Local banks: Too small to survive?

June 23, 2011, 1:00 PM UTC

FORTUNE — When the financial crisis hit three years ago, panicky small business owners scrambled for credit to help run everything from shops to restaurants.

Today, few such businesspeople are looking to borrow, even though the nation’s community banks are all too eager to lend again as they recover from the crisis. It was around this time last year when many economists thought things would finally pick up. But the latest surveys of Main Street business owners show that even while credit is available, virtually nobody wants it. And as many now expect economic growth to slow later this year, the pickup we hoped for isn’t even on the horizon.

Not only does this signal bad news for the overall economy, which largely depends on smaller firms to generate as much as 80% of new hiring, but it also puts further pressure on community banks – potentially leading some to be acquired by bigger firms, analysts say. Unlike big banks like JP Morgan Chase (JPM) or Bank of America (BAC) that profit also from underwriting and trading, small banks profit largely on basic deposits and loans.

During the first quarter of this year, demand for new loans continued dropping for banks of all sizes. For community banks, loan balances dropped nearly 2% or $17.3 billion over the previous quarter – a slightly bigger drop than the bigger players, according to the Federal Deposit Insurance Corporation. And while all types of loans – from mortgages to construction – fell during the quarter, commercial loans actually rose for all except the smaller banks, where such loans declined by about 1%.

To be sure, many smaller banks are also relatively well capitalized. And like larger institutions, they’ve grown more profitable as losses from bad loans have narrowed since the depths of the financial crisis. But while things have improved – albeit, very modestly – the fact that many business owners still can’t justify taking out loans could further squeeze profits at community banks.

“Some will be cost cutting as a means to address the lack of new income coming in,” says Keith Leggett, senior economist and vice president of the American Bankers Association. “You may also find that some will decide that it may be better to sell themselves to larger firms in this environment.”

While deals in the banking sector overall are expected to be sluggish for the foreseeable future, there will likely be more activity in distressed deals among small-cap banks, according to analysts at Sterne Agee.

It all circles back to the consumer. As long as demand for products and services remains weak, firms aren’t going to borrow more. In May, confidence at small businesses fell for the third month in a row, according to the National Federation of Independent Business. One in 4 owners still report weak sales as their biggest problem.

And as long as the U.S. real estate market remains weak, small businesses will have a limited appetite for loans. This is because nearly half of all small business loans are backed by real estate, which has seen prices continue to fall.

However slow the recovery might seem, consumer confidence will eventually pick up. The drop in demand for small business loans may force many smaller banks to consolidate, and it remains to be seen how healthy the survivors will be once the economy turns around. Will your community bank be among them?