How Small Bank Failures Are A Boon For Big Banks

In the past week, two prominent analysts have said they expect hundreds more small bank failures in the second half of this year. At the same time, the Financial Select Sector SPDR ETF, a fund that tracks top U.S. banking institutions, has risen to a year-to-date high. But at what point will the number of regional bank bankruptcies drag on the performance of the bulge bracket institutions?

The answer may be never. More unfortunately still, judging by the numbers, it seems that small bank failures are actually propelling both earnings and investor appetite for the big banks.

Richard Bove, vice president of equity research at Rochdale Securities and one of Wall Street's most influential analysts, said last week that he expects an additional 150 to 200 bank failures in the next 12 months. Meredith Whitney, another celebrity analyst, foresees up to 300 casualties of the subprime crisis. Given that just 106 banks have been shut down by regulators so far, those figures hardly make for encouraging reading.

But that's only if you are one of the little guys. For foreign banks, and for those who are multi-billions in debt to the government, the smaller bank failures actually serve as a bit of a silver lining. For a start, there will be lots more lucrative assets which the bigger banks will have the opportunity to pick on should the analysts' predictions of the number of small bank failures materialize. Two recent examples include BB&T, a small and medium sized business lender, which picked up the assets of Colonial BancGroup at a fire-sale discount thanks to the help of the Federal Deposit Insurance Corporation (FDIC), and Spanish giant BBVA, which swallowed the juiciest parts of Guaranty Bank's remains last week.

Another way in which larger rivals may be able to profit from an increasing number of small bank failures is by making money off increased lending and deposit insurance fees provided to the FDIC in order to keep it in business.

For hedge funds, the continued reign of big banks and the failure of little ones has become as close to a win-win money making scheme as you can get in the asset management business. That's because they have been able to buy the big banks while short-selling the shares of the smaller ones. The trade creates a hedge which is technically shielded against the downside of systematic risk, but which is still making money both ways. For example, while the Financial Select Sector SPDR ETF is up 15 percent year-to-date, the SPDR KBW Regional Banking ETF, which tracks mostly small banks, has dropped 26 percent in the same period. Of course, this sort of trading puts even more pressure on the badly-capitalized banks, while bolstering the reserves of the larger ones, ultimately leading to a sort of self-fulfilling prophecy.

That's a trend that shows no signs of abating, potentially leaving speculators and big bank chiefs with sizeable paychecks at the end of the year, as the financial system becomes increasingly monopolized. After the FDIC has finished cleansing the nation's banking system, consumers and small business owners may end up wondering whether the efforts to do so didn't ultimately cause them more harm than good.