Regulators looking for an early warning of a bank’s financial stress should monitor one simple metric: how far away it is from its borrowers.
During periods of economic expansion, the average distance grows between a US bank branch and its small-business borrowers, according to research by Chicago Booth’s João Granja, Christian Leuz, and Raghuram G. Rajan. But their study finds that greater distance can be associated with greater loan portfolio risk.
The researchers used data collected under the US Community Reinvestment Act for the number and size of small-business loans originated by county and by financial institution. They correlated the information with Federal Deposit Insurance Corporation data showing geographical coordinates of bank branches as well as information from the US Small Business Administration on loan characteristics and addresses of borrowers.
They find that between 1996 and 2016, territorial expansions, in terms of how far from home a bank offered loans, typically occurred during good economic times, when banks were flush and more confident. The average distance between lender and small-business borrower rose from 175 to 350 miles in the three boom years before the 2008–09 financial crisis, according to the data. “These distances, however, quickly slipped back to approximately 200 miles following the 2008 financial crisis,” the researchers write.
When bankers went farther from branch offices, the loans they made defaulted at much higher rates than loans to businesses closer to branches.
Competition for loans partly drives the expansion far beyond bank branches during an economic boom, the research suggests. In the run-up to the 2008 crisis, the entry of a new large bank in a market, for example, spurred local banks to go looking for less-competitive markets and pick up customers further afield. Banks in the most competitive markets expanded lending distances considerably, just to see these distances contract during the Great Recession. By contrast, banks without much competition did not stretch and shrink the areas where they offered loans over the entire economic cycle.
And just as banks looked farther away for loans in good times, when the economy weakened, they contracted to focus on local lending, the researchers find. In recessions, banks dramatically shrunk their lending territories.
Banks already report a litany of complex data about their loan portfolios to help regulators assess risks. But monitoring the average distance from originating branches to small-business customers may give regulators an early warning of trouble ahead, the research suggests. “Since distance is easily measurable,” the researchers write, “it is a metric that bank supervisors could easily track as they monitor lending standards in the economy.” They add one notable caveat: if regulators do start using the metric, that will likely change its usefulness—and bank behavior.