FRBSF Economic Letter
2007-22; July 27, 2007
Regional Economic Conditions and Community Bank Performance
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Community banks, by virtue of their size and emphasis on so-called relationship
banking, typically have limited geographic scope in their activities. This
would seem to imply that their financial performance would be tied closely
to the financial condition of their customers and, thus, to the economic conditions
in regional banking markets. Contrary to this expectation, the empirical evidence
on the relationship between average community bank performance and regional
economic conditions is at best mixed. Moreover, studies tend to find that information
on regional economic conditions is of limited help in predicting the performance
of individual banks.
In this Economic Letter, we argue that part of the explanation for
this puzzle lies in the fact that looking at the average response
of bank performance tends to mask the wide range of responses of individual banks'
performances to regional economic shocks; we find evidence that individual
bank responses run from significantly positive to significantly negative. At
the same time, our analysis suggests that bank-specific factors are important
drivers of the variation in the performance of community banks.
Previous looks at regional impacts on banks
Previous studies have found little evidence of a systematic relationship between
community bank performance and regional economic conditions in regional divisions
such as counties and metropolitan areas. Yeager (2004) uses three measures
of performance—the ratio of nonperforming loans to total loans, net chargeoffs
to total loans, and profitability—and finds little difference between community
bank performance in counties experiencing large economic shocks (reflected
in unemployment rates) and that in other counties. Using a different methodology,
Emmons, Gilbert, and Yeager (2004) find that rates of return at community banks
in the same region were not highly correlated in the late 1980s and early 1990s.
Other studies, such as Meyers and Yeager (2001) and Daly, Krainer, and Lopez
(2003), examine the influences of a variety of measures of state-level economic
conditions and find statistically significant effects on measures of bank performance.
However, in the latter study, regional economic conditions in a state are not
especially useful in predicting differences in the performance of individual
banks in out-of-sample simulations.
A new look at the link
One common feature of most previous approaches is an assumption that the
systematic responses of bank performance measures to a change in economic conditions
are the same for all community banks. However, specialization among community
banks could lead to variation in business strategies and portfolio composition,
which could, in turn, lead to variation in the systematic responses of performance
to regional economic conditions.
In our research (Furlong and Krainer 2007), we allow for such variations
in the responses of individual banks to economic conditions. We study a large
sample of community banks with total assets of $1 million or less. The data
are from the quarterly Reports of Condition filed by all domestically chartered
banks from 1984 through 2004. We use return on assets (ROA)—that is, net income
relative to assets—as our measure of performance.
Bank performance is assumed to depend on aggregate factors, state-level factors,
and bank-specific factors. Drawing on a long tradition in finance, our proxy
for the aggregate factors is the weighted-average ROA for community banks nationwide,
because, at a given point in time, this measure will capture factors, such
as changes in interest rates, that have systematic effects on community banks.
To derive the regional or state shocks, we assume that the banks in a state,
as a group, are exposed to risks unique to that state. First we calculated
the aggregate ROA for community banks in each state for each quarter. The part
of a state's ROA not explained by national ROA in a quarter is defined to be
the state's shock in that quarter. This approach sidesteps the difficult issue
of identifying and measuring the state-specific economic variables that drive
of the time series for the state-specific components of ROA are shown in Figure
1 for three adjoining states—California, Oregon, and Arizona. The figure indicates
that, even for community banks in states that share borders, state effects
can differ substantially at any point in time. The pair-wise correlations for
the state-specific components in these three states are all less than 0.2.
(A value of 1.0 would mean perfect positive correlation and a value of -1.0
would mean perfect negative correlation.)
Differences in systematic responses of individual
With measures of the state shocks in hand, we can assess the systematic relationship
(sensitivity) of the ROA of individual banks to national ROA and the state
shocks using regression analysis. Individual bank regressions were run on the
set of 5,255 community banks that are in our sample for the entire 20 years.
The degree of the systematic relationship can depend on the extent and type
of specialization of a bank and the nature of the economic shocks. For example,
a state's shocks might hit different economic sectors—commercial real estate,
aerospace, information technology, subprime residential real estate loans—at
different points in time. In that case, the performance of a community bank
with a diversified loan portfolio might exhibit a high degree of systematic
exposure to state shocks. In contrast, a highly specialized bank likely would
exhibit a low degree of systematic exposure, even though the bank would be
affected by economic conditions in its own sector of specialization.
The results from statistical analysis reveal considerable variation in the
systematic responses of the performance of individual banks to factors affecting
banks nationally and in their respective states. The solid line in Figure 2
plots the distribution of the estimated responses to changes in ROA at the
national level. The coefficients generally are positive, with a median response
of 0.6. That is, for a 1 percentage point change in national ROA, the median
change in ROA for the sample banks would be 0.6 percentage points. The dashed
line in Figure 2 plots the responses of the ROA of individual banks to state
shocks, and the median value is approximately 0.4. Our analysis indicates that
state shocks had a systematic, statistically significant effect on the performance
of half of the banks in the sample, with positive effects for 42% of the sample
and negative effects for 8%. We would note that this combination of positive
and negative effects would tend to lead to a finding of no significant effect
in terms of the average response to state shocks.
Impact on the distribution of
The variation in responses to state shocks also could bias statistical analysis
toward supporting a conclusion of no effect of regional shocks through changes
in the variation in performance. That is, with quite different responses at
the bank level, a state shock would tend to increase the spread in performance
among community banks in a state, at least temporarily. In statistical analysis,
an increase in spread (variance) would tend to reduce the precision of the
estimated average response. The lower precision would tend to lead an analyst
to accept the idea that the average effect was not different from zero.
As it turns out, state shocks do increase the variation in community bank
performance within a given state market. For this stage of the analysis, we
computed the variance of the distribution of ROA for each state for each quarter
over the sample period. For the state shock we used the absolute value of the
estimates discussed earlier, since both positive and negative shocks would
be expected to widen the distribution of performance. The results show that
the dispersion (variance) of individual bank performance within a state is
positively and significantly related to the absolute value of the state shock.
Relative importance of economic
The evidence so far indicates that regional shocks had statistically significant
effects on the performance of about half the community banks in our sample.
However, our analysis also shows that the systematic response to economic conditions
still accounts for only a modest part of the overall variation in performance
of individual banks. For example, allowing for different responses for each
bank to national ROA could account for 4% or less of the actual variance in
ROA for half of the banks. Allowing for individual responses to the state shocks
improves the picture modestly, accounting for 13% or less of actual variance
for half of the banks.
These results indicate that the bulk of the variation in the performance for
a large number of community banks is idiosyncratic. The bank-specific effects
could be related, in part, to the limited size and customer base, which may
not be representative of the community at large. Credit underwriting and general
business practices also can vary among banks and contribute to bank-specific
risk. Finally, as suggested above, interaction between a bank's degree of specialization
and the nature of the economic shocks can affect the systematic responses of
performance and, thereby, bank-specific risk.
The connection between regional economic conditions and the performance of
community banks is far from straightforward. From our analysis, regional economic
shocks have had statistically significant effects on half of the community
banks in the sample, with the magnitudes and even the direction of effects
varying widely. Also, regional economic shocks tend to increase the variation
in the performance of community banks. At the same time, the performance of
most community banks still appears to be related in large part to bank-specific
The analysis highlights the difficulty in generalizing about the implications
of regional economic shocks for individual community banks. It suggests that
a bank's performance will depend on the nature of the shocks and on the individual
bank's business strategy. Even then, a bank's risk management and general business
practices, as well as its customer base, may end up being more important than
general economic conditions in accounting for the variability of its performance.
Group Vice President
[URLs accessed July 2007.]
Daly, Mary C., John Krainer, and Jose A. Lopez. 2003. "Does
Regional Economic Performance Affect Bank Conditions? New Analysis of an
Old Question." FRB San Francisco working paper 2004-01. http://www.frbsf.org/publications/economics/papers/2004/wp04-01bk.pdf
Emmons, William, Alton Gilbert, and Timothy Yeager. 2004. "Reducing the
Risk at Small Community Banks: Is It Size or Geographic Diversification That
Matters?" Journal of Financial Services Research 25(2-3) pp.
Furlong, Fred, and John Krainer. 2007. "Regional Economic Conditions
and the Variability of Rates of Return in Commercial Banking." FRB San
Francisco working paper (forthcoming).
Meyers, Andrew, and Timothy Yeager. 2001. "Are
Small Rural Banks Vulnerable to Local Economic Downturns?" FRB St.
Louis Review 83(2) pp. 25-38. http://research.stlouisfed.org/publications/review/01/03/0103am.pdf
Yeager, Timothy. 2004. "The Demise of Community Banks? Local Economic
Shocks Are Not to Blame." Journal of Banking and Finance 28(9)
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