Every spring, like little pin-striped swallows returning to Capistrano, members of the Independent Community Bankers Association flock to their annual convention, where they complain, loudly and bitterly, about the myriad real and imagined forces relentlessly pushing small banks into oblivion.  I spent my entire banking career in and around big banks, not small ones.  So I must confess that I typically used to feel something like amusement at this annual spectacle.

This year, though, the community bankers have a point. 

And, if anything, they aren’t making that point as persuasively as they could.  Sooner than they would like, American policy-makers are going to have to make a decision about the appropriate ongoing role of community banks -- because at current course and speed, the combination of credit pressures and government rescue measures will drive a great many of them out of business.  So far, in public policy matters, the score is Goliath-Banks 1, David-Banks 0.

Let’s first review the facts.  The U.S. banking industry has been in a more or less monotonically consolidating phase for the better part of two decades.  The number of FDIC-insured institutions has declined from more than 13,000 to a little over 8,000 in the 15 years from 1993 to year-end 2008.  Today, the top 25 banks in the country hold more than 90% of the industry’s assets; the other 8,000 combined (which, for ease of reference, I call community banks) account for the remaining 10%.

But that long, steady decline was just the preamble for the next few years. 

Evolutionary biologists have identified multiple “mass extinction events” over our planet’s history, when huge numbers of species vanish, in a dramatically non-linear way (think dinosaurs, and comets, and the collision thereof).  Well, the banking sector is about to have a mass extinction event of its own, and the victims will be community banks.   As bad as the credit environment feels right now, most observers agree that conditions will get considerably worse in commercial real estate lending before things get better.  And, pound for pound, community banks are well more than twice as exposed to commercial real estate loans than their larger brethren. 

As much as $700 billion of these loans are on community bank balance sheets, with likely eventual loss content of some $50-$100 billion.  At the pace we are going, the taxpayer’s ability and (especially) willingness to support banks will have been exhausted by big-bank bailouts by the time (later in 2009 and into 2010) these small-bank loans start going bad in large volumes.  Wishful thinking isn’t going to change that fact; we should prepare for it now.

Notably, though, practically every bailout tactic implemented or proposed to date disproportionately benefits large banks and quasi-banks, at the expense of smaller institutions.  Rather than cataloging each of the alphabet soup of programs, it is more useful to describe the three basic strategic forces at work, and how -- if left unchecked -- they will hasten the destruction of a vast swath of community banks across the nation.

First, for all their arguable benefits, the liquidity-enhancing rescue programs devised by the Treasury, Fed, and FDIC systematically have undercut the one great strategic advantage of small banks:  persistent access to low-cost funding.  Despite all the scale, technology, and brand advantages of big banks, historical FDIC data demonstrate, again and again, that smaller firms have been systematically able to build better deposit franchises (that is, more deposit growth, with better duration, for lower prices) than big banks.  I used to make a reasonable living dreaming up all manner of analyses to demonstrate why this is true, but most small businessmen, I suspect, can tell you why, for free:  small banks are structurally better tied to their communities, they provide more attentive service, and they can and do identify and reward good front-line employees (customer service representatives, branch managers, field loan officers) better than big banks do.

But by effectively providing a liquidity backstop for all market participants -- through programs like the otherwise wildly popular TLGP (in which the taxpayer, via the FDIC, effectively guarantees unsecured debt issuance by banks) -- government policy has suddenly diminished the strategic and financial value of community banks’ core deposit franchises.  For a modest fee, big banks that had run risky liquidity profiles (e.g. Citigroup, Bank of America/Countrywide/Merrill Lynch) are suddenly able to issue unsecured debt with the full backing of the FDIC -- as are finance companies (like GE Capital, or American Express), or even broker dealers (Goldman Sachs, or Morgan Stanley), which all have been hurriedly waved under the protective aegis of the banking system by the Fed.

Policy-makers, in effect, have decided to give to big firms, for very close to free, a strategic advantage that small banks have literally spent years and much effort cultivating.

Second, the Treasury, Fed, and FDIC are artificially propping up the kind of non-bank capital market vehicles that pushed community banks to the periphery of lending in the first place.  After all, community banks today focus heavily in the woefully volatile commercial real estate arena less because they enjoy rolling the dice on commercial real estate cycles, and more because they cannot compete with non-bank or off-balance sheet structures that had grown to dominate large segments of the credit market.  Community banks couldn’t possibly compete with the funding subsidies enjoyed by Fannie Mae or Freddie Mac.  They couldn’t possibly compete with the regulatory capital relief afforded to big credit card issuers like Citigroup or Bank of America that securitize credit card loans.  They couldn’t possibly compete with hyper-leveraged finance companies like GE Capital, or CIT, or GMAC.

But the combination of government actions to date has, if anything, perpetuated this marginalization of community bank lending.  Fannie and Freddie have become even more dominant in mortgage lending, because now their taxpayer backing is explicit, not just implicit.  Big credit card banks -- amazingly -- continue to enjoy capital relief from securitization, and the securitization markets themselves have been propped up by the taxpayer through TALF.  And, as mentioned above, when non-bank finance companies inevitably ran into catastrophic liquidity troubles they were backstopped by new government funding programs (like TLGP, or the Fed’s asset-backed commercial paper program) and quickly allowed to re-charter as banks and handed taxpayer capital under TARP.

Government rescue efforts, then, are unwittingly reinforcing the walls that prevent the market’s most efficient liability gatherers -- small banks -- from participating in the largest spread-generating asset businesses, from conforming mortgages to credit cards.

Third, the government’s efforts to cleanse bank balance sheets -- the centerpiece of which is the Public-Private Investment Program -- is almost certain to help big banks and especially Wall Street broker dealers (e.g. Goldman Sachs, Morgan Stanley), but will do virtually nothing for community banks.  The reason is simple.  Under the PPIP, the taxpayer (through the FDIC and the Fed) will extend a subsidy to hedge fund investors, thereby artificially increasing the price at which those investors are willing to buy “legacy” (formerly known as “toxic”) assets.  Securities (especially those held by Wall Street firms) are typically carried on balance sheets at mark-to-market values, so even a modest increase in bid price will immediately enable capital-generative sales of legacy securities.  By contrast, loans (which are the lion’s share of community bank balance sheets) are not marked to market; they are held at original value less some reserves.  Given the relatively low level of those reserves (2-3% for most banks), it is difficult to conceive of a funding subsidy big enough to bridge this gap in valuation, so sales of legacy loans by community banks would destroy capital, not generate it.  Few sales of legacy loans will occur, therefore, and community banks will remain freighted with toxic (sorry, “legacy”) commercial real estate loans. 

This is the same reason, by the way, that FASB’s much-trumpeted relaxation of mark-to-market accounting rules will benefit big banks and broker dealers more than smaller firms.  Broker dealers have disproportionately huge securities portfolios; community banks do not.

So the overall pattern is clear:  a series of large, expensive government rescue efforts will disproportionately help big banks, big broker dealers, and big finance companies -- but not community banks.  And given that markets are still competitive, providing taxpayer assistance to bigger firms will allow those large firms to, on the margin, out-compete their smaller brethren.

Should we care?  After all, community banks, definitionally, are small, even in aggregate. 

I suspect that the answer is that we should care.  A lot.

We are already feeling the effects of a vast credit pull-back in small business and middle market commercial lending.  Relying on finance companies, and big banks, and broker dealers to reverse course and fill this void is not a prudent course.  Those large market participants, unfortunately, tend to rely on credit-scoring methodologies, and on off-balance sheet leverage, that are either demonstrably problematic, or altogether non-existent. 

By contrast, the best community banks reflect a back-to-basics approach to commercial credit, and one that might well be the only viable approach in the near term.  We should not overstate this point -- many community banks, like many big banks, seem irretrievably incompetent when it comes to making credit risk-return decisions.    But the fact is that though community banks may have been a small factor in the credit markets’ recent past, they may well prove to be a necessary part of our immediate future. 

Moreover, the crisis has driven home that while there are some economies of scale in the banking business, there are major dis-economies too (ask any of your friends at Citigroup).  Although the Administration sounds serious about better regulating and mitigating systemically important risks in the future, most of its tangible moves to date have done the opposite:  they’ve artificially created more consolidation, not less.

Policy-makers would be well advised to take heed of these facts while they still can.  We’ve been feeding Goliath too long; David’s going to need a bigger slingshot.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.