Economy: Why Are So Many Banks Still Failing?

While big institutions such as Citi, Bank of America, and Morgan Stanley have grabbed headlines and billions in bailout money, 81 small banks have shuttered their doors so far this year. Despite a rebound in the markets, hundreds of additional banks are expected to close in the coming months as consumers and small businesses default on loans and as local real-estate investments drop.

The Federal Deposit Insurance Corp. warned Thursday that small banks will not rebound from the recession as quickly as the rest of the economy. The FDIC oversees the country's 8,195 small to midsize banks by insuring their deposits, along with those of larger banks, though the fund that covers the deposits has shrunk by 40 percent this year. NEWSWEEK's Nancy Cook recently spoke with Lawrence J. White, professor at New York University's Stern School of Business, about the bank closures to come, why smaller banks are proving to be so vulnerable, and how their closures can dash hopes of economic recovery. Excerpts:

Cook: How many more small banks do you expect will fail, and do you have any ideas as to which ones?
White: We're talking about hundreds of banks. They're mostly going to be small banks that you and I have never heard of that have assets of a couple of billion dollars. By bank standards, that's small. [The bank divisions of financial institutions such as] Citi, Bank of America, and Wells Fargo have $1 trillion and change in assets.

Why are small banks failing more than big ones?
Well, bigger institutions have clearly been propped up by the Feds. If Citibank were a 20th of its size, it would have been put out of its misery a long time ago. It would have had the same fate as IndyMac or Washington Mutual. The little guys have gotten into trouble not because they got involved in the subprime-mortgage-related security fiascoes, but because prices on even good loans have fallen by 50 percent. That's a lot of loans to go underwater. For the most part, the small banks weren't caught in buying problematic securities. They got into trouble the old-fashioned way: by making loans that people couldn't repay.

Another part of the story is that smaller banks often are heavily involved in local commercial real-estate—shopping centers and strip malls. Those have been overbuilt and are in decline as well. As best as I can tell, that's what explains the experience of Georgia's banks, [which] had their share of residential real-estate problems.

So, how does this compare to the savings and loan crisis?
For the small guys, it is very similar. The S&Ls got into trouble because they made too many bad loans, much of [them] with respect to commercial real estate. When the dust cleared, there were over 1,000 S&Ls and over 1,000 commercial banks that went under. Because the commercial banks were pretty small, they barely made a dent in the FDIC at the time. They didn't break the bank, and they didn't require a taxpayer rescue. The savings and loan fund got decimated by those thousands of banks that closed. There had to be taxpayer support to the tune of $150 billion.

So, if small banks keep closing, how will the FDIC insure all of those deposits?
Today, the agency said the fund to insure people's money dropped by $10.4 billion. My guess is that the FDIC will limp through. Most likely, they will have to borrow money from the Treasury. The amount they borrow isn't going to be so big that it can't be repaid from future assessments on the banking industry. But there's not a whole lot that they can do. They simply have to close the banks up, find acquirers, make the necessary payments, and borrow money to insure the deposits. All of those things have to happen. It's all baked in. The important thing is to prevent the banking system from collapsing at the large and small bank level.

How are these bank closings going to hit the larger economy?
Over the long run, as the banks heal, that helps the economy heal. And as the economy heals, that helps the banks heal. They will be mutually supportive as they get better, just as they were mutually supportive on the way down. It's a vicious circle. I think going forward, by the end of this calendar year or early next year, the economy will improve. It looks like housing has stabilized, and that will help the economy. It will also help the banks.