Demise of small banks an undervalued threat

It wasn’t so long ago that Washington bailed out the largest banks in the United States, prompting a wave of criticism from many quarters. But today, the banking system is seeing the effects of non-intervention, which has allowed for the collapse of 100 small American banks in 2009 alone. With these developments, the small bank model is slowly disappearing — an issue complicated by the fact that small banks hold a substantial portion of real estate loans for commercial properties.

There are many signs that the economy as a whole is stabilizing, but trends like these are ominous. Luckily, the failure of these financial institutions has not had much of an effect on the everyday lives of their investors, thanks to the Federal Deposit Insurance Corporation. The FDIC has been closing an increasing number of failing banks, but they have been preserving depositors’ assets in the process.

Granted, there are limits on FDIC insurances to investors; currently, the FDIC covers around $250,000 per account. But the institution’s funds, which previously ran over the $50-billion mark, have still been under increasing strain. In order to balance its budget, the FDIC has begun imposing higher and earlier payments on healthy banks — the costs of which will no doubt be transferred to investors one way or another.

Furthermore, because the current failures are affecting small banks, the old small-town bank is becoming a thing of the past. New ownership by bigger institutions affects communities in somewhat insidious ways. Although most people’s actual money will remain secure, tighter lending policies and the discontinuation of favorable credit and interest rate policies may increase the financial strain on longtime customers.

The larger banks, such as JPMorgan and Goldman Sachs, have been strengthening and rebuilding in recent months. But in many ways, their improvement comes at the expense of their smaller competitors. When the FDIC shuts down a bank, it transfers that institution’s assets into the hands of another bank, which can then close branches and make institutional changes to lower the actual costs of the purchase.

Proponents of this strategy argue that failing banks need to be closed for the sake of the economy at large, because when banks fall into debt, they become increasingly unwilling to lend, stifling the potential investment of many customers.

A main reason why small banks are so critically affected is that members invest overwhelmingly in local real estate projects. But as strip malls and housing developments become less profitable, banks are left feeling the burn of their borrowers’ bankruptcy.

Small banks didn’t always fund housing ventures. In the 1970s, the government worked to fight inflation by raising interest rates and homeowners saw the value of their properties rise substantially. Then at the start of the 1980s, the savings and loan industry, which had funded most major construction projects and private home purchases, collapsed. As the number of new properties being built fell, their demand grew, raising prices and interest rates even more dramatically. At the same time, federal housing assistance decreased and homelessness skyrocketed.

This problem has never truly been resolved, forcing many Americans to pay exorbitant prices for housing or else do without. And most homebuyers have to pay extortionary interest rates on loans which often span half a lifetime, since the average income is not nearly enough to reasonably match the cost of a home. The biggest problem for the banking system lies in the fact that today, roughly half of all commercial real estate loans rest in the hands of small banks. As people lose their jobs and cannot pay off their loans, these institutions are failing rapidly.

Unfortunately, the financial forecast is equally grim: Rather than recovery, analysts expect that increasing numbers of small- and medium-sized banks will be facing closure in the next few years. In fact, Foresight Analytics, a real estate market analysis group, estimates that close to 600 institutions may be at risk of collapse by 2011.

There is still a shred of optimism; larger banks tend to only place a small portion of their investments in commercial real estate, and so remain relatively insulated for now. But even with the big banks’ overall progress, dealing with the baggage of smaller institutions will be not be a fast or simple process.

Rosaleen O’Sullivan is a junior majoring in English and international relations. Her column, “Global Grind,” runs Mondays.