Problem banks list hits 888 by Colin Barr @FortuneMagazine May 24, 2011, 2:03 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons The zombie banking industry took another half step forward Tuesday. The list of banks at risk of failing expanded at its slowest rate since before the credit crisis, the Federal Deposit Insurance Corp. said. The so-called problem bank list rose by just four institutions to 888, FDIC chief Sheila Bair said. One step up That’s still the highest number in two decades and the highest ratio since 1987 as a share of existing banks. It’s a fact that Bair, who is leaving in July after five years on the job, is painfully aware of. When she took the helm at the FDIC in 2006, profits were at a record and the problem banking list comprised just 50 institutions. “Some will refer to that period as a golden age of banking,” she said, but “with the benefit of hindsight we now know that a substantial part of those record profits were illusory.” The profits are coming back now, but in some ways they are just as questionable. Banks posted their biggest quarterly profit since the credit bubble burst in the first quarter, earning $29 billion in the first quarter. That is biggest number since a $36 billion profit in the second quarter of 2007. But as has been the case in recent quarters, the main driver of bank profitability was not revenue growth but the release of loan loss reserves. Banks took $31 billion worth of loss provisions and turned them into profits in the latest quarter, Bair said. So-called reserve releases are legitimate but unsustainable, and point to even more pressure on bank profits till the economy turns around and loan balances start to grow. “There is a limit to how far reductions and loan loss provisions can be in industry earnings,” Bair said. “At some point if banks are to continue to increase their profitability, they will have to grow their revenue.” Meanwhile, loan balances dropped at their fastest clip since the end of 2009, marking their 10th decline in 11 quarters. They dropped at banks both big and small, in what Bair said was a sign of both questionable bank decisionmaking and a weak economy producing soft loan demand. “Loan balances are down at the smaller banks in the quarter, and they need to make loans to make money,” Bair said. “That’s the business model and they are having trouble finding creditworthy borrowers.” Even if this quarter does mark the peak on the problem bank list, it’s going to be a very long time before we see another reading in the double digits.