FRBSF Economic Letter

2000-14 | May 5, 2000

Small California Banks Holding On

Elizabeth Laderman

Western Banking Quarterly is a review of banking developments in the Twelfth Federal Reserve District, and includes FRBSF’s Regional Banking Tables. It is normally published in the Economic Letter on the fourth Friday of January, April, July, and October, but due to scheduling problems this issue is appearing one week later.

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$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.


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

Opinions expressed in FRBSF Economic Letter 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. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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