Market Threats to and Resilience of Community Banks

Ninth District Highlights: December 2015

December 7, 2015

Author

Ron J. Feldman Executive Vice President and Senior Policy Advisor

Market Threats to and Resilience of Community Banks

I am not surprised when I hear claims that a new intermediary will spell the end of community banks. Nor am I surprised when new evidence emerges that reinforces the vital role that community banks play. This push and pull has been a regular feature of the bank policy environment.

This discussion—about the market threats to and resilience of community banks—recently took place at the Federal Reserve and Conference of State Banking Supervisors (CSBS) annual research conference on community banks. Specifically, it occurred in a session on small business lending by community banks, a panel on which I had the honor of participating.

The joint research conference is a great event, which I will describe briefly next. I will then put new research on novel competition that community banks face and support for the continued importance of community banks in a context of the early 1990s, a period when banks were supposedly “dying.” Available evidence suggests resilience in the future of small banks in the face of serious competitive threats. That said, weaknesses in existing data challenge researchers’ ability to determine the strength of the community bank model—especially in light of new markets and firms. I conclude this article with a call for new data.

Federal Reserve and CSBS Community Bank Research Conference

The Federal Reserve and CSBS have now sponsored a research conference on community banks for the past three years. The conference has done an excellent job in spotlighting important new analysis on community banks, encouraging analysts to conduct new work and bringing together bankers, researchers and bank supervisors to discuss the key issues of the day. Indeed, the mix of attendees and community bank discussion topics makes the event unique. In this article, I will summarize key points from one panel from the conference, but I strongly encourage you to view all the conference materials from the event website.¹

I got to chair the first panel of the conference, which concerned small business lending by community banks. This topic is a particularly good kickoff, as knowledge-based small business lending of community banks epitomizes what makes their business model valuable to the American economy. But the four papers in the panel raised the critical question: Does that special intermediary role for community banks still hold? I will highlight a few reasons why the question is particularly relevant today. First, increasing regulatory costs could make a higher-touch lending approach less viable. Second, traditional competitors for community banks using current technology seem particularly potent. Third, and perhaps most importantly, innovations in technology create new competitors from existing firms and new entrants, such as so-called “fin tech” or “market place” small business lenders.

The Prior Market Threat/Resilience Debate

Researchers’ concern about the viability of banks and their potential demise is a familiar story for those at the Minneapolis Fed, and this history helped me understand the current situation and research. In 1994, the Minneapolis Fed published an article by John Boyd and Mark Gertler (BG) called “Are Banks Dead? Or Are the Reports Greatly Exaggerated?” and I wrote an update to the BG analysis in 2007 with Mark Lueck.²

BG’s analysis responded to concerns that banks were going to lose market share to alternative providers of liquidity and credit. The source of the concern should sound familiar: the perceived crushing burden of regulation and new competitors that arose due to advances in information and financial technology. BG noted that several standard metrics showed a big decline in the role of banks in financial intermediation. They argued that the decline mattered because of the unique role that banks play in the economy with the provision of credit to small business serving as a primary example. BG concluded, however, that standard data were not sufficient to identify the actual role banks played. They argued that accounting for the full set of activities of banks, such as so-called off balance sheet activities, confirmed the importance of banks.

I updated BG’s work in 2007 with a colleague because of concern that bank disintermediation by new competitors had resurfaced. In short, we produced roughly the same results as BG. However, we pointed out that the data limitations in our analysis were severe. The data to determine exactly what role banks play in intermediation do not really exist, particularly when new lenders enter the scene.

This history anticipates the research on community bank small business lending presented at the conference. One paper—by Julapa Jagtiani and Cathy Lemiuex—pointed to a variety of data showing community bank relative share or position in small business lending had been declining for some time.³ The authors point to changes in lending technology in the current period as a potential accelerant to the decline. This paper is more in the “banks are dying” camp—to use the BG terms—than not.

Two other papers—by Berger et al. and Black and Kowalik—find that the role of community banks in small business lending remained strong; these papers answer “no” to the question of bank death.⁴ Berger et al. argue that better data and analysis allow them to identify a continued critical role for community banks in small business lending, particularly during times of stress. Black and Kowalik develop a model suggesting that small banks’ role in small business lending remains relevant, and they provide some preliminary data consistent with that.

So these three papers relitigate in some sense the original questions and answers that BG posed.

The final paper—Morris et al.—also focuses on the important competition that small banks face in their small business lending, in this case from the Farm Credit System (FCS).⁵ Unfortunately, current data do not readily allow policymakers to determine the level of competition that the FCS presents to banks. This paper helps reinforce a major conclusion of our update to BG: the data to quantify the role of banks in lending and other activities are weak. Specifically, data from lenders on their small business lending have important weaknesses or are nonexistent. Data from small firms on their borrowing have similar problems.

Calling for more data collection at a time when interested parties want to cut back on that effort seems particularly ill-advised. But the research conference has shown the value of applying strong analytics and solid data to community bank issues. In particular, analysis presented at the conference has shown the social and economic gains to community banking. Such work can then motivate changes to public policy to maintain the value of community banking. Better data on small business loan markets would illuminate the important role that community banks play now and could play in the future.