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Cleveland Fed Weighs in on Branch Closures

The ""Federal Reserve Bank of Cleveland"":http://www.clevelandfed.org/ has released its commentary on the broader economic effects of the recent closure of local bank branches, as lenders struggle to maintain bottom line viability in the marketplace. The brief, developed by Emre Ergungor and Stephanie Moulton, is titled, ""Do Bank Branches Matter Anymore?,"" and the authors' conclusions indicate that the general answer to that large and looming question is a resounding, ""yes.""

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Ergungor and Moulton examined two key influences that brick-and-mortar retail bank branches provide to communities: availability of loans for borrowers in the surrounding areas and, as their research revealed, a lower ratio of defaults on locally initiated loans.

Additionally, Ergungor and Moulton looked at the Community Reinvestment Act (CRA), and its effects and implications for lenders and borrowers.

In an opening statement, the authors' noted the scope of their research, saying, ""Bank branches have been disappearing in some major metropolitan areas, as their populations and economic activity decline. Our research suggests that brick-and-mortar branches provide tangible benefits to consumers, especially in low- to moderate-income neighborhoods. When branches are located in those areas, borrowers living there default less and have greater access to credit.""

Focusing on regions in Ohio, Ergungor and Moulton calculated the total cumulative losses of bank branches in the state's four major metro centers: Cuyahoga County, Lucas County, Mahoning County, and Franklin County. Three of the four regions - Cuyahoga, Lucas, and Mahoning - each showed a decline in the presence of bank branches over the past eight years, though Franklin displayed an increase, and the authors' attribute the expansion in the latter county to population growth in the area, while explaining that the other three counties considered each lost population numbers during the eight-year period of examination.

Ergungor and Moulton clearly acknowledge that population decline is a rational catalyst for banks closing branches in particular areas in Ohio and beyond, but they go on to evaluate the issue of ""adverse selection"" which can be created when retail banking locations dwindle. Describing the problem, the authors' elaborated, saying the following:

""If the lender charges a low interest rate on mortgages to make them affordable to the creditworthy applicant, it will lose money because the other applicant will also get the same mortgage and potentially default.""

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The authors added: ""If the interest rate is high enough so that the lender is compensated for the likely credit loss, then the loan becomes unaffordable to the creditworthy applicant and only the applicant who does not mind missing payments shows up at the branch. Thus the lender finds itself in a bind; no matter what the interest rate is, it is never profitable to lend in this market; as a result, creditworthy borrowers cannot get credit.

""Economists refer to this problem as adverse selection,"" they said.

Extending their commentary on local banking, Ergungor and Moulton went on to note the general shift in mortgage lending, including factors like the shorter time frame now common for closing loans and the collection of ""soft"" information local branches can benefit from when evaluating a borrower. The authors' stated that one of the advantages a lender gains when it conducts loans out of a retail branch is the access to such ""soft"" information that helps originators weigh intangible risk factors.

As to who may derive the greatest benefit from local bank branches, Ergungor and Moulton said the following:

""The beneficial-relationships argument has some interesting implications, which can be validated with data. First, the main beneficiaries among borrowers should be the ones that find it difficult to access credit from banks that use the lower-cost automated underwriting criteria.

""These are people typically with low incomes, tainted credit histories, and low credit scores,"" Egrungor and Moulton said. ""Therefore, they would benefit from any additional piece of information not captured by the score. Second, if relationship lenders are better informed about borrowers' creditworthiness, we should observe fewer instances of default among the loans they make.

""Third"" they added, ""with the uncertainties about borrower quality eased and default risk reduced, credit should become more abundant and cheaper if there are bank branches in low-income area. Our research revealed evidence that supports all three implications.""

The authors continued their critical look at the cost-benefit ratio through examining defaults among locally originated loans. Their findings reveal that borrowers who utilized a retail bank branch in their area to purchase a mortgage were 4.3 percent less likely than an average consumer to enter into default.

Ergungor and Moulton also highlighted the better pricing of mortgage credit in localized branches in lower-income areas versus a lack of the same trend in higher-income regions.

Ergungor and Moulton's ultimate conclusion suggests that a lender's best strategy when dealing with new or existing mortgage loans for low- to moderate-income areas, those known for higher levels of distressed consumers, is to conduct those transactions in a personal, localized, retail bank branch.

In closing, the authors said, ""Our research shows the benefits that come from creditworthy borrowers in declining low-income areas being in close physical proximity to a bank branch. The public policy challenge is to identify how to get those benefits when private markets alone do not provide them.""

About Author: Abby Gregory

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