BUSINESS
11/24/2010 09:30 am ET | Updated May 25, 2011

Small Banks Suffer, As Banking Industry Strengthens

As the banking industry as a whole grows stronger, smaller banks are missing out on a recovery, a new report from the FDIC shows. Weakened local banks could signal trouble for small business.

Net income at FDIC-insured banks totaled $14.5 billion during the period from July to September, a dramatic improvement over 2009's third quarter figure of $2 billion. But the number of banks on the FDIC's "problem list" rose to 860, from 829 at the end of June. And it's the smaller banks that worry the FDIC.

Total assets of banks on the "problem list" declined during the quarter, from $403.2 billion to $379.2 billion, even as their ranks swelled to the most members since 1993. The list's new arrivals are small.

Local banks are a key source of funds for small businesses, which appreciate the personal attention that these banks can provide. For a small business with trouble getting credit, a local bank, where executives might know a business owner personally, is more likely to go easy on its standards.

Small business owners also say the human contact makes transactions more reliable than at big banks. "From a small business perspective, we've been extremely frustrated by the bigger banks that come in and out of the business. There's just no stability," Scott Hauge, president of Small Business California, said.

Trouble at small banks, then, spells trouble for small business. According to the Obama administration's estimate, small businesses create about 70 percent of new jobs.

"To the extent that small banks are suffering more financial problems, that's really bad news for small businesses," Michael Rogers, vice president of communications for the Small Business Association of Michigan, said.

Small banks are far more numerous than their larger fellows. 91.4 percent of FDIC-insured banks have assets less than $1 billion.

FDIC chair Sheila Bair was optimistic about the banking industry overall, but warned that banks shouldn't get too confident. Expenses set aside to cover loan losses at FDIC-insured banks totaled only $34.9 billion, the lowest level since 2007. Banks cut their reserves by $9.6 billion.

"At this point in the credit cycle it is too early for institutions to be reducing reserves without strong evidence of sustainable, improving loan performance and reduced loss rates," Bair said in a statement.

As the WSJ notes, investors are abandoning small banks for big ones, expecting larger industry players to be in a better position to pay dividends. This investor behavior makes it more difficult for small banks to fund their activities.

In a column in Politico earlier this month, special White House adviser Elizabeth Warren, who has been charged with setting up the Consumer Financial Protection Bureau, described the challenges facing small banks. Here's Warren:

"One Ohio banker forcefully explained that his bank didn't believe in pricing tricks, but that he had to compete with lenders who do -- and who sell products that often appear to be cheaper. From his perspective, real competition in the credit market is less about who makes the best product and more about who can hide costs from the customer until it is too late."

This post has been updated to reflect additional reporting.