THE BLOG
09/03/2010 12:08 pm ET | Updated May 25, 2011

Small Banks May Fail but They're Still a Better Bet

Businesses fail. Or at least, a fair number should fail in a healthy capitalist system. Risk -- of failure and reward -- is an essential component of the American way of doing business. Americans have always risked personal and financial failure in pursuit of greatness, as when pioneers settled the West, scientists advanced medicine, or inquisitive minds invented personal computers. But large banks pervert this system: they revel in massive risk-taking with your money because they're confident that the federal government will rescue them from failure. Small banks, on the other hand, have to play the game fair. They do fail, as any business does. But since bank shareholders (not taxpayers) bear the expense, they must manage their risk, and forego profits in doing so. Still, there's no getting around it: community banks fail at much higher rates than large banks. All 118 failed banks year-to-date have been small or regional institutions. But the causes of these banks' failures -- and the explanation of why big banks don't fail -- are among the many reasons why you should move your money to a smaller institution.

One major reason why small banks are failing so rapidly is that they are heavily invested in local residential and commercial real estate. In other words, they're out of luck because, like us and our neighbors, they underestimated the severity of a real estate market collapse. As small banks fold while holding a local mortgage, big banks are propped up despite still gambling on investments that don't boost the economy.

When small banks fail, they don't bring America down with them. Unlike notoriously "too big to fail" commercial bank monstrosities, the government sees little reason to assist small banks. If the American economy is a forest, then a small bank's failure is a lone tree tipping. When a large bank teeters on insolvency, it threatens a ravaging forest fire. Big banks fail less frequently, as Federal Reserve Chairman explained on September 2, not because they're better run, but because they aren't allowed to fail. And they aren't allowed to fail because their failure threatens to uproot entire economy.

Effectively, then, big banks are holding the American economy hostage -- pay up, or else. Bernanke may have no choice but to rescue to them, but you do have a choice. You can move your money to a local institution that offers lots of upside when it succeeds (for example, they promote small businesses and make more local loans) and minimal impact when it fails. Typically, a failed small bank is acquired by a larger bank, usually through a deal brokered by the FDIC. Moreover, contrary to popular belief, when a small bank fails, your taxes do not pay for the lost deposits (deposits are lost because that money has been loaned out to borrowers who cannot repay). Banks insure your deposits through regular premium payments to the Federal Deposit Insurance Corporation (FDIC). Yet, when large banks fail -- or even threaten to fail, as we've seen -- the global economy cowers and could collapse. There isn't enough insurance in the world to guard against that loss.

Even if your local bank were to fail, your money will be safe and you won't be inconvenienced. My bank failed in August. I received an email from the FDIC on a Friday afternoon informing me that my bank had been closed by the agency, and that the acquiring bank would assume my deposits. All the branches have stayed open, my checks remain valid, and online banking access hasn't changed. Currently, the FDIC, an agency funded by financial institutions, not taxpayers, insures $250,000 per depositor -- including corporate accountholders -- plus an additional $250,000 for Individual Retirement Accounts. This coverage is more than enough for the vast majority of bank customers.

This is America. A place where risk and failure are an inevitable, even essential, part of the economy. These features of our system only become problematic when the someone other than the original risk-taker and reward-maker (ie, shareholders and executive officers) assumes the losses associated with failure. And that's exactly what has happened with the big six banks. There are two banking systems in this country: one is a dysfunctional mega-banking network where institutions take wild risks with depositors' money and redefine "success" to mean embarrassing profits followed by hemorrhaging losses requiring taxpayer bailout Band-Aids; the other is a system where moderate risk is the norm and failure is an unfortunate consequence. Which system do you support with your money?