The trends in demand for small-business lending do not look good for community bank profits.

Overall demand for business credit declined in the second quarter for the first time since early 1996, a recent Federal Reserve Board survey found.

The Aug. 21 survey said demand for small-business loans was flat, but even holding steady is a significant shift. In May, the Fed had said banks reporting stronger demand from small businesses outnumbered those reporting weaker demand by a 10-to-1 margin.

"The staple product we sell is small-business loans," said Bill Sones, chairman, president, and chief executive officer of State Bank and Trust Co., Brookhaven, Miss. "That is the key element in our interest spread. Any decrease in demand for your key product is going to impact your business."

"A contraction in business lending of any kind would not be healthy to the profits of community banking," agreed R. Michael S. Menzies, president of Easton (Md.) Bank and Trust.

Small-business loans are so important to community banks that they would be unable to offset drops in business credit with increases in other credit products, said Robert B. Fazzini, president of Busey Bank Commercial Loan Office, the business lending unit of Bloomington, Ind.-based First Busey Corp.

For example, many community banks find it tough to profit in the mortgage market, which is dominated by big players that benefit from economies of scale, he noted. Also, most mortgages are securitized, meaning that few banks even hold the loans on their books.

"You really are not helping your loan portfolio because most of those loans you don't keep," Mr. Fazzini said. "At best you help your fee income."

Substantially increasing available consumer credit is fraught with risk. A lack of business borrowing often foreshadows an economic downturn, which could send consumer delinquencies soaring.

Mr. Fazzini said the final option is to invest deposits in the bond market where yields are much lower. "That means your earnings will suffer," he said, "and guess what happens to your stock price? It will go down."

David D. Gibbons, deputy comptroller for credit risk at the Office of the Comptroller of the Currency, cautioned against reading too much into the Fed survey findings.

The Fed only canvassed a handful of big banks about demand in the second quarter, he said. Conditions could improve in coming months, he said.

Also, foreign banks are withdrawing from the U.S. market, which means both the supply of and demand for business credit are falling. "The European banks have the European Monetary Union and investments of their own in Russia and Asia," he said. "The Japanese certainly have lots of problems."

This means U.S. banks may be able to maintain volume and actually boost market share without eroding underwriting standards because there are fewer competitors, Mr. Gibbons said.

Richard Spillenkothen, the director of banking supervision and regulation at the Federal Reserve Board, warned banks against reacting to falling demand by cutting rates and easing terms to qualify more businesses for loans.

The Fed has repeatedly warned that underwriting standards are already too loose and premised on the false assumption that economic good times will last forever.

"This has been an extraordinary period," he said. "It will not go on indefinitely. Banks need to be prepared for changes in the future."

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