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Number of problem banks isn't shrinking fast enough

May 31, 2013: 5:00 AM ET

The regulations meant to strengthen our big banks may be leaving the U.S. with more troubled small banks.

chart-problem-banksFORTUNE -- The number of banks in danger of failing is the lowest since the beginning of the financial crisis. That sounds like good news, until you consider this: There are still 11 times more problem banks in the U.S. than there were back in early 2007, before the financial crisis. And the number is shrinking slowly.

The slight dip seems particularly odd given the fact that there seem to be few signs of the financial crisis elsewhere. The Dow Jones industrial average (INDU) has recently been hitting new highs. The pipeline on Wall Street for the types of risky loans and structure products that got banks into trouble in the first place is starting to open up again. Hedge funds are making huge gains buying and selling subprime mortgages. And Fannie Mae and Freddie Mac are solidly profitable, and returning money to the Treasury.

Yet a large number of banks continue to languish. On Wednesday, the Federal Deposit Insurance Corp. said there are 612 banks in the U.S. that are in danger of failing. That's down from 651 at the end of last year, but it's still way up from 53 in early 2007.

MORE: This country needs another financial crisis

By end of 2009, that number had shot up to over 700, and peaked at 884 at the end of 2010. But while the way up was a steep incline, the way back to recovery has been more of slope and a gradual one at that. The question is why has it taken so long for U.S. banks to recover.

And the pace of bank recovery seems to be slower than in past crises. For instance, in the last major financial crisis in the U.S., the number of problem banks peaked in 1990 at 1,496. Two years after that recession ended, in early 1991, the list was down by over 60% from the top. The most recent recession has been officially over for nearly four years. Yet the number of troubled banks is still only down 30%.

Other than the total number of banks on its list, the FDIC says little about the problem bank list. It doesn't say which banks they are, or where they are located. A spokesman for the FDIC declined to comment on why the list is coming down so slowly.

The presumption is that most of the banks on the list are relatively small. The average bank on the problem bank list has just under $350 million in assets. JPMorgan Chase (JPM), the largest bank in the U.S., has $2 trillion in assets. And the average size of problem banks has dropped over the past two years from just over $450 million. The FDIC also reported on Wednesday that the conditions at the largest banks in the country continue to improve.

MORE: Jamie Dimon dominates, again

So part of the problem could be the outsized influence of large banks. The government seems less interested than in the past in helping small banks recover. That's probably because they matter less to the economy than they used to. In the S&L Crisis, regulators launched a multi-year effort to rid the banks of troubled assets. This time around, small banks that wanted it got a piece of the bailout pie. But the small bank bailout has mostly been a disaster. The bailout money seems to have done little to help their finances.

A recent report from the Government Accountability Office found that 107 of the banks on the FDIC's problem list got bailout money from the federal government. What's more, SIGTARP, the government agency assigned to police the bank bailout program, found that banks that got government assistance generally lent out less than those that didn't. Worse, the government has been ditching its stakes in small banks as fast as it can, despite the fact that many of those banks are still troubled.

One answer could be that the FDIC is being tougher on small banks in the wake of the financial crisis, leaving many banks on the problem list that in the past would have been given a clean bill of health in the past. That's a good thing.

Recently, there has been some debate about small banks and large banks and regulation. The Independent Community Bankers Association of America, which represents small banks, has jumped on the bandwagon that the U.S. needs to do more to end Too Big to Fail, which means more and stricter regulation of the big banks. The incoming president of the organization, John Buhrmaster, says he would be for Brown-Vitter, the bill that would force the big banks to hold a lot more capital.

MORE: How to solve the bank capital Goldilocks problem

But Tom Brown, a veteran bank analyst who runs Second Curve Capital, says that small banks remain much more concentrated in local commercial real estate loans than their larger rivals, and are therefore more at risk of failing in the next crisis than the big banks.

"If big banks showed the same sort of loan concentrations of many community banks, regulators would force out their managements," Brown recently wrote in a blog post.

What's more, as Brown points out, the big increase in lending to community banks' "bread-and-butter," small businesses, in the past few years has come from large banks. Mortgage lending, too, used to be a pretty good money-maker for the community banks, but the big banks took over that business more than a decade ago. One of the paradoxes of the financial crisis is that it left us with even bigger banks than before. Regulators are focused on doing what they can to make sure those banks are safe from failure. But those regulations may be making the road to recovery for the small banks that much longer. That's the trade off.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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