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WASHINGTON – March 23, 2009 – Small banks could play a key role in spurring the nation’s economic recovery, Federal Reserve Chairman Ben S. Bernanke said Friday, as many appear strong enough to make new loans while bigger institutions have pulled back.

Bernanke urged community bankers “not to let fear drive” their decisions and to make sound loans. In a speech, he told the Independent Community Bankers of America that the Fed has instructed bank examiners to encourage such institutions to make loans so long as they are “economically viable.”

The Fed chairman is working on multiple fronts to try to restart lending, and his words of encouragement yesterday were part of that broader effort. The central bank has already supported government injections of cash into big financial institutions and, this week, launched a new program to fund $200 billion in consumer loans.

Smaller banks have, generally, held up better through the recession than the biggest financial institutions. While 20 banks have failed so far this year, that pace is far slower than in the early 1990s, when hundreds failed annually.

Small banks have tended to make straightforward loans to individuals and businesses, rather than exposing themselves to the complicated securities that dragged down their larger competitors. “If community banks are prudent but opportunistic in extending credit to strong borrowers, they will help the economy recover while benefiting from that recovery themselves,” Bernanke said. He also said that “in some instances, community banks are able to step in at crucial moments when local businesses or consumers have been unable to find credit elsewhere.”

But there are some limits to how much small banks can boost the broader economy. One is scale. The 7,800 smallest U.S. banks had total deposits of only about $1.2 trillion last year, about the size of Bank of America and J.P. Morgan Chase put together. Even though some community banks have seen their deposits rise by up to 8 percent this year, according to Cam Fine, chief executive of the independent bankers group, they would have to grow improbably fast to make up for the total decrease in lending last year.

Moreover, while most community banks have held up relatively well through the recession so far, major losses could still lie ahead. Small banks tend to lend heavily for office buildings, retail centers and other real estate projects in their communities. Losses on those loans are likely to rise in the coming months, analysts have said, as stores and office tenants default and newly developed homes sell for less than had been anticipated.

There are indeed large parts of the country, such as the Southwest, Florida and the industrial Midwest, where commercial real estate is “very, very weak,” Fine said. He argued, though, that small banks, burned by the real estate crash of the early 1990s, made loans on sufficiently conservative terms that most should be able to weather the problems.

Banks as a whole still face major challenges. The Federal Deposit Insurance Corp. said yesterday that the industry lost $32.1 billion in the final three months of 2008, more than the $26.2 billion first reported last month.

Source: FAR