Small banks seek aid program to avoid insolvency

From MarketWatch:

Big banks have gotten not only the lion's share of the public's attention during the economic crisis, but they have also gotten the lion's share of the government bailout money, leading their smaller counterparts to begin clamoring for their share of the federal largesse.

Experts now predict that as many as 1,000 small banks may fail before the economy recovers, and efforts have intensified to have Treasury launch a program that would direct more funds from the TARP to those troubled smaller institutions.

Lobby groups for small banks are seeking to have Treasury develop a program to provide TARP funds to small stressed banks on the cusp of a default. Under the plan, the aid from the government would be equal to the amount the banks could raise in the private markets. For example, a small bank could be eligible for $10 million in TARP funds from a so-called "matching program" if it could show a commitment of $10 million from private investors.

Banks seeking matching funds would need to demonstrate to their state and federal regulators that if they could remove a handful of large bad loans from their balance sheet they would become viable institutions for years to come.

Backers of the proposed program argue it is vital because it would give a much-needed boost to a massive financial sector that is critical to the nation's financial system. Small banks are expected to continue to struggle with large commercial loan losses, a problem that will drive a larger number of small banks into insolvency in the years to come.

The program is important, said ICBA's Cole, because the Treasury hasn't implemented a so-called "Legacy Loan Program," that would use public and private funds to remove toxic mortgages from bank balance sheets. That initiative - which has been stymied by administrative and bureaucratic delays -- would help small institutions more than larger ones because they have more "whole loans" on their books than larger banks.

A recent report by the TARP Congressional Oversight Panel suggests that whole loans are a threat to smaller public banks, with $600 million to $100 billion in assets. Small banks would need to raise significantly more capital, based on pessimistic assumptions the COP considered, as the estimated losses will outstrip the projected revenue and reserves.

The matching program could also complement the TARP capital infusion program, which community bankers argue hasn't helped a sufficient amount of small banks. So far, an estimated 500 community banks have received TARP funds -- about 6% of the 8,000 small U.S. banks.

James Wheeler, a partner in the financial institutions group at Bryan Cave LLP in Washington, said many smaller bank executives have told him that such a program would be vital for their survival. He pointed out that a number of small banks seeking additional TARP money were denied additional funds, while other institutions continued to be rejected. The amount of money involved, is significantly less than the cash infusions provided to larger institutions, he added.

"If you have two bad $1-million loans that are wrecking your balance sheet, a joint funding of $20 million from both the Treasury and private investors could make a big difference," Wheeler said.

The Federal Deposit Insurance Corp., which has a depleted deposit insurance fund, is generally inclined to support such a program, in part, because it could help smaller banks return to viability and escape the kind of failure that requires capital infusion from the agency's drained deposit insurance fund.

Opposition

However, the program would be controversial because the Treasury would be providing funds to faltering banks from a program that was not initially designed to help troubled institutions. Also, unlike large institutions, a smaller bank failure would not have systemically negative impact on the markets, discouraging the need for such a program, said Dwight Smith, partner at Alston & Bird LLP in Washington.

"They are a source of commercial credit to communities that the big banks may not provide but their failure is not systemically risky to the economy," said Smith.

The program would also face administrative difficulties and be susceptible to allegations of political intervention, in part, because regulators would have a hard time identifying which banks should be eligible for the program and which shouldn't.

"Every congressman that has a bank in his or her district would want to help it out," said Nancy Bush, director of NAB Research Inc. "The major problem is not a philosophical one, but it is an administrative problem about who allocates the money and by what qualifications and who doesn't get it."

Critics also argue there could be other problems at the institution that its managers aren't telling regulators about, or they aren't aware of yet. The concern is that a bank receiving taxpayer funds would simply fail six months later.

"When looking at the bank, there could be other time bombs the problem institution isn't telling you about or doesn't know about yet," said Bert Ely, president of financial advisory firm Ely & Company Inc. "Is the government assistance in any way going to save the bank or merely delay its failure?"

Ely added that problem banks, even with cash infusions, contaminate the local credit marketplace and may still not be positioned to do sound lending.

Another problem is the structure of the matched funds. Ely points out that Treasury would likely seek to provide TARP funds that come as senior preferred shares that would match common shares provided by private capital. However, private investors are skittish about making investments, particularly if they would become common investors that could be wiped out, Ely said.

"Treasury is going to have to make it so that private investors can see a way towards a return on their investments," said Bridges.

Voss, head of the First DuPage Bank in Illinois, said he believes there are a group of community banks in Illinois and the U.S. that would greatly benefit from such a matching program if it could be structured in a way that would encourage private investors to participate.

"This concept of matching funds sounds good but finding the private investments is something that is going to be difficult to happen," said Voss.

A matching program would not be for heavily distressed banks on the FDIC's troubled institution list - only those on the verge of being placed on the list. The bank regulator said last month 416 banks were on its "problem list," up from 305 in June.