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The importance of scale economies and geographic diversification in community bank mergers

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Author Info
William R. Emmons
R. Alton Gilbert
Timothy J. Yeager

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Abstract

Mergers of community banks across economic market areas potentially reduce both idiosyncratic and local market risk. A merger may reduce idiosyncratic risk because the larger post-merger bank has a larger customer base. Negative credit and liquidity shocks from individual customers would have smaller effects on the portfolio of the merged entity than on the individual community banks involved in the merger. Geographic dispersion of banking activities across economic market areas may reduce local market risk because an adverse economic development that is unique to one market area will not affect a bank's loans to customers located in another market area. ; This paper simulates the mergers of community banks both within and across economic market areas by combining their call report data. We find that idiosyncratic risk reduction dominates local market risk reduction. In other words, a typical community bank can diversify away its idiosyncratic risk almost as completely by merging with a bank across the street as it can by merging with one located across the country. The bulk of the pure portfolio diversification effects for community banks, therefore, appear to be unrelated to diversification across market areas but, instead, are related to bank size. These findings help explain why many community banks have not pursued geographic diversification more aggressively, but they beg the question as to why more small community banks do not pursue in-market mergers.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2001-024.

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Date of creation: 2001
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Handle: RePEc:fip:fedlwp:2001-024

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Keywords: Bank supervision ; Bank mergers;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Boyd, John H. & Runkle, David E., 1993. "Size and performance of banking firms : Testing the predictions of theory," Journal of Monetary Economics, Elsevier, vol. 31(1), pages 47-67, February. [Downloadable!] (restricted)
  2. Rivard, Richard J. & Thomas, Christopher R., 1997. "The effect of interstate banking on large bank holding company profitability and risk," Journal of Economics and Business, Elsevier, vol. 49(1), pages 61-76, February. [Downloadable!] (restricted)
  3. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Blackwell Publishing, vol. 51(3), pages 393-414, July. [Downloadable!] (restricted)
  4. Kwast, Myron L., 1999. "Bank mergers: What should policymakers do?," Journal of Banking & Finance, Elsevier, vol. 23(2-4), pages 629-636, February. [Downloadable!] (restricted)
  5. Mark E. Levonian, 1994. "Interstate banking and risk," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue Jul 22. [Downloadable!]
  6. Hughes, Joseph P. & Lang, William W. & Mester, Loretta J. & Moon, Choon-Geol, 1999. "The dollars and sense of bank consolidation," Journal of Banking & Finance, Elsevier, vol. 23(2-4), pages 291-324, February. [Downloadable!] (restricted)
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  7. Liang, Nellie & Rhoades, Stephen A., 1988. "Geographic diversification and risk in banking," Journal of Economics and Business, Elsevier, vol. 40(4), pages 271-284, November. [Downloadable!] (restricted)
  8. Michelle Clark Neely & David C. Wheelock, 1997. "Why does bank performance vary across states?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 27-40. [Downloadable!]
  9. Andrew P. Meyer & Timothy J. Yeager, 2001. "Are small rural banks vulnerable to local economic downturns?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 25-38. [Downloadable!]
  10. David C. Wheelock & Paul W. Wilson, 1997. "New evidence on returns to scale and product mix among U.S. commercial banks," Working Papers 1997-003, Federal Reserve Bank of St. Louis. [Downloadable!]
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  11. Boyd, John H. & Graham, Stanley L. & Hewitt, R. Shawn, 1993. "Bank holding company mergers with nonbank financial firms: Effects on the risk of failure," Journal of Banking & Finance, Elsevier, vol. 17(1), pages 43-63, February. [Downloadable!] (restricted)
  12. John H. Boyd & Mark Gertler, 1994. "The role of large banks in the recent U.S. banking crisis," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-21. [Downloadable!]
  13. Rose, Peter S, 1996. "The Diversification and Cost Effects of Interstate Banking," The Financial Review, Eastern Finance Association, vol. 31(2), pages 431-52, May.
  14. Allen, Linda & Jagtiani, Julapa, 2000. "The risk effects of combining banking, securities, and insurance activities," Journal of Economics and Business, Elsevier, vol. 52(6), pages 485-497. [Downloadable!] (restricted)
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  1. Manuel Illueca & José Pastor & Emili Tortosa-Ausina, 2009. "The effects of geographic expansion on the productivity of Spanish savings banks," Journal of Productivity Analysis, Springer, vol. 32(2), pages 119-143, October. [Downloadable!] (restricted)
  2. Timothy J. Yeager, 2002. "The demise of community banks? local economic shocks aren't to blame," Supervisory Policy Analysis Working Papers 2002-03, Federal Reserve Bank of St. Louis. [Downloadable!]
  3. Timothy J. Yeager, 2002. "Community bank performance in the presence of county economic shocks," Supervisory Policy Analysis Working Papers 2002-11, Federal Reserve Bank of St. Louis. [Downloadable!]
  4. Allen N. Berger & Robert DeYoung, 2002. "Technological progress and the geographic expansion of the banking industry," Finance and Economics Discussion Series 2002-31, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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