Sick banks may mean feeble recovery

By Colin Barr, senior writer

NEW YORK (Fortune) -- The rot in the U.S. banking system threatens to warp an already weak economic recovery.

The dynamics that made 2009 such a downer for banks are still in place, the Federal Deposit Insurance Corp.'s quarterly banking review showed Tuesday. FDIC chief Sheila Bair said she expects bank failures in 2010 to surpass last year's 140, as institutions still struggling with mortgage losses gird for a massive commercial real estate bust.

FDIC chief Sheila Bair expects more bank failures this year.

The siege mentality that left Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) near death last year has lifted, thanks to massive federal support for the banks. Yet a year later, even banks that aren't in danger of failing are being stingy, capping the credit creation that's vital for a sustained economic expansion.

Bank balance sheets shrank at the fastest pace on record in the fourth quarter of 2009, the FDIC said, with loan balances tumbling for the sixth straight quarter.

The bad news has continued into this year. Commercial bank loans have dropped by $134 billion in 2010, while consumer credit has slipped 7% since peaking last February, according to Federal Reserve data.

So even as Fed officials talk hopefully of normalizing financial markets and an improving economy, credit watchers are seeing less upbeat signs.

"This is more like Japan than many people think," Gluskin Sheff chief economist David Rosenberg wrote in a note to clients this month. "Try and sustain growth with bank credit shrinking."

The bank pullback comes at a time when other sources of credit to consumers and businesses have shriveled.

The amount of bonds backed by credit card receivables, car loans and other assets has fallen to just $421 billion, barely a third of its 2007 peak of $1.22 trillion.

Plain old consumer loans are also growing scarcer. Bank revolving consumer credit, a category that includes credit cards, dropped 24% over the past year, according to Fed data.

More damaging still, in some eyes, is the banks' practice of reducing outstanding credit lines in a bid to limit exposure to the deleveraging consumer. Bank analyst Meredith Whitney estimates more than $2 trillion in consumer and small business credit lines will have been pulled by the end of this year.

That's particularly problematic for small businesses, which are responsible for much of U.S. job creation.

Fresh evidence that the banks are still on the mend will complicate the Fed's efforts to pull back its broad-based support for the economy and the financial markets.

Fed chairman Ben Bernanke surprised the markets last week by raising the rate at which banks can borrow funds overnight from the central bank. But dour data ranging from rising foreclosures to weak job creation suggest the Fed won't dare execute its so-called exit strategy for many months.

"The government is doing what it can to stand in until private credit creation can get back on its feet," said Brian Olasov, a managing director at law firm McKenna Long & Aldridge. But demands that the Fed promptly scale back its support for the economy "raise the real risk that credit needs could be unmet given a void in private financing," he said. To top of page