Small banks, big problems

NEW YORK (Fortune) -- The New Year is shaping up to be a rough one for community lenders.

Dozens if not hundreds of small banks figure to disappear in 2010, as a weak economy and regulatory pressure lead to more failures and mergers.

President Obama met Tuesday with eight community bank executives, including the chiefs of German American Bancorp (GABC) and Monadnock Bancorp. Obama hailed the bankers as playing a "vital function," and cited "enormous opportunities" for economic growth if they keep lending.

The community bankers surely made for a more receptive audience than the big-bank CEOs Obama addressed last week. Small-business lending, after all, is what smaller banks do best. The Independent Community Bankers of America trade group notes that community banks account for almost a third of small business loans under $1 million.

But the smallest banks have been dropping like flies for years, as they labor to master expensive new technologies and regulatory changes -- at a time when giant banks spawned in a rash of megamergers are expanding their reach.

The consolidation trend should only strengthen in the coming year. Dozens of banks will fail as their customers retrench in a weak economy. Meanwhile, regulators will keep pressuring bankers to lend cautiously -- prompting weaker banks to merge into stronger ones as growth remains elusive.

"A lot of the regional and community banks are going to struggle to remain independent," said Terry Moore, a managing director at Accenture. "We're going to see those numbers shrinking."

They have shrunk a lot already. The number of commercial banks with assets of $50 million or less has dropped by more than 3,600 since 1994, to 1,198, according to recent Federal Deposit Insurance Corp. data.

At the same time, the deposits held by the biggest banks have soared, following years of megamergers punctuated by last year's bailouts. The five biggest banks -- Bank of America (BAC, Fortune 500), Wells Fargo (WFC, Fortune 500), JPMorgan Chase (JPM, Fortune 500), Citi and PNC (PNC, Fortune 500) -- held 37% of all deposits at June 30. That's triple the top five's share 15 years ago, according to the FDIC.

Questions about concentration at the top of the industry have been intensified by a steady drumbeat of small bank failures. This year has brought 140 bank failures, and nearly four times as many institutions are now classified by regulators as troubled -- meaning failures in 2010 are likely to reach into triple digits again.

Given those daunting numbers, the FDIC appears to be focusing on closing weak banks rather than luring in new capital from the likes of private equity investors.

Yet at the same time, even troubled megabanks such as Citi have been able to raise staggering sums in the marketplace, in part because it has become clear the government won't let them fail. This apparent disconnect chafes some observers who say private investors could be helping to rebuild small banks.

"What Citi tells you is there are enormous pools of capital willing to take risk, given the right circumstances," said Hal Reichwald, a lawyer at Manatt Phelps & Phillips in Los Angeles who represents investors.

With tens of billions of dollars of souring construction and commercial real estate loans on their books, regional and community banks could use some of that capital. But the weak economy and the wave of bank failures have made it hard for smaller banks to raise new funds.

Of course, economic stress spells opportunity for stronger community banks. Ted Peters, CEO of Bryn Mawr Bank Corp. (BMTC) in suburban Philadelphia, said he sees the wide-open merger landscape in financial services as "a once-in-a-career opportunity" for him and his $1.2 billion firm.

Bryn Mawr agreed last month to acquire First Keystone Financial, a Media, Pa., savings bank, and Peters said he's considering possible tie-ups with investment firms and other financial institutions.

Peters said the fact that community banks didn't help blow up the economy with derivatives has resonated with lawmakers and now creates another selling point with customers.

"Right now, the big banks are being portrayed as the bad guys and the other 8,100 banks are being seen as the good guys," he said.

He expects this perception to enable his bank to continue to grab market share over the next year. But he isn't expecting any miracles.

For instance, Obama pledged Tuesday, in response to complaints from the Independent Community Bankers of America about heavy-handed regulation, to "see if there are possibilities to cut some of the red tape."

But Peters remains skeptical. "I've been a bank president for 25 years, and I'm still waiting for them to cut red tape for the first time," he said.