The Value of Analytical Research on Community Banking

In this quarter’s edition of Banking in the Ninth, I explain why conducting, and encouraging others to conduct, analytical research on community banking is a high value proposition for the Federal Reserve and others. There are two reasons. First, community banks are important to the economy. Second, government regulation and supervision have an effect on these firms. Both justify understanding community bank activity and the interaction between this activity and the rest of the economy. These reasons motivate analysis we have conducted at the Federal Reserve Bank of Minneapolis on community banking topics, which I describe below.

Why Analytical Research on Community Banking Is High Value

There is no end to the number of interesting topics to research, particularly for an employee of the Federal Reserve, where our direct responsibilities concern, for example, the financial sector, payments and the performance of the economy. Our analytical resources to conduct research are finite, however. The question could arise then, why should community banking make it to the list of high priority topics deserving analytical research?

The first reason concerns the economic role of community banks. These financial institutions typically focus on providing credit to borrowers who, because of their size, activity or location, are relatively costly for an outside firm to evaluate. Community banks have the skills and knowledge to conduct such evaluations and provide credit when other financial institutions might not at “reasonable” terms, conditions and prices. The individuals and businesses receiving such credit produce valuable output with employment—a key focus of the Federal Reserve—typically being a critical input to such production. Less credit to such entities often means less output.

The second reason arises from the supervisory and regulatory authority of the Federal Reserve along with other federal and state agencies. These agencies of the government have a profound effect on the activity of community banks via their oversight capacity. These activities create public and private benefit for society, but also public and private costs. The key to good policy is ensuring that the benefits exceed the costs. Making a determination that government action generates net benefits requires an analytical understanding of the role and activity of community banks. Analytical research is critical for establishing the baseline against which a review of government regulation and supervision of community banks should occur.

Community banking research at the Federal Reserve Bank of Minneapolis, described below, is motivated by the factors just noted. More generally, such factors drive research across the Federal Reserve System and academia and were highlighted at the Community Bank Research Conference sponsored by the Federal Reserve and the Conference of State Banking Supervisors. Last year’s conference brought together a wide range of interesting research on community banking, and I fully expect this year’s conference in September 2014 to do the same.¹

Federal Reserve Bank of Minneapolis Community Banking Research

Our recent analytical research has focused on two closely related concerns of community banks. The first concern is the increased costs facing community banks due to more intense supervision and regulation. The second concern is consolidation—specifically, the view that long-term consolidation in community banks will pick up because of the increased cost of regulation (which depresses returns in community banking). A common feature of each project is providing a quantitative view on an issue often discussed in qualitative terms. Both pieces, along with our quarterly update on banking conditions, can be found on our web site. Before describing the two efforts, I note that the Minneapolis Federal Reserve Bank has a particularly long history in analyzing a topic key to community banks, the so-called too-big-to-fail (TBTF) problem. (See this work on the Too Big to Fail page of our web site.) One reason for our concern about TBTF is the advantage it provides systemically important firms relative to community banks.

Community Bank Regulatory Cost Analysis

In this project, we quantify the cost of increased regulation on community banks. We do so by modeling the impact of new regulatory costs, such as the hiring of additional staff, which result in higher total compensation and lower profitability. We then analyze the changes in the distribution of community bank profitability.

Our approach to analyzing potential costs of additional bank regulation has some advantages. In particular, the approach provides quantification of the issue in a simple, transparent and flexible way. Banks may respond to regulation by increasing training, by shifting staff to activities that generate less revenue or by doing nothing differently. In all cases, the bank’s response will manifest itself in lower profits, as if the bank altered its head count.

In the analysis, we provided the following cost estimate for increased supervision/regulation under a baseline scenario with a fixed set of key assumptions and through cost estimates in which we vary the key assumptions from the baseline scenario. By way of example, we found that the median reduction in profitability for banks with less than $50 million in assets was 14 basis points if they have to increase staff by one half of a person; the reduction is 45 basis points if they increase staffing by two employees. The former increase in staff leads to an additional 6 percent of banks this size becoming unprofitable, while the latter increase leads to an additional 33 percent becoming unprofitable.

We also allow interested parties to customize key model inputs to tailor the simulation via a spreadsheet on our website.

Community Bank Consolidation Analysis

Observers argue that increased regulation and supervision added in response to the financial crisis will speed the decline of community banks. Determining if the rate of community bank consolidation is higher than it would have been absent this additional regulation requires a baseline estimate of community bank consolidation. A baseline estimate is particularly important because the number of community banks in the states of the Ninth Federal Reserve District, and the nation as a whole, has been in a steady rate of decline for several decades.

In this project, we used several simple methods to provide baseline estimates of community bank consolidation. We then compared actual consolidation against these baselines and updated our estimates quarterly to help determine if consolidation proceeds at a higher than expected rate. We continue to update our baseline estimates each quarter. So far we have not seen consolidation occurring at a faster rate than expected for states in the Ninth District or the nation. But such trends can change quickly. We will continue to monitor the historically expected and actual consolidation experiences of community banks.

Community banking analytical research has been and will continue to be a focus of mine and the Federal Reserve Bank of Minneapolis more generally. I welcome your feedback on the work we have done and suggestions for additional work you think merits analysis. Please provide any feedback you may have to Ron.Feldman@mpls.frb.org.

Endnotes