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MAY 2003

Chicago Fed Letter
Whither the community bank? A conference summary
by Robert DeYoung, senior economist and economic advisor

Despite the storied advantages of the community bank business model—at generating
local market information, at building personal financial relationships, at lending to small
businesses—the numbers and market shares of community banks continue to decline
in the U.S. A recent conference at the Chicago Fed brought together small bankers,
government regulators, and research economists to consider the viability of the
community banking model in the information age.

1. Number of community banks
number of banks





On March 13–14, 2003, the Federal Reserve Bank of Chicago and the Journal
of Financial Services Research sponsored
a research conference titled “Whither
the Community Bank?” The conference
brought together approximately 50 community bankers from across the Midwest,
50 bank supervisors from
state and federal regulatory
agencies, and 50 research
economists from universities and government, to
share their views on the future viability of community
banks in a rapidly changing banking industry.

The issue of what the future
may hold for community
banking is certainly a timely one. Both the number
of community banks in
the U.S. (see figure 1) and
Banks with assets < $100 million
Banks with assets between $100 million and $1 billion
the share of industry assets
Banks with assets > $1 billion
held by these banks have
NOTE : Asset categories are defined in year 2000 dollars.
diminished dramatically
SOURCES: Call Report data and author’s calculations.
over the past two decades.
These trends show little
sign of abating. The driving
forces of change in the financial services
industry over the past two decades remain firmly in place—continuous technological change and a regulatory

environment that encourages rigorous
competition—and, at least on the surface, these forces appear to favor large
banks over small community banks.
Given these trends, it is natural to wonder how much further the community
banking sector will shrink, and how
the business strategies of tomorrow’s
community banks will differ from those
of today’s community banks.
The goal of the conference was to foster interaction between two parties who
(ironically) seldom meet: community
bankers and research economists who
study community banks. The presentations and formal discussions exposed
community bankers to high-level banking analysis performed from the viewpoint of objective outsiders, while the
question and answer sessions provided
researchers with valuable feedback from
“the real world” of community banking.
This Chicago Fed Letter provides a brief
summary of the ideas and issues presented at the conference. All of the
research papers, presentations, and
keynote speeches are available at
index.cfm. The Journal of Financial
Services Research will publish selected
papers from the conference in a special proceedings issue in early 2004.

Introduction to the conference

The conference opened with a paper by
Robert DeYoung, William C. Hunter, and
Gregory Udell. The authors presented
a theoretical framework that predicts the
separation of the banking industry into
two strategic groups. One of these groups
is community banks, which will continue to practice locally focused, relationship-based retail and small business
banking. The other group contains large
commercial banks that take advantage
of the scale economies embedded in automated underwriting processes (e.g.,
credit scoring, asset securitization) and
distribution channels (e.g., Internet
banking) to sell financial commodity
products like online brokerage, credit
cards, and mortgage loans to a geographically diverse market. (For details, see
DeYoung, Hunter, and Udell, 2002,
“Whither the community bank? Relationship finance in the information
age,” Chicago Fed Letter, Federal Reserve
Bank of Chicago, No. 178, June.)
The data displayed in figure 2 illustrate
some of the differences predicted by the
authors’ theoretical framework. These
data show that community banks practice a relationship-based business strategy. Both well-managed community
banks (i.e., those with average return
on equity [ROE] above the median for
their peer group) and poorly managed
community banks raise more of their
funds from core deposits, and lend more
of their funds to small businesses, than
do large commercial banks. However,
while the well-managed and poorly managed community banks practice almost
identical business strategies, their financial performances vary considerably. The
well-managed community banks outperform the poorly managed community
banks—and in some cases outperform
even the large commercial banks—in
terms of loans-to-assets, net interest
margins, noninterest income, cost efficiency, and most importantly, ROE.
These data have two implications. They
suggest that the banking industry is
likely to experience further reductions
in the number of small, inefficient, poorly managed community banks unable
to survive in highly competitive, postderegulation banking markets. But

they also suggest that the community
bank business model is financially viable, and that thousands of well-managed community banks will survive.

The conference featured four academic paper sessions. Each presentation of
a paper at these sessions was followed
by a formal discussion by an expert in
the field. The first of these sessions explored the effects of product mix on
the riskiness of community banks.
Over the past two decades, noninterest
income has accounted for an increasing
share of total income in the banking
industry. Kevin Stiroh measured the
risk-adjusted profitability of community banks in the 1990s, and showed that
this measure of overall bank performance tended to decline when banks
shifted away from traditional interestbased activities and into less traditional fee-based activities (e.g., investment
services, insurance products, loan securitization, and trading). However, he
found that risk-adjusted profitability
tended to improve at banks that diversified their activities within either of
these two broad areas. He attributed
his findings to a potential “dark side”
of noninterest income—community
banks that entered just one or two noninterest activities in a big way may have
strayed into areas that were beyond their
managerial expertise or experience.
Mitchell Petersen discussed this paper
and pointed out that some community
banks may simply lack the size required
to diversify across a variety of noninterest activities and, as a result, may be
precluded from capturing the diversification benefits identified by Stiroh.
Mataj Blasko and Joseph Sinkey examined the financial performance of community banks that specialized in real
estate lending from 1989 through 1996.
The authors showed that these relatively undiversified banks are accepting
higher interest rate risk (i.e., funding
long-term, fixed rate assets with shortterm, variable rate liabilities) in exchange
for lower credit risk and, hence, lower
regulatory capital requirements. Although these banks mitigate interest
rate risk to some extent by holding

substantial amounts of adjustable-rate
mortgages, the authors concluded that
these banks still have a higher-than-average risk of insolvency. Discussant
Marsha Courchane pointed out that
while the balance of credit risk, interest
rate risk, and bank capital may put individual real-estate-intensive community banks at risk, this does not raise a
concern for systemic risk to the banking system or the economy. Moreover, she
encouraged the authors to extend their
analysis using more recent data in order
to better assess current levels of risk.
Keynote speakers

The first day of the conference closed
with a keynote address by Federal Reserve Board Governor Mark W. Olson
on “Community Bank Performance in
the 21st Century.” Olson reinforced
many of the themes mentioned during
the afternoon presentations. He especially emphasized the robust financial
performance of the community banking
sector in recent years—even as the nation’s largest financial institutions were
experiencing earnings uncertainty—as
evidence that “the community banking
franchise remains vital and vibrant.” The
key to this vitality, Olson stressed, is the
ability of community banks to attract
stable deposits and identify profitable
lending opportunities by leveraging their
connections with the local community.
Continued success will require community banks to avoid some key missteps of
the past, such as risky concentrations of
commercial real estate loans, undue
exposure to unexpected swings in interest rates, and lax internal controls.
The second day of the conference
opened with a breakfast keynote address
by Federal Reserve Bank of Kansas City
President Thomas M. Hoenig on “Community Banks and the Federal Reserve.”
Hoenig focused on the importance of
community banks to the three missions
of the Federal Reserve: the transmission
of monetary policy, the supervision of
commercial banks, and oversight of the
payments system. Although community
banks account for only small portions
of the economy’s banking assets and financial flows, Hoenig stressed that community banks are disproportionately

2. Averages for various groups of U.S. commercial banks, 1996–2001
Large banks
(assets over $1 bil.)

Medium community banks
(assets $100–$500 mil.)
ROE above

Business strategies
Core deposits to assets
Small business loans
to assets
Performance targets
Loans to assets
Net interest margin
Noninterest income
to operating income
Cost efficiency ratio
Overall profitability
Return on equity

ROE below

Small community banks
(assets under $100 mil.)
ROE above

ROE below






















Robert DeYoung, William C. Hunter, and Gregory Udell (2003), “Whither the Community Bank?,” conference
presentation, available at

important because of their central role
in local and rural economies, especially in funding small businesses. Hoenig
expects the number of community banks
to continue to decline but to remain
in the thousands, and he foresees no
decline in the importance of community banks as providers of financial services in local markets.
Economic growth

Community banks specialize in lending
to small businesses, and small businesses are an important source of new job
creation. Allen Berger, Iftekhar Hasan,
and Leora Klapper extended this financial chain one step further by testing
whether countries with large numbers
of community banks experience more
rapid macroeconomic growth. The
authors examined data from 49 countries and found stronger gross domestic product growth in both developed
and developing nations in which small,
efficiently run, privately owned banks
held a relatively large share of banking
industry assets. Discussant Philip Strahan
stressed the potential importance of
this study, as it provides the first crosscountry evidence linking small banking institutions to macroeconomic
growth. If the results of this study are
accurate, Strahan concluded, they raise
an important question for economic
policymakers: Should we provide financial or regulatory subsidies to encourage more community banks to enter
the market or should we rely on the

crucible of market competition to determine the optimal number of community banks?
Business lending

The local geographic focus of community banks makes them a natural clearinghouse for information that is valuable
to small businesses, and the high-touch,
relationship-based approach of community banks makes them effective at
underwriting and monitoring loans to
informationally opaque small businesses. As a result, small business lending
should be a profitable line of business
for community banks; indeed, this line
of business should be more profitable for
community banks than for large banks.
The research findings presented at this
session were consistent with both of
these expectations.
Jonathan Scott used survey responses
from 2,000 small businesses to measure
the amount of “soft information” produced for these firms by their primary
banks. (Soft information is information
that is not easily quantifiable—for example, the reliability of individual businesspeople.) Based on Scott’s interpretation
of the survey data, small businesses received more and better soft information
when their banks were relatively small
and when they worked with the same
loan officer for a long time. These
findings suggest that locally focused,
relationship-based community banks
deliver extra value-added to their small
business borrowers. Discussant Mitch

Berlin applauded this study for its
contribution to the relationship lending
literature, but considered these issues
within the context of a wider question:
As it becomes increasingly less expensive
to produce, process, and disseminate
hard information, is soft information
production worth paying for?
David Carter and James McNulty provided some evidence for considering
Berlin’s question. They found that between 1996 and 2001, community banks
earned a higher risk-adjusted rate of
return on small business loans than did
large commercial banks—consistent with
the notion that small banks are better
than large banks at evaluating and monitoring loans to informationally opaque
small businesses. Discussant Larry Wall
characterized the study’s findings as “suggestive” rather than “compelling,” and
he stressed that these findings may not
persist into the future. All agreed, however, that soft information is a main stock
in trade for community banks, and
whether small businesses are willing to
pay a premium for it is a crucial determinant of how community banks will
operate in the future.
Bankers’ panel

A midday panel comprising four community bankers and one finance professor
reflected on the presentations made and
topics discussed up to this point in the
conference. The panelists were in unanimous agreement that the community
Michael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; David
Marshall, team leader, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System. Articles may be reprinted if the
source is credited and the Research Department
is provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
60690-0834, tel. 312-322-5111 or fax 312-322-5515.
Chicago Fed Letter and other Bank publications
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ISSN 0895-0164

Industry consolidation

The final conference session was devoted
to bank mergers and industry consolidation. There have been over 9,000 bank
mergers during the past two decades, and
about half of these mergers combined
two community banks. These mergers increase the size of the participating banks,
create the potential for enhanced financial performance, and often alter the
manner in which the post-merger banks
serve their local markets.
To study the potential impact of mergers on the riskiness of community banks,
William Emmons, Alton Gilbert, and
Timothy Yeager created 1,000 “simulated” community banks by randomly
combining the financial statements of
actual community banks from the 1990s.
They found that the simulated banks
were less risky on average than the actual pre-merger banks, and that these
risk reductions stemmed mostly from
increases in bank size (i.e., reduced
exposure to idiosyncratic risk) and
only to a lesser degree from greater

geographic diversification (i.e., reduced exposure to local market risk).
Discussant Frederick Furlong agreed
with the general finding that risk reduction begins with idiosyncratic risk,
but he cautioned that the actual community bank mergers that occur in the
coming years may behave somewhat
differently than simulated mergers
based on 1990s data. In particular, bank
managers do not select merger targets
randomly, but with an eye toward the
synergistic benefits a particular target
will bring to the acquiring bank.
In the final paper of the conference,
Robert Avery and Katherine Samolyk examined how bank mergers affect small
business lending in local markets. The
study utilized branch-level banking data,
an innovation that allowed the authors
to measure more carefully post-merger
changes in local market lending caused
by mergers of multi-market banks. Their
results illustrated the important role of
community banks: Small business lending tended to increase in local markets
after two local community banks merged,
especially if a third community bank also
operated in those markets. Discussant
Richard Rosen stressed that the relationships between local economic conditions,
bank merger activity, and bank lending
behavior are complex, and that the nature of these relationships may not be fully understood until the banking industry
completes its ongoing structural adjustments and settles into a new equilibrium.

Chicago Fed Letter

This lesson of adaptation in the face of
change, while remaining focused on a
traditional core business strategy, was
echoed by the four community bankers
on the panel: Robert Atwell, Nicolet
National Bank in Green Bay, WI; Lowell
Stahl, Labe Bank in Chicago; Alan
Tubbs, Maquoketa State Bank and
Ohnward Bancshares in Maquoketa, IA;
and Robert Yohanan, First Bank &
Trust of Evanston, IL. They discussed
how small banks can maximize the performance of the community banking
business model going forward. On one
hand, they stressed general business

axioms that are crucial for any small
business, like the paramount importance
of choosing a good physical location
and the central role of personal service.
On the other hand, they offered numerous examples of how locally focused
community banks offer a clear alternative for households and small businesses that are not well-served by increasingly
large banking franchises.

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P.O. Box 834
Chicago, Illinois 60690-0834
(312) 322-5111

bank business model faces a long and
healthy future. George G. Kaufman, of
Loyola University Chicago, drew a lesson
for the future of the banking industry
from the history of the grocery industry.
Similar to banking, grocery retailing has
experienced periods of substantial technological and environmental change
(e.g., transportation, refrigeration, suburbanization), and an industry once
characterized by small, owner-operated
“Mom and Pop” grocery stores now features regional and national chains of
supermarkets. But, small grocery retailers have not disappeared. Today, they
thrive in the form of convenience stores
and mini-marts, not just because they
adapted to the changing environment,
but because they provide convenient
service—a core business strategy that
small banks and small grocery retailers
have shared for generations.

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