- The Washington Times - Friday, August 21, 2009

While attention has focused on the improving fortunes of the nation’s largest banks and Wall Street firms, an increasing number of smaller banks have succumbed each week to a slow tidal wave of defaults on consumer and business loans.

The Federal Deposit Insurance Corp. has closed 77 community and regional banks this year. Meanwhile, Goldman Sachs, JP Morgan and other large banks have reported robust profits, thanks in part to generous government support. The disparity has raised questions about the fairness of the “too big to fail” doctrine that keeps alive big banks that took risks that helped bring about the financial crisis.

Citigroup, Bank of America and other large banks were targeted for government rescue because their failures would have posed a danger to the broader financial system and credit markets. The nation’s more than 8,000 small banks hold only about 20 percent of total bank assets, while a few dozen large banks hold about 80 percent.

Christopher Whalen, managing director of Institutional Risk Analytics, said the government’s various subsidies, including debt and asset guarantees and stock purchases, have given big banks an unfair advantage. Without those subsidies, he said, the big banks would be insolvent “zombies” rather than reviving institutions in financial markets.

“As a small institution, not only are they going to treat you badly compared to the zombies, but they may even put you out of business,” he said. “If you’re not GMAC bank, for example, or some other government-sponsored institution, then you’re really out of luck.”

Mr. Whalen expects that as many as 2,000 small banks ultimately will be shut down as a result of the financial crisis and recession, which were largely spawned by risky lending practices at big banks and Wall Street firms.

Conservatives and liberals have criticized favoritism toward the largest institutions, though few have proposed measures to stop it, apparently out of fear of reigniting turmoil in the financial markets.

After plunging by more than half over the winter in response to the big banks’ woes, stock and credit markets have made major rallies since the government conducted “stress tests” on the 19 largest banks in March and put in place extraordinary rescue measures.

Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., has questioned whether banks should be allowed to become too big to fail. She has urged Congress to give the FDIC and other regulators powers to curb excessive concentration at banks, as well as downsize and close the largest institutions - just like the small banks - when their risky practices lead to insolvency.

The FDIC also has proposed making big banks pay higher insurance premiums because of the high costs of government rescue. The Obama administration has proposed harsher fees and other requirements to offset the privileged status of big banks.

The concentration of assets in the biggest U.S. banks started before the financial crisis last year but is only getting worse, said Nancy Cleeland, director of the Bailout Analysis Project at the Employment Policy Institute, a labor-affiliated think tank.

“There’s certainly been a lot of concern about the handful of banks that are considered too big to fail, and discussion about whether any institution should be allowed to get that big and complex,” she said. “But even as this crisis plays out, the big banks are getting even bigger … and the number of banks has been shrinking.”

“They have huge advantages over us,” said William Dunkelberg, an economist who co-founded a small bank in New Jersey in 2004. He said small banks are not able to benefit as much as big banks from the generous liquidity programs instituted by the FDIC and the Federal Reserve.

None of the small bank failures this year has been significant enough to disrupt the financial markets like the massive failures of Lehman Brothers, Washington Mutual and Wachovia last year, analysts say, but the increasing number is taking a toll.

The closures of small banks reduce competition and feed caution about extending new loans to consumers and small businesses.

The number of problem banks as a result of the credit crisis has forced the FDIC to augment its staff while rapidly depleting its $75.5 billion bank insurance fund. The agency has listed more than 300 institutions as troubled, but does not disclose which banks are on the list to avoid creating panic.

The agency brokered the biggest bank failure of the year earlier this month when it arranged the takeover of failing Colonial Bank by BB&T;, a healthier regional bank. The transaction exposed the FDIC insurance fund to more than $3 billion in losses, the most since the failures of Washington Mutual, Wachovia and IndyMac last fall.

“The past 18 months have been a very trying period,” said Ms. Bair. But she noted that the insurance reserves, which are funded by fees on banks that the FDIC has increased this year, have been adequate to cover all the losses while enabling the FDIC to make good on its guarantee of nearly $300 billion in consumer and businesses deposits in the banks it has closed.

The closures and government takeovers of failing banks have become so routine that they barely gets noticed each Friday when the FDIC makes its announcements. Bank closures usually occur over a weekend to minimize disruptions for customers while management is transferred.

While the banking crisis began with escalating defaults and foreclosures on home mortgages, the increase of bank failures in recent weeks has been driven by rising losses on commercial real estate loans, which are starting to default in large numbers. Community and regional banks hold a disproportionate share of commercial real estate and construction loans.

“Institutions in the banking industry with the highest commercial real estate and construction loan exposures are the most vulnerable to further credit deterioration and, therefore, are among those with the highest risk of failure,” said Standard & Poor’s credit analyst Robert Hansen.

“We also expect that loss severities among defaulted construction loans will be materially higher during this economic downturn compared with earlier downturns, given significant price declines among residential homes and condominium projects - especially in certain economically depressed states like Florida,” he said.

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