Federal legislation permits nationwide

Implications of Banking Consolidation for the Financing of Rural America R. Alton Gilbert Federal legislation permits nationwide branch banking next year. Implications of this change for the financing of rural America depend on answers to the following questions: 1. Will large banking organizations establish branches in rural areas? 2. If so, will they capture large shares of the banking business in areas where they establish rural offices?. If they do, will the large banking organizations finance activities that are important for rural economic activity? 4. If not, will rural residents (individuals and firms) be able to obtain credit from nonbank sources on terms comparable to those provided by banks prior to nationwide branch banking? This paper examines what we can learn from existing studies, or could learn from existing data, about the implications of banking consolidation for the financing of economic activity in rural areas. The evidence indicates that large organizations will expand their offices in rural areas. The role of relatively small banks headquartered in rural areas as providers of banking services in their communities will be diminished. Some of the evidence indicates that this change in banking structure will restrict the access to credit by rural residents. The paper examines the implication of such a change in credit availability for the regulation of small, rural banks. WILL LARGE BANKING ORGANIZATIONS BECOME MAJOR PROVIDERS OF BANKING SERVICES IN RURAL AREAS? The effects of nationwide branch banking on the financing of rural economic activity will depend on whether large banking organizations establish offices in rural areas and the success of the large organizations in attracting banking business through their rural offices. Survey of the literature Amel and Liang (1992) report that the rate of entry into banking markets through de novo branches increased after states relaxed their restrictions on branching and interstate banking. Unfortunately, for purposes of this study, they do not examine separately the effects of changes in state banking laws on entry into rural banking markets. Also, they do not break down the entry by that of relatively large and small banks. Lawrence and Klugman (1991) find that rural banks which were purchased by out-of-state banking organizations did not increase their share of deposits among banks in their market areas after acquisition. While their finding is relevant for this paper, it rests on a small number of observations (40 acquired banks) over a few years

12 R. Alton Gilbert (changes in market shares over four years after acquisitions). Existing studies provide limited information on the likely effects of nationwide branch banking on rural banking markets. New evidence One way to project the role of large banking organizations in rural banking markets under nationwide branching is to examine the structure of rural counties located in states that have permitted statewide branching for many years. While the effects of nationwide branching may not be the same as statewide branching, this may be the only method for making projections that is based on actual observations, rather than simulations based on the assumptions of models. Table 1 presents information on the role of the offices of relatively large banking organizations in rural counties. For each state, large banking organizations are identified as the five largest (in terms of total banking assets) with offices in the state. Under regional interstate banking, these large banking organizations may have their headquarters outside the state. Twelve of the 21 states included in Table 1 have permitted statewide branch banking for many years. The other nine states, which permitted multibank holding companies (MBHCs) but prohibited statewide branching, are in the Kansas City Federal Reserve District and other parts of the Midwest. All observations on the size and location of banking offices are as of June 1990, because of changes in banking regulations in several states around that time. Some of the first nine states in Table 1 lifted restrictions on statewide branching around 1990. Effects of these recent changes in branching restrictions on the presence of large banking organizations in rural areas may be incomplete at this time. Rural counties generally are defined as those located outside of metropolitan areas. In this study the counties outside of metropolitan areas are divided into three groups, based on their population as of 1990, to determine whether large banking organizations tend to restrict their offices to the rural counties with the relatively large population. Patterns in Table 1 indicate that the presence of large banking organizations in rural counties reflects state banking restrictions on multioffice banking. The states with the most limited presence of large banking organizations in their relatively small rural counties are among the first six states listed in Table 1, which imposed various restrictions on the size of each MBHC relative to total deposits in the states. Note in particular the limited presence of large banking organizations in the smaller counties of Arkansas, Kansas, Nebraska, and Oklahoma. In states that permitted statewide branching for many years prior to 1990, large banking organizations tended to be the dominant organizations in most of the rural counties. For instance, note the banking structure of the 18 rural counties in California. The five largest banking organizations in the state had offices in 1 of these 18 rural counties. In each of these 1 counties the banking organization with the largest share of was one of the five largest banking organizations in the state. 1 The five largest banking organizations together accounted for over half of county deposits in each of the 1 counties where they had offices, and accounted for over 75 percent of deposits in most of these counties. While smaller banking organizations had offices in these rural California counties, their significance as providers of banking services to their communities was limited relative to the more dominant role of the large banking organizations. Similar patterns hold for the rural counties of most of the statewide branching states. There are exceptions, however; the largest banking organizations in

Implications of Banking Consolidation for the Financing of Rural America 1 Table 1 PRESENCE OF LARGE BANKING ORGANIZATIONS IN RURAL COUNTIES June 1990 Percentage of counties in which: State Range of population in rural counties No. of counties The five largest banking organizations in the state have at least one office The largest banking organization in the county () is one of the five largest banking organizations in the state The five largest banking organizations account for at least: 50 percent of 75 percent of Multibank holding companies (MBHCs) permitted, subject to state limits on their growth Arkansas 1 Up to 15,000 Iowa 2 Up to 15,000 Kansas Up to 15,000 Missouri 4 Up to 15,000 Nebraska 5 Up to 15,000 Oklahoma Up to 15,000 Colorado 7 Up to 15,000 New Up to 15,000 Mexico 8 Wyoming 9 Up to 15,000 29 25 47 0 9 72 15 7 52 11 75 7 14 14.4 12 42. 40 77.8 2.8 20 85.7.5 9.7 90.9 4 42.9 8. 7.1 7.1 8 50 10. 20 55. 1.4.7 71.4 2.9 9.4 72.7 2.7 14. 50 7.1 7.1 MBHCs permitted, no state restrictions 42 8 2 1 4 1 5 11.9 50 50 8.5 50 75 7.9 9.5 50 7.7 1.7 50 2.1 40 8 4.. 44.4 1.4 11.5 24.2 18.2 2.7 9.5 50 25 8.5 0 4 2.1.8 9.1 1. 2.4 7.7 20 (continued)

14 R. Alton Gilbert Table 1 (continued) PRESENCE OF LARGE BANKING ORGANIZATIONS IN RURAL COUNTIES June 1990 State Range of population in rural counties Arizona Up to 15,000 California Up to 15,000 Idaho Up to 15,000 Maine Up to 15,000 Maryland Up to 15,000 Nevada Up to 15,000 North Carolina No. of counties The five largest banking organizations in the state have at least one office Percentage of counties in which: The largest banking organization in the county () is one of the five largest banking organizations in the state Statewide branching permitted for many years prior to 1990 Up to 15,000 Oregon Up to 15,000 South Carolina Up to 15,000 Utah Up to 15,000 2 2 1 27 8 0 2 0 4 9 4 1 17 20 15 10 7 12 10 15 7 2 50 75 7.5 85 8.7 75 90 7. 50 85.2 50 50 4.7 5 7. 90 70 7. 85.7 The five largest banking organizations account for at least: 50 percent of 50 85.2 50 4.7 70 90 58. 70 7. 85.7 75 percent of 50 50 70.4 25 75 47.1 55 40 70 85.7 1.7 0 0 71.4 50 (continued)

Implications of Banking Consolidation for the Financing of Rural America 15 Table 1 (continued) PRESENCE OF LARGE BANKING ORGANIZATIONS IN RURAL COUNTIES June 1990 State Range of population in rural counties Vermont Up to 15,000 Washington Up to 15,000 No. of counties 1 4 9 5 The five largest banking organizations in the state have at least one office 75 Percentage of counties in which: The largest banking organization in the county () is one of the five largest banking organizations in the state 8. 80 The five largest banking organizations account for at least: 50 percent of 8. 80 75 percent of 77.8 0 1 Arkansas: MBHCs permitted as of September 198, subject to a limit by any holding company of 10 percent of state deposits. This limit was raised to 12 percent in July 1984 and 15 percent as of January 1985. 2 Iowa: Prior to July 1984, deposits of each MBHC were limited to 8 percent of bank deposits in the state. As of July 1984, the limit was raised to 10 percent of deposits of all banks, thrifts, and credit unions in the state. Kansas: Branching statewide permitted by merger or acquisition as of April 1987. Restrictions on statewide branching removed in February 1990. MBHCs permitted, subject to a limit of 9 percent of deposits at state bank and thrifts controlled by any one MBHC, as of July 1985. 4 Missouri: No state restriction on MBHCs prior to 1975. As of January 1975, each MBHC became subject to a limit of 1 percent of deposit of banks in the state. As of August 1988, the denominator of the deposit cap was broadened to include the deposits of all banks, thrifts, and credit unions in the state. 5 Nebraska: MBHCs prohibited in March 19, with existing MBHCs grandfathered. An exception made in March 198 for the acquisition of failing banks. As of September 198, MBHC acquisitions permitted, subject to a limit of 9 percent of the deposits of all banks and thrifts in the state controlled by any one MBHC. This limit was raised to 11 percent in March 1985, and to 12 percent in January 1990. Oklahoma: Statewide branching as of March 1988. MBHCs permitted as of October 198, subject to a limit of 11 percent of deposits of banks, thrifts, and credit unions in the state controlled by any one MBHC. 7 Colorado: No state restrictions on MBHCs. 8 New Mexico: No state restriction on MBHCs. 9 Wyoming: As of April 1988, statewide branching by merger or consolidation. No state restrictions on MBHCs. Note: Source for footnotes to Table 1 is Amel (199).

1 R. Alton Gilbert Vermont were not the dominant organizations in the five rural counties with population up to 0,000. If banking structure in states that have permitted statewide branching is a reliable indicator of the effects of nationwide branch banking, relatively large banking organizations will be the dominant organizations in rural counties throughout the nation. This outlook indicates that while relatively small firms may continue to offer banking services in rural areas, the offices of large banking organizations will account for most of the banking business in their market areas. Such a change in the role of large banking organizations in rural areas may be more limited in the states that set caps on the percentage of state deposits in any one organization. As noted above, the states with the most limited presence of large banking organizations in rural areas were among the states that placed limits on the size of any one banking organization. These state limits remain in effect under nationwide branch banking. It would be appropriate to examine the numbers for more states, however, before drawing more firm conclusions about the effects of these state limits on the presence of large banking organizations in rural areas. DO LARGE BANKING ORGANIZATIONS FINANCE ACTIVITIES IMPORTANT TO RURAL ECONOMIC ACTIVITY? Limitations of the data Studies surveyed in this section use data on bank lending that have important limitations for purposes of answering the question in this section heading. 1. Reports on lending are by bank, not by banking office. Reports by large banks with many branches, therefore, provide no information on lending through their offices located in rural areas. 2. Reports do not specify the location of borrowers, except U.S. addressee or foreign.. Some reports provide information on the size of individual loans, but not the size of borrowers (such as asset size or sales). Some of the small loans may be made to large firms. Survey of the literature Lawrence and Klugman (1991) report that the rural banks in their sample acquired by out-ofstate MBHCs were large relative to other banks in their rural counties prior to acquisition and had lower percentages of their loans in the agricultural sector. After acquisition the only significant change was a rise in the ratio of loans to deposits at the acquired banks relative to ratios at other banks in their counties. Lawrence and Klugman suggest that this rise in the loan-todeposit ratio at these rural subsidiaries of the interstate MBHCs reflects loans originated by other subsidiaries of the holding companies that are held on the books of their rural subsidiaries. The authors, however, present no direct evidence of this use of rural bank subsidiaries by interstate MBHCs. Gilbert and Belongia (1988) report that the subsidiaries of large MBHCs located in rural areas invested lower percentages of their assets in agricultural loans than other banks located in the same counties. This gap in agricultural loan ratios was positively related to the asset size of the holding companies. Gilbert and Belongia interpret their findings as evidence that the rural banks which are not subsidiaries of large MBHCs have more limited opportunities to diversify risk in their loan portfolios; they invest relatively high percentages of their assets in agricultural loans because they are dependent on

Implications of Banking Consolidation for the Financing of Rural America 17 local borrowers (farmers) for lending opportunities. Subsidiaries of large MBHCs, in contrast, can participate in loans originated by affiliates with offices in other geographic areas. This interpretation supports the view that banking consolidation will have adverse effects on the access to bank credit for rural residents. Evidence in Lawrence and Klugman (1991), however, suggests an alternative interpretation of the evidence: Perhaps the subsidiaries of the large MBHCs had relatively low agricultural loan ratios prior to their acquisition by the holding companies. In that case, acquisition of the banks by large MBHCs may not have reduced agricultural lending by rural banks. Keeton (199) examines the effects of mergers on lending by rural banks. The only significant effect was a reduction in business loans when rural banks were acquired by out-of-state banking organizations; the impact is measured over three years after the merger. It is not possible to determine from this evidence, however, whether the decline in business loans reflects the objectives of the new owners or decisions of borrowers to shift their business to other lenders. Berger, Kashyap, and Scalise (1995) conclude that nationwide branch banking will reduce bank lending to small businesses. They measure lending to small businesses using data from the Federal Reserve s Survey of Bank Lending. Banks in the survey report detailed information on each new business loan made during one week of each quarter. Berger, Kashyap, and Scalise assume that the dollar amounts of lending in the survey reflect the size of the borrowers. Their conclusion concerning the effects of nationwide branch banking is based on the observation that most of the loans by large banks are for large dollar amounts, and most of the loans by smaller banks are for smaller dollar amounts. Although Berger, Kashyap, and Scalise draw strong conclusions about the implications of nationwide branching for bank lending to small businesses, various aspects of their study limit its relevance for the financing of rural America in the future. First, they do not present evidence to support the assumption that the small business loans were made to small businesses. Second, the size distribution of loans by large banks prior to nationwide consolidation does not necessarily indicate the size distribution of their business loans after they expand their offices over wider geographic areas, especially into rural areas. And third, they do not consider whether the effects of nationwide branch banking on business lending will be different in urban and rural areas. In a careful study of the effects of multi-office banking on lending to small businesses, Keeton (1995) surveys prior studies and presents some new evidence. Some of the earlier studies, dating back to the 190s, indicate that small businesses were more likely to view their activities as constrained by the availability of credit if located in states that permitted multi-office banking. The prior studies cited by Keeton, however, have mixed conclusions concerning the implications of multi-office banking for the availability of bank credit for small businesses. The new evidence in Keeton (1995) is derived from new disclosures on small loans to businesses required of all banks annually since June 199. These data suffer from some of the same limitations as that used by Berger, Kashyap, and Scalise: There are no reports on small business loans by branch, since there is one report per bank. Also, the reports disclose the distribution of business loans by dollar values of individual loans, not the size of the borrowers. There are two advantages of the data used by Keeton, however. First, the report by each bank is for all small-denomination business loans outstanding as of a point in time, whereas the data in Berger,

18 R. Alton Gilbert Kashyap, and Scalise are for loans made during one week each quarter. The stock of data on loans outstanding is likely to provide a more reliable profile of business loans by dollar denomination than the flow of data on business loans made during one week of each quarter. Second, the data used by Keeton are reported by all banks, whereas the data used by Berger, Kashyap, and Scalise are from a sample of banks. Given the limitations of the data, the most relevant comparisons in Keeton (1995) involve the reports by banks that are subsidiaries of MBHCs, which are the closest approximation possible with existing data to reports on small business loans by banking office. Keeton reports that on average the ratios of small business loans to total deposits are smaller for subsidiaries of MBHCs than for independent banks with similar characteristics. In results not reported in the article, the differences in loan ratios are similar for the rural banks in his sample. Whalen (1995) uses data from the same reports on small loans by banks as in Keeton (1995). Whalen finds the opposite pattern. Subsidiaries of MBHCs invest higher percentages of their assets in small business loans than independent banks. In making these comparisons, however, Whalen holds constant only one characteristic of the banks: their total assets. The subsidiaries of MBHCs and independent banks, however, differ in other ways. For instance, a much higher percentage of the independent banks in his sample were located outside of metropolitan areas. Overcoming limitations of the data One rich source of data on bank lending to small business firms not used in the studies cited above is from the Survey of Small Business Finances (Elliehausen and Wolken (1990) for a description of the survey for 1987). In the survey as of 1987, a sample of,405 small business firms provided detailed information on their finances, including sources of credit by type of lending institution; 1,52 of these firms had their headquarters in rural areas. Information on the small business firms includes restrictions on branching in states in which the firms had their headquarters. Use of data from this survey eliminates uncertainty about whether small loans are to small businesses and where the borrowers are located. These data would indicate whether small business firms headquartered in the rural areas of states that permit statewide branching borrow from nonbank sources such as finance companies to a greater extent than small firms located in other states. Data from a new Survey of Small Business Finances (as of 199) will be available for analysis soon. Cole and Wolken (1995) and Cole, Wolken, and Woodburn (199) provide descriptions of the 199 survey. Several states liberalized their branching laws between 1987 and 199. It would be possible to use data from the two surveys to test the hypothesis that shifts of financing to nonbank sources was more pronounced among small businesses in rural areas of the states that liberalized their branching laws. Jayaratne and Strahan (199) use an alternative approach to estimating the effects of branching restrictions on economic growth. They present evidence that relaxation of restrictions on intrastate branch banking increased the rate of state economic growth, especially during the first ten years after the change. They conclude that lifting branching restrictions promotes economic growth by shifting bank lending to more productive uses. An interesting extension of their study would investigate the effects of lifting branching restrictions on economic growth in rural areas. If the more productive uses of bank credit are concentrated in urban areas, lifting branch-

Implications of Banking Consolidation for the Financing of Rural America 19 ing restrictions could reduce economic growth in rural areas. IMPLICATIONS OF THE EVIDENCE FOR THE REGULATION OF RURAL BANKS Suppose that through nationwide branching large banking organizations come to have the dominant role in most rural communities the pattern in states that have permitted statewide branching for many years. In addition, suppose the large banking organizations change the mix of bank lending in rural communities in ways that restrict the access to credit for important sectors of rural communities. In this outcome, the small banks headquartered in rural areas would become important sources of credit to sectors of rural communities not served by the large organizations. Given this important role for the small banks in rural communities, relief for these banks from regulatory burden that does not undermine safety and soundness may be appropriate. Some recent changes in regulations reflect an attempt to limit the burden of relatively small banks. For instance, the federal supervisory agencies may choose to examine relatively small banks with good supervisory ratings less frequently than once a year, the standard for larger banks. The recent revision in the standards for compliance with the Community Reinvestment Act includes different procedures for large and small banks. The role of small banks in rural communities in the future reinforces the case for directing regulatory relief to small banks. CONCLUSIONS If the effects of nationwide interstate branch banking on rural banking markets will be similar to the effects of statewide branching, large banking organizations will become the dominant banking organizations in most rural counties. The role of large banking organizations in the rural counties of some states may be limited by restrictions that the states place on the shares of banking activity at each organization. It would require more analysis of the data, however, to draw strong conclusions about the effects of these state limits. Existing studies present some evidence that a more dominant role for large banking organizations would restrict the availability of bank lending to small businesses in rural areas. These studies, however, have important limitations that reflect the nature of the data that banks report on their lending. Since banks do not report information on their lending by branch, there is no information on the lending by large banking organizations through their rural branches. Also, there are problems in drawing inferences from the data used in existing studies about lending to small businesses in rural areas, since the studies rely on reports that do not indicate the size or location of borrowers. It may be possible to avoid these limitations of the existing studies by using data from the Survey of Small Business Finances. A recent study uses a more direct approach to assess the effects of banking consolidation on economic activity: estimate the effects of liberalization of state branching restrictions on state economic activity. An interesting extension of this study would estimate separately the effects of changes in state branching restrictions on the rural and urban areas of the states that have liberalized their branching restrictions. Some recent changes in bank regulation are designed to reduce the regulatory burden of relatively small banks. The evidence in this study is consistent with an argument for regulatory relief directed at small banks. These banks may become more important as sources of credit for rural residents not served by large banking

140 R. Alton Gilbert organizations, which will account for larger shares of the banking business in rural communities. Regulatory relief might make small, rural banks more effective in providing this service to their communities. ENDNOTES 1 are those of individuals, partnerships, and corporations. REFERENCES Amel, Dean F. 199. State Laws Affecting the Geographic Expansion of Commercial Banks, manuscript, Board of Governors of the Federal Reserve System., and J. Nellie Liang. 1992. The Relationship Between Entry into Banking Markets and Changes in Legal Restrictions on Entry, The Antitrust Bulletin, Fall, pp. 1-49. Berger, Allen N., Anil K. Kashyap, and Joseph M. Scalise. 1995. The Transformation of the U.S. Banking Industry: What a Long, Strange Trip It s Been, Brookings Papers on Economic Activity, 2, pp. 55-218. Cole, Rebel A., and John D. Wolken. 1995. Financial Services Used by Small Businesses: Evidence from the 199 National Survey of Small Business Finances, Federal Reserve Bulletin, July, pp. 29-7., John D. Wolken, and R. Louise Woodburn. 199. Bank and Nonbank Competition for Small Business Credit: Evidence from the 1987 and 199 National Surveys of Small Business Finances, Federal Reserve Bulletin, November, pp. 98-95. Elliehausen, Gregory E., and John D. Wolken. 1990. Banking Markets and the Use of Financial Services by Small and Medium-Sized Businesses, Board of Governors Staff Study 10, September. Gilbert, R. Alton, and Michael T. Belongia. 1988. The Effects of Affiliation with Large Bank Holding Companies on Commercial Bank Lending to Agriculture, American Journal of Agricultural Economics, February, pp. 9-78. Jayaratne, Jith, and Philip E. Strahan. 199. The Finance- Growth Nexus: Evidence from Bank Branch Deregulation, Quarterly Journal of Economics, August, pp. 9-70. Keeton, William R. 1995a. Multi-Office Bank Lending to Small Businesses: Some New Evidence, Federal Reserve Bank of Kansas City, Economic Review, Second Quarter, pp. 45-57.. 1995b. Do Bank Mergers Reduce Lending to Businesses and Farmers? New Evidence from Tenth District States, Federal Reserve Bank of Kansas City, Economic Review, Third Quarter, pp. -75. Lawrence, David B., and Marie R. Klugman. 1991. Interstate Banking in Rural Markets: The Evidence from the Corn Belt, Journal of Banking and Finance, December, pp. 1081-91. Whalen, Gary. 1995. Out-of-State Holding Company Affiliation and Small Business Lending, Economic and Policy Analysis Working Paper 95-4, Comptroller of the Currency, September.