Many animals use natural camouflage to defend against predators. Many community banks exhibit similar behavior, according to Chicago Booth’s Rimmy Tomy.
Faced with competition from a bank planning to enter its territory, a local community bank may increase its loan-loss provisions. This legitimate accounting move makes the community bank appear to be less profitable and, by extension, makes the geographic area look less enticing. This may discourage a would-be rival from moving in.
Banks are required to set up provisions based on loss-causing events, such as the bankruptcy of a large local business that employs a significant number of workers. Because of this, loan-loss accruals may serve as a leading indicator of local market credit quality. Banks of all sizes consider competitors’ publicly available financial statements when they scout out new territory, and surveys indicate that banks prefer to locate in markets where incumbents have high profitability and low credit losses.
Banks that use this kind of camouflage appear to have an unintended ally: government regulators.
Therefore, loan-loss accruals may influence the behavior of potential entrants, says Tomy, and manipulating accruals seems to work as a defensive strategy, her research suggests.
Tomy constructed a sample using 1994–2005 branch-level data from the Federal Deposit Insurance Corporations’s Summary of Deposits database, and 1992–2008 bank-level data from the Report of Condition and Income from the Federal Reserve Bank of Chicago. As the legacy banks in the sample increased their loan-loss provisions, fewer new entrants entered the market in the counties in which the legacy banks operated.
Banks that use this kind of camouflage appear to have an unintended ally: government regulators. Charged with ensuring the safety and soundness of the banking system, regulators were more likely to be concerned about underprovisioning—underestimating the likelihood of loan losses—than overprovisioning, or overestimating the chances of bad loans. Indeed, the loan-loss provisions set up by banks outstripped the dollar value of loans that went bad, Tomy finds.
Banks appear to follow a herd instinct: when one institution overprovisions as a way to fend off potential new entrants, others follow, even if they’re not really worried about new competition. In a kind of follow-the-leader strategy, Tomy says, “banks generally benchmark their level of loss provisions against peers in the local market. Besides assessing performance, they have an incentive to avoid regulatory attention, as the bank with the lowest level of provisions in a local market faces additional scrutiny by regulators.”
Tomy’s study sample includes mostly relatively small community banks, with assets of $500 million or less, in “small metropolitan areas” with populations of 500,000 or less. “These banks are most likely to face an increase in competition from the entry of larger players into their local markets,” she notes.
Tomy also compared privately held banks to publicly listed banks within the same boundaries. She expected to find that privately held banks would be quicker to raise their loan-loss provisions, since publicly listed institutions face capital market–related incentives to appear more profitable. But in fact, publicly listed banks increased their provisions to a greater extent in the face of an increased competitive threat. This could indicate that public banks face increased regulatory attention, she says, or it could be that they tend to be larger, and so could have a bigger incentive to deter competitors.