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Business
Review
Federal Reserve Bank of Philadelphia
November • December 1994___________ ISSN 0007-7011

Small Borrowers and the Survival
of the Small Bank:
Is Mouse Bank Mighty or Mickey?
Leonard I. Nakamura

The Impact of Geographic Deregulation




Business
Review

The BUSINESS REVIEW is published by the
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2
Federal Reserve Bank of St. Louis

NOVEMBER/DECEMBER1994

SMALL BORROWERS AND THE
SURVIVAL OF THE SMALL BANK:
IS MOUSE BANK MIGHTY
OR MICKEY?
Leonard I. Nakamura
Large banks have many advantages com­
pared with their smaller brethren: more
diversified portfolios, larger loans, and
wider branch networks—just to name a
few. So, why haven't small banks disap­
peared? Leonard Nakamura speculates
that one reason small banks survive is
that they appear best able to lend to local
small businesses.
THE IMPACT OF GEOGRAPHIC
DEREGULATION ON
SMALL BANKS
Paul S. Calem
This article examines consolidation in the
banking industry as it has affected small
banks. The author investigates trends in
the asset shares of small banking compa­
nies on a state-by-state basis and dis­
cusses the relationship of these trends to
geographic deregulation. From these find­
ings, the author draws inferences regard­
ing the future of small banks when inter­
state branching becomes a reality.

FEDERAL RESERVE BANK OF PHILADELPHIA

Small Borrowers and
the Survival of the Small Bank:
Is Mouse Bank Mighty or Mickey?
Leonard I. Nakamura *

S

mall banks— those having less than $1
billion in assets—account for 97 percent
of all banks in the United States, but only
about 33 percent of banking assets. These small
banks are subject to many disadvantages com­
pared with their bigger brethren, who can have
more diversified portfolios, make larger loans,
benefit from economies of scale in check pro­
cessing and other automation technology, offer
wider branch networks and more diverse ser­
vices to their customers, and acquire capital
more easily on public markets. As a conse­
quence, it's often projected that small banks
^Leonard Nakamura is a senior economist and research
adviser in the Philadelphia Fed's Research Department.




will disappear rapidly somewhere in the nottoo-distant future.
That future in which larger banks monopo­
lize the U.S. banking system has not arrived,
and it appears little, if any, closer than in the
past. While the number of small banks has
fallen by 1000 or so in the past 30 years, there
are still many of them (Table 1). Why haven't
small banks disappeared as so many have pre­
dicted?
One reason is that small banks appear best
able to lend to local small businesses (here
"small" businesses are defined as businesses
that have less than $10 million in annual re­
ceipts and borrow less than $3 million from all
sources). This is because small banks have the
3

BUSINESS REVIEW

NOVEMBER/DECEMBER1994

TABLE 1

Number of Banks by Asset Size
(Size Categories Adjusted
for Inflation, 1990 $)
Size

1960

1975

1990

less than
$100 million

12031
(91%)

11809
(82%)

9247
(75%)

$100 million1 billion

1040
(8%)

2327
(16%)

2710
(22%)

$1 billion10 billion

136
(1%)

230
(2%)

326
(3%)

more than
$10 billion

10
(0.1%)

17
(0.1%)

47
(0.4%)

Bank Assets Held
by Banks of Different Sizes
(Size Categories Adjusted
for Inflation, assets in billions 1990 $)
Size

1960

1975

1990

less than
$100 million

269
(25%)

405
(19%)

359
(11%)

$100 million1 billion

270
(25%)

570
(27%)

651
(21%)

$1 billion10 billion

337
(31%)

621
(30%)

1037
(34%)

more than
$10 billion

198
(19%)

490
(24%)

997
(33%)

Data in parentheses are percents of total for each year.
Source: Call Reports


4


ability to closely monitor these firms, and their
tight organizational structures enable them to
effectively use the resulting informational ad­
vantage.1 Before we discuss that, however, we
look at some of the reasons that small banks
have to envy large banks. To do so, we inves­
tigate the daydreams and competitive con­
cerns of Ms. M. Mouse, the chief executive
officer of Mouse Bank in Cheeseburgh, PA, a
bank with roughly $200 million in assets.
DO LARGE BANKS
HAVE ALL THE ADVANTAGES?
First, Ms. Mouse longs to have a more diver­
sified p o rtfo lio .2 D uring the recession ,
Cheeseburgh's chief employer, Cheeseburgh
Quarry, laid off a dozen workers and fell be­
hind on its loan repayments, causing her many
sleepless nights. If only Mouse Bank were a big

1Another reason small banks remain numerous is that in
general banks have not yet been allowed to branch across
state lines. Instead they can cross state lines only as bank
holding companies by setting up separate banking subsid­
iaries. Moreover, as we shall see below, there are some
reasons that bank holding companies might prefer small
bank subsidiaries to remain independent even when laws
permit the subsidiary to become a branch of the main bank.
But even if we treat bank holding companies as a single
banking organization rather than counting them as separate
banks, there is little indication that small banks are rapidly
disappearing. See, for example, Boyd and Graham (1991);
and Paul Calem's article on geographic deregulation in this
issue.
2Diamond (1984) argues that a fully diversified bank,
with appropriate use of hedges, could be more or less risk
free, even though the individual loans the bank makes are
inherently risky. Diamond's theory, which assumes that
risk in the bank portfolio is costly, implies that if diversifica­
tion were the only relevant variable, banks would be as
large as possible in order to diversify risk as much as
possible. Laderman, Schmidt, and Zimmerman (1991) show
that where branching is restricted, banks in rural areas
specialize more heavily in agricultural loans and banks in
urban areas specialize more heavily in nonagricultural loans,
which suggests that branch locations geographically limit
lending and portfolio diversification.

FEDERAL RESERVE BANK OF PHILADELPHIA

Small Borrowers and the Survival of the Small Bank

bank, she thinks, then when Cheeseburgh was
in recession, other borrowers, say in Hong
Kong or Atlanta, would be paying on time and
keeping the bank's profits steady.
In addition, Mouse Bank's costs of handling
a transaction are twice as large as Money Bank's.
Tellers are encouraged to chat with customers
to encourage good relations, and many cus­
tomers still have passbook savings accounts,
which means that the tellers have to go back
and forth to the passbook stamping machine
instead of being able to handle all transactions
at their stations. Ms. Mouse knows it would be
more technologically efficient to turn her check
handling over to a big bank that could fully
automate the process, but her customers expect
a lot of personal service, which would not be
practical if the checks were being handled au­
tomatically outside of the bank. For example,
her good customers expect to be warned when
their accounts are close to being overdrawn
and to be able to expedite a transfer of funds
when special circumstances arise.
The lack of more extensive automation also
affects her costs of complying with regulations.
If more of Mouse Bank were automated, it
would be easier for her to comply with the
myriad bank regulations. Her compliance ex­
penditures are substantially greater as a share
of assets than those of her larger competitors.3
She wishes she had more branches, too,
because she knows that some of her neighbors
bank with Everywhere Bank, the super-regional
bank that has opened a branch in Cheeseburgh.
Everywhere Bank offers branches statewide,
which is useful to commuters and to businesses
with multiple plants, offices, or stores. As Paul
Calem's article on branch banking in the M ay/
June 1993 issue of this Business Review points
out, branch banks offer customers greater con-

3Thakor and Beltz (1993) present survey evidence that
smaller banks pay relatively higher costs to comply with
consumer protection regulations.




Leonard 1. Nakamura

venience. As a result, depositors are often will­
ing to accept lower interest rates on their ac­
counts at these banks.
She wishes she didn't have to keep her bank's
capital level so high. Mouse Bank has $20
million in equity capital—the bank's original
stock issue plus retained profits—for a 10 per­
cent capital-asset ratio. Most of this money
belongs to Ms. Mouse, her sister, and her Uncle
Rodney, and she would prefer that her family's
eggs weren't all in one basket. But she knows
that when Cheeseburgh hits hard times, as it
has recently, the high capital ratio keeps the
bank from losing its best customers. Money
Bank and Everywhere Bank have much lower
capital ratios, but they can more readily raise
additional funds by issuing stock or subordi­
nated debt, since they are publicly traded com­
panies monitored by Moody's and Standard
and Poor's bond raters.4If worse came to worst,
Money Bank and Everywhere Bank could force
shareholders to add to the banks' capital by
making rights offerings.5 She couldn't do the
same thing with Mouse Bank, since she knows
that her family couldn't raise much extra cash.

4It is well known that small banks have higher capitalasset ratios than large banks. See, for example, evidence in
Boyd and Graham (1991). One reason for this is that obtain­
ing new outside capital is more expensive for small banks
should they have losses. For example, obtaining a bond
rating, which enables a borrower to more easily get outside
capital, involves a minimum cost of thousands of dollars
above and beyond interest payments and fees. These pay­
ments and fees are proportionately less for a large bank than
for a small bank. Thus, small banks like to have larger
capital cushions against losses.
5Bank public debt issue is called subordinated debt
because it has a lesser claim on bank assets than do checking
and savings deposits. In a rights offering, shareholders are
given the right to buy additional shares at a price below the
market value. The rights offering results in a dilution of
stock value, as old shares become worth less than they were.
In general, all shareholders will exercise their rights, as any
shareholder who doesn't will suffer the dilution without
recompense.

5

NOVEMBER/DECEMBER1994

BUSINESS REVIEW

Finally, if Mouse Bank were a bigger bank it
could make larger loans. In general, commer­
cial banks are not permitted to make loans to a
single entity that represent more than 10 per­
cent of capital. When Cheeseburgh Quarry
wanted to borrow $4 million to invest in a new
gravel loading system, Mouse Bank had to
refer the loan to Money Bank, Mouse Bank's
correspondent in Philadelphia, because mak­
ing the loan would have meant exceeding Mouse
Bank's $2 million ceiling on loans to a single
borrower.6* Loan limits exist, in part, to ensure
that banks have diversified portfolios, and it
may well be to Mouse Bank's advantage that it
couldn't lend more to Cheeseburgh Quarry.
But Mouse Bank remains limited in the choice
of loans it can make on its own, compared to a
larger bank, and may well be prevented from
making some large loans that offer good re­
turns and actually reduce risk.
One factor that does work in her favor is
deposit insurance. Because of deposit insur­
ance, depositors with less than $100,000 are
fully insured. As a result, her depositors can be
as confident about the safety of their deposits
as the depositors at Money Bank and Every­
where Bank, despite the fact that more current
information about the larger banks is available,
since their credit standing is reviewed by bond
rating services. Deposit insurance is crucial to
her bank's existence.
A second advantage is that Mouse Bank
pays less interest because its deposits are in
checking and small savings accounts; Money
Bank pays more interest because it funds loans
with large time deposits in competition with
nonbank financial institutions. Thus operating
costs per dollar of deposit decrease with bank
size, but total cost, including interest payments,

6In a correspondent banking relationship a larger bank
performs a variety of services for a smaller bank, including
payment, credit, and advisory, and the smaller bank main­
tains a deposit balance at the larger bank.


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6
Federal Reserve Bank of St. Louis

is more or less flat, as lower operating costs at
larger banks are offset by higher interest costs.
With deposit insurance and lower interest
expense, and despite some disadvantages,
Mouse Bank earns a higher return on assets,
and just as high a return on equity, as do Money
Bank and Everywhere Bank. So while Ms.
Mouse is usually fairly modest about her own
abilities, she often wonders whether she might
do better than Money Bank and Everywhere
Bank if she were running a larger bank.
Academic research suggests that she prob­
ably would not, for small banks are recurrently
found to outperform large banks. The average
bank with assets below $1 billion had superior
returns compared with banks with assets above
$1 billion (Table 2).

TABLE 2

Profitability of U.S. Banks
Return on Assets and Return on Equity
(percent)
Period
Size

1980-83

1984-87

1988-90

less than
$25 million

1.01
10.7

.86
9.0

$25 million100 million

1.07*
13.0*

1.02*
12.3

.72
8.2

$100 million1 billion

.88
12.4

.98
13.9*

.82*
10.9*

more than
$1 billion

.54
12.5

.69
8.8

.54
10.0

n.a.
n.a.

Data are taken from Boyd and Graham (1991).
*Best for this time period and profitability measure.

FEDERAL RESERVE BANK OF PHILADELPHIA

Small Borrowers and the Survival of the Small Bank

SMALL BANKS
HAVE INFORMATION ADVANTAGES
Perhaps this profit advantage arises from
the fact that small-bank presidents like Ms.
Mouse know more about what is going on in
their towns than anyone else—partly because
customers seeking loans reveal a lot of informa­
tion to the loan officers and partly because
Mouse Bank is able to make effective use of this
information and of the information inherent in
checking and savings account activities of the
bank's local customers. Consequently, Ms.
Mouse knows who's saving money and who
isn't and which businesses are making money
and how much.7 For example, when Loan
Officer Katt at Mouse Bank hears a rumor that
Harvest Drug may be in trouble, he can check
Harvest Drug's checking account to see if Har­
vest Drug's sales receipts have fallen off. If so,
Mr. Katt can set up informal or, if need be,
formal meetings with the store's management
to review the store's loans.
Looking at Harvest Drug's bank accounts
not only allows Mr. Katt to quietly check up on
how the business is doing, but it's also ex­
tremely useful in helping Mr. Katt get accurate
information from Mr. Harvest. Mr. Harvest
knows that Mr. Katt has access to a lot of
confidential financial information, both about
Mr. Harvest and about other businesses in the
town and the surrounding area—so Mr. Har­
vest is always aware that Mr. Katt would easily
catch any lie. A similar line of reasoning en­
sures that when Mr. Katt talks to Ms. Mouse
about how his loan portfolio is doing, he is
always frank— Ms. Mouse has a legendary
knowledge of Cheeseburgh business. In turn,
this allows Ms. Mouse to extend to her loan
officers much greater freedom than large branch
banks like Everywhere Bank and large money
center banks like Money Bank can extend to
theirs.8

7See Nakamura (1990) for evidence.




Leonard 1. Nakamura

Ms. Mouse knows that a nonbank lender
would not have access to the kind of day-today information she and her officers can ex­
tract from checking and savings accounts. So
she doesn't worry about direct competition
from nonbanks.
She also doesn't worry about Money Bank,
which has an extensive branch network in Phila­
delphia and its nearby suburbs, but does not
have a branch in Cheeseburgh. It lends to large
commercial borrowers. Because Money Bank
lacks deposit relationships with Cheeseburgh
businesses, Ms. Mouse knows that it can't evalu­
ate them nearly as well as her bank can.
On the other hand, Everywhere Bank's
branch in Cheeseburgh is very much on Ms.
Mouse's mind. Everywhere Bank offers some­
thing Ms. Mouse can't: branches located across
the state and affiliates outside the state. As a
consequence, Mouse Bank has lost some cus­
tomers Ms. Mouse would very much like to
have: active business leaders who make use of
Everywhere Bank's extensive branch network.
Moreover, it seems likely to Ms. Mouse that
sooner or later Everywhere Bank will be al­
lowed to consolidate its regional banking sys­
tem into a single bank with interstate branches.
But these advantages are offset by the way
Everywhere Bank tends to make small loans. If
a loan doesn't quite fall within their strict guide­
lines, the loan officer has to request an excep­
tion; and when an exception fails, the loan
officer gets in very hot water. As a result, the
Cheeseburgh branch of Everywhere Bank has
only a small share of the town's loan business,
and Ms. Mouse feels that Everywhere Bank
does not seriously threaten her bread-and-but­
ter small loan business.

8Technically speaking, Mouse Bank is better at delegated
monitoring than is a larger bank. In Diamond's theory
(1984) banks possess "inside" (that is, nonpublic) informa­
tion about lenders. To Diamond's theory we have to append
a notion that monitoring of loan officers within the bank
becomes more difficult as the bank becomes larger.

7

BUSINESS REVIEW

So when Ms. Mouse thinks about the wider
scheme of things, she realizes that her bank has
every reason to thrive. Mouse Bank earns a
higher return on lending because Ms. Mouse
has better information, and she has better infor­
mation in part because she has access to confi­
dential information from the checking accounts
at her bank and in part because of her long
history of lending in Cheeseburgh. Because
Mouse Bank is so respected as the business
leader in Cheeseburgh, new firms come to it for
advice. As old customers retire and businesses
grow large or fail, Mouse Bank continues to
attract most of the new commercial accounts in
Cheeseburgh, and thus keeps gaining access to
new information about new businesses in the
area.
While Ms. Mouse considers expanding into
neighboring towns, she will satisfy her desire
for wider horizons gradually in order to main­
tain the informational advantage she has built
up in banking in Cheeseburgh and the sur­
rounding area. From the perspective of the
student of banking, Ms. Mouse is right to be
cautious. (See Small Bank Holding Companies:
The Best o f Both Worlds?)

NOVEMBER/DECEMBER1994

INFORMATION AND MONITORING:
MODERN BANKING THEORY
Much recent work in the theory of banking
focuses on how banks use information in lend­
ing. One theory focuses on the edge that banks
have as lenders because they can look at bor­
rowers' checking accounts (Nakamura 1990,
1993a,b). This information is most valuable
with small commercial loans. The second stage
of the argument is that large banks are not good
at making small commercial loans because they
lack the flexibility and good internal informa­
tion flows found at smaller banks. Thus small
banks do have a strength in small commercial
lending, which offsets the various advantages
that larger banks have.
A foundation stone of this theory is that
borrowers do not always have the right incen­
tives to repay loans (Nakamura, 1991). Any
ongoing firm makes commitments to several
parties: for example, lenders, landlords, cus­
tomers, suppliers, and employees. When a
firm gets into trouble and income dries up, the
firm is forced to renege on its promises to at
least some of these parties. Who gets paid will
depend on the power any given party has to

Small Bank Holding Companies: The Best of Both Worlds?*
Is there some way to combine the strengths of the small bank in lending with some of the advantages
of size available to large banks, such as their ability to diversify, obtain capital, and automate? One approach
would be to create a network of largely independent banks that were subsidiaries of a large bank holding
company. Indeed, some bank holding companies have attained much of their growth by trying to provide
as much independence in traditional bank lending as possible to the small banks that they have acquired,
while gaining the capital funding advantages and other economies of scale associated with a large network
of banks.3 For example, some of these holding companies see informational gains to maintaining a local
board of directors at small bank subsidiaries, gains that would be lost if the small banks were amalgamated
as branches of one large bank, even though amalgamation would reduce administrative costs. Yet the
holding company form implies some degree of loss of control for the small bank subsidiary. Decisions at
headquarters, based on overall company strategic considerations, may contravene what would be
preferred by the individual subsidiary. As a consequence most small banks have remained independent.

3 See, for example, the Harvard Business School case entitled, "Banc One Corporation, 1989."


8


FEDERAL RESERVE BANK OF PHILADELPHIA

Small Borrowers and the Survival of the Small Bank

Leonard I. Nakamura

enforce payment.9 Employees may leave a firm mation as possible about the financial condi­
if wages are not paid promptly, for example. A tion of the borrower.
Monitored lending is what banks do better
supplier may stop supplying materials until
previous shipments are paid for. A landlord than nonbanks because banks are better able
may evict a tenant for failing to make lease than other potential lenders to obtain informa­
payments. When a loan is guaranteed by collat­ tion about the financial condition of borrowers.
eral, the lender may be able to seize the collat­ In collateralized lending, the lender must watch
eral. Otherwise a lender's only real line of the value of the collateral, but generally the
defense is to closely monitor the borrower and economic status of the borrower is of less con­
threaten to deny future loans or force bank­ cern. As a consequence, banks compete only
ruptcy, threats that are potent only as long as with other banks for monitored lending, but
the borrower has some possibility of returning they must compete with many nonbanks (like
to a sound footing and so wants to avoid the finance and m ortgage com panies) for
consequences of having these threats carried collateralized lending.10
One reason why banks, large and small, may
out.
In collateralized lending, the borrower prom­ have an intrinsic advantage as monitoring lend­
ises to give up a valuable asset if he or she ers compared with other financial intermediar­
defaults on loan payments. The classic ex­ ies is that the access to borrowers' transactions
amples of collateralized loans are mortgages obtained through their checking accounts gives
and auto loans. If a borrower defaults, the banks additional ability to monitor loans. This
lender can seize the house or auto and resell it. gives institutions legally permitted to issue
A nd b ecau se the lend er has recourse to the checking accounts a unique edge. The direct
collateral, the borrower has a strong incentive deposit of paychecks into a bank account gives
to repay the loan in full. As Jeffrey Lacker a bank a current record of employment and
(1991) points out, for collateralized lending to income.11 The ongoing deposit history that
work well, the property must be more valuable banks have of the businesses they lend to gives
to the borrower than the amount borrowed. them a unique ability to monitor sales.12 Check­
The collateral then becomes a way to enforce ing account information can be used to enforce
payment because the borrower loses more by covenants in a timely manner, and banks are
giving up the collateral than by refusing to better able to administer loan workouts out­
side of bankruptcy as a consequence.13
repay the loan.
In monitored lending, the lender must closely
watch the borrower's financial condition. If it
begins to deteriorate, the lender must step in
10See Nakamura (1993b) for a further discussion of the
actively and defend its own interest by threat­ difference between collateralized and monitored lending.
ening to refuse future loans or force bank­ Lacker (1990,1991) discusses collateralized lending and
ruptcy. This means that the lender must be Diamond (1984) discusses monitored lending.
vigilant and must have access to as much infor11Black (1975) proposed that when households borrow
from banks, their checking accounts provide useful infor­
mation in assessing the riskiness of loans to the households.
9Sentiment, the degree of relationship and obligation felt
by the parties, also may play a role. Unless a bank has an
unusually close relationship with a borrower, parties with
more regular contact with the borrower (employees, for
example) are likely to have more powerful sentimental ties
than loan officers.




12Fama (1985) extended Black's argument to business
lending.
13Nakamura (1990) presents evidence from bank loan
manuals as well as theory.

9

BUSINESS REVIEW

Checking accounts should be of most value
for monitoring small businesses.14 The main
checking account of a small single-location
business provides readily accessible informa­
tion that the lender can easily interpret. By
contrast, large multilocation businesses in the
United States typically use multiple accounts at
a number of different banks.15 As a result, no
one ban k has a clear view of the detailed activ­
ity of the multilocation business. Moreover,
the complicated character of the financial trans­
actions of a large business makes it very diffi­
cult for any lender to interpret all the informa­
tion in its transactions.
In a related vein, when a small bank does
business within a community of depositors
who transact frequently with one another,
checking and savings accounts can provide
information about local economic conditions
that may not be available in a timely fashion
from any other source. This information is
most valuable, again, in lending to small busi­
nesses with primarily local customers.
Not only do small banks have an informa­
tional advantage, their loan officers are able to
make better use of such information than are
loan officers at large banks. For example, loans
at many large banks are reviewed using stan­
dardized, objective criteria that do not bring
into consideration all the special information
that may be available to a loan officer.16 This

14See Nakamura (1993a,b) for this viewpoint.
15A survey of large corporations in 1971 found that of
161 corporations, 59 had dealings with more than 100 banks
and a majority had relationships with more than 50 (Confer­
ence Board, 1971). Only eight had relationships with fewer
than 10 banks. Subsequent studies and anecdotal evidence
confirm that these multiple relationships are ongoing. In
recent Congressional testimony, for example, an Occidental
Petroleum manager said that the company used 43 financial
institutions in its banking business.
16Udell (1989) discusses the formal loan review as a
means for monitoring loan officer performance.


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10
Federal Reserve Bank of St. Louis

NOVEMBER/DECEMBER 1994

objective review is necessary because, other­
wise, loan officers at large banks may be tempted
to abuse their lending powers. For example, a
loan officer at a large bank might find it easier
to conceal a loan that has gone bad because the
large bank's senior management has much more
in its purview and can't follow loans as closely.
From the loan officer's perspective, taking steps
against a troubled loan could be a doubleedged sword. Doing so might save the loan,
but it would also be an admission that the
borrower has gotten into trouble and, perhaps,
that the loan shouldn't have been made in the
first place. This loan officer might be tempted
to ignore the first signs of trouble with a loan
and hope that nothing happens until the loan
officer is transferred to a better position. Then,
whoever takes over the loan may be unable to
show that the loan was bad to begin with. This
situation is less likely to happen at small banks
because the senior management is closer to the
loans and can more easily assign blame for loan
losses.17
This theory suggests that large banks may
cope with their decreased capacity for moni­
toring their loan officers by having each officer
use more rigid criteria to make loans, on aver­
age. Large banks also appear to have their loan
officers make fewer but larger loans on aver­
age. This may reflect differences in the ability
to use information, as these larger loans are
made to large borrowers about whom more
public information is available, and the small
number of loans is easier to supervise.18

17I make this argument in Nakamura (1993a,b). See
McAfee and McMillan (1989) for a discussion of the difficul­
ties that hierarchies encounter in monitoring. Mester (1991)
applies this idea to mutual savings and loans.
18Data from the Federal Reserve's Functional Cost Analy­
sis show that among small banks reporting in the survey,
loan officers at larger banks handle fewer loans. Anecdotal
evidence suggests that this finding applies as well to large
banks.

FEDERAL RESERVE BANK OF PHILADELPHIA

Leonard I. Nakamura

Small Borrowers and the Survival of the Small Bank

In practice, large and small banks do tend to
specialize in loans of different sizes as this
theory suggests. In 1988, for example, banks
with assets less than $1 billion made threefourths of all bank loans smaller than $1 mil­
lion, while banks with assets more than $1
billion made nine-tenths of all bank loans larger
than $1 million (Table 3).
The fact that a small bank possesses special
"inside" information about its loans gives it an
advantage in making small loans. But some­
times its reliance on that information can be a

drawback. Recent banking theory explores the
negative side, too. It's easy for "outsiders" who
lack this special information to become ner­
vous about whether the loans are, in fact, going
to be good and that makes the loans illiquid.19
No one would buy small loans from a small
bank that faced a temporary liquidity problem
because the buyer couldn't tell for sure if the
19See Gorton and Haubrich (1991) for a discussion of the
market for loan sales, which is mostly restricted to large
loans made by large banks.

TABLE 3

Who Makes Large and Small Loans?
Distribution of Banks Making Loans for Each Loan Size
(percent)
Loan Size*

Bank Size*
Share of Small Loans
Loans < $1 mil

Share of Large Loans
Loans > $1 mil

less than $100 million

27

1

$100 to $300 million

26

3

$300 million to $1 billion

20

8

$1 to $3 billion

18

17

$3 to $10 billion

7

33

$10 to $30 billion

3

23

$30 billion +

1

15

(Assets)

*The table shows 1988 data to avoid distortions that might result from the 1989-90 downturn. The loan size to which
a loan is assigned is the larger of the actual loan amount or the commitment of which the loan is a part. Totals may not add
to 100 percent due to rounding.
Note: Loans are commercial and industrial loans greater than $1000. Includes advances of funds, takedowns under
revolving credit agreements, notes written under credit lines, renewals, bank's portion of loan participation, commercial,
industrial, construction, and land development loans. Excludes purchased loans, open-market paper, accounts receivable
loans, loans made by international division of bank, and loans made to foreign businesses.
Source: Quarterly Terms of Bank Lending to Business, Federal Reserve Board.




11

BUSINESS REVIEW

loans were good ones. Large loans at large
banks are less troubled by (but not free of) this
problem because more public information is
available about the borrowers. As a conse­
quence, a rumor that a small bank is in trouble
could easily be self-confirming, leading to a run
on deposits that the bank could not meet be­
cause even the good loans the bank has made
could be sold only at a substantial loss. That is
why small banks typically have high capital-toasset ratios and also why deposit insurance is
particularly crucial for small banks: by assur­
ing depositors that their money is safe, a high
capital-to-asset ratio and deposit insurance re­
lieve the small bank of the risk of failure caused
by a bank run.
SMALL BANKS' EARNINGS
COMPARED TO LARGE BANKS'
Even when banks specialize in the size of
loans they seem best suited to make— that is,
small banks making small loans and large banks,
large ones— small banks appear to be doing
better. The data show that banks with less than
$1 billion in assets earn higher interest income
per dollar of assets than larger banks (Table 4).
This accords with evidence (in Table 2) that
return on assets is higher for banks with asset
size less than $1 billion than for banks with
asset size more than $1 billion and that the same
holds true for return on equity, although the
evidence is less dramatic. Indeed, the evidence
from return on assets is that banks with less
than $100 million in assets had a greater return
than banks with larger assets. However, the
smallest banks— those with assets of less than
$25 million— generally do not earn the highest
net returns because their noninterest costs tend
to be higher than those of larger banks.
Why don't large banks do as well at lending
to large firms as small banks do at lending to
small firms? One reason could be that small
banks are better monitors than large banks,
even for the loans large banks are best suited to
make.

12


NOVEMBER/DECEMBER1994

But another reason is that small banks have
the advantage of less competition. Timothy
Hannan (1991) provides evidence that small
loans pay higher interest rates in concentrated
banking markets, but the evidence on large
loans is inconclusive. This suggests that greater
returns are likely to be derived from small
loans than from large loans. Many small banks,
like M ouse Bank, h ave an in form ation al ad v an ­

tage in their home markets that comes from
their deposit business. Small banks need fear
competition in small business lending only
from other local banks, because only other local
banks can offer deposit accounts to their cus­
tomers. A bank with branches an hour's drive
from Cheeseburgh is simply not a competitive
threat to Mouse Bank because Cheeseburgh
business owners are not willing to do their
banking that far away.20 By contrast, the de­
posit business of large banks, such as Money
Bank and Everywhere Bank, does not give
them as big of an advantage in lending. Money
Bank's large business customers can go to banks
headquartered in San Francisco or Chicago for
loans. So small banks more often have market
niches in which competition is limited, and as
argued by Paul Calem in this issue, these mar­
ket niches will probably survive interstate
branching.
One concern is that small banks may be
earning higher returns because they may be
riskier than large banks. Since deposit insur­
ance makes risk-taking cheaper, greater risk
would result in higher returns to the bank's
owners at the potential expense of higher losses
to the deposit insurance fund.21 But this doesn't

20Elliehausen and Wolken (1990) document that almost
all small businesses obtain their checking services from a
bank or thrift located within 12 miles of the firm.
21Until 1993, banks with riskier portfolios paid the same
deposit insurance premiums as other banks. When this is
true, much of the cost of the greater downside risk is ab­
sorbed by the deposit insurer, while the greater upside risk

FEDERAL RESERVE BANK OF PHILADELPHIA

Leonard I. Nakamura

Small Borrowers and the Survival of the Small Bank

TABLE 4

Interest Income as Percent of Assets
(Adjusted for Loan Losses and Taxes)
Size of Bank in Dollars
Date

Less Than
100 Million

100 Million
to 1 Blillion

1 Billion to
10 Billion

Greater than
10 Billion

1984

9.52

9.43

8.88

9.12

1985

8.80

8.65

7.97

7.95

1986

7.81

7.60

7.00

6.85

1987

7.50

7.43

6.84

6.06

1988

7.74

7.76

7.47

7.62
8.01

1989

8.36

8.45

8.17

1990

8.31

8.26

7.76

8.09

1991

7.99

7.68

6.93

6.84

1992

7.09

6.53

5.88

5.69

1993

6.18

5.94

5.38

5.28

7.93

7.77

7.23

7.15

AVERAGE
Source: Call Reports

seem to be the case, since small banks fail no
more often than large banks.22
Overall, the data suggest that small banks
have less competition as lenders and are better
able to use their knowledge to make profitable
loans. One of the ongoing challenges for any
thriving bank is to continue to provide quality
service to small businesses as the bank in­
creases in size.
The natural process of growth that any busi­
ness undergoes is, for small banks, clearly
double-edged. As a bank ages, its best custom­

benefits the bank's equity holders. Since the beginning of
1993, the riskier banks pay more for deposit insurance, but
most analysts believe that the spread between the highest
and lowest premium rate is too small, so that deposit insur­
ance still provides an implicit subsidy to riskier banks.
22See Boyd and Runkle (1993).




ers also grow—and, in the process, become less
profitable to the bank as their funding options
expand. The growing bank must keep on its
toes to continue to attract risky new borrowers
who, troublesome as they are, may ultimately
be its best hope for a profitable future.
CONCLUSION
As long as the deposit insurance system
remains in place, it appears likely that small
banks will play an important role in the U.S.
economy. A central role of small banks is
providing funds to small businesses. Small
banks are able to efficiently provide funds to
small businesses because they can use the infor­
mation derived from checking accounts to
monitor loans. Also, the small bank has short
managerial lines of command and communica­
tion, which permits it to use information effec­
tively.
13

NOVEMBER/DECEMBER1994

BUSINESS REVIEW

REFERENCES
Black, Fischer. "Bank Funds Management in an Efficient Market," Journal o f Financial Economics 2 (1975),
pp. 323-39.
Boyd, John FI., and Stanley L. Graham. "Investigating the Banking Consolidation Trend," Federal Reserve
Bank of Minneapolis Quarterly Review (Spring 1991), pp. 3-15.
Boyd, JoFin H., and David E. Runkle. "Size and Performance of Banking Firms: Testing the Predictions of
Theory," Journal o f Monetary Economics 31 (February 1993), pp. 47-67.
Calem, Paul S. "The Proconsumer Argument for Interstate Branching," this Business Review (May-June
1993), pp. 15-29.
Conference Board, The. Cash Management. New York, 1971.
Diamond, Douglas W. "Financial Intermediation and Delegated Monitoring," Review o f Economic Studies
51 (July 1984), pp. 393-414.
Diamond, Douglas W., and PFiilip H. Dybvig. "Bank Runs, Deposit Insurance and Liquidity," Journal o f
Political Economy 91 (June 1983), pp. 401-19.
Elliehausen, Gregory E., and John D. Wolken. "Banking Markets and the Use of Financial Services by Small
and Medium-Sized Businesses," Board of Governors of the Federal Reserve System Staff Studies 160,
1990.
Elliehausen, Gregory E., and John D. Wolken. "Small Business Clustering of Financial Services and the
Definition of Banking Markets for Antitrust Analysis," Antitrust Bulletin 37 (Fall 1992), pp. 707-35.
Fama, Eugene F. "W hat's Different About Banks," Journal o f Monetary Economics 15 (January 1985), pp. 2940.
Gorton, Gary and George Pennacchi. "Banks and Loan Sales: Marketing Non-Marketable Assets," NBER
Working Paper No. 3551, 1991.
Hannan, Timothy H. "Bank Commercial Loan Markets and the Role of Market Structure: Evidence from
Surveys of Commercial Lending," Journal o f Banking and Finance 15, (February 1991), pp. 133-49.
Hetzel, Robert L. "Too Big to Fail: Origins, Consequences and Outlook,"
Richmond Economic Review 77 (November/December 1991), pp. 3-15.

Federal Reserve Bank of

Humphrey, David B. "Why Do Estimates of Bank Scale Economies Differ?" Federal Reserve Bank of
Richmond Economic Review 76 (September/October 1990), pp. 38-50.
Lacker, Jeffrey M. "Collateralized Debt as the Optimal Contract," Federal Reserve Bank of Richmond
Working Paper No. 90-3, 1990.


http://fraser.stlouisfed.org/
14
Federal Reserve Bank of St. Louis

FEDERAL RESERVE BANK OF PHILADELPHIA

Small Borrowers and the Survival of the Small Bank

Leonard I. Nakamura

Lacker, Jeffrey M. "Why Is There Debt?" Federal Reserve Bank of Richmond Economic Review 77 (July/
August 1991), pp. 3-19.
Laderman, Elizabeth S., Ronald H. Schmidt, and Gary C. Zimmerman. "Location, Branching, and Bank
Portfolio Diversification: The Case of Agricultural Lending," Federal Reserve Bank of San Francisco
Economic Review (Winter 1991), pp. 24-38.
McAfee, R. Preston, and John McMillan. "Organizational Diseconomies of Scale," California Institute of
Technology mimeograph, 1989.
Mester, Loretta J. "Agency Costs Among Savings and Loans," Journal o f Financial Intermediation 1 (June
1991), pp. 257-89.
Nakamura, Leonard I. "Loan Workouts and Commercial Bank Information: Why Banks Are Special,"
mimeo, Federal Reserve Bank of Philadelphia, 1990.
Nakamura, Leonard I. "Lessons on Lending and Borrowing in Hard Times," this Business Review (July/
August 1991), pp. 13-21.
Nakamura, Leonard I. "Commercial Bank Information: Implication for the Structure of Banking," in
Michael Klausner and Lawrence J. White, eds., Structural Change in Banking. Homewood, 111.: Business
One/Irw in, 1993a, pp. 131-60.
N ak am u ra, L eo n ard I.

"R e ce n t R esearch in C o m m ercial B anking : In fo rm atio n and L e n d in g ," Financial

Markets, Institutions and Instruments 2 (December 1993b), pp. 73-88.
Thakor, Anjan V., and Jess C. Beltz. "An Empirical Analysis of the Costs of Regulatory Compliance," in
Proceedings of Conference on Bank Structure and Competition (Federal Reserve Bank of Chicago, 1993),
pp. 549-68.
Udell, Gregory F. "Loan Quality, Commercial Loan Review and Loan Officer Contracting," Journal o f
Banking and Finance 13 (July 1989), pp. 367-382.




15

NOVEMBER/DECEMBER1994

BUSINESS REVIEW

ANNOUNCEMENT:
Information and Screening in Real Estate Finance:
A Special Issue of the Journal of Real Estate Finance
and Economics
C o-sp onsored b y the F ed eral R eserve Bank o f P hiladelp hia

The issue of racial discrimination in mort­
gage lending has recently received widespread
publicity. A central paradox for researchers,
policymakers, and the public is how such dis­
crimination can persist when nationwide mort­
gage banking firms can readily enter local mort­
gage markets and when laws such as the Fair
Housing Act and the Community Reinvest­
ment Act have been written to prevent dis­
crimination. On March 3-4, 1994, the Federal
Reserve Bank of Philadelphia and the Journal o f
Real Estate Finance and Economics co-sponsored
a research conference at the Bank on "Informa­
tion and Screening in Real Estate Finance." Six
research papers were presented and discussed,
and five groups of investigators presented re­
ports on current research.
The November 1994 issue of the Journal o f
Real Estate Finance and Economics includes an
introduction to information issues in real estate
finance by Leonard Nakamura and William
Lang and the papers presented at the confer­
ence: "List Price Signaling and Buyer Behavior


16


in the Housing Market," John Knight, C.F.
Sirmans, and Geoffrey Turnbull; "Bias in Esti­
mates of Discrimination and Default in Mort­
gage Lending: The Effects of Simultaneity and
Self-Selection," Anthony Yezer, Robert Phillips,
and Robert Trost; "Borrower and Neighbor­
hood Racial and Income Characteristics and
Financial Institution Mortgage Application
Screening," Michael Schill and Susan Wachter;
"Performance of Residential Mortgages in Lowand Moderate-Income Neighborhoods," Edwin
M ills and Luan' Sende Lubuele; "R ace,
Redlining, and Residential Mortgage Loan Per­
formance," James Berkovec, Glenn Canner,
Stuart Gabriel, and Timothy Hannan; and
"Wimp or Tough Guy: Sequential Default Risk
and Signaling with M ortgages," Timothy
Riddiough and Steve Wyatt.
The discussants at the conference, whose
comments are also published in the issue, were
Chester Spatt, Jan Brueckner, Loretta Mester,
John Duca, Dennis Capozza, and Daniel Quan.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Impact of Geographic
Deregulation on Small Banks
Paul S. Calem *
'ew, long-awaited federal legislation
makes it permissible for banks to branch
across state lines (effective June 1,1997).
Will nationwide interstate branching lead to
the decline of small banks and ultimately re­
duce the availability of credit to small busi­
nesses and local communities? Recent trends
affecting small banks suggest such a possibil­
ity. The number of banking organizations
smaller than $1 billion in assets has been declin­
ing, a contraction that has been particularly
pronounced in some states. These trends are
worrisome because banking institutions in this

N

*Paul Calem is an economic adviser in the Research Depart­
ment of the Philadelphia Fed. Paul thanks Rose Kushmeider
of the General Accounting Office for providing him with
data on small-bank market share.




size category originate a disproportionately
large share of small business credit.
Legislative moves to grant interstate branch­
ing powers to banks have prompted such con­
cerns because geographic deregulation has been
a major impetus to industry consolidation.
During the 1980s, many states relaxed in-state
branching restrictions, and almost all states
authorized out-of-state holding companies to
acquire in-state bank subsidiaries, prompting
numerous mergers and acquisitions. Prohibi­
tions against acquisition or establishment of in­
state branches by out-of-state banks were re­
tained, however. Those favoring such restraints
feared that their removal would prompt fur­
ther contraction of the small bank sector and
that this would harm small businesses and
local communities.
17

BUSINESS REVIEW

This article examines consolidation in the
banking industry as it has affected small banks.
Trends in the asset shares of small banking
companies are investigated on a state-by-state
basis, and the relationship of these trends to
geographic deregulation is discussed. From
these findings, inferences are drawn regarding
the future of small banks when interstate branch­
ing becomes a reality.
A principal finding is that where in-state
branching restrictions have been relaxed, the
small bank sector generally has contracted.
Relaxation of interstate restrictions thus far,
however, has not had a significant impact on
the small bank sector. These findings suggest
that loosening interstate branching restrictions
will not lead to further substantial contraction
of the small bank sector. Removal of in-state
branching restrictions had such an impact on
small banks only because such restrictions had
precluded many of these banks from achieving
efficient size. Since most banks are now pretty
close to efficient size or can choose among
many potential merger partners or acquirers to
achieve scale efficiencies, removal of interstate
branching restrictions is unlikely to have a
major impact in this regard. Rather, interstate
branching activity will probably be driven by
motives other than realizing scale efficiencies.
If so, then allowing banks to branch interstate
should not substantially affect the status of
small banks.
CONCERNS REGARDING COMMUNITY
BANKS AND INTERSTATE BRANCHING
Historically, the federal government and the
states have regulated geographic expansion by
banking organizations in the United States.1 As
recently as 1985, 22 states imposed substantial
limitations on in-state bank branching. Table 1

NOVEMBER/DECEMBER 1994

lists these states and the nature of their branch­
ing restrictions (moderate or severe) as of Janu­
ary 1985. Seventeen of these states had re­
pealed or significantly eased their branching
restrictions by January 1991.2 Table 1 also indi­
cates any such changes in state branching laws
during this period.
Since 1956, the Douglas Amendment to the
Bank Holding Company Act has prohibited the
interstate acquisition of any bank by a bank
holding company, except where authorized by
the acquired bank's home state. Until the
1980s, states did not provide such authoriza­
tion, so that the Douglas Amendment pre­
cluded the formation of multistate bank hold­
ing companies.3 During the 1980s, however,
most states adopted legislation opening their
borders to entry by out-of-state bank holding
companies.4 Almost all of this legislative activ­
ity occurred during 1985 through 1989. By
January 30, 1991, all but four states (Hawaii,
Kansas, North Dakota, and Montana) had
adopted laws allowing entry by an out-of-state
holding company.5 Thirty-three of these states
authorized entry on a nationwide basis, with
the stipulation (in most cases) that the entering
bank's home state have a reciprocal law; 13

2Since January 1991, Illinois and New Mexico have elimi­
nated branching restrictions; Colorado has authorized con­
solidation of holding company subsidiaries; and there has
been further relaxation of branching restrictions in Arkan­
sas.
3The Bank H old ing C om pany A ct provided
"grandfathered" rights to 19 multistate holding companies
that predated its passage, allowing them to maintain their
interstate status. Over time, the number of grandfathered
multistate holding companies decreased to seven. See Sav­
age (1993) for additional discussion.
4The first state to open its borders to entry by out-of-state
holding companies was Maine in 1978, followed by New
York and Alaska in 1982.

:My primary source of information on state laws gov­
erning in-state branching and interstate banking is Amel
(1993).


18


5Kansas, Montana, and North Dakota have since adopted
interstate banking laws.

FEDERAL RESERVE BANK OF PHILADELPHIA

Paul S. Calem

The Impact o f Geographic Deregulation on Small Banks

TABLE 1

State Branching Restrictions
1985 and 1991
State
Arkansas
Colorado
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Minnesota
Mississippi
Missouri
Montana
Nebraska
New Mexico
North Dakota
Ohio
Oklahoma
Tennessee
Texas
West Virginia
Wisconsin
Wyoming

Restrictions: January 1985a
moderate
severe
severe
moderate
moderate
severe
moderate
moderate
severe
moderate
moderate
severe
severe
moderate
severe
moderate
severe
moderate
severe
moderate
moderate
severe

Status: January 1991
relaxed11
no significant change
relaxed11
eliminated11
no significant change
eliminated*1
eliminated11
eliminated*1
no significant change
eliminated*1
eliminated0
relaxed11
relaxed11
no significant change
no significant change
eliminated0
eliminated0
eliminated0
eliminated0
eliminated0
eliminated0
eliminated0

aA state's branching restrictions are classified as severe if more than five branches or "full service facilities" are
prohibited. Absent such severe numerical limitations, a state's branching restrictions are classified as moderate if
branching is restricted to city or town limits or to within a county or county plus contiguous counties.
Twelve states not listed in Table 1 imposed milder restrictions on bank branching as of January 1985. These include
Alabama, Connecticut, Florida, Georgia, Massachusetts, and Virginia, each of which authorized branching statewide by
merger or acquisition but restricted de novo branching (the establishment of a new branch); Pennsylvania, which permitted
branching within a county plus contiguous and bicontiguous counties; Michigan, which allowed branching by merger or
acquisition within a 25-mile radius of a bank's home office (effectively permitting branching into contiguous and
bicontiguous counties); New York and Oregon, which prohibited branching into any town with population less than 50,000
in which the principal office of another bank is located; New Hampshire, which prohibited branching into any town with
population less than 2500 where another bank is located; and Hawaii, which imposed liberal numerical ceilings on
branching within Honolulu.
bBranching restrictions are characterized as having been relaxed in Arkansas, where county-wide branching replaced
branching within city or town limits; in Illinois, where numerical limits were increased significantly; in Montana, which
instituted statewide branching by merger subject to a proviso that grandfathered out-of-state bank holding companies
could merge their existing subsidiaries but could not otherwise establish branches; and in Nebraska, which instituted
statewide branching by merger subject to a proviso that no bank could operate more than five branches within its home city.
branching limitations are characterized as having been eliminated if either full statewide branching or statewide
branching by merger or acquisition was introduced.




19

BUSINESS REVIEW

states plus the District of Columbia authorized
entry on a regional reciprocal basis. The major­
ity of states permitted the acquisition of exist­
ing banks but prohibited the establishment of
de novo bank subsidiaries by out-of-state hold­
ing companies.
The passage of state laws authorizing inter­
state expansion by bank holding companies
did not affect federal prohibitions against
branching by banks across state lines. The
McFadden Act, a federal law dating from 1927,
ruled out interstate branching by national banks
(banks that are chartered by the federal govern­
ment as opposed to a state government). The
Federal Reserve Act applied this constraint to
state-chartered banks that are members of the
Federal Reserve System.6 Thus, into the 1990s,
interstate branching restriction remained an
important legal constraint on geographic ex­
pansion by banking organizations.
In each of the past three years, proposals to
permit nationwide interstate branching have
been floated in the U.S. Congress. Although
these proposals have been controversial, a bill
authorizing nationwide interstate branching
finally was passed by the Congress in Septem­
ber 1994 (see The Nation's New Interstate Banking
Law). President Clinton signed this bill into law
on September 29.
Opponents of interstate branching had ar­
gued that geographic deregulation leads to
fewer and larger banks and that this has an
adverse impact on small business borrowers
and local communities; see, for instance, vari­
ous testimony in U.S. House of Representatives
(1991,1993). In support of this view, they point

6Further, all but seven states generally prohibit the op­
eration of in-state branches by out-of-state banks. The seven
exceptions are Alaska, Massachusetts, Nevada, New York,
North Carolina, Oregon, and Rhode Island. Nevada per­
mits branching only into counties with population less than
100,000; the other six states require reciprocity. In effect,
these laws authorize entry by state-chartered banks that are
not members of the Federal Reserve System.


http://fraser.stlouisfed.org/
20
Federal Reserve Bank of St. Louis

NOVEMBER/DECEMBER1994

to declining numbers of small banks nation­
wide and cite evidence that larger banking
organizations may be less willing to lend to
small businesses and local communities.7 One
study commonly cited in this regard is Deborah
Markley's examination of the availability of
credit to small businesses in rural New En­
gland, reprinted in U.S. House of Representa­
tives (1993).
Indeed, the number of U.S. banking compa­
nies smaller than $1 billion in assets (measured
in 1992 dollars), including both independent
banks in this size category and bank holding
companies with total assets under $1 billion,
decreased from 10,316 to 8550 between Decem­
ber 1986 and December 1992, according to a
recent study released by the U.S. General Ac­
counting Office (GAO). This consolidation was
primarily the result of mergers and takeovers,
not bank failures.8 Opponents of interstate
branching feared that it would hasten the pace
of this consolidation.
Consolidation of the small bank sector is a
matter of concern because smaller banks evi­
dently focus more heavily on serving small

7Of course, this is not the only argument proffered by
opponents of interstate branching. For example, they argue
that larger banks pose greater risk to the deposit insurance
system because they tend to be involved in riskier activities,
that larger banks are more apt to be poorly managed or
inefficient, and that banking is becoming less competitive as
a result of the industry's consolidation. Consideration of
these other issues is outside the scope of this article.
8See U.S. General Accounting Office (1993). According
to Atkinson (1994), the number of banks with assets under
$1 billion continued to decline through 1993. The numbers
cited in Atkinson's article do not distinguish between inde­
pendent small banks and small banks that are subsidiaries
of larger holding companies.
V ariou s explanations can be offered for why small
institutions are more oriented toward small business lend­
ing than larger organizations. For instance, Leonard
Nakamura argues that hierarchical management structures
at large banks make them inefficient originators of loans to
small firms.

FEDERAL RESERVE BANK OF PHILADELPHIA

Paul S. Calem

The Impact of Geographic Deregulation on Small Banks

The Nation’s New Interstate Banking Law
On September 13, 1994, the Senate approved H.R. 3841, the Riegle-Neal Interstate Banking and
Branching Efficiency Act. The bill, which had been approved earlier by the House, was signed into law by
the President on September 29.
One year after enactment, a bank holding company (BHC) will be able to acquire a bank in any state, so
long as certain conditions are met. The BHC must be in a safe and sound condition (i.e., adequately
capitalized and adequately managed), and its community reinvestment record must pass a review by the
Federal Reserve Board. The transaction must not leave the applicant in control of more than 10 percent of
nationwide deposits or 30 percent of deposits in the state. The bank to be acquired must meet any age
requirement, up to five years, established under state law. There is an exemption from the concentration,
community reinvestment, and age limits for acquisitions of failing or failed banks.
With regard to branching, the bill provides that beginning June 1, 1997, bank holding companies may
consolidate their interstate banks into a branch network, and free-standing banks may branch interstate by
merging with another bank across state lines. Such mergers would be subject to the safety and soundness,
community reinvestment, concentration, and age requirements described above for BHC interstate
transactions. States are allowed to "opt-out" of interstate branching by merger before June 1,1997, and they
can also authorize it earlier ("opt-in"). To allow de novo branching (i.e., branching other than by merger
with an existing bank), states must specifically authorize it.
Interstate branches of national banks will be subject to the laws of the host state regarding consumer
protection, intrastate branching, community reinvestment, and fair lending, unless the Comptroller of the
Currency determines that federal law preempts such state laws or that they would have a discriminatory
effect on national bank branches. Interstate branches of state-chartered banks are subject to all of the laws
of the host state while also under the jurisdiction of the chartering state.
The new law contains some significant community reinvestment provisions. In particular, evaluations
by federal regulators of an institution's community reinvestment performance must be conducted on a
state-by-state basis for institutions with branches in more than one state. In addition, by June 1,1997, federal
regulators must prescribe regulations that prohibit out-of-state banks from using interstate branches
"primarily for deposit production" rather than for helping to meet community credit needs.
Source: Congressional Liaison Office, Board of Governors of the Federal Reserve System.

businesses and local communities.9 Leonard
Nakamura (1993) documents that institutions
smaller than $1 billion in assets originate a
disproportionately large share of small busi­
ness credit.10 Similarly, Paul Bauer and Brian

10Analyzing data from the Federal Reserve's 1988 Sur­
vey of the Terms of Bank Lending to Business, Nakamura
finds that small banks, with assets less than $1 billion,
dominate the lending of amounts less than $1 million to
individual commercial borrowers, and most of these small
loans are made to small businesses. Moreover, the com­
parative advantage of lending to small borrowers appears
to extend to banks as large as $3 billion in assets.




Cromwell document that small banks originate
a disproportionately large share of credit to
startup businesses.11
Proponents of interstate branching counter

n Alan Greenspan recently provided a telling example
of small banks' role in local communities: "During last
year's floods, many banks in Iowa offered lowered loan
rates and deferred payments. Indeed, business failures
declined by a third in Iowa in 1993, despite the flood...Iowa
bankers during this period also collected critical informa­
tion for state and federal agencies and acted as a conduit to
provide a great deal of needed information to their custom­
ers and communities" (Greenspan 1994, p. 7).

21

BUSINESS REVIEW

that its potential impact on availability of small
business credit has been exaggerated. That is,
small institutions will continue to occupy prof­
itable niches, in large measure because of their
special expertise in serving small businesses
and local communities.12 As Federal Reserve
Chairman Alan Greenspan points out, 'Th e
basic product lines, as well as those evolving—
mutual funds, security brokerage, and even
insurance sales—small banks can and do offer.
Plus, small banks can add to the product mix
what larger banks cannot: personalized ser­
vice, local market knowledge, and easy access
to officers of the bank." Proponents also em­
phasize that merger and acquisition activity is
governed by the Bank Merger Act and federal
antitrust laws, which promote competition in
banking and protect against concentration of
financial resources. Preservation of local mar­
ket competition helps to ensure access to finan­
cial services for consumers and small busi­
nesses.
In fact, a study by Donald Savage concludes
that, on average, local banking markets have
not become more concentrated over the past
decade.13 Moreover, although the total number
of small banking companies has been declining
nationwide, much of that decline may be tied to
consolidation among very small institutions
(up to $500 m illion in assets) seeking to
strengthen their competitive standing vis-a-vis
larger institutions. When a modest-sized insti­
tution is created out of the merger of two
smaller institutions, small business lending

12See various testimony in U.S. House of Representa­
tives (1991,1992). For an excellent discussion of the factors
favoring small bank viability, see Spong and Watkins (1985).
13Of course, the goal of bank merger regulation is not
simply to preserve competition on average, but to prevent
anticompetitive mergers or acquisitions in any market where
such consolidation cannot be justified on the basis of costefficiency or other mitigating factors. This requires a caseby-case evaluation.


22


NOVEMBER/DECEMBER1994

probably continues unabated. For this reason,
the share of banking assets held by small bank­
ing companies is a more meaningful indicator
of availability of small business credit than the
total number of small institutions. By the share
measure, industry consolidation thus far has
had an ambiguous impact on the status of small
banks. At the national level, the share of total
banking assets held by companies smaller than
$1 billion in assets (measured in 1992 dollars),
including both independent banks in this size
category and bank holding companies with
total assets under $1 billion, has remained con­
stant at 21.5 percent between December 1986
and December 1992, according to the GAO
study cited above. The share of assets held by
small banking companies declined in some
states but increased in others.14
For each state in the U.S., Table 2 indicates
the share of state banking assets held by small
institutions as of December 1986, the share as of
December 1992, and the percentage change in
share between those dates. The asset share of
small banking organizations declined by at
least 5 percent in just 18 states; these states are
highlighted in Table 2. Thus, a simple extrapo­
lation from current trends does not yield any
obvious inferences regarding the likely impact
of further geographic deregulation.
In an additional four states, the percentage
decline in the share of assets held by small
banking organizations was less than 5 percent
during this period. It would not be appropriate

14Note that in positing a correspondence between a
decline in the asset share of small banking companies and a
decline in the availability of small business credit, one is, in
effect, considering a "worst-case" scenario. That is, one is
abstracting from the possibility that a small bank acquired
by a medium-sized or large bank holding company may be
operated as a separate subsidiary with a high degree of
independence, so that the credit decisions and customer
relationships of the acquired banks may be unaffected.
Thus, a decline in the asset share of small banking compa­
nies may overstate the impact of consolidation.

FEDERAL RESERVE BANK OF PHILADELPHIA

Paul S. Calem

The Impact o f Geographic Deregulation on Small Banks

TABLE 2

Shares of State Banking Assets Held by Organizations
Smaller Than $1 Billion in Assets: 1986 and 1992
Share
Dec.
1986

Share
Dec.
1992

Percent
Change

Alaska

60.6

28.2

-53.4

Alabama

30.3

29.4

-3.1

Arkansas*

81.0

74.4

-8.0

0.5

11.0

4.5

State

Arizona

Share
Dec.
1986

Share
Dec.
1992

Montana*

63.3

82.6

30.6

Nebraska*

66.8

56.1

-16.0

New Hampshire

47.9

54.2

12.9

New Jersey

14.2

13.5

-4.4

State

Percent
Change

California

14.6

18.7

28.7

New Mexico

40.3

48.1

19.3

Colorado

36.3

41.5

14.3

Nevada

19.8

15.8

-20.5

Connecticut

15.6

16.7

6.7

New York

2.7

4.0

47.3

North Carolina

6.8

8.1

19.4

3.0

7.7

-36.0

Florida

21.5

23.2

8.3

North Dakota

70.4

86.2

22.6

Georgia

24.9

26.2

5.5

Ohio*

19.5

17.6

-9.8

Hawaii
Iowa

24.6
67.8

13.7
66.6

-44.5
-1.8

Oklahoma*
Oregon

73.4
13.6

75.2
15.0

2.4
10.7

Idaho

24.6

21.8

-11.3

Pennsylvania

17.1

18.0

5.7

Illinois*
Indiana*

37.1
46.1

34.0
35.0

-8.5
-24.0

Rhode Island
South Carolina

12.1

25.1

23.9

5.1
31.2

Kansas*

86.0

81.0

South Dakota

27.8

43.5

Kentucky*

59.5

53.0

-5.8
-10.8

Tennessee*

38.2

33.8

56.6
-11.4

Louisiana*

54.6

52.0

-4.7

Texas*

33.6

41.8

24.3

7.5

8.3

10.1

Utah

23.7

39.5

66.6

Maryland

17.4

20.5

17.7

Virginia

17.2

20.2

17.6

Maine
Michigan

15.7

23.2

47.3

Vermont

79.0

51.2

-35.2

16.6

17.0

2.6

Washington

15.7

17.0

8.1

Minnesota

39.4

18.3

West Virginia*

81.1

62.5

-22.9

Mississippi*

33.3
51.7

45.9

-11.3

Wisconsin*

45.4

39.3

-13.4

Missouri*

33.4

35.6

6.5

Wyoming*

80.4

75.4

-6.3

Delaware

Massachusetts

30.5

Source: United States General Accounting Office, except for Delaware figures, which were computed directly from Call
Report data. Delaware's limited purpose banks were omitted from the computations because these banks are subject to
restrictions on competition with in-state banks. The $1 billion size category is CPI adjusted; i.e., for the purpose of
determining bank size in 1986, bank assets in 1986 are measured in 1992 dollars.
^States where branching restrictions were eliminated or relaxed between January 1985 and January 1991.




23

BUSINESS REVIEW

to interpret these small declines as signalling a
trend. For instance, in New Jersey, the asset
share of small banking companies declined
during 1987 and 1988, but this decline was
largely reversed between year-end 1988 and
year-end 1992.
IMPACT OF GEOGRAPHIC
DEREGULATION: A CLOSER LOOK
Having observed that the share of assets
held by small banking organizations declined
in some states but not in others, one may won­
der how this pattern might be related to geo­
graphic deregulation. As we shall see, an
analysis of this relationship may provide clues
as to the likely impact of interstate branching
on the small bank sector.
A joint examination of Tables 1 and 2 yields
an important observation: there is a close corre­
spondence between the states that experienced
a substantial contraction of the small bank
sector between December 1986 and December
1992 and the states that eliminated or substan­
tially relaxed in-state branching restrictions
between January 1985 and January 1991 (which
are marked with an asterisk in Table 2).15 In
fact, the small bank sector contracted by 5
percent or more in 12 of the 17 states in which
branching restrictions were eased (the excep­
tions were Louisiana, Missouri, Montana, Okla­
homa, and Texas), while contracting by 5 per­
cent or more in only six of the remaining 33
states. This comparison, which is summarized
in Table 3, indicates a strong correlation be­
tween repeal or relaxation of a state's branch­
ing laws and a decline in the share of state
assets held by small banking organizations.
Although five states did not experience such
a contraction of the small bank sector following

15I restricted my attention to changes in state branching
laws that occurred between January 1985 and January 1991
to allow for up to a two-year lag between the easing of
branching restrictions and the effect on the small bank
sector.


http://fraser.stlouisfed.org/
24
Federal Reserve Bank of St. Louis

NOVEMBER/DECEMBER1994

liberalization of branching laws, four of these
exceptional cases are easily explained. In Mon­
tana, the reformed branching law directly fa­
vored the small bank sector because of a pro­
viso that allowed grandfathered out-of-state
holding companies to branch only by merging
existing subsidiaries (see footnote b of Table 1).
As of year-end 1992, these grandfathered hold­
ing companies were the only organizations
present in Montana that exceeded $1 billion in
assets. In Louisiana, Oklahoma, and Texas
during the latter part of the 1980s, the banking
industry was beset by problems tied to a weak
regional economy.16 In Texas, several large
bank holding companies failed, and these fail­
ures were accompanied by a contraction and
restructuring of the state banking industry that
increased the share of state banking assets held
by small banking companies.17 In Louisiana
and Oklahoma, eroding capital positions of the
largest banking organizations precluded them
from acquiring smaller banks following the
elimination of these states' branching restric­
tions in 1988.18

16For instance, over the three-year period 1987-1989,
these three states experienced an extraordinarily high num­
ber of bank failures. Their 414 failures of FDIC-insured
commercial banks and trust companies during this period
accounted for 70 percent of all bank failures in the nation,
representing failure rates far greater than in any other state
except Alaska.
17Various small subsidiaries of large, failed organiza­
tions were spun off and merged into small banks. Total
assets of FDIC-insured commercial banks and trust compa­
nies in Texas declined from $209 billion to $169 billion
(unadjusted for inflation) between year-end 1985 and yearend 1990.
18The mean ratio of total equity capital to total assets of
large banks (over $1 billion in assets) in Louisiana declined
from 6.8 percent to 5.3 percent between year-end 1988 and
year-end 1990; in Oklahoma over the same period, this ratio
fell from 5.8 percent to 4.8 percent. In contrast, nationwide
during this period, the mean ratio of total equity capital to
total assets among large banks increased from 6.3 percent to
6.5 percent.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Impact of Geographic Deregulation on Small Banks

Paul S. Calem

TABLE 3

Branching Law Reform and Changing Asset Shares
of Small Banking Organizations
Number of
states that eased
branching restrictions

Number of
states with no change
in branching laws

Total

States where asset
share of small banking
companies declined by
more than 5%

12

6

18

States where asset share
of small banking com­
panies declined by less
than 5% or increased

5

27

32

Total

17

33

In contrast to relaxation of in-state branch­
ing restrictions, geographic deregulation via
interstate banking legislation has not been cor­
related with changes in the status of small
banking companies. This can be seen by focus­
ing on the 33 states where there was no legisla­
tive activity related to in-state bank branching.
As noted above, the small bank sector con­
tracted by more than 5 percent in only six of
these states: Alaska, Delaware, Hawaii, Idaho,
Nevada, and Vermont. Clearly, interstate bank­
ing played no role in Hawaii, which has no
interstate banking law. Neither was interstate
banking a contributing factor in Vermont. There,
the share of state deposits held by out-of-state
holding companies was a minuscule 4.4 per­
cent as recently as June 1993, reflecting owner­
ship of a small Vermont bank by a small hold­
ing company (Arrow Financial Corporation,
which is considerably smaller than $1 billion in
assets) based in New York state.
The contraction of the small bank sector in
Alaska, Delaware, Idaho, and Nevada, while



directly related to interstate banking, was a
consequence of exceptional circumstances.
Banking in these four states, very small in
population, is not representative of much of the
nation. As of year-end 1986, each had only a
few banks and hardly any that were larger than
$1 billion in assets or that were subsidiaries of
sizable holding companies based in those states.
Delaware had three banking companies in that
size category; Idaho, Nevada, and Alaska each
had one.19 Subsequently, these states figured
into the regional expansion strategies of some
very large organizations. Some of these expan­
sion-minded companies then acquired banks
smaller than $1 billion in assets because they
had few or no alternatives.

19The GAO figures somewhat exaggerate the decline in
the status of the small bank sector in Nevada, because
Citibank Nevada, a credit card bank, was incorporated into
the computations. Asset growth at Citibank Nevada was
not supported by in-state deposits, and therefore this growth
did not disadvantage the state's smaller banks.

25

BUSINESS REVIEW

Moreover, in Alaska, interstate banking was
only a secondary factor contributing to the
contraction of the small bank sector between
year-end 1986 and year-end 1992. The primary
factor was a weakened banking industry, bat­
tered by an economic slump brought on by
depressed oil prices. One-third of the state's
banks had failed or been rescued during 1985
and 1986, and an additional one-third failed
during the period 1987 through 1990. Between
year-end 1986 and year-end 1992, total banking
assets in the state declined by one-quarter (from
$6.4 billion to $4.7 billion in 1992 dollars).
These woes contributed to the growth in the
asset shares of subsidiaries of large out-of-state
organizations, which absorbed some of the
failing banks. Moreover, Alaska-based First
National Bank of Anchorage grew (through
absorption of failing banks) beyond the $1 bil­
lion threshold during this period, substantially
augmenting the measured decline in the asset
share of small banks.
In sum, reform of in-state branching restric­
tions has had a major impact on the status of
small banks, triggering consolidation of small
banking organizations into larger organiza­
tions. Relaxation of interstate restrictions thus
far appears to have had only a marginal effect
on the status of small banks. That is, in most
states other than those that relaxed in-state
branching restrictions, the share of assets held
by small banking organizations has not de­
clined, despite easing of restrictions on inter­
state expansion by bank holding companies.
IMPLICATIONS FOR
INTERSTATE BRANCHING
What can one extrapolate from this experi­
ence, as regards the likely impact of allowing
banks to branch interstate? Will nationwide
interstate branching be analogous to the lifting
of in-state branching restrictions, having a great
impact on the status of small banking compa­
nies? Or will it primarily involve further con­
solidation among medium-size and large banks?

26


NOVEMBER/DECEMBER1994

The Past: Impact of In-State Branching Re­
strictions. To attempt to answer these ques­
tions, we must first determine why states that
relaxed branching restrictions typically experi­
enced substantial declines in the asset shares of
small banks. An important motive driving
consolidation in these states was the potential
for many small banks to be operated more
efficiently as branches of other banks rather
than as independent organizations. Under in­
state branching restrictions, many small banks
maintained an independent existence only be­
cause they were barred from being acquired
and turned into branches. It would have been
more efficient or would have better served
customer needs for these banks to be branches
of a larger bank.
In other words, in states where branching
was restricted, banks were too numerous and
too small from an efficiency perspective. Thus,
when the legal restrictions were lifted, many
small banks were sought out for acquisition
and converted into branches of larger banks.
Various evidence supports this view. The
empirical literature on scale efficiencies in bank­
ing, as reviewed and interpreted by David
Humphrey, indicates that "branching, far from
being an extra cost of customer convenience,
actually lowers both bank and customer costs.
Branching permits a banking firm to lower
costs by producing services in more optimally
sized offices rather than producing virtually all
of the output at a single office, as occurs in
[states with severe limitations on bank branch­
ing]."20* Moreover, recent studies of scale effi­
ciency in banking find that efficiency of bank­
ing organizations tends to increase with size
(average cost per unit of assets tends to decline)
up to at least $75 million in assets. Loretta
Mester (1994) observes that studies of small

20The convenience value of branching to bank customers
is further discussed in Calem (1993).

FEDERAL RESERVE BANK OF PHILADELPHIA

The Impact of Geographic Deregulation on Small Banks

banks generally find that scale economies are
exhausted somewhere between $75 million and
$300 million in assets. Beyond this range, most
studies find efficiency to be generally unrelated
to size.21 Thus, empirical evidence confirms
that there were operating efficiencies to be
achieved through the acquisition of small insti­
tutions by larger organizations in states where
branching restrictions had been lifted.
De novo entry by large organizations into
local markets may have been an additional
factor affecting the status of small banks in
states where branching restrictions had been
repealed or relaxed. Large banks may have
established de novo branches and successfully
competed for market share from small banks,
after branching restrictions were lifted.22
The Present: Can We Draw an Analogy? In
sum, relaxation of in-state branching restric­
tions tended to bring about declines in the asset
shares of small banks because these restrictions
stood as an important barrier to entry (via
acquisition or de novo) into local banking mar­
kets. We cannot extrapolate from this experi­
ence, however, to conclude that nationwide
interstate branching will also have such an
effect. Since major legal barriers to entry have
already been relaxed, the remaining obstacle—
interstate branching restrictions—is of second­
ary importance. Interstate branching restric­
tions are not analogous to in-state branching
restrictions because interstate restrictions exist
in a context of otherwise unrestricted entry into
local banking markets.

21For example, Berger and Humphrey (1991) find that
scale efficiencies are achieved up to $100 million in assets.
A few studies, however, find further economies of scale at
the upper end of the size distribution of banks; see Mester
(1987) for a survey.
22Amel and Liang (1992) demonstrate that relaxation of
state branching restrictions increased de novo entry into
local markets via bank branching.




Paul S. Calem

Except in states where branching remains
restricted, potential acquirers of small banks
include multiple larger institutions. Thus, in
general, small, independent banks no longer
are artificially precluded from achieving scale
efficiencies. Rather, as emphasized by Leonard
Nakamura (1994), most small banks are rural
banks or urban or suburban niche banks that
are prospering as independent organizations.
Similarly, there exist numerous potential de
novo entrants into most local markets. Few
small banks remain artificially protected from
competition with larger organizations.
Why, then, are there still so many U.S. banks
smaller than $100 million in assets (nearly 7800
as of year-end 1993, according to the FDIC),
which various banking cost studies suggest are
inefficiently small? The explanation is simple:
even if the typical bank in this size category
operates at a comparatively high cost per-unitof-assets, this doesn't mean that the bank should
be acquired by or merged into a larger bank.
The bank's lending policies, management prac­
tices, or other aspects of its "organizational
culture" may be appropriate for the particular
community it serves but may be difficult to
reconcile with those of potential acquirers or
merger partners.23*Further, increasing the num­
ber of potential acquirers by permitting inter­
state branching will not necessarily lead to
acquisition of these banks.
Evidence from Pennsylvania supports this
line of reasoning. Prior to 1982, Pennsylvania
restricted bank branching to the county in which
a bank's principal office was located and con­
tiguous counties. In March 1982, this con-

23Also, antitrust considerations may preclude particular
mergers between small banks that are competitors in a
concentrated rural market. Of course, much ongoing merger
activity involves small banks merging with other small
banks. Thus, when the appropriate opportunity arises,
small banks do seek to achieve economies of scale through
consolidation.

27

BUSINESS REVIEW

straint was relaxed to allow for branching within
bicontiguous counties.24 This easing of in-state
branching restrictions was followed by a de­
cline in the share of state banking assets held by
small banks: between year-end 1982 and yearend 1986, the share of assets held by banking
companies smaller than $1 billion in assets
declined by about 40 percent.25 In March 1990,
Pennsylvania instituted full, statewide branch­
ing. This further easing of branching restric­
tions, however, had no impact on the status of
the small bank sector; the share of assets held
by small banking companies in Pennsylvania
has been stable since year-end 1986. This record
suggests that the initial easing of branching
restrictions in 1982 enabled small banks to be
absorbed into larger institutions in most in­
stances where there were efficiencies that could
be achieved through such consolidation. It
seems reasonable to expect that, like statewide
branching in 1990, nationwide interstate branch­
ing will have no more than a marginal impact
on the status of the small bank sector in Penn­
sylvania.
The Future: Likely Patterns of Consolida­
tion Under Interstate Branching. What, then,
can we expect with regard to industry consoli­
dation under interstate branching? In many
cases, holding companies will simply consoli­
date existing subsidiaries to create unified
branch networks. This would be done to en­
hance customer convenience and reduce costs,
but it would not affect the share of assets held
by small banking organizations as defined in
this article.
In other cases, small banks may seek to
merge with other small banks across state lines
in order to achieve scale efficiencies. Only if the
merged bank exceeds $1 billion in assets would

24In other words, a bank could branch into counties
contiguous to its headquarters' county and also into coun­
ties contiguous to these.
25The $1 billion threshold is measured in 1992 dollars.


28


NOVEMBER/DECEMBER1994

this affect the asset share of the small bank
sector as defined in this article. As noted
above, however, most studies indicate that
banks achieve scale efficiencies at a size well
below $1 billion.
Otherwise, interstate branching activity will
be driven by various familiar motives affecting
banks of all sizes. Some banks may seek to
diversify geographically as a risk-management
strategy.26 Others may seek to build or main­
tain a dominant share of regional banking as­
sets, for perceived associated benefits such as
name recognition.27 Still others may seek to
improve the managerial efficiency of the orga­
nization they acquire or to shed excess capac­
ity.28 Finally, some banks may expand geo­
graphically to better serve their customers'

26Liang and Rhoades (1988) and Lee (1993) present evi­
dence that geographic diversification has tended to reduce
financial risk by reducing earnings variability. Gilbert and
Belongia (1988) and Lawrence and Klugman (1991) present
evidence that rural bank subsidiaries of geographically
diversified holding companies have greater opportunities
to diversify risk than independent rural banks.
27Cornett and Tehranian (1992), examining mergers of
large bank holding companies, found that mergers increased
an institution's overall ability to attract deposits and loans.
This finding is consistent with a regional-share rationale for
expansion.
Boyd and Graham (1991) argue that the creation of
superregionals through consolidation may have been moti­
vated by the perceived benefit of being "too-big-to-fail" and
by potential gains in market power from merging with
competitors. Consolidation toward such ends can be dis­
couraged by disabusing the industry of the notion that
banks can grow "too-big-to-fail" (which the Federal De­
posit Insurance Corporation Improvement Act of 1992 may
have already accomplished) and by continuing the enforce­
ment of antitrust laws in banking.
28In other words, well-managed banks may acquire less
well-managed banks and institute improvements that re­
duce total operating costs. Such cost-savings should not be
confused with reductions in average cost that result when
two efficiently run banks merge to achieve economies of
scale; see Mester (1994) for further discussion.
The extent to which merger and acquisition activity

FEDERAL RESERVE BANK OF PHILADELPHIA

The Impact of Geographic Deregulation on Small Banks

needs. Banks located in multistate metropoli­
tan areas will have a particular incentive to
respond in this way. Current patterns of con­
solidation in the industry suggest that such
motives tend to yield combinations of large or
medium-size banks with other sizable banks,
or consolidations of small banks into banks that
may still be categorized as small or modest in
size. Hence, there is little reason to expect that
under nationwide interstate branching, small
banks will commonly be targeted for acquisi­
tion by medium-size and large banks.
Of course, we may continue to see frequent
acquisitions of small banks by larger institu­
tions in the few states where in-state branching
restrictions have recently been lifted and ad­
justment is not yet complete.29 These might
include Colorado, Illinois, Minnesota, and New
Mexico, where restrictions have been lifted
only within the past three years, and Louisiana
and Oklahoma, where consolidation subse­
quent to the lifting of branching restrictions
may have been delayed due to financial diffi­
culties affecting the regional banking industry.
And even in states that have long permitted in­
state branching we may see some acquisitions
of small institutions by larger organizations
trying to fill a gap in the larger institution's
banking network or gain a foothold in a new
market. Because interstate branching could
reduce the cost of acquiring banks on an inter­
state basis, such "foothold acquisitions" may
become marginally more common.
In addition, interstate consolidation may
reduce risk by allowing greater diversification

among large and medium-size banks has yielded such per­
formance gains is a topic of current debate among banking
researchers. See Rhoades (1993) for a survey.
29Since the new federal statute does not preempt states'
intrastate branching laws, it should not substantially affect
the share of assets held by small banks in states where in­
state branching remains substantially restricted, namely, in
Arkansas, Iowa, Montana, Nebraska, and North Dakota.




Paul S. Calem

of a bank's deposit base and loan portfolio,
especially in the case of a small, locally limited
bank being acquired by a geographically diver­
sified holding company. Because interstate
branching could reduce the cost of acquiring
banks on an interstate basis, such acquisitions
also may become marginally more common.
There is also the possibility that small banks
in some markets may face intensified competi­
tion because of benefits accruing to large insti­
tutions and their customers through interstate
branching. Specifically, multistate holding com­
panies may achieve cost savings by consolidat­
ing separate subsidiaries into branch networks,
and bank customers may obtain convenience
benefits from interstate branching.
Overall, however, the impact of interstate
branching on small banks' asset shares can be
expected to be minimal. "Foothold acquisi­
tions" of small banks by larger institutions are
relatively uncommon. Small banks have alter­
native means of diversifying risk (such as
through asset sales) and appear able to success­
fully balance the various advantages and dis­
advantages of being locally limited. Most im­
portant, small banks have demonstrated their
ability to prosper as independent organiza­
tions under competitive conditions by effec­
tively serving market niches. Small banks have
demonstrated such ability in California and in
other large states where statewide branching
has long been permitted.30
CONCLUSION
Geographic deregulation of the banking in­
dustry spurred industry consolidation during
the 1980s, and in some states, consolidation has
been accompanied by a decline in the share of
assets held by small banking institutions. In

30See Calem 1993. Rose (1992), in a study of the effects of
interstate acquisitions, finds further evidence of the ability
of small local institutions to compete effectively against
larger, geographically diversified organizations.

29

NOVEMBER/DECEMBER1994

BUSINESS REVIEW

most such cases, the decline in the asset share of
small banking companies was tied to a relax­
ation of in-state branching restrictions. Relax­
ation of interstate restrictions thus far has had
only a marginal effect on the status of small
banks. That is, in most states other than those
that relaxed in-state branching restrictions, the
share of assets held by small banking organiza­
tions has not declined, despite easing of restric­
tions on interstate expansion by bank holding
companies.
Congress recently removed the most impor­
tant remaining legal constraint on geographic
expansion by banking organizations: the gen­
eral prohibition against interstate bank branch­
ing. Proposals to allow interstate branching
had been controversial because geographic
deregulation is perceived to have an adverse
impact on the status of small banks. But one

cannot extrapolate from the experience in states
where in-state branching restrictions were eased
to conclude that interstate branching would
adversely affect the status of small banks. Re­
moval of in-state branching restrictions had a
substantial impact on small banks because such
restrictions had precluded many of these banks
from achieving efficient size. Since most banks
are now close to efficient size or can choose
among many potential merger partners or
acquirers to achieve economies of scale, re­
moval of interstate branching restrictions is
unlikely to have a major impact in this regard.
Rather, interstate branching activity will
probably be driven by motives other than real­
izing economies of scale. If so, allowing banks
to branch interstate should not have a major,
adverse impact on the status of small banks.

REFERENCES
Amel, Dean F. "State Laws Affecting the Geographic Expansion of Commercial Banks," mimeo, Board of
Governors of the Federal Reserve System (September 1993).
Amel, Dean F., and J. Nellie Liang. "The Relationship between Entry into Banking Markets and Changes
in Legal Restrictions on Entry," Antitrust Bulletin 37 (1992), pp. 631-49.
Atkinson, Bill. "1993 Buyouts Thinned the Ranks of Small Banks to a 60-Year Low," American Banker (March
21, 1994), p. 1.
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Calem, Paul S. "The Proconsumer Argument for Interstate Branching," this Business Review (May/June
1993), pp. 15-29.
Cornett, Marcia M., and Hassan Tehranian. "Changes in Corporate Performance Associated with Bank
Acquisitions," Journal o f Financial Economics 31 (1992), pp. 211-34.
Gilbert, R. Alton, and Michael T. Belongia. "The Effects of Affiliation with Large Bank Holding Companies
on Commercial Bank Lending to Agriculture," American Journal o f Agricultural Economics (1988), pp. 6978.

30


FEDERAL RESERVE BANK OF PHILADELPHIA

The Impact of Geographic Deregulation on Small Banks

Paul S. Calem

Greenspan, Alan. "Remarks at Dedication Ceremonies for a Chair in Banking and Monetary Economics,
Wartburg College, Waverly, Iowa," Board of Governors of the Federal Reserve System (May 6, 1994).
Humphrey, David B. "Why Do Estimates of Bank Scale Economies Differ?" Economic Review, Federal
Reserve Bank of Richmond (September/October 1990), pp. 38-50.
Lawrence, David B., and Marie R. Klugman. "Interstate Banking in Rural Markets: The Evidence from the
Corn Belt," Journal o f Banking and Finance 15 (1991), pp. 1081-91.
Lee, William. "Bank Diversification: The Value of Risk Reduction to Investors and the Potential for
Reducing Required Capital," Research Paper 9312, Federal Reserve Bank of New York (1993).
Liang, Nellie, and Stephen A. Rhoades. "Geographic Diversification and Risk in Banking," Journal of
Economics and Business 40 (1988), pp. 271-84.
Mester, Loretta J. "How Efficient Are Third District Banks?" this Business Review (January/February 1994),
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Mester, Loretta J. "Efficient Production of Financial Services: Scale and Scope Economies," this Business
Reviezv (January/February 1987), pp. 15-25.
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Michael Klausner and Lawrence J. White, eds., Structural Change in Banking. Homewood, Illinois:
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Nakamura, Leonard I. "Small Borrowers and the Survival of the Small Bank: Is Mouse Bank Mighty or
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Rose, Peter S. "Interstate Banking: Performance, Market Share, and Market Concentration Issues,"
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Interstate Banking: Benefits and Risks o f Removing Regulatory Restrictions

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31

INDEX 1994
January/February
Loretta ]. Mester, "How Efficient Are Third District Banks?"
Theodore M. Crone, "New Indexes Track the State of the States"

March/April
Sherrill Shaffer, "Bank Competition in Concentrated Markets"
Anne Case, "Taxes and the Electoral Cycle: How Sensitive Are Governors to Coming Elections?"

May/June
Satyajit Chatterjee, "Making More Out of Less: The Recipe for Long-Term Economic Growth"
Gregory P. Hopper, "Is the Foreign Exchange Market Inefficient?"

July/August
D. Keith Sill, "Managing the Public Debt"
James McAndrews, "The Automated Clearinghouse System: Moving Toward Electronic Payment"

September/October
Carlos Zarazaga, "How a Little Inflation Can Lead to a Lot"
Richard Voith, "Public Transit: Realizing Its Potential"

November/December
Leonard I. Nakamura, "Small Borrowers and the Survival of the Small Bank: Is Mouse Bank Mighty or Mickey?"
Paul S. Calem, "The Impact of Geographic Deregulation on Small Banks"

FEDERAL
RESERVE BANK OF
PHILADELPHIA
Business Review Ten Independence Mall, Philadelphia, PA 19106-1574
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