Small Banks Fail, Large Banks are Supported by Government

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The Financial Times (via Doug Hendren) describes the failure of a small bank in Georgia and how the FDIC assists in transferring the assets of the bank to a bank from South Carolina. There have been hundreds of small banks in the US that have been shut down because of bad loans. Most of them made loans to land developers, using the land as collatera. The collapse of the real estate market, and the drop in land values, sunk the banks when the developers were unable to service their debt.

Georgia is one of the states most hard hit by the failure of small banks. State regulators failed in their supervision of the banks, largely because they were underfunded and understaffed. The banks competed for funds by offering high interest rates to depositors and they were forced to find investors who would pay high interest rates for development loans that eventually went bad. The depositors were willing to take the risk of bank failure because their deposits were insured by the FDIC. The hot money left the banks quickly at the first sign of trouble. The owners of the banks and their creditors took the loss when the banks failed. This contrasted sharply with the treatment of the large Wall Street Banks which were deemed to big to fail, and which were bailed out by government. The implication is that stockholders and creditors will be bailed out the next time that they get in trouble. Consequently, stock investors and bond investors are encouraged to invest in the too big to fail banks. In effect, the assurance of government support for those who fail subsidizes the big banks because the investments are perceived to be risk free. The interest rates demanded by creditors does not reflect the actual risk of default.