Don’t Sweat the Small Stuff

Story Highlights:

• With the government's bank stress tests over, attention is now shifting to smaller banks' health.
• In a Wall Street Journal study, 940 small and midsized banks could face over $200 billion in total loan losses, and more than 600 could see their capital shrink to worrisome levels.
• Recessions always claim smaller banks, and historically, the US banking industry has always emerged intact, if not leaner and meaner.
• Banks are likely to get a lot more government help if needed—regardless of size.
• An estimated total loss of roughly $200 billion in a worst-case scenario is but small change when scaled correctly.

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The big banks hogged most of the spotlight throughout the financial crisis and ensuing months, what with their trillions of dollars in write-downs necessitating billions in government bailouts. But as the government's bank stress tests concluded rather anticlimactically—with all 19 big banks found able to survive the worst-case scenario (pending some additional capital requirements), attention is now shifting to smaller banks' health.

The Wall Street Journal examined 940 small and midsized banks using the government's stress tests. Under the stress tests' worst-case scenario, the WSJ estimates total loan losses at these banks could reach over $200 billion, and more than 600 could see their capital shrink to worrisome levels. Extrapolate that to 92% of all American banks (of the 8,300 banks in America, 92% are considered small or midsized, with assets below $1 billion), and the banking system seems doomed indeed.

But a few things must be considered. First, smaller banks tend to go under by the dozen during a recession—this is nothing new—and the US banking industry has always emerged intact, if not leaner and meaner. More than 1,200 institutions failed during the savings and loan crisis; so far, there have been 58 bank failures since January 2008.

Second, banks are likely to get a lot more government help if needed—regardless of size. A current FDIC proposal could even benefit smaller banks at the expense of big banks. The FDIC is considering how to levy a one-time fee on member banks to replenish its deposit-insurance fund, from which it draws to help troubled banks. Its proposal could make bigger banks pay a higher fee if the fee is based on assets vs. deposits. And in a recent speech, Treasury Secretary Geithner hinted repaid TARP funds could be recycled to smaller banks as needed.

Third, an estimated total loss of roughly $200 billion in a worst-case¬ scenario is but small change compared to the trillions we've already seen in write-downs, the trillions in new spending, and our $14 trillion US economy. When scaled right, $200 billion in maximum losses is far from Armageddon territory.

It's no secret banks face a tough road ahead. There will likely be more loan losses, more regulation, and more punitive restrictions. But the financial system is undoubtedly stabilizing, with Libor and the Ted spread signaling credit markets are returning to normalcy. And the banking environment right now is very profitable thanks to steeply positive yield curves. It's easy to sweat the small stuff—but it helps to look at the bigger picture.