Economics of De Novo Entry
Banking Brief for Pennsylvania, New Jersey, and Delaware

From the Research Department of the
Federal Reserve Bank of Philadelphia
www.phil.frb.org

First Quarter 2001

Community banks in the tri-state area and large banking organizations in both the tri-state area and the nation reported a slightly lower average return on assets during the first quarter of 2001 compared with the same period last year. The decline was primarily due to a decrease in net interest margins. Total loans and deposits at large banks declined, especially in the tri-state area. On the other hand, total loan volume at community banking organizations, fueled by real estate lending, rose at a healthy clip in the first quarter. Informal interviews with local bankers provide evidence of greater home equity lending, resulting from individuals' consolidating debt and borrowing against home equity credit lines for car purchases and home improvements. Mortgage refinancing was also strong. Overall, the housing market has been resilient despite the recent economic slowdown, particularly because of favorable mortgage rates.

The nonperforming loan ratio at tri-state area banks remained low and actually declined from one year ago. Nationally, however, the ratio of nonperforming loans is on the rise. This trend is concentrated among larger banks that deal primarily with large- and middle-market borrowers: more than two-thirds of our large tri-state area banks reported higher nonperforming loans than in the previous quarter. According to the Federal Reserve Board, over the past quarter many banks tightened credit terms on business loans for large- and middle-market borrowers in response to a less favorable or more uncertain economic outlook, industry-specific problems, and a lower tolerance for risk.¹

Economics of De Novo Entry

There has been an unprecedented level of merger activity within the U.S. banking industry since 1980. From 1980 to 2000, there were almost 9000 mergers. This tremendous wave of consolidation can be explained by changes in banking legislation and regulation, and changes in technology, among other factors. While thousands of banks consolidated, and a number of others failed, thousands of newly chartered, de novo banks were formed. These new institutions could conceivably increase competition in local banking markets.

A de novo's decision to enter a market is based on its expectation of profitability. Some researchers have suggested certain local market factors that might stimulate entry by de novos: 1) strong economic growth, 2) weak competition among existing banks in highly concentrated banking markets, and 3) a relative scarcity of small banks, which are potential competitors of de novos.² That would suggest that de novo banks are more likely to target local markets in which mergers have reduced the number of competitors and small businesses are underserved or dissatisfied with banking services provided by larger, and frequently out-of-area, institutions.³ These smaller new entrants might be better positioned than larger incumbents to provide personal service to small businesses.

But it is only recently that researchers began investigating these phenomena, and there is still no consensus on the results. For instance, according to one study of banks and thrifts between 1995 and 1997, merger activity in the local market deterred de novo entry.⁴ In contrast, another study finds that the probability of de novo entry is higher in local markets that have experienced mergers or acquisitions, particularly those involving large commercial banks.⁵

Mirroring the pattern observed in the nation, the tri-state area experienced an upsurge in the number of consolidations and new entries in the past five years. Over this short period of time, 55 new area banks opened their doors for business. Amazingly, all but two of these de novo banks still exist today. (The two disappeared because of corporate reorganization.) In terms of performance, de novo banks, like any typical start-up businesses, are vulnerable to failure in the early years of operation. Financial statements can fluctuate rapidly and dramatically during the first few years of business.⁶ In our sample, the median de novo bank was unprofitable in its first year but attained profitability by its third year (ROA of -2.7 percent in the first year and 0.3 percent in the third). The trend in the return on average equity was similar (ROE of -10.6 percent in the first year and 2.3 percent in the third).⁷

Recent research suggests that a de novo bank must survive long enough (estimated at seven years) to become financially viable and stable so that it can become a reliable source of credit and compete effectively with other banks (see DeYoung, 1999). The recent rise in de novos dates mostly to the second half of the 1990s, so we will soon be able to look for evidence of their effect on competition in local banking markets.

1. See the Federal Reserve Board's Senior Loan Officer Opinion Survey on Bank Lending Practices, May 2001.
2. R. Moore and E. Skelton, "New Banks: Why Enter When Others Exit?" Federal Reserve Bank of Dallas Financial Industry Issues (First Quarter 1998), pp. 1-7.
3. R. De Young, "Birth, Growth, and Life or Death of Newly Chartered Banks," Federal Reserve Bank of Chicago Economic Perspectives (Third Quarter 1999), pp. 18-35.
4. S. Seelig and T. Crotchfield, "Determinants of De Novo Entry in Banking,"' Working Paper 99-1, Federal Deposit Insurance Corporation (January 1999).
5. A.Berger, S. Bonime, L. Goldberg, and L. White, "The Dynamics of Market Entry: The Effects of Mergers and Acquisitions on De Novo Entry and Customer Service in Banking," Proceedings from a Conference on Bank Structure and Regulation, Federal Reserve Bank of Chicago (1999).
6. P. Brislin and A. Santomero, "De Novo Banking in the Third District," Federal Reserve Bank of Philadelphia Business Review (January/February 1991), pp. 3-12.
7. These ratios are calculated from our sample of de novo banks that entered the tri-state area in 1996 and 1997.