Community banks are defined as banks owned by organizations that have less than $1 billion in banking assets. Several people view community banks as banks that are small in size and that operate in small communities only. However, in reality, community banks also do business in wider geographic areas, not in small communities only. Moreover, community banks put high emphasis on building relationships with customers (Keeton, 2003). In other words, they are known to focus on “relationship banking.” This means that community banks make decisions based on their personal knowledge of customers’ creditworthiness and a deep understanding of customers’ business conditions in the communities community banks operate (Keeton, 2003).

By the end of 2002, there were over 6,900 community banks. Half of the community banks at that time were owned by organizations that were less than $100 million in size. Due to the small size of community banks, they account for less than a fifth of total community bank assets. In terms of assets, organizations that are between $100 million and $500 million in size, own community banks that consist over half of all community bank assets. In the past 20 years, there has been an increase in merger activity, causing the number of community banks to decline (Keeton, 2003). The banking system in the United States has gone through massive changes due to deregulation and mergers. It can be understood that community banks these days have a smaller share of total banking activity, especially in asset shares, compared to 20 years ago (Keeton, 2003).

By the end of 2002, community banks represented 89% of all banks in the United States. Community banks accounted for 34% of bank offices, 19% of bank deposits, 16% of bank loans, and 15% of bank assets (Keeton, 2003). The reason community banks hold a smaller share of bank assets and loans than of bank deposits is that they have less access than larger banks to non-deposit sources of funds such as federal funds, repurchase agreements, and subordinated debt. Since 1980, the community banks share of banking offices has fallen 18% and their share of bank deposits, loans, and assets have fallen by 15%. There has been a continuous decline in community banks market share. It can be understood that the large banks, those that are over $100 million in size, have increased the most during this era (Keeton, 2003). 

Some of the advantages of having more community banks in the United States include the fact that deposits and assets tend to grow faster in community banks than in larger banks after adjusting for mergers (Keeton, 2003). Community banks that have surpassed and survived consolidation, had almost little to no difficulty competing for customers. The reason for the faster growth in deposits within the community banks is due to the fact that community banks also offer higher deposit rates than large banks. Community banks are known to be valuable for people living in rural communities and smaller metropolitan areas. In metropolitan areas where less than people live, community banks operate 31% of all banking operations and offices and control 23% of all deposits in these areas (Keeton, 2003). Besides providing enormous amounts of banking services in rural areas and smaller cities, community banks also serve as providers of relationship-based and information-intensive banking services. Smaller customers such as small businesses, family farmers, and depositors of low to moderate income, are the main consumers of the community bank services.

Additionally, community banks have some important advantages over larger banks in making small business loans (Keeton, 2003). Loan officers at small banks can take into account a wide variety of factors in reviewing applications for small business loans, including the character of the borrower and special features of the local market. On the other hand, it is time consuming and costly for large banks to go over every small loan application and decision, so for that reason they instead rely on a borrower’s credit score. The credit scores will indicate a borrower’s probability of repayment based on the borrower's personal wealth and past credit history. Another reason community banks are considered better in making small business loans is that the lending process often requires a close, long-term relationship with the borrower. This means that lending will be provided to those with little credit history, however, the community banks would monitor the borrower’s business performance over the course of the loan (Keeton, 2003).

Researchers have found that even after small banks adjust for loss rates, they have been able to earn higher deposit rates of return on their small business loans than large banks. The high loan returns not only enabled banks to pay higher deposit rates than large banks, but also allowed them to maintain higher net interest margins (Keeton, 2003). Community banks are still operable because they are continuing to be charted. After the number of community banks kept on declining in the mid-1980s, the number of new bank charters in the United States increased sharply during the 1990s, exceeding 200 banks at the end of the decade. Several of these new banks started to operate during the time when large banks were actively acquiring smaller banks (Keeton, 2003). The act of acquiring smaller banks shows that there is a high number of depositors and borrowers that still prefer the personal service that community banks tend to provide for people. 

To provide additional evidence that community banks are still in demand, it is best to start with the fact that community banks have maintained their profitability compared to large banks during most of the decade (Keeton, 2003). At the beginning of the 1990s, the community banks that were under $1 billion in size, were more profitable than community banks that were over $1 billion in size. This was during the time when community banks with over $1 billion in size, were still recovering from heavy losses on commercial real estate and business loans. The difference in the profitability of small size banks and large size banks gradually disappeared during the decade. The two size groups ended up earning the same average return on assets in the rest of the decade (Keeton, 2003).

Furthermore, starting in the 2000s, there were differences in profitability trends between different sized community banks (Keeton, 2003). During the mid-1990s through 2001, the profitability trends were leaning downwards for small community banks. However, the profitability trends of large community banks remained high during the years. For instance, the average return on assets for banks between $300 million and $1 billion in size continued to increase till 1999. However, the average return on assets for banks under $100 million in size, decreased more than 20 basis points, meaning profitability trends dropped under 1% in 2001. It can be understood that the banks that were under $100 million in size were the least profitable amongst all of the bank sizes (Keeton, 2003).

On the other hand, the reason why community banks are reducing in the US banking system is because community banks are found to be cost-inefficient. The smallest community banks are located mainly in areas where there is no proper economic growth, such as in rural counties that are dependent on traditional agriculture. It has been found by researchers that in recent years, profitability trends for small community banks have been declining. There has been advances in technology that have been beneficial to large banks in producing cost-effective banking services and solutions. However, these advances in information and communication technology are reducing the community banks’ comparative advantage in relationship-based lending, especially small business lending. Moreover, several rating agencies and credit bureaus have become quick at collecting massive amounts of information about firms' financial condition. They have also been quick in distributing information more efficiently to lenders.

There is an increase in different ways to access financial information from small businesses (Keeton, 2003). The technological advancement has increased the amount of credit-scoring methods. The new methods of determining credit, actually reduces the need for loan officers to collect information from a loan applicant’s prospects. Moreover, loan officers no longer have to monitor loans through personal contact and on-site visits. The online banking activities have made operations easier for large banks, mutual funds, and brokerage firms. Online banking has made it easier in terms of seeking deposits in a more flexible manner. Also, institutions can seek deposits in smaller communities without having a physical branch or office there. This in return would make community banks lose some of their depository customers because the lower costs of online banking companies allow them to offer more favorable rates.

Lastly, community banks are the opposite in their role with large banks because community banks specialize in relationship-based banking and provide credit based on that to small businesses (Keeton, 2003). Community banks mainly serve customers that live in rural areas and small metropolitan areas where they are not served by large banks. They are also known to be important lenders in the farm economy. Although the number of community banks will continue to decline because of merger activity, they will continue to play an important role for the future (Keeton, 2003).

Keeton, W. (2003). “The Role of Community Banks in the U.S. Economy.” Economic Review - Federal Reserve Bank of Kansas City, Second Quarter 2003, pp. 15-43.

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