Bank geographic diversification and funding stability

BIS Working Papers  |  No 1221  | 
22 October 2024

Summary

Focus

Banks are getting larger, while the number of physical bank branches is rapidly declining. These trends have raised important questions. Do larger banks imply greater risks to financial stability? And will the demise of bank branches, which are crucial for collecting soft information about borrowers, impair small business lending and hurt local economies?

Contribution

Drawing on detailed branch-level deposit data for US banks, I study how the structure of branch networks, and in particular their geographic distribution, affects banks' funding stability and liability structure. Moreover, I investigate the consequences of the geographic diversification of banks' deposit base for the asset side of their balance sheet, namely liquidity creation and small business lending. I provide new evidence on the consequences of branch closures and contribute to the long-standing debate on the costs and benefits of bank diversification, one of the central questions in finance.

Findings

While the total number of bank branches has declined, the number of branches per bank has risen over the past decade. Moreover, the geographic diversification of banks' deposit base has steadily increased. This greater geographic diversification is shown to improve banks' funding stability and foster liquidity creation. First, I find that banks with greater geographic diversification have higher dispersion in deposit growth rates across their branches, implying that they reduce their exposure to idiosyncratic branch-level deposit shocks. Subsequently, they experience lower volatility in deposit growth rates over time, especially among demand deposits. Moreover, by shifting from costly time deposits into cheaper demand deposits, geographically diversified banks benefit from lower funding costs. Second, I show that this diversification enables banks to engage in increased liquidity creation. More geographically diversified banks also increase their small business lending, with positive effects for local economic activity. These findings suggest that, despite the steady increase in bank size and decline in total branches, the contemporaneous increase in geographic diversification of banks' deposit base can improve funding stability and benefit firms.


Abstract

The recent banking turmoil has renewed focus on banks' branch networks and deposit taking activity. This paper provides novel evidence that the geographic diversification of banks' deposit base enhances their funding stability. I establish that banks with greater diversification exhibit higher dispersion in deposit growth rates across their branches; and lower volatility in deposit growth rates over time. Subsequently, banks benefit from lower deposit rates, partly by shifting from time deposits to cheaper demand deposits. These patterns are consistent with diversification improving funding stability. I then show that deposit diversification spurs banks' liquidity creation and small business lending, with positive effects for real economic activity. The funding stability channel of geographic diversification is distinct from previous findings on banks' asset-side diversification. It also highlights benefits of branch networks for bank lending that go beyond local information acquisition.

JEL Classification: G20, G21, G28

Keywords: bank diversification, deposits, funding stability, liquidity creation, risk