Financial weakness is spreading from the biggest banks to smaller community institutions, according to the FDIC’s latest Quarterly Banking Profile. Bank earnings were $1.7 billion in the third quarter, down $27 billion — 94 percent — from the same quarter in the previous year.

These results produced the second-worst quarter for the industry since 1990, with nearly one out of every four institutions reporting a net loss. “That’s more than double the proportion of institutions that were unprofitable a year ago,” FDIC Chairman Sheila Bair noted.

Declining asset quality was the main reason for this earnings weakness, Bair added. “Provisions for loan losses were dramatically higher than they were a year ago, exceeding $50 billion for the second straight quarter, representing an almost $34 billion increase over third quarter 2007.”

Asset quality continued to deteriorate as it has since 2006, with the erosion concentrated in two major loan types — residential mortgages and construction and development loans. “We’ve been saying for some time that the rising tide of troubled loans means that bad loan expenses will remain high. There is nothing in these results that alters that basic message,” the Chairman declared.

Losses, Reserves Increase

Many institutions are increasing their loan reserves, the FDIC report said, yet overall reserve growth continues to lag behind the growth in troubled loans. Losses from bad loans are rising steadily, driven by consumer loans such as mortgages, home equity lines, and credit cards.

Losses on commercial loans are rising as well. “At this stage of the credit cycle,” Bair observed, “loan performance problems are spreading to a much wider range of lenders and categories of loans. This trend is linked to a weakening economy and uncertainty in financial markets.”

Smaller Banks Struggle

Bair emphasized that smaller banks — assets less than $1 billion — are beginning to show stress similar to the industry as a whole. Nonetheless, capital levels among these banks remain higher than average. “Combined with their strong retail deposit base, community banks are traditionally a steady source of credit for Main Street America,” Bair said, “So it’s essential that these banks have full opportunity to participate in Treasury’s capital purchase program.”

Recently problems have spread more widely across bank balance sheets. “We anticipate that a challenging credit environment will persist for some time to come,” the FDIC Chairman noted, “but we also need to recognize that financial markets are driven by expectations. Things are rarely as good as they appear in good times, nor as bad as they appear in bad times.”

Concerns about the economy and the size of losses in bank portfolios have contributed to wide and volatile credit spreads, as well as to liquidity problems for some institutions. The government has sought to stabilize markets and institutions — most recently with regard to Citigroup. This assistance was given to ensure the bank’s access to funding, Bair said, and to prevent a more serious problem in financial markets.

However, “We must be patient and give these programs time to work,” she said. The rules for the FDIC’s liquidity program, for example, were just finalized last Friday. Bair said she is confident that the industry will take full advantage of this guarantee program. “We remain committed to using all of our resources to preserve the strength of our banking institutions, to promote the process of repair and recovery, and to manage risks,” she declared.