Should the Bailout Have Done More for Small Banks?

It turns out that the bank bailout wasn't so helpful to small banks after all. Of course, the banking behemoths are all doing just fine these days; they're nearly back to business as usual. But the Congressional Oversight Panel for the bailout has found that many smaller ones that got aid are still struggling to survive. This is neither surprising nor a significant criticism of the bailout.

First, the problem is pretty well-described through a blurb from the lengthy report (.pdf):

CPP-recipient small banks appear to be no healthier than other small banks, and the broader small bank sector is struggling under the general strain of a poor economy and the more acute strain of commercial real estate liabilities. One in seven small banks in the CPP has already missed a dividend payment, and fewer than 10 percent of CPP-recipient small banks have repaid taxpayers. At the moment Treasury has $24.9 billion in CPP funds outstanding at small banks, and the prospects for full recovery are uncertain.

CPP is a fancy acronym for the bailout. Unlike the big banks, these smaller institutions are having trouble, despite the government assistance.

One immediate response to this is: well, of course small banks are having more trouble. They are far less diversified than the big banks. They often kept more risk on their balance sheets related to still-troubled residential and commercial mortgages. They also lack the trading platforms that Wall Street banks have, which have done quite well over the past year or so. Finally, smaller banks will have more trouble securing new outside capital. They generally can't sway a big investor in Singapore or even Santa Fe.

Did the architects of the bailout really expect small banks to recover as quickly as the large ones? It's hard to imagine that they would have. After all, the bailout was designed to stabilize the financial system under near collapse due to systemic risk, which explicitly required propping up the big banks.

The bailout was never really intended to benefit small banks. Sure, they were part of the industry, and to the extent that small capital injections might prevent some of them from failing, the Treasury was willing to play ball. But it was designed to reduce the systemic risk in the system, which was created by the big banks. It accomplished that feat very well. Its essential purpose was really to save large institutions from failing; the smaller ones just came along for the ride so appease critics who didn't want to only bail out Wall Street.

Moreover, it's hard to see what a better alternative might have been. Sure, you could have given these smaller banks cheaper or free capital, but the government isn't really in the businesses of blindly bailing out firms that don't pose any systemic risk to the economy (or have lots of political union-driven clout, like GM and Chrysler). While the failure of a few hundred small banks might be extremely lamentable, it won't bring down the financial system.

Without the bailout money, many of these smaller banks that continue to struggle would likely have failed by now. Some still might, while others will manage to wait out the storm. Ultimately, fewer banks will fail than would have if they didn't get capital from Uncle Sam. The hope that the government could save all of these institutions, some of which were under significant stress, simply isn't realistic. Even if the bailout manages to keep a significant number of them afloat that otherwise would have failed, then that's certainly better than the alternative.