N°25-29: Small is Beautiful, … and Efficient. On the Efficiency Premium of U.S. Community Banks

In 2012 the U.S. Federal Deposit Insurance Corporation defined community banks and recognized their distinct role. In 2020 this definition was reaffirmed. But what makes community banks special? To answer this question, we measure the efficiency of community banks versus comparable other banks using a stochastic frontier model. We decompose cost efficiency into long-and short-run components. We find that community banks are almost 20% more efficient on average, with structural factors-not managerial performance-driving this "efficiency premium". Especially smaller community banks outperform larger competitors. Efficiency gains also stem from micropolitan presence and agricultural lending, while income diversification weakens efficiency. A one standard deviation increase in core deposits raises long-run efficiency by almost 5%. Despite overall efficiency improvements during COVID-19, community banks' efficiency has remained stable. These findings highlight the need for regulators to support innovation while preserving locally focused financial institutions.