De Novo Bank Exit

Robert DeYoung
Economic Research Department
Federal Reserve Bank of Chicago

Abstract: Newly chartered banks provide an additional credit source for small businesses, but the staying power of new banks can be weak. A multi-state exit model is estimated for U.S.commercial banks chartered between 1980 and 1985, as well as for a benchmark sample of small established banks. New banks and established banks fail for similar operational reasons, but new banks are more sensitive to adverse changes in local market conditions. Nonparametric hazard functions for new bank exit-by-failure correspond to a life-cycle pattern, but hazard functions for new bank exit-by-acquisition do not. Evidence on the effectiveness of regulations aimed at reducing new bank fragility is mixed.

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Introduction

As the U.S. banking industry has consolidated, thousands of small community banks disappeared through merger, acquisition, or failure.1 Community banks often specialize in small business lending, so when a merger replaces a small local bank with a larger regional or super-regional bank, the supply of credit to small businesses can decline. Newly chartered banks can help fill this gap. Over a thousand new commercial banks have been chartered in the U.S. since 1995, and recent research indicates that these 'de novo' banks tend to locate in postmerger markets and tend to make a large portion of their loans to small businesses. But like most new business start-ups, newly chartered banks can be financially fragile, and the degree to which they are reliable long-run sources of competition and credit depends on whether they can survive to financial maturity.

This study investigates the financial fragility of 1,664 new commercial banks chartered in the U.S. between 1980 and 1985, a period of especially intense chartering activity just prior to the turbulent banking conditions of the late 1980s and early 1990s. The long-run probability of de novo bank exit (by failure, acquisition, or branch conversion) is estimated using a multivariate logit approach, conditioned on the financial structure, business mix, and external environment for each bank at the end of its first year of operations. The logit model is also estimated for a series of rolling three-year event windows, and the results are used to construct hazard functions for de novo failure, acquisition, and conversion. Similar multivariate logits are estimated for 2,371 small established commercial banks located in the same geographic markets as the de novo banks.

The tests generate a rich set of empirical results. The estimated failure rates and acquisition rates for de novo banks were initially similar to those estimated for established banks, but as de novo banks aged - consuming their start-up capital and outlasting legal restrictions on purchasing new banks - they became substantially more likely than established banks to fail or be acquired. The de novo bank failure rate rose to almost five times the established bank rate before declining back to 'normal' levels after about a decade. Failure rates also depended on the alignment of a de novo bank's life cycle with the business cycle. New banks chartered in 1984-85 (in the midst of the bank failure wave) were more likely to fail, and tended to fail more quickly, than new banks chartered in 1980-81. Abstracting from these life-cycle effects, de novo banks and established banks tended to fail for similar reasons. Imprudent financial practices (e.g., aggressive lending practices, poor cost control, reliance on non-core deposits) were associated with higher rates of failure for both sets of banks. Difficult external conditions (e.g., intense competitive rivalry, slow economic growth) were also associated with higher failure rates for both sets of banks, although the statistical relationships were more systematic for the de novo banks.

The results also shed light on the efficacy of past and present regulatory treatment of de novo banks. State laws that delayed the acquisition of de novo banks were positively associated with de novo failure, and in the long-run led to higher, not lower, de novo acquisition rates. There was no evidence that the laissez-faire chartering policies practiced by the Office of the Comptroller of the Currency (OCC) during the 1980s contributed to high failure rates for de novo banks. Finally, there was no evidence that the extra-high minimum capital levels imposed on newly chartered banks during the 1990s were more justified for de novo banks than for small established banks.

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