When the only bank branch in a community closes, the lack of financial services can cause serious inconvenience for local residents.

Although residents and small businesses can turn to digital and mobile banking options after physical branches disappear, they will face a scarcity of credit and cash deposit channels, a gap that is especially difficult to fill.

According to a report released by the Federal Reserve in Novemberreport, between 2012 and 2017, U.S. banks closed6,764 branches, accounting for 7% of all branches.

The Federal Reserve noted that 44 counties were identified as "severely affected" areas—these counties had 10 or fewer branches in 2012 and lost at least half of them by 2017. Of these, 39 counties were rural.

These "banking deserts"—areas where no bank can be found within 10 miles of a densely populated area—are becoming increasingly common. According to the National Community Reinvestment Coalition (NCRC), 86 new banking deserts emerged in rural areas between 2008 and 2016.

Rural areas are especially vulnerable to becoming banking deserts due to already limited market access.

"These places don't have the booming economic growth of big cities, and young people leave as they grow up," James Angel, a finance professor at Georgetown University's McDonough School of Business, told Banking Dive. "When banks close, it becomes harder for struggling local small businesses to do their banking. Whether it's exchanging change for customers or applying for small business loans to finance inventory, it basically makes it more difficult for small towns in America to thrive."

The trade-offs of physical branches

Angel said the reason banks are leaving rural America is simple: profit.

"When banks assess how much profit a branch can generate, they think, 'Wait, we're not running a charity. We can't afford to keep this branch open.' So they make the difficult business decision to close unprofitable branches," he said.

As customers embrace digital banking and smartphone transactions become increasingly convenient, some financial institutions are rethinking their physical branch networks.

For example, PNC Bank said it plans toclose 80 to 100 branches per yearover the next five years. But while consolidating branches in areas it no longer considers profitable, the Pittsburgh-based bank is also expanding into new markets.

"What we're hearing from banks is that there's some kind of readjustment happening," Jason Richardson, director of research at NCRC, told Banking Dive. "They're closing banks in some cities while opening them in others; or closing branches in one part of a city and moving the bank elsewhere."

JPMorgan Chaseplansto open 400 branches in 20 new marketsover the next five years. The bank said 30% of the new branches will be in low- to moderate-income communities.

Despite the $20 billion expansion plan, the bank's branch network is still shrinking as it cuts underperforming locations. According toCNBCreports, JPMorgan had 5,036 branches at the end of 2018, down about 2% from the previous year.

Richardson said banks are also streamlining branches to retain only the profitable parts.

"Micro-branches allow banks to save on rent and labor, the two most expensive operating costs," he said. "But if it's basically just an upgraded ATM lobby, I'm not sure they can meet the community's banking needs."

The loss of "soft information"

Research by an economist at the University of California, Berkeleyfoundthat when a merging bank closes a branch, the number of small business loans in the area falls by 13% over the following eight-plus years.

"There's a very strong relationship between commercial lending and branch location," Richardson said. "A lot of that has to do with how commercial lending works—much of it is highly relationship-based. Business owners know the local branch manager or business specialist."

This "soft information"—intangible traits like character, competence, and work ethic accumulated through relationship banking—is lost when a branch leaves the community.

"A key part of small business credit is the relationship with a banker who truly knows the person in a way that's much harder to digitize than with ordinary consumers," Angel said.

Richardson said small businesses may struggle to regain access to credit once a branch closes.

"It takes years for them to rebuild those relationships with other banks," he said. "Banks perform roles that go far beyond functions that can be measured by transactions."

Credit unions step in

In some cases, departing banks partner with another financial institution to complete the branch transition.

When Regions Bank, headquartered in Birmingham, Alabama, decided to stop operating several branches in the Mississippi Delta, it contactedHope Credit Unionto ask if it would be willing to take them over.

In 2015, the credit union took over four branches from Regions Bank. This aligns with the credit union's mission to "improve the quality of life for low-income, low-wealth individuals and communities in the Deep South," said Ed Sivak, executive vice president and chief communications officer at Hope Credit Union.

Regions Bank worked with Hope Credit Union to ensure uninterrupted customer service during the transition. Regions also helped Hope Credit Union reach out to new customers in the area.

"It's a win for Regions, a win for Hope Credit Union, and a win for the community," Sivak said.

He said Hope Credit Union's member-owned, nonprofit model allows it to operate in areas that would otherwise become banking deserts.

"When we see the power of financial institutions providing services where people are, the credit union model—especially member-owned institutions—really highlights the power of these relationships, programs, and partnerships," Sivak said.

In recent years, transactions between banks and credit unions have become a point of contention. According toAmerican Bankerreports, credit unions announced 16 bank acquisition deals in 2019, nearly double the 9 deals from the previous year. It's worth noting that Hope Credit Union did not purchase Regions' branches—the bank donated them.

Critics claim that credit unions'tax-exempt statusallows them to expand without the same regulatory constraints as banks. Opponents also say aggressive growth strategies contradict the credit union mission of serving low-income families.

However, National Credit Union Administration ChairmanRodney Hood saidthat without credit unions deciding to acquire community banks, some communities would have no access to banking services.

"That would leave them vulnerable to predatory payday lenders," he testified before the House Financial Services Committee in December.

"Credit unions are more likely to keep these branches open, even if they're not necessarily profitable," Jordan van Rijn, senior economist at the Credit Union National Association, told Banking Dive. "They don't have shareholders breathing down their necks saying, 'Hey, you have to maximize profits.' Their pressure comes from members. So they may be more willing to keep branches open in less profitable areas to serve members, while also opening new branches in low-income, diverse areas, and possibly rural areas."

The digital banking opportunity

According to data from Peak Performance Consulting Groupdata, the operating cost of a branch is typically $600,000 to $800,000 per year, including administrative and back-office support costs.

"Physical infrastructure—especially branches—accounts for a significant portion of banks' total cost base," said Daniel Simon, CEO and co-founder of Vested, a financial services communications firm.

Simon said the weakening of physical branch networks among large banks presents an opportunity for digital banks, which don't bear the overhead of maintaining physical branches.

"European digital banks likeMonzo、N26andRevolutare targeting the U.S. market partly because they anticipate traditional banks will leave a large number of American consumers underserved," he said.

Berlin-based N26 entered the U.S. market in July and announced last month it had 250,000 U.S. users. British challenger bank Monzo has launched a waiting list in the U.S., while U.S. digital banks like Chime and Varo are also competing for users.

Varo CEO Colin Walsh said the bank is closely monitoring the growth of banking deserts in the U.S. Varo is seeking a national bank charter.

"We're very focused on this issue and believe virtual banks and digital banks like ours can play a role here," he told Banking Dive.

Walsh said the bank is reaching underserved areas through a partnership with mass media company iHeartMedia.

"We now have such broad local reach in towns and communities across the country, and we're working with local DJs to start spreading the message that digital banking is a very viable alternative," he said.

However, NCRC's Richardson said digital banks will never be the sole solution to banking deserts.

"They can't fulfill several key functions that physical bank branches perform," he said. "A bank branch is first and foremost a sign that a community is financially stable."

Richardson said physical branches provide much-needed cash services for small businesses and serve as commercial tenants in low- to moderate-income areas, functions that digital banks cannot replace.

"Online banks have been around for quite some time, and they will play their role," he said. "But the physical footprint is a key component of banking. If it shrinks, that's going to be a problem."