated since the Great Recession because the majority of recent entrants have been spinoffs from larger holding companies and converted non-bank lenders. It examines the lack of de novo banks and posits two explanations for the dramatic decline in the influx of new banks since 2009: weak economic growth and restrictive banking regulations. The article concludes by discussing the implications that the current pace of decline of commercial banks could have if it continues.

The Direct Costs of Bank Compliance around Crisis-Based Regulation for Small and Community Banks

Author: Ken Cyree, University of Mississippi School of Business Administration; Director, Mississippi School of Banking

Abstract: This paper looks at the impact of regulatory policy changes and legislation from the past 25 years, the Dodd-Frank Act in particular, on compliance costs for community banks. The 2014 KPMG Community Banking Survey indicates that many bankers find the regulatory burden placed on community banks to be the largest constraint to growth.

This study looks at pre-tax return on investment and loans per employee as measures for banks’ performance and output. Salaries-to-assets, average pay, and technology and fixed assets are all used as measures for the changes in resource allocation and expenditure. The paper explores the reasons that changes in these variables following the Dodd-Frank Act deviate from patterns seen with several other major regulatory changes going back to 1991. Findings show that direct and indirect compliance costs have complex manifestations that go beyond hiring more people to perform additional regulatory and compliance tasks.

Post-Crisis Residential Mortgage Lending by Community

Authors: John Driscoll, Board of Governors of the Federal Reserve System; William Bassett, Board of Governors of the Federal Reserve System

Abstract: Since the recent financial crisis, policymakers have made several changes to the supervision and regulation of originations of mortgage loans with the intent of selling and securitizing them. Some banks and researchers have argued that these changes in the regulatory environment have restricted community bank activities in this market. This study looks at bank Call Reports to examine the profitability and participation of banks in mortgage sales and securitization. Analysis shows that community banks engaged in these activities have higher returns on assets and equity than larger banks. The paper argues that banks have not been, on net, deterred from engaging in these activities, have become a more important part of the market, and have profited from mortgage sales and securitization.