FRBSF Economic Letter
2000-14; May 5, 2000
 Economic
Letter Index
Small California Banks Holding On
A cursory look at the data on bank profitability suggests that, since
the end of 1995, small banks headquartered in California have been significantly
less profitable than medium-sized banks in the state. In addition, it
appears that small bank performance in California lags that of small banks
in the rest of the country.
Although small banks account for only about 2% of total California banking
assets, the health of these institutions can be very important to the
communities in which they operate. In this Economic Letter, I
take a closer look at the data on medium-sized and small banks in California,
and I find that part of small banks' performance is explained by the inclusion
of newly opened banks in the data; these new institutions typically are
less profitable than more established banks. In addition, while earnings
among small California banks have been lagging, steady improvement in
their profitability led to a narrowing in the earnings gap relative to
medium-sized banks in the state and to small banks elsewhere in the U.S.
Not a pretty picture
Figure 1 illustrates
the difference in profitability among small, medium-sized, and large California
banks during the 1990s by plotting their four-quarter moving average of
aggregate annualized returns on average assets (ROAA). (Small banks =
assets <$100 million; medium-sized banks = assets $100 million to $1
billion; large banks = assets >$1 billion.) As the banking industry
recovered from the early 1990s recession, changes in the ROAA for medium-sized
banks usually were met by roughly proportional changes in the ROAA of
small banks.
By the end of 1995, ROAA for California's small banks was up to 0.75%,
close to the medium-sized bank ROAA of 0.84%. However, since that time,
ROAA for the small banks has fallen slightly, to 0.65% in 1999. In contrast,
medium-sized banks have increased their returns to 1.15%, which is about
equal to the ROAA for large banks. (The temporary plunge in ROAA for large
banks in the second half of 1998 was due to special factors at several
large California banks, some of them related to mergers.) In 1999, then,
California's small bank ROAA trailed medium-sized bank ROAA by half a
percentage point.
Furthermore, the profitability of small banks in California has lagged
the profitability of small banks in the country as a whole throughout
the 1990s, though it had kept pace during the 1980s. In 1999, ROAA for
small U.S. banks stood at 1.02%, 37 basis points higher than ROAA for
small California banks.
The role of new banks
While the situation at California's small banks looks, at first glance,
to be rather grim, the picture brightens when we consider that the small
bank category includes nearly all the brand new banks, because their presence
in the data tends to decrease small bank ROAA. On average, new banks are
less profitable than more established banks and often show losses.
The rate of new bank formation in California has been especially high
in recent years. Between the end of 1995 and the end of 1999, new bank
formation each year averaged 3.77% of all California banks (8.79% of small
California banks), compared with 1.3% (2.29% for small banks) between
1991 and 1995. New bank formation also has been higher in California than
in the U.S. in recent years. For example, between the end of 1995 and
the end of 1999, new bank formation each year in the U.S. averaged 2.6%
(4.12% for small banks).
The higher rate at which California is adding new banks accounts for
part of the gap between California small bank ROAA and U.S. small bank
ROAA. Data excluding banks that are less than two years old indicate that,
in 1999, the gap between small established U.S. bank ROAA and small established
California bank ROAA was 23 basis points.
While this is appreciably smaller than the original 37 basis point gap,
it still is large enough to warrant a look at banks' income statements
to see what might be contributing to the shortfall. It turns out that,
relative to assets, California's small banks have significantly higher
noninterest expenses, such as salaries and premises expenses, than do
small banks in the U.S. as a whole. (Here and throughout, the analysis
deals with income and expense items relative to assets.)
Omitting new banks from the analysis also reduces the gap between small
and medium-sized bank ROAA within California. As shown in Figure
2, ROAA for established small banks was at 0.91% in 1999, notably
higher than for all small banks, while ROAA for established medium-sized
banks was essentially the same as that for all medium-sized banks. The
spread in the ROAA between medium-sized and small established banks at
the end of 1999 was 22 basis points, considerably lower than the 50 basis
point spread in Figure 1.
Small bank asset quality catches up
The presence of new banks in the data explains only part of the gap that
has opened up between medium-sized bank and small bank profit rates in
California. An additional contributing factor has been differing rates
of asset quality improvement.
Between the end of 1995 and the third quarter of 1998, medium-sized banks
recovered more quickly than small banks from asset quality problems originating
in California's recessionary period. Consistent with this, the four-quarter
moving average of medium-sized banks' ratio of nonearning assets (assets,
including repossessed real estate and nonaccruing loans, on which no interest
is earned) to total assets declined 189 basis points, while small banks'
nonearning ratio declined only 139 basis points during this period. As
a result, nonearning assets were less of a drag on interest income for
the medium-sized banks.
Differing rates of asset quality improvement also are reflected in the
two groups' loan loss provisions. (Loan loss provisions are expenses against
current earnings.) Between the end of 1995 and the third quarter of 1998,
medium-sized banks reduced their loan loss provisions by more than did
small banks.
At the end of 1998, medium-sized banks began to improve asset quality
more slowly, while small banks maintained a steady rate of improvement.
In particular, small established California banks' nonearning ratio declined
47 basis points in 1999, compared with 24 basis points for medium-sized
banks. In addition, small banks reduced their loan loss provisions faster
than did medium-sized banks during this period. These adjustments contributed
to the narrowing of the gap between medium-sized and small bank ROAA beginning
at the end of 1998.
Conclusion
At first glance, the performance of small California banks appears to
be seriously lagging the performance of medium-sized California banks
and small banks in the country as a whole. However, once the relatively
high rate of new bank formation in California, itself an auspicious sign,
is taken into account, the picture looks more favorable. In addition,
in 1999, earnings among small California banks continued to improve, while
profitability of medium-sized California banks and small banks elsewhere
in the U.S. leveled off. As a result, the earnings gap for small California
banks narrowed.
Elizabeth S. Laderman
Economist
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
Federal Reserve Bank of San Francisco
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