Community Banks: Their Recent Past, Current Performance, and Future Prospects

By: Tim Critchfield, Tyler Davis, Lee Davison, Heather Gratton, George Hanc, and Katherine Samolyk

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Executive Summary:

Community bank numbers were cut almost in half since 1985, and they also suffered significant losses in both deposit and asset share. Small community banks (those with less than $100 million in assets) were most affected by these trends. (Community banks are defined as independent banks and savings institutions and bank and savings institution holding companies with aggregate assets less than $1 billion).1 At first glance, these trends might point to dire conclusions about the future of community banks, but this is not necessarily the case.

Community banks still make up 94 percent of the banking industry, a figure essentially unchanged from 1985. Moreover, detailed analysis of the changes in the number of community banks that have taken place yielded some surprising results: rather than finding types of markets or states where reductions in the number of community banks were particularly large, instead we find that community banks maintained their presence in all types of markets?urban, suburban and rural, and this remained true for markets that experienced both population growth and decline; in addition, there was only a slightly greater decline in community banks in formerly unit-bank states in comparison to non-unit-bank states. As already noted, small community banks did experience a greater decline in numbers, but this was partly because many institutions grew rapidly out of the small-bank category.

Community banks' deposit share declined significantly since 1985, during a time when large banks greatly extended their geographic reach throughout the country; the period also saw modest gains in deposit share by large credit unions. Still, an analysis of community bank presence in local deposit markets suggests that community banks continue to play an important role, albeit a smaller one than before, in all types of local banking markets. Moreover, community banks' ability to provide personal service to depositors continues to be one of their strengths. Although community banks' asset share also dropped (as the asset shares of both larger banks and credit unions have increased), an examination of community bank lending demonstrates that they continue to hold their own in real estate lending to businesses, and continue to provide a disproportionately large amount of credit to small businesses and the agricultural sector. Community banks' ability to assess the creditworthiness of borrowers without long credit histories remains an advantage in this kind of lending, one that large banks may find difficult to emulate.

The earnings performance of community banks since 1985 has, until very recently, been comparable to that of the very largest banks. For the decade since 1992 it has been stable, with a return on assets of at least 100 basis points, a level that many industry observers would term ?satisfactory?. Moreover, this is true even in areas that have experienced population declines.

As might be expected, community banks' return on equity has been consistently lower than that of larger banks, partly because of higher capital ratios.

Not only has community bank performance been relatively strong, but the market has provided an impressive case for the continued presence of the community bank in today's banking landscape. More than 1,250 new community banks have been established since 1992. New bank owners have therefore been willing to risk their capital in these ventures, and often have done this in areas where existing community banks have been acquired by large and distant banks.

Community banks do face challenges. The number of community banks is likely to decline in the years ahead. Many community bankers state that it is difficult to both find and retain qualified employees. Competition with nonbank competitors, including credit unions, will continue. The fixed costs of regulatory requirements fall more heavily on community banks than on larger ones. Regulatory burdens could, therefore, have a significant negative effect on community banks' future prospects. Nevertheless, the evidence from the recent past about community banks' market presence, industry share, and earnings performance, coupled with the continued creation of new community banks, points strongly to community banks being a viable business in the future.

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