Rural Banking and Information Technology: A Community Bank Perspective

If technology is supposed to be the greater equalizer and rural financial markets are increasingly similar to urban/national markets, then it follows that rural community banks are jumping like mad onto the technology bandwagon. But they're not. Meantime, their larger brethren have used technology to extend their reach and, through the Internet, are knocking on the doors of even the most remote communities for deposit dollars and fee-based services. This paper reports the results of a survey of non metro banks in the North Central U.S., examining the Internet's impact on competition in their markets and the banks' use of the Internet to compete. The message to rural banks: Wake up.

Historically, rural markets have been less competitive for the financial services industry, if simply because lower population density and higher transportation costs have discouraged infiltration. That's changed, of course. By lowering transaction costs and allowing complex human interaction independent of distance, the information revolution offers the possibility to enhance competition in rural areas.

What are rural banks doing about it? A recent USDA report on rural credit markets noted: "The range of [rural] institutions involved is likely to be different, often narrower than that serving urban communities, and competition for rural loans is often not as keen as it is for urban loans." The structure of non metro financial service markets and the way in which they operate remain remarkably similar to the structure and processes in place half a century ago. But data suggests that rural America is not lagging behind more metropolitan areas in its adoption of PC and Internet use. Current market conditions suggest that the percentage of households and farmers "wired" and able to access financial services electronically is poised to grow rapidly.

The growth in Internet-based business activities is projected to increase rapidly. Jupiter estimates that 75% of all retail purchases will be Web influenced by 2005. This trend should result in $199 billion in online purchases and $632 billion in Web-influenced sales offline. This projection is based on 85 million online buyers being present by 2003. Forrester projects e-commerce revenues to exceed $6.8 trillion by 2004. This dramatic increase in electronic business participants will affect traditional community banking relationships as customers demand on line account access..

Non metro community banks have been the dominant providers of financial services in many rural markets. So it makes some sense to ask how the information revolution will affect these organizations. Will non metro community banks be displaced by large banks and other competitors making extensive use of the Internet or other delivery systems? Or will community banks adapt and use information technology to expand their markets and gain the efficiencies needed to compete in today's market? It's a matter of perception.

Technology Investment

U.S. banks invest $20-$30 billion dollars per year in information systems. The Royal Bank of Canada professes to be the largest commercial user of information technology in Canada. This bank spends $1 billion (Canadian) per year on IT services and employs 2,000 in the IT division. The Royal Bank indicates that this level of commitment is competitively driven and the bank has used these systems to create a new set of information products.

Traditional economic models focus on the mechanical aspects of financial transactions as the source of value in financial intermediation. However, by recognizing the importance of informational friction and the fact that no one has perfect information, current financial economic theory emphasizes the role of the financial intermediary as an information processor. A financial intermediary, whether it is a commercial bank or an insurance company, creates value by processing information to develop a financial contract or transaction.

For example, in the process of making a loan, a bank adds value by collecting and analyzing data about the borrower and using this information to establish loan terms and pricing that will generate a profit. It is important to make the distinction between raw data, sometimes referred to as digital information, and economically useful information. In the case of a farm operating loan, the raw data might include the borrower's balance sheet, current income statement, credit bureau history, and some additional demographic characteristics. The loan officer transforms this data into the information needed to make a loan decision through an analytical process, much of which is IT driven.

Financial intermediaries handle an array of financial contracts and transactions in different markets. Traditionally, financial intermediaries are placed into categories based on the type of contracts or financial assets they handle. Financial intermediaries can be classified into two broad classes--asset transformers and brokers.

Asset transformers carry financial risk on their balance sheet while brokers avoid carrying financial risk. Examples of asset transformers include banks, credit unions, and direct lending Farm Credit associations, while mortgage brokers, financial advisors, and stock brokers fall into the broker category. Brokers process information to identify profitable deals and put buyers and sellers together in a "public market." Asset transformers process information to identify the risks that can be profitably held in their investment portfolio. Although the two types of intermediaries differ in their handling of financial assets and risk, they share a common output--information. From the perspective of investors and borrowers, the activities of brokers and asset transformers are substitutes with respect to processing information. A new homeowner can get a mortgage loan from a mortgage broker selling to Fannie Mae or from a savings and loan that holds the loan in portfolio. Both types of intermediaries create value by processing information, and their common output or product is information.

Different amounts and types of information are required to serve various groups of consumers, and the effort required to produce this information may vary substantially. For example, more data, analysis, and managerial input is required to produce the information needed to make a $1 million loan for a large new construction facility than would be required to renew a $100,000 annual operating loan to an established customer. However, informational requirements are not always related to the size and complexity of a particular transaction. For example, a $50,000 operating loan to a young farmer without a credit history would require an informational commitment that is much greater than a $100,000 loan to an established borrower.

The key to the information-based model of financial intermediation is that it views information, rather than dollars, as the output. A one-dimensional scale to describe the intensity of customer information requirements can be adapted to practical loan issues (Figure 1). Their scale ranges from 1, the most transparent or least information intensive customers, to 7, the opaque or most information-intensive customers. Transparent segments of the market are easily served with standardized products with existing or available information systems, while the more opaque segments of the market may require customized products or services as well as extensive monitoring and/or technical assistance.

Financial intermediaries in this context can be placed into two categories based upon degree of risk bearing and their prevailing cost structures. Brokers require relatively little physical (bricks and-mortar) or financial capital and their costs are mostly variable in nature. In contrast, asset transformers have substantial requirements for physical and financial capital in addition to the variable costs of labor, data collection, and data transformation. These differences in the costs of information processing combined with distinct informational requirements for specific market segments can be used to explain the division of financial markets between brokers and asset transformers.

Because brokers have lower fixed costs and make less use of capital, they have flatter average cost curves than asset transformers, as shown in Figure 2. At the end of the scale where customers are less information intensive, brokers have a pronounced cost advantage. As information requirements intensify, diminishing marginal returns affect broker intermediaries sooner. However, the use of specialized capital allows asset transformers to profitably serve the less transparent market segment At the opaque end of the scale are customers who cannot be served profitably, even by the more capital-intensive asset-transforming intermediaries. These customers are subsequently "rationed out" of the market.

Figure 3 illustrates how this model might be applied to the market for home mortgages.

Customers with established credit looking for a conforming mortgage with standard terms on a suburban home are generally served by mortgage brokers or bankers with the loan being rapidly sold to Fannie Mae or Freddie Mac and ultimately being securitized. However, a customer with less standard needs, such as a jumbo loan (one too large to be eligible for sale to Fannie Mae or Freddie Mac), would more likely secure a mortgage from a savings and loan or bank. Therefore, unserved customers may be rationed out of the market because they are perceived to be too risky--the costs of making and monitoring loans to them are too high to be profitable.

Information Revolution and the Structure of Rural Financial Service Markets

Bank adoption of information technology affects the segmentation and structure of financial intermediation by shifting intermediaries' cost curves. Just as mechanical technology led to order-of-magnitude declines in the cost of producing textiles, steel, and other physical products during the industrial revolution, subsequent order-of-magnitude declines in the cost of processing digital data has become the catalyst behind much of the information revolution within the banking sector.

Although advances in information technology are often seen as the primary drivers of the information revolution, innovations in economic and financial applications are equally important. For example, the combination of low-cost processing power and increasingly sophisticated financial models has allowed financial engineers to develop complex financial products and strategies. (Remember when we hadn't heard of credit derivatives). Similarly, information technology has allowed credit scorecards and rapid loan approval processes to become commonplace.

Declining information costs directly affect the structure of financial intermediation in the following ways:

1. By expanding the market for financial intermediation to include more information intensive customers.

2. Shifting the boundary between brokers and asset transformers outward, so brokers are serving an increased share of the market.

3. Reducing the market for financial intermediation by creating electronic markets directly linking customers with investors.

Lower transactional and information costs provide for the expansion of the overall customer base, which allows financial intermediaries to profitably serve more opaque customers. The expansion occurs because declines in information costs make both loan origination and servicing for opaque borrowers more cost-effective. This leaves fewer customer segments unserved or underserved. One current example of this effect in consumer credit markets is the growth of lending to "subprime" customers.

A second effect of reduced transactional and information costs is a shift in the market boundary between brokers and asset transformers. The decline in information costs shifts this market boundary because it drives down brokers' average costs further than the average costs of the asset transformers. The greater decline in information costs for brokers is a result of the fact that electronic data costs make up a greater share of brokers' costs than of asset transformers' costs. The growth in the share of home mortgage lending originated by mortgage brokers in recent years is an example of this second effect.

Information technology's third effect is to reduce the aggregate market for financial intermediation by allowing borrowers and investors to interact directly through electronic negotiations (markets). Disintermediation is nothing new in financial markets. In the past, disintermediation has generally been driven by regulation of financial intermediaries. For example, the regulation Q limits on interest rates for deposits drove such a large wedge between investors and borrowers that it became worthwhile for many borrowers and investors to incur the high transactions costs of direct exchange and avoid the intermediary. Technology-driven disintermediation results from a decline in these transaction costs rather than from a regulatory wedge. Although technology-driven disintermediation has been limited to date, a few companies have issued their own stock and marketed it directly over the Internet.

The following issues begin to emerge from the impact of information technology's implementation on the structure of financial intermediation:

1. The market share of asset-transforming intermediaries, such as non metro community banks, will decline.

2. The total volume of transactions for asset-transforming intermediaries will decline, unless the growth in the market outweighs the loss of volume to electronic markets and brokers.

3. The volume and market share of various brokers will increase, unless the decline in transaction costs and changes in financial market regulation lead to a dramatic increase in electronic markets and disintermediation.

Implications for Rural Community Banks

What do these broad implications for financial intermediaries mean for non metro community banks? Rural community banks are dominantly asset transformers, and they generally hold a large percentage of the loans they originate in their own portfolios. If information technology reduces the market share of asset-transforming intermediaries, then rural community banks' share of the financial service market will likely decline. The model also suggests that rural banks are likely to face increasing competition from other financial intermediaries, especially brokers for their least information intensive products and services.

Unless a community bank is located within a growing market, it will need to adopt new business strategies to grow or remain viable. The conceptual model above suggests that such strategies might include a shift from asset transformation toward brokering (off-balance-sheet) activities. Another alternative is to expand the bank's geographic trade area.

Rural Banks and the Internet: Survey Results

To gain a better understanding of how the Internet is affecting rural banks, a questionnaire was mailed to 275 banks in the North Central U.S. (primarily in North Dakota and Minnesota). The survey instrument was designed to determine community bank activities on the Internet. The survey data from these banks was then matched to June 1999 bank financial performance data.

Sixty banks responded to the survey with a total of 58 usable responses. As shown in Table 1, the sample banks are predominantly non metro community banks--the largest bank had total assets less than $600 million-- with a large share of their portfolios in agricultural loans. Typical of non metro community banks, the respondents had a low loan/deposit ratio.

Competition on the Web

Information technology is a significant share of costs at these banks IT costs averaged 11% of total noninterest expense and IT employees represented 15% of total employees in 1999. IT costs are an increasingly important component of costs for these banks; the IT share of noninterest expense more than doubled over the past five years. Although these banks have made significant IT investments as a group, many individual banks appear to be lagging--nearly 20% of the banks reported spending less than 5% of total noninterest expenses on information technology.

Survey results indicate that many rural community banks are facing Internet-based competition in the markets for core products on both sides of their balance sheets. Figure 4 shows the percent of responding banks reporting Internet-based competition by product and competitor. More than half of the sample banks indicated that one or more of their competitors were using the Web to reach customers in their market area. The greatest response on Internet-based competition was in the markets for the least information-intensive products, such as transaction deposits, CDs, and consumer credit loans. Fewer banks reported competition in markets for more information-intensive products, such as residential and farm real estate loans. Responding banks reported less competition in the markets for the most information-intensive products--small business and farm operating loans.

The types of financial intermediaries most often reported as Internet competitors were regional and super regional banks. Large banks are using the Internet to expand the geographic scope of their markets. Many of these banks have invested heavily in sophisticated interactive Web sites that allow customers to choose from a wide range of products.

Community banks were also sited as a source of competition over the Internet. Other intermediaries, including credit unions, thrifts, and finance companies, were mentioned less often as a source of competition over the Internet. However, nearly 40% of the responding banks mentioned the Farm Credit System as a source of competition on the Internet for farm real estate and operating loans.

Rural Bank Use of the Web

Many of the sample banks (38%) reported that they had a Web site. Table 2 reveals that 38% of the sample banks have Web sites. Responding banks within metro areas seem to be lagging as a group, with only 20% reporting that they had a Web site. Although many of the sample banks had a Web site, most of these sites provide only basic information such as bank hours, products and office locations. Only seven banks, less than one third of the 22 banks with Web sites, had such advanced features as account information, bill paying or online loan applications.

Although more than 40% of the responding banks have a Web site, a much smaller share of the banks seem to have incorporated the Web into their business plan. As Table 3 indicates, only 20% of the responding banks indicated that they were using the Internet to penetrate distant markets for CDs. Even fewer banks reported that they planned to use the Web for more complex products such as loan origination.

Summary and Conclusions

The information-based model of financial intermediation presented in this paper suggests that the rapid adoption of information technology is likely to lead to a loss of market share for non metro community banks as a group. These banks will need to adopt new business strategies in order to grow or even in order to remain viable.

Survey results confirm that rural community banks in the North Central United States are facing competition over the Internet in the markets for core products on both sides of their balance sheet. Internet based competition seems to be the most prevalent in the markets for the least information intensive products. The most important competitors over the Internet are regional and super regional banks--large sophisticated intermediaries that are using the Internet to expand the geographic scope of their markets. These results are consistent with the implications of the information based model of financial intermediation.

Only a few of the surveyed banks plan to use the Internet as a tool to expand their markets. Although many of the banks in this survey have Web sites, most of them provide only basic information about products, office location and bank hours. Few of these sites offer interactive features like account information, bill paying, or loan applications. Without these advanced features a Web site does little to enhance a bank's competitive position.

These results suggest that the information revolution will have a significant impact on rural community banks and the structure of rural financial service markets. Consumers with low information intensity who have access to national markets for financial services via the Internet stand to benefit substantially from the information revolution. However, the effect of information technology on consumers with more information intensive needs and consumers without access to the Internet is less clear.

Recommendations

As non metro community banks focus on Internet based strategies the following issues need to be ascertained: Cost of the Internet banking implementation. Does this investment reduce the cost of doing business relative to the traditional banking structure? What is the effective cost of the infrastructure and maintenance of the Web-based delivery model. Assuming that the costs are lower for business operations and a sustained effort in upgrading and improving technology are evident then the implementation can progress.

Understanding the dimensions of the target market and the implications of customer driven demand needs to be determined with respect to Internet banking applications. Do customers want a complete banking array available on line? Is a subset of banking functions adequate to structure a Web based implementation. Following the completion oftentimes forces the hand of market participants. The use of technology within the banking sector technology has been rapidly embraced from a competitive focus. This approach should also foster Internet banking facilitation.

This study has indicated that non metro community banks have not adequately structured a strategic view of the Internet banking question. The need for a strategic approach to Web based banking is critical to the overall success of the firm. Many industries have lacked a strategic focus to Internet business activities and this had led to lower than expected performance as competition gains an advantage position. Given the changing role of non bank competition, industry consolidation, cooperative lender restructuring and shifting demographics community banks face challenges that Internet banking may be able to counteract with proper Web directed strategies and implementation.

Kagan is professor, Morrison School, Arizona State University Tempe, Arizona; Conklin is director, Markets and Trade Division, Economic Research Service, Washington, D.C.

Sources

Emmons, W. R. and S. I. Greenbaum. 1996. "Twin Information Revolutions and the Future of Financial Intermediation." Working Paper OLIN-96-48, Olin School, Washington University, St Louis MO.

Forrester 2000. http://www.forrester.com/ER/Press/Release/0,1769,281,FF.html

Gupta, UG. and W. Collins, 1997. "How Small Medium and Large Banks Use Computers." ournal of Retail Banking Services, Winter 1997 Vol 19 No 4 pp 25-31.

Jupiter Communications 2000 http://www.jup.com/company/pressrelease.jsp?doc= pr000816

Marshall, J., 1997. "Giving Technology the Royal Treatment." US Banker Vol 107 No 11 (November) pp 49-53.

National Agricultural Statistics Service, 1997. U.S. Department of Agriculture, "Farm Computer Usage and Ownership." http://usda.mannlib.cornell.edu/reports/nassr/other/computer/farm_com puter_usage_07.30.97, July 30.

Sheshunoff Information Services. June 1999 BankSearch Data for Banks, S&Ls, and Credit Unions. [C] 1999 Sheshunoff Information Services Inc.

Simpson, P., 1997. The 1997 Home Banking Report, Jupiter Communications, New York.

USDA. 1997. "Credit in Rural America." http://www.econ.ag.gov/epubs/pdf/aer749/ Rural Economy Division, Economic Research Service, Agricultural Economic Report No. 749.

                        Profile of Responding Banks
Total Number of Banks                 58
 MSA                                  15
 Outside MSA                          43
Average Assets (millions)          $71.0
 Less than $35M                       19
 $35 million - $60 million            20
 Over $60M                            19
Farm Loans/Total Loans               33%
Loan/Deposit Ratio                   77%
IT Employees/Total Employees         15%
IT Costs/Total Noninterest Expense
1999                                 11%
1993                                  5%
                            Bank Has a Web Site
        No     Yes     Total
Non MSA 24 56% 19  44%  43
MSA     12 80%  3  20%  15
Total   36 62% 22  38%  58
     Participating Banks Use of the Internet to Penetrate Remote Areas
Application                 Usage
Transaction Deposits         8.6%
CDs                         20.7%
Consumer Credit Loans        8.6%
Residential Mortgage Loans  10.3%
Commercial/Industrial Loans  8.6%
Farm Real Estate Loans       8.6%
Farm Operating Loans         8.6%
           Internet-Based Competition by Product and Competitor
                             Community    Thrifts   Credit Unions
                               Banks
Transaction Deposits            0.5     0.224137931  0.224137931
CDs                             0.5     0.224137931  0.189655172
Consumer Credit Loans       0.448275862 0.206896552  0.275862069
Residential Mortgage Loans  0.431034483 0.24137931   0.189655172
Farm Real Estate Loans      0.327586207 0.051724l38  0.086206897
Commerical/Industrial Loans 0.293103448 0.058065517  0.103448276
Farm Operating Loans        0.310344828 0.051724138  0.086206897
                            Regional Banks Super Regional Foreign Banks
                                               Banks
Transaction Deposits         0.568965517    0.568965517    0.103448276
CDs                          0.568965517    0.586206897    0.086206897
Consumer Credit Loans        0.551724138    0.551724138    0.068965517
Residential Mortgage Loans   0.534482759    0.551724138    0.068965517
Farm Real Estate Loans       0.362068966    0.310344828    0.051724138
Commerical/Industrial Loans  0.413793103    0.413793103    0.068965517
Farm Operating Loans         0.379310345    0.344827586    0.051724138
                            Farm Credit   Finance      Other
                              System     Companies
Transaction Deposits        0.103448276 0.155172414 0.034482759
CDs                         0.068965517 0.137931034 0.017241379
Consumer Credit Loans       0.068965517 0.206896552 0.034482759
Residential Mortgage Loans  0.103448276 0.25862069  0.034482759
Farm Real Estate Loans      0.396551724 0.137931034 0.051724138
Commerical/Industrial Loans 0.172413793 0.172413793 0.034482759
Farm Operating Loans        0.396551724 0.189655172 0.017241379

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