Small Banks Need Capital, Too, But Could Face Harder Time

Big banks aren't the only ones under stress—their smaller competitors also need to raise billions in capital to meet tighter government standards but may have trouble doing so, some analysts believe.

While investors have focused mostly on the nation's largest 19 banks that were the subject of the government stress tests, shares of some smaller banks have been getting pummeled since last week's rollout of the test results.

One of the reasons: the stricter capital requirements for all banks—not just the 19 biggest—may prove too onerous for some of the regional and community institutions, causing some of them to fail.

"Most of these little banks won't be able to do it," said Richard Bove, banking analyst at Rochdale Securities. "We're headed to a situation where the focus is going to be on small banks. The small banks are going to fail in, I think, pretty large numbers. I'm guessing 150."

The news may come as a bit of a shock to investors, who have been told for months that the smaller, regional banks are generally healthier than the big institutions—mainly because they avoided risky mortgage-related debt that imploded last year. But the credit crisis has made it difficult for all banks to raise capital, which could cause problems as the government imposes tougher requirements on the smaller banks down the road.

The government last week said the stress-tested banks would need to raise $74.6 billion to meet guidelines. Since then, many of those banks have put the process in motion to raise the necessary capital.

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But a privately conducted separate stress study released earlier this week using guidelines similar to the government's showed that community and regional institutions will have to raise capital as well.

Of the 161 companies outside the 19 stress-tested institutions, 59 are going to need about $12.8 billion in capital to meet government standards, financial services firm Keefe, Bruyette & Woods said in an independent stress test.

Atop the list is Huntington Bancshares , a Columbus, Ohio institution that will need about $1.6 billion. The company's share price, though higher Thursday, is off about 20 percent for the week.

A Huntington official said the bank wouldn't comment specifically on the study but did say KBW's standards are different than the government's. In its narrative, KBW did say there were disparities between the tests but said many of the numbers were "comparable" to the government model..

Similarly, Montgomery, Ala.-based Colonial BancGroup also is among the banks at the top of the list, requiring $840 million to meet the guidelines. Colonial's shares have tanked as much as 35 percent since their opening Tuesday, when the KBW report was released. A Colonial spokesman declined comment.

Other leaders on the list include Zions Bancorporation , which needs $1.3 billion; Marshall & Ilsley , $1.2 billion; and M&T Bank , $800 million, according to the KBW figures.

The smallest capital need of those who will need to do so comes from MetroCorp Bancshares , which could require $10 million and announced earlier this week it is suspending its dividend.

Requests for comments at the other banks weren't immediately returned.

Many of the banks will have trouble raising capital due to a variety of factors, among them a "crowding out" factor in which the larger banks will scoop up the lion's share of the investment money available, and the big banks' diversity of business that contrasts to many smaller institutions' stock-in-trade of basic retail lending.

"The ones that can't access capital are going to have to basically get on their knees and go to a larger bank to take them over," said Michael Cohn, chief investment strategist at Atlantis Asset Management in New York. "Over the next six months there's going to be some consolidation with the banks that can't raise capital, that are OK now but don't meet the stress-test guidelines. Basically the government's going to force them to consolidate."

An additional factor, Bove suggests, is a fundamental desire by the government to knock out the weaker community banks and concentrate financial power in the hands of larger institutions.

That would fit into a philosophy that the comparatve lack of mega US banks and the capital to which they have access makes domestic corporations less competitive with their foreign counterparts, he said.

"The policy of the US government from the mid-1980s on has been to try to eliminate as many small banks as possible, although I doubt any government would admit that's what they are doing," he said.

Implementing the stress tests and putting the large banks into position where they would become over-capitalized is consistent with a strategy the government has been implementing since the administration of President George H.W. Bush.

Indeed, bank earnings have soared since the early 1990s, coinciding with government efforts to force banks into increasing capital.

Commercial bank earnings exploded in the decade—from just under $16 billion in 1990 to almost $49 billion in 1995 to $74 billion in 2001. Bank earnings peaked out at $128 billion in 2006 before falling to $99 billion the following year, according to Federal Deposit Insurance Corp data.

The drop in earnings, due in large part to the subprime collapse and the ensuing credit crunch, has government regulators hungry again for recapitalization, something that should provide a boon to bank balance sheets.

"I know that when banks get into that condition you get earnings explosions in the subsequent three- to five-year period," Bove said. "I don't see any reason why it won't happen this time unless we are slipping off a cliff toward depression, which I don't think is happening."

For investors, those looking at small bank stocks will have to wrestle with the notion that a group once considered the safest bet in the industry could come under intense pressure.

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To be sure, though, some of the community banks will emerge from the process and could even come out stronger. Investors will use a variety of gauges to determine which way to go, and some portfolio managers speak of conducting their own stress tests to determine the new investment paradigm.

Ability to repay and willingness to accept government bailout money from the Troubled Asset Relief Program also will play a role. Those that do have diverse business models also should prosper.

"Our general approach has been throughout this whole episode to avoid firms that have taken TARP capital, be they large or small," said Thom Forsha, co-portfolio manager for the Aston/River Road Dividend All-Cap Value Fund in Chicago. "There are a number of small banks that did not and remain very attractive investments. That's where we've focused our efforts."

At the same time, even some of those listed by KBW as not needing capital have done poorly so far this week. Access National , for instance, is off 8 percent since the release of the KBW analysis.

More broadly speaking, many of the smaller banks are listed on the Nasdaq, which is heavily weighted toward tech stocks but has slipped more than 3 percent since Tuesday.

"Until we get out of the woods with the banks it's all dead money," Atlantis's Cohn said. "I'm personally taking a little money off the table here. I've gotten people back almost (to even) and I'm willing to sit around and wait to see what happens here."

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