Toxic debt warning for smaller US banks

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The US financial system is still at risk of instability because of toxic loans clogging bank balance sheets, according to the latest report of a watchdog set up to monitor the government bailout.

While the nation’s biggest banks do now seem to have the capital to weather the economic storm, smaller institutions could still have to find tens of billions of dollars to replace losses on mortgages and commercial property loans, the Congressional Oversight Panel said.

Without a refinancing of those smaller banks, it will continue to be difficult for them to expand lending to the small and medium-sized businesses that are the lifeblood of the economy, it said.

"The US Treasury must be prepared to turn its attention to small banks in crafting solutions to the growing problem of troubled whole loans," the panel said. In particular, it suggested carrying out a similar exercise to the “stress tests” of the 19 biggest US banks in April which set out how they would fair in a serious recession and ordered the weakest firms to raise capital.

The government could also pledge to offer additional capital to those that cannot find money in the private sector, it proposed. Triggers for further supportive actions could come if unemployment remains high and residential foreclosures continued to mount.

An analysis done by the panel showed that under a scenario 20 per cent worse than assumptions used in the Federal Reserve's stress tests, about 719 banks with assets between $600m and $100bn would need to raise some $21bn in new capital to offset loan losses.