Reducing the Risk at Small Community Banks: Is it Size or Geographic Diversification that Matters?*

Abstract

Most community banks face relatively high levels of diversifiable credit risk because they have relatively few loan customers (idiosyncratic risk) and are not geographically diversified (local market risk). We simulate mergers among community banks to quantify the relative contributions of idiosyncratic risk and local market risk to the default risk assumed by community banks. We find that the greatest risk-reduction benefits are achieved by increasing a community bank’s size, regardless of where the expansion takes place. We interpret this result as evidence that idiosyncratic risk dominates local market risk, especially at rural banks. Community banks face enormous pressure to grow, yet the pressure to geographically diversify is limited. As a consequence, larger community banks are likely to replace smaller community banks, but their focus on relationship lending will not disappear.