The importance of scale economies and geographic diversification in community bank mergers

Mergers of community banks across economic market areas potentially reduce both idiosyncratic and local market risk. A merger may reduce idiosyncratic risk because the larger post-merger bank has a larger customer base. Negative credit and liquidity shocks from individual customers would have smaller effects on the portfolio of the merged entity than on the individual community banks involved in the merger. Geographic dispersion of banking activities across economic market areas may reduce local market risk because an adverse economic development that is unique to one market area will not affect a bank's loans to customers located in another market area. ; This paper simulates the mergers of community banks both within and across economic market areas by combining their call report data. We find that idiosyncratic risk reduction dominates local market risk reduction. In other words, a typical community bank can diversify away its idiosyncratic risk almost as completely by merging with a bank across the street as it can by merging with one located across the country. The bulk of the pure portfolio diversification effects for community banks, therefore, appear to be unrelated to diversification across market areas but, instead, are related to bank size. These findings help explain why many community banks have not pursued geographic diversification more aggressively, but they beg the question as to why more small community banks do not pursue in-market mergers.