Determinants of profitability of community banks in the USA: a cost-frontier-based decomposition approach
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Determinants of profitability of community banks in the USA: a cost-frontier-based decomposition approach Guohua Feng1
· Chuan Wang2
Received: 9 March 2020 / Accepted: 22 September 2020 © Springer-Verlag GmbH Germany, part of Springer Nature 2020
Abstract This paper investigates the determinants of the poor profitability of community banks relative to that of large banks in the USA over the period 2001–2017, by decomposing the relative profitability of community banks into five multiplicative cost-frontierbased explanatory factors. To compute these explanatory factors, we estimate a Bayesian true fixed effects stochastic cost frontier model, which has the advantages of allowing the unobserved heterogeneity term to be correlated with the observed explanatory variables and providing statistical inferences on the cost-frontier-based explanatory factors. Our decomposition shows that community banks’ lower profitability was attributable mainly to their lower technical change, lower scale efficiency and higher funding costs. In addition, the latter two factors were also the two main contributors to the deterioration in the profitability of community banks. Keywords Community and large banks · Profitability · Productivity and efficiency · Stochastic cost frontier model JEL classification D24 · G21 · C23
We would like to thank Professor Erwin Diewert at the University of British Columbia, Professor Knox Lovell at the University of Queensland, and Professor Emili Grifell-Tatjé at UAB Barcelona for discussing with us the decomposition of the profitability index in a cross-sectional context. All errors remain ours alone.
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Guohua Feng [email protected] Chuan Wang [email protected]
1
Department of Economics, University of North Texas, Denton, Texas 76203, USA
2
Wenlan School of Business, Zhongnan University of Economics and Law, Wuhan 430073, Hubei, China
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G. Feng, C. Wang
1 Introduction Community banks plays a vital role in the US economy, accounting for 50 percent of all loans to the small business sector of the economy that accounts for 99.9 percent of all US firms and nearly half of private-sector employment (The Federal Reserve System 2019). However, due to advances in information technology, changes in banking regulation, and increased competition, the number of community banks and the shares of bank branches, deposits, and assets that are held by community banks in the USA have all declined substantially over the past three decades (Congressional Research Service 2019). For example, the number of community banks with less than $1 billion in assets fell by almost two-thirds over the past three decades—from 17,514 in 1986 to 4704 in 2018 (Congressional Research Service 2019). The poor performance of community banks has not only raised major concerns among policy-makers about the long-run viability of community banks (e.g., Federal Reserve Board 2019; Congressional Research Service 2019), but also stimulated an increasing amount of research attempting to identify reasons behind the weak performance
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