Banking experts say the health of Indiana institutions is taking baby steps forward along with the tepid economic recovery.

But in these times, recovery looks grimmer than one might expect.

Consider:

• Thirteen percent of Indiana banks lost money in the second quarter.

• Close to 7 percent of the state’s banks, including Indiana Business Bancorp in Indianapolis and Shelby County Bank in Shelbyville, are classified by the Bauer Financial rating agency as “problematic.” The designation means the banks are struggling on one or more fronts but are a level above banks at risk of imminent takeover.

• Six of 15 banks with a strong presence in the Indianapolis area and analyzed by IBJ reported losses in the second quarter. Five of the banks suffered with nonperforming assets at 5 percent or more of total assets—a figure that might have set off alarm bells in better times.

That the numbers indicate improvement reflects a reality that the times are anything but normal. More than two years after the recession set in deep, local banks are still struggling as homeowners and businesses continue to grapple with a sizable unemployment rate and meager economic growth.

“Banks are not going to recover,” said Mike Renninger of Carmel-based financial consultancy Renninger & Associates, “without the economy recovering.”

Indiana banks are laboring to improve their books. Low interest rates have helped improve their margins because depositors reap relatively low returns. In some cases, banks are digging out from beneath nonperforming assets by selling off the properties tied to the loans.

But the market for the properties remains weak. And issuing solid new loans remains difficult in a tough regulatory climate and as consumers and businesses continue to be cautious about borrowing.

Indiana banks are faring well compared with a year ago, when 20 percent of the state’s banks were losing money.

They also stack up well against the

national picture. Data collected by the FDIC shows 20 percent of banks nationally lost money in the second quarter, compared with Indiana’s 13 percent.

Bauer Financial, headquartered in Coral Gables, Fla., classified 12.6 percent of banks nationwide as problematic, compared with about 6.8 percent of Indiana’s banks.

The better health in Indiana is related to several factors, said S. Joe DeHaven, president and CEO of the Indiana Bankers Association. Since the mid-1980s, many banks have consolidated, which has weeded out some of the institutions with weaker management.

And while Indiana, like other states, has struggled with the drop in the residential real estate market, housing prices in the Hoosier state haven’t been as volatile as those in areas such as the Sunbelt or the East Coast, DeHaven said. That’s helped minimize banks’ losses when the houses sell after borrowers fail to make their mortgage payments.

Still struggling

But relativities aside, the state’s banking sector’s strength remains a fraction of what it was before the recession set in nearly three years ago.

None of the 15 banks surveyed by IBJ came close to meeting the profit levels of $1 for every $100 in assets, or $10 for every $100 in equity, that were standard during good times.

Instead, they lost an average of 3 cents for every $100 in assets and 38 cents for every $100 in equity.

Before the recession, banks also aimed for less than 1 percent of their assets to be nonperforming. The 15 IBJ surveyed had an average of 4 percent in the second quarter.

Nonperforming loans are driving much of the ongoing difficulty. Businesses and consumers have struggled to make loan payments at the same time the collateral backing those loans has diminished in value.

That’s been at the heart of the challenges for Greensburg-based MainSource Financial Group, which listed about 4 percent of its $2.9 million in assets as nonperforming in the second quarter.

Commercial loans to contractors and developers made up only 8 percent of the bank’s portfolio, but 30 percent of that segment is troubled, said Carrie Stapp, MainSource’s vice president and director of sales and marketing.

When borrowers miss payments, banks such as MainSource must set aside reserves to offset the losses, eating into their income.

At Indianapolis-based Indiana Business Bancorp, non-performing assets neared a whopping 9 percent in the second quarter. Jim Young, president and CEO of the 2004 startup, which has $90 million in assets, said his bank loans heavily to small businesses, whose owners have felt the brunt of the recession.

Instead of taking punitive action, Young said, in many cases his bank has worked with those borrowers to come up with payment plans.

“We’re a locally based bank and, as such, we deal with our customers differently than large, regional [banks],” he said. “Our customers are our neighbors.”

For institutions such as Shelby County Bank, mortgages have been the main headache. Close to 6 percent of the bank’s $260 million in assets are nonperforming.

Chairman Russell Breeden said the bank is gradually regaining collateral from the borrowers—and points out his bank, like others on the IBJ list, has plenty of capital to cushion its risk.

Those banks’ experiences exemplify why the economy continues to batter community banks, in particular, said Andreas Hauskrecht, an associate professor of business economics at Indiana University’s Kelley School of Business.

The contraction in household, government and business spending has left few alternative routes for such banks to reap profits.

“I don’t see where the revenues would come from,” Hauskrecht said.

Slow recovery

Bank officials say they are trying to generate revenue in the form of new deposit accounts.

Breeden’s bank is going after customers in Shelby County who might want to leave the larger national banks for a more personal experience.

“We see a great opportunity to reach out to those customers,” Breeden said. “We believe we can continue to build on that already large presence in the community.”

Stapp of MainSource said her bank, too, has pursued new consumer and small-business accounts.

And while MainSource is more stringent about its loan criteria these days, “we definitely are not [adopting] the philosophy that we want to lend less,” Stapp said.

Efforts to lend have been stymied not only by a soft loan market, but also by more scrutiny from federal regulators that make the practice more difficult. Some say greater scrutiny could stall a strong turnaround for a few years.

Hauskrecht is among the economists who believe there won’t be substantial economic growth until at least 2012.

When that atmosphere does improve, some in the industry worry new federal laws coming online in the next few years as part of a financial reform bill passed this summer could cause further setbacks.

DeHaven of the Indiana Bankers Association said he expects some of those 200 to 500 new regulations will decrease bank revenue while adding to banks’ expenses by requiring them to hire staff to carry out the reforms.

If the economy doesn’t improve when the regulations go into effect, he anticipates some smaller banks could consolidate. And when it comes to recovery, he’s not overly optimistic.

“We’re going to be waiting for consumer demand to increase, and that’s going to come in inches, rather than miles,” DeHaven said. “It’s going to be a difficult atmosphere for some time.”•