Smaller banks struggle to recover, failure rate higher in 2010 than 2009

While most sectors and metrics of the U.S. economy have improved or at least stabilized, bank failures have actually increased in 2010 from both 2009 and 2008.

So far in 2010, 118 U.S. banks have already failed, compared to the 84 banks that have failed January 2009 through August 2009, according to the FDIC.

Including August numbers, banks are failing at the rate of 14.75 banks per month in 2010. At this rate, there will be 177 bank failures this year, compared to 140 in 2009 and 25 in 2008.

The vast majority of failed banks from 2008-2010 have been smaller banks that have less than $10 billion in assets -- in fact, about 80 percent of all failed banks had less than $1 billion in assets, according to NERA Economic Consulting.

In almost all cases, the deposits of the failed bank were assumed by another financial institution.

Michael Cosgrove, principal of the Econoclast in Dallas, said bank failures are a lagging indicator, meaning its deterioration and recovery lags those of the broader economy. Indeed, bank failures did not peak until third quarter 2009; by then the worst of the recession was already over and economic recovery was gaining momentum.

Currently, about mid-way through third quarter 2010, banks are still failing at an alarmingly high rate. Cosgrove said the smaller banks have a larger share of their portfolio in real estate compared to big banks. Consequently, the quality of their balance sheets remain poor as the U.S. real estate sector continues to struggle with the aftermath of its crash.

Banks like these will likely fail for the remainder of this year and the next year; indeed, they will continue to fail until the real estate sector stabilizes, said Cosgrove.

In addition to their real estate problems, small banks are struggling with lending revenues; they are constrained by regulators limiting the amount of loans they can make and a dearth of creditworthy borrowers.

Dividing the data by quarter, 21 banks failed in first quarter 2009, 24 in second quarter 2009, 50 in third quarter 2009, 45 in fourth quarter 2009, 41 in first quarter 2010, 45 in second quarter 2010 and 32 so far in third quarter 2010.

Interestingly, bank failures have been inversely correlated with U.S. economic performance and the stock market. In 2008, the stock market plunged 37 percent. In first quarter 2009, it dropped another 14 percent percent. Then, from second quarter 2009 to first quarter 2010, the stock market surged 44 percent.

Similarly, U.S. GDP contracted at an annual rate of 4.9 percent in first quarter 2009, contracted 0.7 percent in second quarter 2009, expanded 1.6 percent in third quarter 2009, then expanded 5.0 percent in fourth quarter 2009 and advanced 3.7 percent in first quarter 2010.

Meanwhile, as illustrated above, the number of bank failures were relatively low from 2008 to the second quarter 2009, but picked up and remained high since the third quarter of 2009.

In the second quarter of 2010, the economy hit a soft patch. The stock market declined 12 percent and GDP growth slowed to 2.4 percent. The number of bank failures is little changed and remains elevated at 45 in this period.