Small Banks: How Fragile Are They?

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Smaller banks do have some advantages over their bigger rivals. Tiny community banks often can raise extra capital from existing shareholders, who often live in their service area.

Also, credit quality has held up slightly better at smaller institutions. The percent of all loans and leases that were "noncurrent"—in which borrowers have fallen behind in payments—was 1.71% in the first quarter, according to the FDIC. That compared with 1.4% at banks with less than $100 million in assets and 1.53% at banks with $100 million to $1 billion of assets.

That suggests smaller banks were more conservative in their lending in the past decade. The 6,770 banks with assets of less than $1 billion represent 79% of the total number of banks in the U.S., though those institutions hold only 11.4% of the total assets in the banking system.

New Banks Vulnerable?

An advantage for all banks over previous crises: As banks have merged and expanded in the last few decades, the U.S. banking system has gotten much stronger, says Columbia Business School's Charles Calomiris. Spanning wide geographies and offering a variety of new products, bigger banks can prosper despite economic problems in particular geographies or credit problems in particular loan products.

Many smaller institutions, however, are paying for their lack of geographic and product diversity. None has indicated they are in danger of going out of business, but examples of institutions in hard-hit areas include Silver State Bank (SSBX), based in Henderson, Nev., which recently announced plans to raise $40 million in capital; BankUnited Financial (BKUNA) in Coral Gables, Fla., which will raise $400 million through a stock offering; and Downey Financial (DSL) in Newport Beach, Calif., which has seen its nonperforming assets soar from 1.3% to 14.3% in the past year. All of their stocks are down more than 90% in the past year. Conditions are especially bad for the vast array of new banks that sprang up in these once-hot real estate markets.

It may be inevitable that dozens of these banks ultimately fail or are sold off at deep discounts. The Federal Reserve tried to help by lowering interest rates and lending cash cheaply to troubled institutions through its so-called discount window. But the central bank, worried about inflation, is reluctant to lower rates further. And liquidity from the Fed is only a temporary salve to banks' big losses.

Ultimately, these institutions need capital to permanently repair their balance sheets. If they raise cash, broader problems for the banking industry could be avoided. But that is made difficult by the volatility of bank stocks and the uncertainty about the companies' futures.

Is the Market Overreacting?

Instead of raising capital to recover from credit troubles, banks are being forced to scrounge for cash to handle losses yet to come. And no one knows how big those losses could get, Ellison says. "We had a record number of people buy a record number of homes at record high debt levels," he says. "It's a problem that goes beyond any regulatory or governmental scheme to fix."

Columbia's Calomiris is confident the banking system is strong and that home prices are not declining as quickly as some doomsayers believe. But his optimism is shaken by what he calls the stock market's "overreaction" to the banks' troubles. If banks can't raise capital on reasonable terms, he says, they may be forced to save cash in other ways, such as sharply restricting their lending.

The "extreme price movements" of bank stocks are alarming, Polini says. "No matter how bad it is, it's going to be worse if we don't go through this process in an orderly fashion."

President Franklin Roosevelt took office in 1933 in the midst of a far worse banking crisis, yet his inaugural address still resonates today: "The only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance."

And right now, many banks, and their investors, are very afraid.

Steverman is a reporter for BusinessWeek's Investing channel.