Adding Branches May Not Yield Big Profits

Banking can be a profitable business. The basics are simple: Take money in from those who need a depository and lend to those whose needs exceed their available funds.

Lend wisely to those who will pay you back, and manage the spread between the interest expense paid to the depositors and the interest income from those who borrow. Hold down expenses, and you have a profitable bank.

As the industry hurtles toward the 21st century, these basic elements are becoming scrambled. Instantaneous electronic blips move funds in ranging from $100 to billion of dollars in a fraction of a second.

Banker lingo is peppered with HLTs, LDCs, ATMs, HMDAs, CRAs - to the point where the basic banking elements are as difficult to find as the needle in the haystack.

At this point, many step back and ask the question: "Where is the profitability in banking?" Is it in the big bank? The small bank? The city bank? The country bank?

Economies of Scale

Since the early 1960s, studies of banking behavior have tried to identify the most profitable type and size of bank. Steven A. Rhoads and Donald T. Savage, economists at the Federal Reserve Board, have conducted three of these studies over the past 12 years.

Their latest study, completed in 1990, concludes: "Overall, the data presented here suggest that small banks continue to be viable competitors with large banks."

This finding parallels the conclusions of their two earlier studies as well as the vast majority of other analyses, which have found that economies of scale in banking tend to peak at a relatively low level.

The study shows that banks attaining the magic figure of 1% return on assets are most likely to be found in the range of $25 million to $5 billion. While non-interest expenses decline as a percent of assets as banks become larger (indicating some economy of scale) these expenses remain relatively constant above the $25 million to $50 million bracket.

Consistency at Most Sizes

At the $1 billion to $5 billion bracket and thereafter, the non-interest expense ratio begins to rise again. The consistency in this ratio over the wide range of size categories indicates that scale economies in banking operations are elusive.

Interest expense, banks' largest cost factor, consistently increases as bank size increases, although at a moderate pace until, again, the $1 billion to $5 billion category. At that level, a significant jump occurs.

Service charges, an income factor, decline as bank size increases - until that magic $1 billion to $5 billion size, where they rise markedly.

The study also suggests that when banks' noninterest expenses bottom out, they continue at about that level (as does the interest expense of acquiring funds) until the $1 billion to $5 billion bracket.

The fact that service charges decline as an income factor, while expenses are relatively stable, could be due to some economies of scale in operations. More likely, fee-income pressure is a result of competition from other institutions, creating inducements to obtain low-cost, core deposits.

At the $1 billion to $5 billion range, interest expenses jump while noninterest expenses rise moderately. Institutions respond by increasing service charges, probably to offset higher expenses.

The overall result is a decline in net income from banking operations. Somewhere above the $1 billion level, banking starts to be less profitable than it was below that size grouping.

Savings from Consolidation

The Treasury claims that consolidation will save the banking industry $10 billion. Our calculations show potential earnings from an industrywide consolidation to be much lower - considerably less than $1 billion, and perhaps as low as $214 million.

In third-quarter 1990, 157 bank holding companies operated banks outside their home states. These holding companies owned a total of 719 in-state banks and 678 out-of-state banks. Their total assets were $2.255 trillion, or about 65% of all U.S. banking assets.

Roughly one-fourth of these assets - $586 billion - are in the holding companies' out-of-state subsidiaries. Noninterest expenses for these out-of-state institutions total only $25.6 billion. Remember: Treasury says these companies will save $10 billion if allowed to consolidate across state lines.

We estimate that interstate bank holding companies' potential savings from interstate consolidation would fall somewhere between 0.03% of their total assets, or $716 million, and 1.66% of their out-of-state noninterest expenses, or $424 million.

Extrapolating estimated savings figures published by one institution, NCNB's North Carolina National Bank, industry savings could be as low as $214 million.

The Treasury proposal argues that technology, internationalization, globalization, and the revitalization of the American competitive spirit will all require much bigger banks than we have today. These bigger banks will supposedly be more profitable, and their success will ensure the survival of the U.S. banking system.

How will larger banks be more profitable? Could they further lower their expenses? The data show that both interest and noninterest expenses begin to rise at some point above the $1 billion level, with interest expenses leading the way.

Could these larger banks raise their income? It already appears that they do raise their service charges in the face of increased expenses. They would probably not be able to increase the interest rate charged on loans because the market sets those rates.

Other options available include trying to control certain loan markets, such as credit cards, or the old-fashioned practice of driving their competitors out of the market.

The changes proposed by the Treasury Department are simply not consistent with the economic statistics of profitable bank operations.

Perhaps, if the market is allowed to work effectively over time, an orderly consolidation can find ways to be profitable.

Starting a "gold rush" to nationwide branching does not guarantee greater profitability.

Mr. Watt is president of the Conference of State Bank Supervisors, Washington.

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