Are Mergers Responsible for the Surge in New Bank Charters?

By William R. Keeton
Federal Reserve Bank of Kansas City

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After stagnating for many years, the rate of new bank formation has increased sharply in the second half of the 1990s. The financial press attributes this development to the high volume of bank mergers, which are said to have encouraged new entry by reducing service to some bank customers. It is commonly asserted, for example, that many new banks serve small businesses whose banks were taken over by larger banks uninterested in making small business loans. Most banking experts agree that such an increase in new banks in response to mergers would be healthy, helping maintain competition in local banking markets and offset reductions in service.

The view that mergers encourage new bank formation has recently come into question. Examining data on new bank charters and mergers in the 1990s, a study released early last year concluded that mergers have actually discouraged new bank formation. Shortly thereafter, another study came to the opposite conclusion, finding that mergers encourage new entry. Economists are famous for disagreeing, but it is surprising that two studies examining the same period could reach such different conclusions on an important issue of public policy.

Taken together, these studies raise two important questions. First, is merger activity positively or negatively related to new bank formation? Second, if mergers are positively related to new bank formation, which types of mergers account for the link? The mergers that could reasonably be expected to encourage start-ups are those in which small banks are taken over by large banks or local banks are taken over by distant banks, because such mergers can drive away small businesses and other customers who value personal service. Thus, the more these mergers account for the positive relationship between merger activity and new bank formation, the more confident we can be that the relationship is not just a coincidence.

This article reexamines the relationship between mergers and new bank charters, distinguishing more carefully than the other two studies between different types of mergers. The results, based on data for the second half of the 1990s, provide strong support for the view that mergers encourage the formation of new banks. Specifically, the article finds that markets with more merger activity experienced higher rates of new bank formation, and that the mergers with the strongest link to new bank formation were those in which small banks were taken over by large banks or local banks by distant banks.

The first section of the article describes how the controversy over the relationship between mergers and new bank formation arose. The second section explains the economic arguments behind the controversy, pointing out how mergers could either encourage or discourage new bank formation. The third section summarizes and evaluates the two recent studies. The fourth section looks at the relationship between new bank formation and total merger activity in roughly 300 urban markets from June 1995 to June 1999. The fifth section investigates whether new bank formation depends on the form taken by bank mergers.

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