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Financial
Industry Perspectives
1998
Other Issues of Financial Industry
Perspectives
With some of the largest mergers in history now taking place in the financial services
industry, the fact that consolidation is also occurring among small banking institutions
is often overlooked. The factors that are promoting consolidation in the banking
industry are also relevant for the smallest banks, namely the need to spread the cost of
technological and administrative overhead and the desire to maintain earnings growth. With
limited growth opportunities in many rural communities, smaller banks often choose to
merge with other nearby rural banks as the means to gain asset size and improve
efficiency.
Using a case study approach that focuses on nineteen rural banks that participated in
in-market mergers, this article examines whether smaller community banks that followed
this merger strategy realized efficiency gains. The results show that such mergers have
usually been successful from both a profitability and a cost efficiency perspective.
Further, these gains were typically achieved without closing branch offices. These
successes are important to rural bankers as they seek opportunities for consolidation.
They are also important from a public policy perspective and should be carefully
considered by regulators in their evaluation of small bank mergers.
Bank managers, stockholders, and directors must work closely together in deciding what
risks their bank will assume and how to control the bank's overall risk exposure. Each
decision-maker will have to understand the risk preferences of others in order to make
mutually acceptable decisions and develop policies that reflect all of their concerns. To
the extent that weak risk control is tied to management and ownership structure, bank
examiners must also understand the basic components of a sound management and ownership
structure if the examiner is to suggest corrective steps for a problem institution.
This study looks at a sample of Tenth Federal Reserve District banks to investigate the
relationship between bank risk, ownership of the bank by managers, and the degree to which
managers and owners have their wealth concentrated in their bank stockholdings. Data for
270 randomly selected banks reveal that ownership and wealth diversification of bank
owners and managers do influence bank risk. These effects extend not only to the overall
risk of the bank, but are also reflected uniquely in asset quality measures, bank
leverage, and other parts of a bank's risk exposure.
Major findings highlight connections between bank risk, ownership structure, and manager
wealth. Banks are less risky when bank managers have a higher concentration of wealth in
their bank and, thus, have more to lose from taking on additional risk. Possibly seeking
to avoid large loan losses that could threaten their employment, hired managers typically
operate their banks with lower credit risk than banks with owner managers. Using capital
as a buffer against risk, owner-manager banks tend to have higher capitalization than
banks with hired managers. Stock ownership by hired managers provides incentives to
operate their bank more in line with the risk preferences of owners. Finally, a
hired-manager bank will be less risky when a major owner monitoring the bank has much of
his or her wealth concentrated in the bank's stock.
Thus, ownership structure and concentration of wealth in bank equity have a significant
influence on bank risk. Understanding how risk preferences depend on ownership and wealth
diversification can be valuable information to managers and owners as they grapple with
the level and type of risk to take in their banks.
The structure of Colorado's banking industry has recently undergone significant change
and, therefore, provides a good case study with which to gauge the impact of consolidation
on sources of loans and access to credit for small business. We find that between 1994 and
1996, lending to small businesses in Colorado by small to medium size banking
organizations grew much faster than lending by large organizations. This lending pattern
was similar across in-state and out-of-state banking organizations. Thus, the difference
is largely driven by size rather than by the location of the organization's headquarters.
Some large banking organizations lost market share, but others were aggressive lenders to
small business. As a whole, large banking organizations still provided close to 40 percent
of small business loans made by banks in 1996.
Small business borrowers faced a shift in the source of bank finance, but there was a
large overall increase in loans, and so it appears that their financing needs were
adequately met. The large increase in small business lending by small and medium banking
organizations is a particularly striking example of responding to the opportunities
created by consolidation. In the future, however, large banks may reclaim market share as
they expand new and lower cost methods of small business lending.
In the short span of just ten to fifteen years, Tenth District banking has made the
dramatic leap from predominantly a unit banking or single office framework to one that
encompasses both statewide branching and interstate banking. This article examines the
major factors behind these changes and then looks at the District's evolving banking
structure. Overall, the total number of banks operating in Tenth District states has
declined by about 40 percent since 1985. This decline, though, has been accompanied by a
significant increase in the number of bank branches and facilities.
Other significant changes are also occurring. About one-third of all banking deposits
in Tenth District states is now under the control of out-of-state organizations. In
addition, banks are developing and expanding alternative ways for delivering services. For
instance, the District's ATM population continues to grow rapidly and an increasing number
of banks are opening branches in supermarkets and other retail locations. Moreover, the
Internet Web sites of District banks have expanded quickly over the last year both in
terms of number and the complexity of services offered. While all of these developments
pose a variety of issues and challenges for District bankers and customers, this changing
banking framework is opening up new opportunities and will likely lead to a more
convenient and efficient banking system, with a broader choice of services.
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