The Future of Small Banks in our Financial System

R. Alton Gilbert *

Until recently I thought the consensus view on the future of the banking industry included the idea that there would continue to be thousands of small banks. The owners of these small banks would be independent of the large, nationwide banks that are emerging through mergers with regional banks. According to this view, the customers of small banks value personal service and their opportunities to have personal relationships with the top decisionmakers in their banks.

Recently John McCoy, President and CEO of Bank One Corporation, challenged this consensus view by claiming that the Internet has undermined the future of small banks (McCoy, 1999). The following are some quotes from this speech: "When you combine the power of the Internet as a new delivery channel [and] the partnerships that have developed [among] a broad range of product providers, it is difficult for me to … define what role community banks will play in the future. It's even difficult to predict the future viability of banks up to $20 billion in assets. This is a scale business and smaller institutions won't be able to compete since they simply won't have a competitive access to either products or the new delivery channels."

Later he said, "Because this is a scale business, smaller [credit] card programs are no longer profitable and many banks are now trying to sell their portfolios to the larger players. So, it is important that you don't think about the Internet as technology. Think about the Internet as the future of the banking system."

McCoy also mentioned that some lenders are originating small business loans over the Internet.

I do not agree with this pessimistic view of the future of community banks. Briefly, I will explain why, discussing four points:

First, if the Internet has eliminated the future of the community bank, many bankers and investors have not got the message. Many new bank charters are being granted: 77 commercial bank charters in 1997, 110 in 1998, and through mid-May of this year, 43 charters, about the same pace as in 1998.

My second point deals with the statement that economies of scale are driving community banks out of the credit card business. If community banks were getting out of the credit card business, selling their credit card loans to larger banks, credit card loans would be disappearing from their balance sheets. Table 1 indicates the percentages of banks in various size groups that had credit card loans on their call reports as of the fourth quarters of 1993 and 1998. About 80 percent of community banks with total assets over $100 million had credit card loans on their balance sheets in both periods. Table 1 does not indicate a tendency for community banks to get out of the credit card business.

The third point involves making small business loans over the Internet. Loans to small businesses originated over the Internet by banks without offices near the small businesses would be a significant threat to the viability of community banks.

I have some questions about how Internet banks could offer this type of service to small businesses without networks of offices located near their small business customers. Can they really get all of the information they need to judge credit quality from national databases? How can they monitor the operations of their small business borrowers? If the loans become past due, how can the Internet banks work with their borrowers to maximize the return on the problem loans without staff located near the small business borrowers?

In attempting to answer these questions, I looked at the home pages of banks that offer their services only through their Internet sites. The loans offered by these Internet banks are limited to credit card and mortgage loans. The closest thing I found to small business loans was equipment leasing.

I have some additional information about loans to small businesses by banks with no offices near the locations of the small businesses. In recent years large banks have been required to report information on the locations of their small business borrowers to their supervisors, under the Community Reinvestment Act (Bostic and Canner, 1998). We look at this information in some banking antitrust cases to determine whether lenders without offices in local market areas should be considered important competitors in making small business loans. We find that such loans to small businesses often turn out to be credit card loans (Cyrnak, 1998). Credit card loans and the loans made by community banks to their small business customers must be priced differently, since the percentage of loans that banks charge off as losses is so much higher for credit card loans than for the loans by community banks to their small business customers. In the last 10 years the charge-off rate on credit card loans was 3.4 percentage points above the charge-off rate by small banks on their commercial and industrial loans. Because of these differences in charge-off rates, credit card loans will not undermine the role of community banks in making loans to small businesses that they know well, monitoring closely the activities of these borrowers, and working out problems with these borrowers rather than simply charging off their past-due loans.

My fourth and final comment involves the participation of relatively small banks in the delivery of banking service over the Internet. If the Internet threatened the existence of small banks, we would expect to find few if any small banks capable to providing Internet banking services. Table 2 presents information on the banks with Internet sites through which their customers can conduct transactions. As of June 1998, about 75 percent of these Internet banks had assets below $1 billion. Small banks can offer these Internet banking services because Internet service providers have reduced their prices substantially in recent years. The initial cost to community banks of establishing Internet sites has fallen to between $25,000 and $50,000 (Marenzi, 1998).

During his luncheon talk in May 1999, John McCoy mentioned a particular form of Internet banking in which small banks will not be able to compete: bill presentment and payment. Banks and nonbank vendors are developing systems for delivering bills from companies to their customers over the Internet. Bank customers will go to the home pages of their banks to view bills sent to them by businesses. The bank customers will send instructions to their banks over the Internet to pay the bills. This service is not in operation on a large scale at this time, but developers of bill presentment systems think this arrangement for receiving and paying bills will become an important banking service.

I do not understand why small banks would be unable to provide their customers with bill presentment and payment services. A bill presentment service that would be the most useful for businesses and their customers would link as many businesses and banks as possible. The banks and nonbank service providers that are developing these systems have incentives to include small banks.

Developers of bill presentment services might face legal problems if they attempted to exclude some potential participants. Because of the economies of scale in the operation of bill presentment services, one system is likely to become dominant. A dominant provider of bill presentment and payment services would assume social responsibilities that it did not have when developing its system. It is important that those who control the service not be permitted to set terms for access and pricing that will give some billers or some banks advantages over others in providing services to their customers.

State governments have dealt with this type of issue in the operation of the payments system, in regulating the operations of ATM networks. Several states require ATM networks to share their networks with all banks. ATM networks became essential facilities for banks, and those who developed these essential facilities were limited in their discretion to restrict the participation by banks.(1) To me the same logic would apply to a dominant provider of bill presentment and payment services that becomes an essential facility for participating in the banking business. I am not a lawyer, however, and this is as far as I will go in playing the role of lawyer.

In sum, then, I do not think the evidence supports the argument that the Internet has undermined the viability of community banks.

* Mr. Gilbert is Vice President and Banking Advisor of the Federal Reserve Bank of St. Louis <>. The thoughts Mr. Gilbert expresses here are his own, and not necessarily those of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

  1. See Baker (1995 and Balto (1995) for their analysis of these issues involving the operation of ATM networks.
  • Baker, Donald I. "Shared ATM Networks — The Antitrust Dimension," Federal Reserve Bank of St. Louis Review (November/December 1995), pp. 5-17.
  • Balto, David A. "Payments Systems and Antitrust: Can the Opportunities for Network Competition be Recognized?" Federal Reserve Bank of St. Louis Review (November/December 1995), pp. 19-40.
  • Bostic, Raphael W. and Glenn B. Canner. "New Information on Lending to Small Businesses and Small Farms: The 1996 CRA Data," Federal Reserve Bulletin (January 1998), pp. 1-21.
  • Cyrnak, Anthony W. "Bank Merger Policy and the New CRA Data," Federal Reserve Bulletin (September 1998), pp. 703-15.
  • Egland, Kori L., Karen Furst, Daniel E. Nolle, and Douglas Roberstson. "Banking over the Internet," Quarterly Journal, Office of the Comptroller of the Currency (December 1998), pp. 25-32.
  • McCoy, John B., President and CEO, Bank One Corporation, luncheon address, the 35th Annual Conference on Bank Structure and Competition, sponsored by the Federal Reserve Bank of Chicago, May 7, 1999,
  • Marenzi, Octavio. "The Home Banking Outsource Dilemma," Financial Service ONLINE (July/August 1998), pp. 55-57.

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