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Wednesday, March 08, 2006

Bernanke Discusses Changes in Risks Faced by Community Banks

Traditional community banks have an advantage over large banks when information on borrowers is costly or difficult to obtain, a situation encountered most often with smaller local businesses. By developing a relationship with a local bank, information flows between the bank and business develop over time and allow these businesses to take out loans that would not otherwise be available. Thus, community banks play an important intermediation role.

However, advances in information technology are eroding this advantage for community banks creating new competitive pressures from larger banks. Ben Bernanke reviews changes in the structure of the community banking industry and discusses how the change impacts the Fed's role in bank regulation.

Because the traditional business for community banks is becoming increasingly competitive, smaller community banks have turned more and more to commercial real estate lending to fill the void. This change in the type of loans made by commercial banks, along with an apparent decline in underwriting standards, is the focus of the Fed's concerns. The Fed is particularly focused on risks to community banks that are heightened when output falls as in an economic slowdown or when interest rates rise:

Community Banking and Community Bank Supervision in the Twenty-First Century, by Ben Bernanke, March 8, 2006: ...Today, I will begin by making some observations, based in part on research done at the Federal Reserve and elsewhere, about the health of community banks and their evolving role in our economy. Community banks are generally doing quite well... But community banks also face a changing business environment that presents a number of important long-run challenges. ... I will speak a bit about how the Federal Reserve, as the supervisor of many community banks, is also adjusting to a changing environment, and ... some of the key financial risks facing community banks.

Developments in Community Banking

By a wide variety of indicators, the overall performance of community banks in recent years has been quite strong. ... But I am sure that many in this audience would agree that community banks also face serious challenges. ...

Indeed, we have seen major shifts in the structure of the U.S. banking industry in recent decades. ... the share of banking industry assets held in community banks has fallen from about 20 percent in 1994 to a little more than 12 percent in 2005. In addition, the number of community banks has dropped from more than 10,000 in 1994 to about 7,200 in 2005. ... Most of this consolidation is a result of mergers. ...

The Evolution of Relationship Finance

These developments notwithstanding, research by our staff and other economists supports the view that community banks continue to play an important role in the provision of financial services, particularly to small businesses, but also to a wide range of retail customers nationwide. Indeed, conventional wisdom ... is that "the central principle of community banking is 'relationship finance'" (DeYoung et al., 2004, p. 81). By relationship finance I mean financial services whose value-added depends importantly on the ongoing personal interactions of bankers with their customers, interactions that improve the flow of information and allow for more customized services. Relationship finance strengthens the economy by allowing credit and other financial services to be provided more efficiently.

But recent research also confirms what many community bankers tell us--that traditional notions of relationship finance are changing, along with the nature of community bank-customer relationships.

The conventional research paradigm included the idea that small businesses and households tend to be informationally "opaque"; that is, information about these potential borrowers can be costly to obtain and hard to quantify. ... This paradigm holds that large banks have a comparative advantage lending to those relatively transparent customers from which they can obtain "hard," or quantitative, information, such as standardized accounting data, and community banks have a comparative advantage lending to relatively opaque small businesses and households.

However, this division of labor between large and small institutions has begun to blur. Today, practitioners and researchers understand that low-cost information processing, improved credit-scoring, and more sophisticated management techniques are rapidly reducing the effective opacity of many small businesses and households. ...

Although ... community banks face increasing competition, including from nondepository providers, they also highlight the importance of one of the traditional strengths of community banks: local presence. ... Being close and convenient is important. Data collected as part of the banking agencies' Community Reinvestment Act (CRA) activities also demonstrate the importance of proximity. ... These data show that between 1996 (the year we began collecting such data) and 2004, the competition from out-of-market lenders has increased, a result that will not surprise you. However, in value terms, the share of small-business loans made by out-of-market firms did not exceed 18 percent in any year. Small-business owners look overwhelmingly to local lenders for credit. ...

In financial terms, community banks remain quite strong, and there is considerable entry into the business. New technologies and management methods have eroded some of the traditional informational benefits of relationship finance, however, and community banks have lost market share to larger banks and to nondepository institutions. But the data also show that many customers want to be served locally; they value proximity and convenience. ...

Supervisory Perspectives

Like community banks, bank supervisors must also adapt to a changing financial and economic environment. I would like to discuss some of the ways in which the Federal Reserve's supervision of community banks has evolved in recent years and also briefly review some of the key financial risks that we see...

Banking has always been a business of taking and managing risks, but evolving market and economic conditions affect the types of opportunities available. In recent years, community banks have become more focused on commercial real estate lending, leading to a significant shift in the balance sheet and risk profiles of growing numbers of banks.

In most local markets, commercial real estate loans have performed well. Our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. ... However, more recently, there have been signs of some easing of underwriting standards. ...

In response to these developments, the federal banking agencies have recently proposed guidance that would focus examiners' attention on those loans that are particularly vulnerable to adverse market conditions... I emphasize that, in proposing this guidance, supervisors are not aiming to discourage banks from making sound loans in commercial real estate or in any other loan category. ...

Adjusting to changes in the level of short-term interest rates can also pose challenges to community banks. Thus far, the relative stability of community bank net interest margins suggests that they have done a good job of managing their interest rate risk... However, we continue to see a small number of institutions with concentrations in longer-term assets. ...

I emphasize that, on the whole, we do not have broad supervisory concerns with community banks. But it is only prudent to reiterate the importance of sound risk management to the continued success of community banks.

Conclusion

In closing, I want to return to where I began. In my judgment, well-managed and innovative community banks will continue to play a critical role in the U.S. economy. Community banks provide vital services for their customers and are key contributors to sustained economic growth, both locally and nationally. Indeed, the performance of community banks over the past decade has been very impressive. But neither bankers nor their supervisors should become complacent. Doubtless the future will continue to require both of us to evaluate and respond to changes that are often complex and difficult to understand, much less to predict. It has been my pleasure to be here today, and I look forward to working with you in the coming years to ensure the continued vitality of the U.S. banking and financial system.

    Posted by on Wednesday, March 8, 2006 at 11:54 AM in Economics, Fed Speeches, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (1)

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