Reducing the Risk at Small Community Banks: Is it Size or Geographic Diversification that Matters?

Posted: 5 Aug 2004

See all articles by William R. Emmons

William R. Emmons

Federal Reserve Bank of St. Louis - Banking Supervision and Regulation; Washington University in St. Louis

R. Alton Gilbert

Federal Reserve Bank of St. Louis - Research Division

Timothy J. Yeager

University of Arkansas - Sam M. Walton College of Business

Abstract

Most community banks face relatively high levels of diversifiable credit risk because they have relatively few loan customers (idiosyncratic risk) and are not geographically diversified (local market risk). We simulate mergers among community banks to quantify the relative contributions of idiosyncratic risk and local market risk to the default risk assumed by community banks. We find that the greatest risk-reduction benefits are achieved by increasing a community bank's size, regardless of where the expansion takes place. We interpret this result as evidence that idiosyncratic risk dominates local market risk, especially at rural banks. Community banks face enormous pressure to grow, yet the pressure to geographically diversify is limited. As a consequence, larger community banks are likely to replace smaller community banks, but their focus on relationship lending will not disappear.

Keywords: Community banks, idiosyncratic risk, market risk, geographic diversification

Suggested Citation

Emmons, William R. and Gilbert, R. Alton and Yeager, Timothy J., Reducing the Risk at Small Community Banks: Is it Size or Geographic Diversification that Matters?. Available at SSRN: https://ssrn.com/abstract=572562

William R. Emmons (Contact Author)

Federal Reserve Bank of St. Louis - Banking Supervision and Regulation ( email )

411 Locust St
Saint Louis, MO 63011
United States

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1208
Saint Louis, MO MO 63130-4899
United States

R. Alton Gilbert

Federal Reserve Bank of St. Louis - Research Division ( email )

411 Locust St
Saint Louis, MO 63011
United States

Timothy J. Yeager

University of Arkansas - Sam M. Walton College of Business ( email )

Fayetteville, AR 72701
United States

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