United States. Congress. House. Committee on Small.

The effects of bank consolidation on small business lending : joint hearing before the Subcommittee on Taxation and Finance and the Subcommittee on Government Programs of the Committee on Small Business, House of Representatives, One Hundred Fourth Congress, second session, Boston, MA, March 4, 1996 online

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Online LibraryUnited States. Congress. House. Committee on SmallThe effects of bank consolidation on small business lending : joint hearing before the Subcommittee on Taxation and Finance and the Subcommittee on Government Programs of the Committee on Small Business, House of Representatives, One Hundred Fourth Congress, second session, Boston, MA, March 4, 1996 → online text (page 17 of 21)
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business loans.

This case study of New England banks raises issues of
whether larger institutions will retain small business loans.
Unfortunately, it is impossible to distinguish whether these
decreases in small business loan shares reflect the choices of
lenders or of borrowers. On the one hand, a target bank may be
adjusting its portfolio composition to conform to the wishes of
its eventual acquirer. On the other hand, small firms value
lending relationships and perhaps the flexibility and personal
attention often less available at larger banks, and thus tend to
have, and benefit from, banking relationships at small banks
(see, for example, Petersen and Rajan 1994; Berger and Udell
1994; Elliehausen and Wolken 1990). Consequently, the reductions
in small business loans at these banks may reflect a desire among
small business borrowers to terminate their relationship with the
target bank in order to establish a lending relationship with
another small bank. In this way, a small firm would avoid having
its primary banking relationship switched to the larger acquiring
bank that may be less able to satisfy its needs and, at the same
time, avoid the uncertainty associated with having its primary
lending relationship with a bank faced with the upheaval of an
acquisition.

By absorbing small bank loan portfolios into larger banks,
the borrower concentration constraint associated with the
acquired portfolio is relaxed, freeing the acquiring bank to



196



reallocate portfolio shares away from small loans if it so
chooses. Small banks, on the other hand, have little choice.
Because of their small capital base, their business is, for the
most part, limited to small loans. To be successful, they must
be able to exploit their information advantages to offset any
loss in economies from their small size. Given that numerous
studies have documented that small banks are generally more
profitable than large banks, apparently many small banks are able
to do this well (for example, Boyd and Graham 1991) . If the
larger acquiring bank retains the acquired small loan portfolio,
it must be because the larger bank believes it can maintain the
business line's profitability. However, to keep a small loan
portfolio viable, a large bank must hold down the fixed costs
associated with making these loans, while at the same time being
more flexible in its loan underwriting procedures than may have
previously been the case.

This case study of small business loans in New England
indicates that most acquisitions by larger banks actually result
in a shrinkage of small business loans. Thus, it appears that
most of these acquisitions are driven by reasons other than
acquiring the small business loan portfolios of smaller banks.
It is possible that acquiring core deposits, greater geographic
diversity, or potential cost savings, rather than the small
business loan portfolios and the associated business expertise
and private information about loan customers, drive these
acquisitions. Consistent with this view, Whalen (1994) argues



197



that mergers are, in part, driven by gains in operational
efficiencies, since he finds that intracompany mergers of
subsidiary banks by multibank holding companies result in
significant, positive abnormal stock returns. Similarly, Cornett
and Tehranian (1992) find that merged banks tend to have better
than average performance, perhaps associated with being better
able to attract loan and deposit customers as we'll as attaining
gains in efficiency.

If larger institutions choose not to maintain a significant
presence in small business lending, it becomes critical for small
business borrowers to find other small banks interested in having
small business loan customers. As consolidation continues,
borrowers in some areas may have few viable alternatives for
satisfying their small business borrowing needs. This will
require existing small business lenders to increase their market
share or de novo entry to fill the gap.

Can De Novo Banks Fill the Void?

If a void in small business lending were to occur as a
result of acquisitions by large lenders, would de novo entry be
able to fill the gap? Some guidance may be provided by examining
the experience in New England over the past decade, a period of
unusually active de novo entry. During that time, 80 new FDIC-
insured banks were created in New England. As can be seen in
Table 7, most new entries occurred during a boom period in New
England, with 56 banks started from 1985 through 1988. With the



198



collapse in real estate prices and the accompanying increase in
nonperf orming loans at most banks, de novo entry dramatically
declined during the subsequent years of widespread banking
problems, with only seven new entrants over the past four years.
Thus, while research has documented diminished credit
availability in New England in the early 1990s, it resulted in
relatively little entry. Instead, entry occurred during a period
characterized by rapidly expanding loan portfolios at most banks
in New England.

Although spawned by a boom period, fewer than half of the
New England banks started from 1985 through 1988 are still in
existence as independent banks, and not one has yet grown to be a
large bank. Of the 56 banks, 20 had failed by 1994 and another
11 were acquired in non-assisted transactions (five of which were
mergers within the same holding company) , leaving only 25 of the
de novo banks started between 1985 and 1988. The average size of
these survivors remains quite small, despite their being in
existence for more than five years. One might suspect that this
is a consequence of selection bias, perhaps with the faster-
growing de novo banks being more successful and thus becoming
attractive acquisitions for larger banks, or perhaps just the
opposite, with the faster-growing banks accomplishing their
growth through excessive risk-taking and consequently failing.
However, this is not apparent from the data. The assets of both
failed and acquired banks from this set of de novo banks averaged
well under $100 million.



199



Similarly, the average size of the more recent de novo banks
remains well below $100 million. Thus, de novo banks could fill
any void created by a credit crunch or bank consolidation only to
a limited extent, given the small number of recent new entrants
and their small average size. And the timing appears such that
entry occurs in the good times, rather than in periods when banks
are under severe pressure and, thus, more likely to be
contracting lending than expanding it.

The second panel of Table 7 provides an indication of the
areas of specialization of the surviving new entrants. The
average size of the small business loan portfolios (defined as
loans of less than $1 million) of de novo entrants operating for
at least two years averages well above the 22.6 percent of assets
for small commercial banks and significantly above the 13.9
percent for all small banks.* Thus, the de novo banks have been
targeting small business lending, although perhaps not totally by
choice, given the borrower concentration limits. In general,
these banks have also had a smaller exposure in residential
mortgages and securities than that for small commercial banks. 5

The capital-to-asset ratios show the typical pattern for de
novo banks, high capital ratios at the outset and much lower
capital ratios as the new banks lend sufficiently to reach their
target capital ratios. Surprisingly, de novo banks created prior
to 19 89 all have average capital ratios below the average for
existing small commercial banks in general. Thus, significant
further expansion of these de novo banks is unlikely in the



200



absence of an infusion of additional capital. Consistent with
the pattern of capital ratios, the nonperf orming loan ratios
shown in the final column indicate that the older de novo banks
have more loan problems and, again, are less likely to be in a
position to step in and increase lending to fill any void in
small business lending created by bank consolidation.

The third panel of Table 7 shows the growth in capital and
in asset categories from 1993:11 to 1994:11. The de novo banks
created after 1988 have grown much faster than the average for
all small commercial banks, and this growth has been particularly
rapid in the loan categories. While the growth in total assets
has been typical for those de novo banks created during the 1987-
88 period, their growth rates of total loans and small business
loans were more than twice the all -banks average, although their
growth in total business loans was only slightly larger. For
those banks created in the 1985-86 period, the growth in capital
was much slower than average and the growth in total assets and
small business loans somewhat slower than average. This likely
is a consequence of this subset of banks having lower than
average capital ratios and higher than average nonperforming loan
ratios.

In summary, de novo banks are unlikely to fill any major
void in small business lending. De novo entry has occurred
during boom periods, when alternative sources of funds are most
likely to be available. While de novo entrants have focused on
small business loans, their small size and the observation that



201



most de novo entrants remain small institutions after as long as
a decade indicate that such entries can till niches, but not
voids .

IV. Conclusion

Bank consolidation that leads to larger lenders could make
small business borrowers less dependent on the vagaries of local
banking markets, if the merged institutions maintain the acquired
small business lending line of business. During the recent
period of reduced credit availability, bank -dependent borrowers
in New England had few borrowing alternatives because both large
and small banks had portfolios dependent on New England economic
conditions. Greater diversification across geographic regions
and across product lines would have ameliorated the problems
faced by small businesses as a result of the shocks to bank
capital and the consequent reduction in loan supply to bank-
dependent borrowers.

Nonetheless, the move towards large consolidated
institutions carries some risks for bank -dependent borrowers.
Much of the recent growth in small business loans has been at
small banks. Banks engaged in acquisitions in New England have
not fostered the small business loan segment of the market, with
both the share and the amount of small business loans declining
after most acquisitions. While this may be an artifact of
examining data in New England over a short period of time, it
raises questions about the availability of credit to small



202



business in areas that become dominated by large lenders.

The potential benefits of bank consolidation are clear: in
particular, we have evidence that a lack of sufficient bank
diversification has been a problem for credit availability when
banks have been subjected to local shocks that reduced capital.
The potential costs are less certain, but nonetheless they
deserve the attention of policymakers. We have not yet attained
a level of bank consolidation that would produce a shortage of
viable lenders to small business. However, the New England
evidence does suggest that as restrictions on both product and
geographical diversification are eliminated, potential problems
for small business credit availability will be an important
issue. It is possible that other sources of credit to small
businesses will become available if bank consolidation leads to a
reduction in small business credit availability. However, it is
likely that, at the very least, there will be transitional
problems .



203



References

Berger, Allen N. and Gregory F. Udell. 19?4. "Lines of Credit
and Relationship Lending in Small Firm Finance."
Manuscript, revised July.

Berger, Allen N. and Gregory F. Udell. 1995. "The Size and

Complexity of Banking Organizations and the Future of Small
Business Lending." Presented at Conference on Universal
Banking, Salomon Center, Leonard N. Stern School of
Business, New York University, February 23-24.

Boyd, John H. and Stanley L. Graham. 1991. "Investigating the
Banking Consolidation Trend." Federal Reserve Bank of
Minneapolis Quarterly Review , Spring, 3-15.

Cornett, Marcia Millon and Hassan Tehranian. 19^2. "Changes in
Corporate Performance Associated with Bank Acquisitions."
Journal of Financial Economics , 31, pp. 211-34.

Elliehausen, Gregory E. and John D. Wolken. 1990. "Banking
Markets and the Use of Financial Services by Small and
Medium-Sized Businesses." Staff Studies No. 160, Board of
Governors of the Federal Reserve System, September.

Peek, Joe and Eric S. Rosengren. 1995a. "Bank Regulation and the
Credit Crunch." Journal of Banking and Finance , vol. 19(1),
forthcoming.

Peek, Joe and Eric Rosengren. 1995b. "Banks and the Availability
of Small Business Loans." Federal Reserve Bank of Boston
Working Paper No. 95-1, January.

Petersen, Mitchell A. and Raghuram G. Rajan. 1994. "The



204



Benefits of Lending Relationships: Evidence from Small
Business Data." Journal of Finance . 49(1), pp. 247-67.

Scanlon, Martha. 1981. "Relationship Between Commercial Bank
Size and Size of Borrower." Studies of Small Business
Finance, Interagency Task Force on Small Business Finance.

Whalen, Gary. 1994. "Wealth Effects of Intraholding Company

Mergers: Evidence from Shareholder Returns." Comptroller
of the Currency Economic & Policy Analysis Working Paper 94-
4, May.



205



Footnotes



1. The "original amount" of a loan is the size of the loan at
origination, rather than its current size, unless the latter is
larger. For a line of credit or loan commitment, it is the size
of the line of credit or loan commitment when most recently
approved, extended, or renewed. For loan participations and
syndications, it is the entire amount of the credit originated by
the lead lender.

2. The ratio used is equity capital divided by unweighted assets,
which most closely resembles the leverage ratio. Because some
items used in capital ratio calculations were not detailed in the
past, it is impossible to replicate exactly the current
definition of the leverage ratio.

3. We do not include transactions that involve institutions that
are not insured by the FDIC, since the call reports include data
only for FDIC- insured institutions.

4. The lower average percentage for the total of all New England
small banks is due to the prevalence of savings banks,
traditionally residential mortgage lenders. However, in recent
years they have been expanding their business lending,
particularly to small businesses.

5. Among the existing de novo banks are a few savings banks.
This has the effect of understating the small commercial loan
numbers when compared to the sample of all small commercial
banks .



206



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Online LibraryUnited States. Congress. House. Committee on SmallThe effects of bank consolidation on small business lending : joint hearing before the Subcommittee on Taxation and Finance and the Subcommittee on Government Programs of the Committee on Small Business, House of Representatives, One Hundred Fourth Congress, second session, Boston, MA, March 4, 1996 → online text (page 17 of 21)