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“Most small banks bailed out by US taxpayers during the financial crisis are unlikely to be able to repay the Treasury department, the Obama administration says.” (FT.com)

This came out in a blog post on the Treasury’s website yesterday. See “Winding Down TARP’s Bank Program,” by Timothy Massad, assistant Treasury secretary for financial stability. The Treasury does not expect “the majority of the nearly 350 lenders still partially owned by US taxpayers to repurchase in the next 12-18 months the preferred stock that Treasury received in exchange for bailing them out.”

The “smaller” banks are defined as those with less that $10 billion in assets.

This is just another piece of information that keeps leaking out that the state of the health of the US banking system is still not what it should be. We await new information from the FDIC on the number of commercial banks still on its problem list.

On December 31, 2011 there were more than 800 institutions still on the FDIC’s problem list. And, we know the problem list does not include all those banks that are “troubled.” The FDIC not only oversees the closing of troubled banks, it also is active in assisting “acquisitions” of banks that are experiencing difficulties. In 2011, for example, there were 92 banks that closed. However, from December 31, 2010 to December 31, 2011, 240 banks dropped out of the banking system.

The point is, the banking system is still not out of the woods. I am still standing by my prediction that the banking system will decline by more than 2,000 institutions over the next five years, dropping from 6,290 banks on December 31, 2011 to less than 4,000.

This decline will take place as the bigger banks in the United States become even bigger and as more and more big foreign banks increase their presence in the US. On this last note I refer you to the list of the world’s strongest banks published by Bloomberg Markets magazine. Of the top 10 strongest banks in the world, four were from Canada, and there were two more near these, one coming in as the 18th strongest and one as the 22nd strongest.

Note: only three American banks showed up in the top twenty, JPMorgan Chase (NYSE:JPM) at number 13, PNC Financial Services Group (NYSE:PNC) at number 17, and BB&T Corp. (NYSE:BBT) at number 20.

Adding to this movement, let me just add two more aspects of the future of banking that work against the smaller banks. First, there are the advancements in technology taking place in the world. Banks are becoming more and more wired (just notice the new bond trading platform introduced yesterday by Goldman Sachs (NYSE:GS), a development that is highly dependent upon scale) and more and more mobile. As the world, even the world of Main Street becomes more connected, the smaller banks will be less able to compete.

Second, the “shadow banking” sector continues to grow. The “new” idea is for banks to outsource some of their “core” small business lending to a new crop of loan funds…”shadow banks.” (FT.com) Financial innovation continues to accelerate.

And, how important is shadow banking? Well, take a look at the accompanying charts.

Shadow banking is huge and is growing. The smaller banks will not be able to compete with them.

The United States banking system still has major adjustments to go through. The structure of banking is changing. Whereas America has always had a “small bank” culture -- my banker grandfather was a staunch advocate of “unit” banking where a bank could only have one branch and must keep its business interests within that state. Within the current environment, however, is the Canadian banking system, where there are only eight oligopoly banks, more realistic?

The United States banking system is not stable in its current position. Huge changes are to be expected. From the Treasury blog post we understand that there still is a solvency problem. The Fed will continue to keep excess reserves in the banking system to preserve as much stability as possible for the health of the economy. The economy and the financial system are heading in the right direction but it takes a long time to unwind 50 years or so of economic mismanagement. We must understand the still fragile condition of the financial system in order to understand why the government and the regulators are acting the way they are.

Source: Small Banks Unlikely To Be Able To Repay TARP Funds