Does scale define the winners in community banking?
Some have argued that the burden placed on community banks by the regulatory reforms mandated by the Dodd-Frank Act, as well as the need to increase investment in technology, have disproportionately raised community banks’ costs, thereby inhibiting their ability to lend in their local communities. In contrast, others believe that small banks have true advantages in relationship lending that are fundamental to their effectiveness and cannot be matched by models or algorithms used by larger banks, no matter how sophisticated. If so, then community banks might outperform large banks when it comes to relationship lending, even in light of increased costs. At the same time, since there a fixed cost component to the increased costs imposed by regulation and technology, there may be size below which the costs outweigh lending advantages, so that smaller community banks may underperform larger community banks. In this paper, we investigate these issues by comparing the financial performance of smaller vs. larger community banks. We ask how their lending portfolio composition, funding, and growth strategies affect their financial performance. Our initial results suggest that larger community banks perform better, on average, than smaller community banks. Our performance measures include Tobin's q-ratio and market-value efficiency, which is a stochastic frontier measure of banks' potential market value and their systematic failure to achieve it.