March 26, 2016
As the pressure on the banking system increases, banks are looking for ways to cut down on costs and transform their business models to stay relevant. One of the ways that banks respond to changing needs and tightening competition from neobanks is by closing branches and shifting their focus towards digital experiences.
The trend of cutting down on physical presence, however, started even earlier. Since the financial crisis in 2008, nearly 5,000 bank branches were closed in the US. Aside from transforming the banking industry, the massive branch shutdown raised concerns about certain areas in the country turning into banking deserts as expressed by the Federal Reserve Bank of New York. The phenomenon could lead to reduction of credit access, even with other branches present, by destroying soft information about borrowers that influences lenders’ credit decisions.
As mentioned before, US banks closed 4,821 branches between 2009 and 2014, according to the FRB. The number accounted for around 5% of bank branches in the country. Economists believe the trend could be demand- or supply-driven. Since the demand for physical branches has decreased, banks saw maintaining them as an unprofitable activity, which led to the closures. There are different opinions on the reasons that the demand for braches has decreased, but the two most vivid ones state that slower economic growth since the crisis, increased online banking, increased cost of supplying those services (owing to more stringent bank regulation or other factors) could have been a significant contribution to the trend.
Either way, while the trend may be seen as a positive one from the innovation point of view and the shift towards online banking, there are major downsides to it discovered by experts.
As the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York shared, there is evidence that access to bank credit, particularly for small businesses, declines as the distance between the bank and borrower grows (which is a result of a branch shutdown). Moreover, the study Distance, Lending Relationships, and Competition performed in 2005 has revealed that small business loan rates increased with the heater distance between firm and bank. As with real estate, location matters for customers’ access to and use of banking services.
A study called Do Bank Branches Still Matter? The Eﬀect of Closings on Local Economic Outcomes published in October 2015 by UC Berkley economist Hoai-Luu Q. Nguyen has revealed that when merging banks close a branch, the number of small business loans decreased by 13% for more than 8 years afterward. Moreover, the supply of mortgages also fall, although temporarily.
The most interesting part was, however, that the shortage and fall in small business lending continued even when new branches arrived instead of the closed one. The conclusion that the author came to was that the trend continued because of the loss of information when the local branch-business relationship was broken.
Bank branch workers and small business owners in neighborhoods are usually connected through personal relationships more than through CRM, which leads to a loss of leads and opportunities when a branch closes and workers are not serving their contacts anymore. Branch managers usually know borrowers on a more personal level and are armed with more detailed information than a record in the system. They understand particular traits and needs of those entrepreneurs and are more successful in serving their needs than a fresh entrant would be. That kind of information is permanently lost once the branch is closed and a manager is fired. A new branch would take years to create those bonds and develop a deep understanding of the client base.
Despite the positive effects bank branch closures may have (like cost reduction, focus on superior mobile experience, higher convenience of online than physical branch, etc.), the banking industry should address the drawbacks and negative effects that bank branch closure has on small businesses and on lending.
There are important implications, as we have mentioned before. One of them is that bank branch closure causes high barriers for borrowers to access loans and hence, may have to go through rough times (economic shocks or other unforeseen traumatic events). Small businesses lose connections with branches that know them personally and are aware of their needs better than a new branch worker would be. While major financial institutions would find benefits from cutting down on branches, they often underestimate the consequences for the ones on the other side.
Another important insight is that while regulators and big banks take into account the number of branches, they fail to recognize the importance of destroying the lender-specific information. It is not the count of branches that is important, rather it is every particular branch that matters. Two new branches that come in place of one will not be able to restore the damage done to borrowers and the small business community. The number of branches have little to no impact on actual credit access in the end.
And finally, even though the technology has advanced tremendously and online lending is seen as the next level of service, there are markets and segments of the population that heavily rely on local branches with history in their neighborhoods. They play an immense role in fostering financial inclusion and providing access to credit for low-income and disadvantaged neighborhoods.