In an era of global finance, it has become clear that there exist close relationships between economic growth and finance. The recent financial problems in Asia, Russia, and Brazil and resultant economic slowdown in these regions clearly illustrate this. Surprisingly, there has not been much effort to look at the influence of finance on growth and development at the regional and local scales. For example, while infrastructure developments such as highway, community, and education developments have long received attention in various Appalachian regional development programs, very little systematic effort has been made toward development of a financial structure conducive to the growth and development, with the exception of a few early attempts such as Checchi and Company (1969) and Dreese (1974). In light of mainstream macroeconomic thought, this is a rather peculiar situation. There are at least two important aspects of evaluating the role of finance in regional growth. The first is the amount of money available to a region. The second is the institutional structure of the financial industry in a region that may affect the flow of financial resources within and between regions. In a national economy where no region specific monetary policy helps determine the amount of money circulating in a underdeveloped region, the institutional aspect of finance becomes the more crucial element of the two. Under a given federal monetary policy, institutional structure may affect the amount of the money flowing into a region, and thus affect regional growth. This paper deals with issues related to the second aspect of regional finance, i.e. the institutional structure of the financial industry. Specifically, this paper analyzes institutional characteristics of the banking industry in the Appalachian region, especially those that may hinder the flow of financial resources from the national to the regional market. The focus area is Appalachian Kentucky, an area lying in the heart of Appalachia and representative of the problem districts throughout the Appalachian region. Study of this nature may shed light on the market structure of the financial industry as a cause of slow growth of Appalachia, in addition to the traditional causes of poverty such as isolation, a resource-based economy, and other historical, socioeconomic factors.

Regional Financial Market and Economic Growth
 
    The last two decades have seen the emergence of a theory of regional financial markets, following the work by Amos (1992), Dow (1987, 1982), Harrigan and McGregor (1987), Moore and Hill (1982), Mathur and Stein (1980), Garrison and Chang (1979), Roberts and Fishkind (1979), Fishkind (1977), and Beare (1976). The theory of regional financial markets rejects the conventional assumption that financial capital has perfect mobility. It is argued that there exists a spectrum of regional segmentation of financial markets, ranging from perfect financial capital mobility to complete segmentation. The financial segmentation, or the imperfect mobility of financial capital between regional and national markets arises partly due to less than competitive institutional structure of the local banking industry. A competitive financial market will drive up regional interest rates relative to the national rates. The upward price movement tendency will induce national capital to flow into the region and augment the credit supply. In contrast, in a less than competitive market fix-price tends to prevail via mechanisms such as price-leader. Fix-price will result in the allocation of funds via rationing in which an "implicit contract" is struck between the lender and borrower to minimize the risk (Harrigan and McGregor, 1987). In ordinary conditions, the economically stressed regions or a local market unfamiliar to investors at the national financial market, may be required to pay a location-related premium on top and above the regular interest charge to correct the investment risk associated with the region (Salvatore, 1991). In contrast, fix-price and implicit contracts in less than competitive markets may force down such location-related premiums, and thus discourage financial flow from national to regional markets. The result is an inadequate supply of credit in a local area.

    Amos (1992) points out that small, rural communities experience a higher degree of segmentation, and have a greater degree of local credit and production interaction than larger urban areas. An expansion of local credit can bring cumulative expansion of production expansion, while a contraction of credit may bring a cumulative decrease in production. Accordingly, in small rural communities, a less than competitive financial market may lead to an insufficient amount of credit available, and to slower than normal growth rate or even long-term contraction. It is in this sense that the institutional structure of the local banking industry exerts influence on economic growth. It should be pointed out that credit-production interaction may also be affected by other factors such as economic structure. A community with resource-based industry such as agriculture or energy would experience more acute credit-production interaction than diverse urban economies. While analyzing the institutional structure of the banking industry in rural counties that constitute Appalachian Kentucky, this study takes rural counties in non-Appalachian Kentucky as the comparison group. Therefore, the effects of the economic structure are more or less controlled for.
 
Appalachian Kentucky
 
    There have been various definitions of Appalachian Kentucky (Bradshaw, 1992; Raitz and Ulack, 1984; Langman, 1971; Bowman and Haynes, 1963; Ford, 1962). This paper defines Appalachian Kentucky as all rural counties in Kentucky that are designated as part of the Appalachian region by the Appalachian Regional Commission (ARC) under the 1965 Appalachian Development Act. It should be noted that this definition excludes all metropolitan counties in the official designation of the Appalachian region, due to the significant differences in socioeconomic characteristics between rural and metropolitan counties. As for present time, of the forty-nine Kentucky counties that have been designated as ARC Appalachia, 44 are non-metropolitan rural counties.

    Most of the eastern segment of Appalachian Kentucky forms part of the Cumberland Plateau within Kentucky, with dissected topography and densely wooded hillsides. Toward the west, the region extends to the Interior Low Plateaus. To the northwest, the region covers part of the Blue Grass region. As in the Appalachian region as a whole, the stagnation in Appalachian Kentucky has multiple causes ranging from isolation, exploitation, and outmigration, to reliance on coal mining, basic manufacturing, and agriculture (Raitz and Ulack, 1984; Langman, 1971). These causes have historical roots as well as contemporary ramifications (Caudill, 1983). In 1995, per capita income in most of rural Appalachian Kentucky was less than 70% of the U.S. average. During the current national economic growth cycle, the longest during the post war era, Appalachian Kentucky experienced the highest unemployment rate of all Appalachian regions. In 1996, unemployment rate in Appalachian Kentucky stood at 8.1%, while the corresponding number for the U.S. was 5.4%, and for the Appalachian region as a whole 5.7%. In the same year, 15 rural non-metropolitan Appalachian Kentucky counties had a 2-digit unemployment rate. All rural Appalachian Kentucky counties are designated distressed counties by the ARC except for 7 (Garrard, Green, Adair, Pulaski, Laurel, Fleming, and Montgomery). In these distressed counties, per capita income is no more than two-thirds of the national average and poverty and unemployment rates are at least 150 percent of the national rates.

    To relieve the region of the high poverty rate, low per capita income, and low employment rate, a more dynamic and diverse economic base is needed. A new economic base requires necessary finance. This includes both the initial start-up capital for a new business, adequate working capital and credit for building up inventories, capital for new technological innovation, loan packaging assistance, and long-term debt financing for newer companies or businesses that are seeking to expand. Though public funds may come forth as development capital via various regional development programs, the financial industry in general, and the banking industry in particular should provide the bulk of the resources needed for long-term and sustained development.
 
Banking Industry in Appalachian Kentucky
 
    As of the mid-1997, there were 74 commercial banks headquartered Appalachian Kentucky, with $8.11 billion in assets, $6.85 billion in deposits, $5.28 billion in loans, and 3723 equivalent full time bank employees. In comparison, 120 banks were headquartered in non-Appalachian rural Kentucky, with $12.99 billion in assets, $10.21 billion in deposits, $8.43 billion in loans, and 5353 equivalent full time bank employees. In the same year, all Kentucky metropolitan counties housed only 66 banks but with substantially larger financial clout: $40.01 billion in assets, $26.76 billion in deposits, $27.71 billion in loans, and 12269 equivalent full-time bank employees. In the state of Kentucky, Appalachia Kentucky stood out as an area possessing scarce banking resources. For example, the region's 1997 population was 886,000, about a fifth of the Kentucky population, while its bank assets were only 13.3% of the state total. As a result, per capita bank assets for Appalachian Kentucky were only $9,153, compared with $10,700 for Kentucky non-Appalachia rural counties, and $22,129 for Kentucky metropolitan counties. The above comparison has not revealed the full extent of the scarcity of banking resources in Appalachian Kentucky because it excludes resources owned by out-of-state banks, which tend to be concentrated in metropolitan counties. Nonetheless, the scarcity of banking resources in Appalachian Kentucky is clear when compared with other Kentucky regions.

    The above comparison suggests that Appalachian Kentucky supplies less per capita banking resources when compared with other areas of Kentucky. It only seems natural that per capita banking resources are low in an economically under-developed region. In fact, this is the exact argument that supports public funds as the an indispensable source of capital necessary for the development of a new economic base in Appalachia (Appalachian Regional Commission, 1997). However, the theory of regional financial markets points to another possible cause of low per capita financial resources: the less than competitive institutional structure of the regional financial industry. It is in accordance with this line of argument that this paper designs the research methodology and necessary variables.
 
Methodology, Variables, and Data
 
    In analyzing the institutional characteristics of the banking industry in Appalachian Kentucky, this paper uses principal component analysis applied to a variety of banking performance and socioeconomic indicators. The extracted components are then used in a logistic regression to help distinguish banks in rural Appalachian Kentucky counties from those in non-Appalachian rural Kentucky counties, according to characteristics of banking firms embodied in these components. This strategy is used in order to control for the collinearity associated with the use of multiple variables.

    Fifty-four banking performance indicators are used in the principal component analysis, which can be divided into three groups of variables. The first group includes 13 variables, which are either directly taken from the bank balance sheet or income statement, or calculated by using information from the balance sheet or income statement information. These variables are bank aggregates that reflect the operating size of the banking firms. Specifically, variables include the amount of assets, total deposits, loans, interest income, interest cost, non-interest income, non-interest costs (total expense and its sub-components such as expenses on salaries, physical capital, and other items), net interest income (interest income minus interest cost), profits (total income minus income cost, i.e., the balance of interest income, non-interest income, interest cost, and non-interest cost), and the number of equivalent full time bank workers.

    The second group of indicators includes 18 financial ratios, calculated by using information obtained from the balance sheet or income statement. Four variables reflect labor productivity such as the amount of bank assets, deposits, loans, and profits, averaged by per bank employee; six variables represent asset productivity such as profit, loans, deposits, physical capital expense, wage expense, and other expense, averaged by bank assets; six variables reflect real resource use structure such as percentages of physical capital, salaries, and other expenses in the total non-interest expense, the amount of physical capital per worker, the amount of other expense per worker, and wage rates; and two variables reflect growth such as the asset growth rate and loan growth rate over the previous quarter.

    The third group of indicators consists of 23 variables and reflects the structural conditions in the banking market. The banking market here refers to the county, which is commonly used in academic study and regulatory practice concerning rural banking market. Six variables reflect the aggregate size of the financial market, which include the number of bank offices in a county, the number of thrift institution offices in a county (including savings and loan associations, and savings banks), the number of credit union offices in a county, the total number of financial institution offices in a county (the sum of bank, thrift, and credit unions), county population, and the total county deposits. Here deposits include bank deposits, deposits in thrift institutions, and shares and deposits in credit unions. Two variables reflect the market power of commercial banks. One such variable is the bank market share measured by the percent of bank deposits in the total county deposits in all depository institutions in a county (commercial banks, thrifts, and credit unions). The other measure is the squared market share, which is also a common indicator of market dominance (so called Herfindahl-Hirschman Index is the sum of all such squared values in a market). Four variables are measures of "banking density", i.e., the number of financial institution offices, the amount of deposits in depository institutions, bank assets, and bank loans for every 1,000 people in the county. Finally, a group of 11 variables reflect the location patterns of ownership and competitions. Of them, 4 variables record the ownership locations of banks, a value of 1 or 0 is assigned to each bank to indicate whether its ultimate ownership resides in an Appalachian county, a non-Appalachian county, a metropolitan county, or an out-of-state location; 3 variables are the percent of deposits of commercial banks, thrifts, and credit unions in a county that compete with a bank in the market; 2 variables are the amount of deposits held by metropolitan banks and out-of-state banks, competing with local banks; and the last 2 variables are the amount of deposits held by metropolitan and out-of-state thrifts, competing with local banks. These structural variables are designed to measure whether Appalachian banks are more likely to face competition from banks, thrifts, and credit unions in general, and banks and thrifts headquartered in metropolitan and out-of-state locations in particular, than non-Appalachian banks.

    The banking performance information is obtained from the bank balance sheet and income statement for the second quarter in 1997. Information for the thrift industry is obtained from the FDIC/OTS Summary of Deposits files for 1997. Information on credit unions is extracted from the National Information Center Website. In addition, county population figures are the estimates for 1997 by the Bureau of the Census.
 
Principal Component Analysis
 
    Principal component analysis with the Varimax rotation is performed on the 54 variables discussed previously. Fourteen components extracted have an eigenvalue of over 1. The eigenvalues of these components, their percent in the total variance, and cumulative percent of total variance are shown in Table 1. In total, 87.5% of the total variance in the data set is accounted for by the 14 components.
 

    The seventh component is clearly associated with two growth variables, 97.4% with asset growth rate, and 97.1% with loan growth rate. Therefore, it is interpreted as "Growth." Component 8 is called "Presence of Credit Unions" because of its high and positive correlations with the number of credit unions (78.0%) and with the deposits of credit unions (76.5%). The 9th component is moderately correlated with 2 variables measuring thrift institutions, 64.5% with deposits held by metropolitan thrifts, and 66.1% with thrifts in general. Therefore this component can be called "Competition from Metropolitan Thrifts." The 10th component is called "Loan-Asset Ratio" since it is strongly and positively correlated with the loan and asset ratio (89.1%). The next component is strongly and positively correlated with the non-Appalachian ownership (86.7%), and moderately but negatively correlated with the Appalachian ownership (-56.6%), indicating the presence of competition between Appalachian and non-Appalachian banks. Accordingly, this component is named "Competition from Non-Appalachian Banks." Component 12 can be neatly named "Wage Rate" due to its 86.1% correlation with the wage rate. The correlation between the 13th component with deposit-asset ratio is -73% and the component is therefore called "Low Deposit-Asset Ratio." The final component strongly but negatively (-88.4%) correlated with out-of-state thrift and thus is called "Less Competition from Out-Of-State."
 
Logistic Regression Analysis
 
    The fourteen components identified and defined above illustrate the general characteristics that are associated with the Kentucky rural banking industry. These components portray an industry that can be described by size, competition conditions separately attributable to market size, presence of thrifts, and credit unions, labor productivity, use of resources, banking availability due to market power, growth, wage rates, loan-asset ratio, and deposit-asset ratio. The task here is to use these components to predict the membership of banks and to establish statistical associations of the Appalachian banks with some of these characteristics. In estimation, 4 banks are dropped out of the data set due to their extremely large or small size.

    Table 3 shows the main statistical parameters obtained from the logistic regression. The chi-squared test for the model is statistically significant at the 5% level. The correct prediction rates are extremely high at 95.15% for the model; 94.7% for the non-Appalachian banks, and 95.9% for Appalachian banks. Statistically significant components
 

    Two components that act in accordance with the conventional wisdom concerning banks in distressed areas are Wage Rate and Low Deposit-Asset Ratio. Both components have a negative sign. For the former, this seems to indicate that Appalachian banks can be characterized by lower wage rates than non-Appalachian banks, a portrait consistent with the low income regional profile. For the latter, the negative sign indicates that Appalachian banks are less characterized by low deposit-asset ratio. In other words, the Appalachian banks have a higher deposit-asset ratio than their non-Appalachian counterparts. Banks in remote and isolated areas are more likely to obtain their liability through deposits, a feature that is traditional in banks but which is experiencing rapid change in banking, especially for large banks with good reputations which enable them to acquire liabilities via other means such as money market instruments.

    A few components demonstrate striking features that defy conventional wisdom. The component Bank Size has a positive sign, indicating that Appalachian bank membership is associated with large size. This is a striking result in light of the conventional notion that remote and isolated rural areas are characterized by small banks (Dreese, 1974). Although the conventional wisdom is true for non-Appalachian banks, Appalachian Kentucky banks are actually large in size compared with their non-Appalachian counterparts in rural Kentucky. Similarly striking is the fact that component High Use of Capital is of a positive sign, indicating that Appalachian banks are likely to use more physical capital than non-Appalachian rural banks in Kentucky. Since component High Use in Other Real Resources is not statistically significant, the lower wage rate and higher use of physical capital illustrate an Appalachian banking industry that allocates more real resources to physical capital (bank premises, furniture and fixtures, equipment and other assets representing bank premises, including capitalized leases, owned by the institution) than to the labor force.

    Components Low Market Power due to Market Size, High Per Capita Banking due to Low Monopoly, Competition from Non-Appalachian Banks, and Presence of Credit Unions provide crucial insights into the structural characteristics of the market facing Appalachian banks. All these four components have a negative sign, indicating that banks in Appalachian Kentucky is less characterized by these components than banks in non-Appalachian rural Kentucky. Specifically, a low degree of Low Market Power due to Market Size means that Appalachian banks are more likely to exert market power due to the small size of the bank market. A low degree of High Per Capita Banking due to Low Monopoly means that Appalachian banks are more likely to operate in an environment where per capital banking resources (the amounts of deposits, loans, and assets, and the number of bank offices) are low due to high market shares of individual banks. A low degree of Presence of Credit Unions means that Appalachian banks are less likely to face competition from credit unions due to the latter's scant existence than non-Appalachian rural banks in Kentucky. In addition, a low degree of Competition from Non-Appalachian Banks means that Appalachian banks face less competition from non-Appalachian banks compared with non-Appalachian banks. Given the distance decay effect, this last characteristic is hardly of any surprise. However, it does reinforce the effects from the previous three components. These four components, Low Market Power due to Market Size, High Per Capita Banking due to Low Monopoly, Competition from Non-Appalachian Banks ,and Presence of Credit Unions, collectively portray an Appalachian banking industry that is characterized by small market size, high market power from individual firms, low competition from credit unions, and low per capita banking resources.

    It should be noted that the large market power demonstrated in components Low Market Power due to Market Size and High Per Capita Banking due to Low Monopoly should not be associated with the large size of banking firms represented by component Bank Size. This is so because the two components are not correlated (in fact, zero correlation). Given this situation, it seems more appropriate to interpret the high market power in Appalachian bank markets as a result of the small size of the market and lack of competition from credit unions.

    When seen in light of the theory of regional financial markets, these findings concerning characteristics of banking market in Appalachian Kentucky seem to form a web of interactive relationships that may point to how the financial market in the Appalachian region hinder economic growth. Small, isolated, rural bank markets of Appalachia are prone to be less than competitive due to the their small size and a lack of institutional diversity. Such market imperfections would lead to relative market dominance by individual firms, which in turn would lead to financial segmentation. The financial segmentation would reduce the amount of financial resources that would otherwise come into the region under competitive market conditions. The result is the low per capita financial resources. In an interdependent economic system, a lack of readily available financial resources would discourage investment, cause slow growth, higher employment, and low income.

    Findings on market structure may also help explain some early findings in the paper concerning the high spending on physical capital by Appalachian banks. While profits in Appalachian banks do not particularly justify their high spending on physical capital, bank market structure seems to render explanation based on the Expense Performance hypothesis. According to this hypothesis, under imperfect market conditions, bank managers may choose to maximize utility instead of profit by expanding expense on the premises, furniture, etc. In a market characterized by the market imperfections as those seen in Appalachian Kentucky, the dominance of individual banks and a lack of competition, in conjunction with the separation of management and ownership, may reduce the managers' incentives for cost-cutting and profits-earning, and thus encourage the spending on physical capital items above that justified by necessity.
 
Summary and Concluding Remarks
 
    This study finds that the banks in Appalachian Kentucky conform to a certain extent to the conventional characteristics of financial institutions in economically distressed areas in terms of having a low deposit-asset ratio and low wage rate. However, the paper finds striking characteristics that defy the conventional wisdom for financial institutions in underdeveloped areas. These features include the large size of banks and over spending on physical capital. The most revealing characteristics of Appalachian banks are found to be operating in markets that are small in size, lack of competition, relative domination by individual banks, and low per capita banking resources. In light of the theory of regional financial markets, these findings seem to suggest that the institutional structure of the financial industry in the Appalachian region may hinder regional growth by cutting off the financial resources that would otherwise flow into the region.

    Various state and federal development programs in the Appalachian region overwhelmingly focus on the issues of infrastructure, human resources, and community development. While these public programs may be necessary to spread the seeds of growth, they are mainly forms of public investment, which tend to fluctuate with governmental budget cycle and the political atmosphere in public spending. The long-term, sustainable growth and development of the Appalachian region should rely on private initiatives, regional entrepreneurship, and the resources from nation's financial market. Therefore, development programs in Appalachian region should also address the issue of how to mobilize financial markets for Appalachian development. This study shows that in order to utilize private funds that are available from the national financial market, changing the institutional structure of the financial industry of Appalachian region may be an area that the public policy is able to address.
 
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