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Too Small to Survive

While federal banking regulators wrestle with the too-big-to-fail problem, the seemingly unending cost of rescuing small thrifts and community bank...

Instead of capping the size of banks or downright eliminating gigantic financial institutions, how about culling the small fry? It’s a question almost no one is asking. While small banks aren’t interconnected and complex the way a JPMorgan Chase is, they’re still dangerous.

There are numerous reasons why small financial institutions trouble me. Five years after the banking crisis, small thrifts and community banks are still failing, and many are close to collapse. They require close monitoring by federal regulators and have lost plenty of money for the U.S. government. And they have also been fertile ground for banking executives’ malfeasance.

Still, they pop up every banking cycle as the lending business booms and investors jump into financial services with the approval of Washington.

On Wednesday, Problem Bank List noted that at first quarter’s end almost 9 percent of all U.S. banks were still on the Federal Deposit Insurance Corp.’s troubled bank list. The list has 612 banks, representing $213 billion of assets. That’s an average of $348 million in assets per bank.  Although the FDIC does not release the names of the banks, “it is safe to say that no large banks are on the [list],” said Problem Bank List in a post.

The FDIC closed four banks in the first quarter and nine in the second. (Fifty-five were “absorbed” by other banks.) The dollar amounts are relatively small: the largest failure in the year-to-date was on April 26, when $317 billion-asset Douglas County Bank of Douglasville, Ga., was sold to another Georgia bank through FDIC receivership.

Though relatively small, these failures aren’t cost-free. The Douglas County intervention and sale means a loss to the FDIC deposit insurance fund of $86.4 million. And, to get the buyer to bite, the FDIC had to share in any future losses on $159 million of Douglas County’s loans. Those agreements often run for eight to 10 years depending on the type of loan. (The FDIC maintains that it saves money by not having to sell the assets into the market immediately, where buyers would want steep discounts.)

As a paper by Goldman Sachs’ Global Markets Institute pointed out this week, data shows that on a per-dollar-of-deposit basis, “realized losses from FDIC interventions” have been considerably higher at small banks. During 2006 to 2011, banks with between $160 million and $370 million of assets caused the FDIC to lose 31 cents on a dollar of deposits, while failures at banks above $50 billion produced no losses. Banks below $80 million in assets (yes, there are some) lost 37 cents on a dollar of deposits for the FDIC.

What’s more, a total of more than 400 banks with assets below $50 billion have yet to repay some or all of the government bailout they received through the Troubled Asset Relief Program. The government has gotten $14 billion in total and half of the bill is still outstanding. “The government has written off a further $3 billion to these small banks entirely,” according to Goldman. In addition, of the 330 that exited TARP,  40 percent did so by using funds from other government programs to do so, specifically one set up to stimulate small-business lending.

Goldman is not exactly an unbiased source on this issue, but its numbers stand up to scrutiny.

As to malfeasance, maybe it’s because they are easy prey, but the only executives convicted of any misdeeds related to the financial crisis have been from small banks.

Executives at the Bank of Commonwealth, a Virginia financial institution that reached $1.6 billion in assets in 2009, were found guilty of hiding the bank’s financial condition as it deteriorated and giving preferential financing to less-than-creditworthy borrowers so they could buy properties that the Bank of Commonwealth owned.

In another case, a former chief operating officer of the equipment finance arm of the Bank of Lancaster Country was sentenced to 15 years in federal prison last year for making bogus loans that led to $53 million in losses, a sale to PNC Bank and 300 lost jobs.

Small banks aren’t inherently bad. But they’re not inherently good either, as community-banking lobbying groups like to portray. Their closeness to a community can result in some pretty shady dealings.

Although often technically well-capitalized, small banks can also have shakier balance sheets. They often rely on deposits from brokerages, which chop up large-denomination deposits from other banks and sell them in small pieces. These deposits are less stable than deposits that come directly from customers’ putting funds in checking and savings accounts.

If regulators want to stabilize the U.S. banking system, part of their task will be to ensure that small banks have better sources of liquidity and stricter limits on leverage. Basel III might achieve some of this, if community banking lobbyists don’t succeed in getting the regulation watered down.

The good news is that federal regulators are discouraging the creation of new, or “de novo,” banks. In 2009, the FDIC heightened its scrutiny of newly chartered banks, and now conducts examinations yearly instead of every 18 months. It is also closely monitoring banks that have a high percentage of brokered deposits. In addition, last quarter was the seventh consecutive quarter in which no new FDIC-insured financial institutions were granted permission to operate. As American Banker reported in April, the last de novo bank approved was the $39 million Start Community Bank in New Haven, Conn.

If we want banks to be less reliant on bailouts and government intervention in a crisis, it would be fairly easy to take steps to shore up smaller financial institutions for the future. In the meantime, the FDIC will continue to broker rescues, until the last tiny troubled bank recovers, is wiped out or is absorbed. Then, when the climate is right, the spawning will take place again, and new banks will spring up in every community, until the next big banking crisis. And round and round we go.