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Scale economies and geographic diversification as forces driving community bank mergers

  • William R. Emmons
  • R. Alton Gilbert
  • Timothy J. Yeager

Mergers of community banks across economic market areas potentially reduce both idiosyncratic and local market risk. Idiosyncratic risk may be reduced 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 in different market areas. This paper simulates the mergers of community banks both within and across economic market areas by combining their call report data. We find that the potential for idiosyncratic risk reduction dominates the marginal contribution to risk reduction by diversifying across local markets. In other words, a typical community bank can reduce its insolvency risk about as much 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, appears to be unrelated to diversification across market areas and instead is related to bank size. These findings may 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 Supervisory Policy Analysis Working Papers with number 2002-02.

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Date of creation: 2002
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Handle: RePEc:fip:fedlsp:2002-02
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  1. 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.
  2. 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.
  3. Joseph P. Hughes & William W. Lang & Loretta J. Mester, 1998. "The dollars and sense of bank consolidation," Working Papers 98-10, Federal Reserve Bank of Philadelphia.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  9. 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.
  10. Mark E. Levonian, 1994. "Interstate banking and risk," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jul22.
  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.
  12. Kwast, Myron L., 1999. "Bank mergers: What should policymakers do?," Journal of Banking & Finance, Elsevier, vol. 23(2-4), pages 629-636, February.
  13. 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.
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