As the American economy shows encouraging signs of improvement, one crucial relationship threatens to impede expansion: Many small banks remain in poor shape, making them unable to lend to small businesses -- a potentially significant source of new jobs.
Last week, the Federal Deposit Insurance Corp. which guarantees the savings parked at 7,715 American banks, disclosed that the number of banks it considers troubled swelled to 860 from 829 during the summer months. The vast majority of the additions to the "problem" list are small institutions.
For small businesses, the troubles of small banks pose a crucial a barrier to expansion plans. Such businesses typically prefer banking with smaller institutions, and are often ignored by larger lenders. But many small banks are confronting balance sheets full of bad commercial real estate loans, forcing them to set aside increasing pools of dollars in reserve to cover growing losses. That has left many unable to lend even to companies with good credit and solid sales prospects.
At the same time, many small businesses are themselves struggling, making them reluctant to borrow, depriving local banks of a further source of revenue. Locked in a codependent relationship, small businesses and the institutions that lend to them are holding each other down, constituting a potentially major barrier to a still tentative economic recovery.
For a nation still facing near-double digit unemployment, this is a problem. Small businesses create the majority of the country's jobs -- the Obama administration puts that figure at 70 percent -- meaning that the strains of smaller communities imperil the broader economy.
"There are plenty of banks out there, unfortunately, who cannot make loans, or are being very tight with their credit," said Ray Davis, CEO of Portland, Ore.-based Umpqua Bank, which has about $12 billion in assets, and lends throughout the Pacific Northwest. "They're either weakened, or the FDIC said to them, 'You cannot make any more loans, and if you do, you're in trouble. You cannot expand, you cannot grow.'"
The root of small banks' problems lies in their balance sheets. Many lent aggressively to commercial real estate developers during the boom while keeping few dollars in reserve. Now that real estate prices have plunged, their assets are worth far less. That has made many small banks potential targets for the FDIC, which is supposed to seize banks that are unable to meet demands for withdrawals from ordinary depositors.
After accounting for the institutions it added to the problem list between July and September, the FDIC now considers about 11 percent of all banks it regulates to be at risk.
"It's a vicious cycle," said Edward Friedman, an economist at Moody's. "Commercial real estate crashed, and the small local banks themselves became insolvent or got on the target list."
Unlike their Wall Street cousins, small banks don't have the means to engage in large-scale financial transactions, so most of their profits come from local lending. Commercial real estate lending tends to be a particularly large part of their business, constituting 28.5 percent of the holdings of banks whose total asset size is between $100 million and $1 billion, compared to 8.6 percent at banks whose assets are larger than $10 billion, according to the new FDIC report.
Small banks must also pay higher interest rates for the cash they use to deliver loans, given that they are seen as a greater credit risk. When commercial mortgages tank, small banks feel the squeeze.
"A lot of these banks have the vast majority of their assets tied into the local economy," said John Silvia, chief economist at Wells Fargo. "When that local economy has trouble, then they have problems as well."
Many small businesses feel more comfortable dealing with a local bank, while complaining that larger institutions treat them as a low priority. Small business owners value the face time they can gain with their local banker, whom they may encounter at the local mall or on the golf course. When small business owners have trouble gaining credit, these relationships can prove crucial, enabling them to secure an easing of standards or a little extra time to come up with a payment.
"Small community banks are more personality- and community-oriented," said Michael Rogers, spokesperson for the Small Business Association of Michigan. "A small business owner who wants to start a business or expand is more likely to have socialized with the bank president or bank board and developed a personal relationship."
Joseph Ruiz, owner of Rhapsody Painting & Environmental Services, a San Francisco business whose activities include safely removing hazardous lead from old paint jobs, fondly recalls dealing with his local bank, Cal Fed, before Citibank took over the institution in 2002.
January was the worst month in the history of the company, Ruiz said. Rhapsody Painting, which Ruiz said makes just over a million dollars a year, was a week and a half late paying $50,000 toward a $100,000 credit line from Citi. Because of that delay, the business's account missed a $300 automatic interest payment -- a payment that, Ruiz said, his business could easily have made if only he had known it was due. But instead of calling him and offering fair warning, Ruiz said, Citi terminated the credit line. Making matters worse, Ruiz didn't find out about the termination until after he had paid the $50,000, which subsequently got "lost in the cracks," he said. It took him three months, and a host of bounced checks, to recover the credit.
"There was really no kind of business relationship, of calling me," Ruiz said. "We had hard times, there was no forgiveness and no help. It was just shoot the guy because he missed one $300 payment."
In response, Citi spokesperson Robert Julavits said in an e-mail, "Citibank is committed to improving the experience of our small business customers, and over the last year we have significantly expanded our resources and ability to serve this crucial market."
As more small banks go onto the FDIC's problem list, and as they eventually become consolidated into larger banks, more small business owners like Ruiz are likely to contend with impersonal megabank bureaucracy.
And financial experts expect the bleed to continue.
Small banks are "basically in slow liquidation mode," said Mark Sunshine, chief executive of financial advisory firm MA Sunshine Capital. "They're the backbone, supposedly, of small town America and Main Street."
The trouble is not simply that small banks do not want to lend. In many communities, their would-be customers are themselves weak and reluctant to borrow. According to a recent report by the National Federation of Independent Business, 52 percent of small business owners in October said they did not want loans. Demand among small businesses for commercial and industrial loans has been declining since the end of 2006, with especially large drops during the worst of the financial crisis, according to surveys conducted by the Federal Reserve. Although demand recently has been slightly stronger than two years ago, the trend is still downward.
"Demand for credit has definitely slowed," said Davis, the Umpqua Bank chief executive. "When things get difficult, people aren't out borrowing money. If anything, they're deleveraging."
This reality is often masked by the political narrative, in which all banks are supposedly sitting on their money to the detriment of the economy. But in many local communities, the situation is far more complex, with banks and businesses dependent upon one another and neither faring well as a result.
"I know many small business owners say, 'I can't get a loan,' but in a lot of cases that's because their prospects don't look that good right now," said Dean Baker, co-director of the Center for Economic Policy and Research in Washington. "You have a really bad economy."
The economy is waiting for co-dependence to give way to mutual sustenance, with banks feeling emboldened to lend through stronger balance sheets, and small businesses more eager to borrow as the recovery strengthens.
"You have to have two things happening," said Paul Merski, chief economist at Independent Community Bankers of America. "You have to have the banks in a solid capital position to lend, and then you need to see the loan demand come back in earnest as well."