Under pressure from federal regulators and weighed down by an unhealthy exposure to commercial real estate, small and mid-size banks — in the $10 billion to $100 billion asset range — are cleaning up their balance sheets, according to Oakland, Calif.-based Foresight Analytics.

In the fourth quarter alone, the nation's small banks cut the total outstanding balance of commercial construction and land loans by about 13%, while large banks with assets of $100 billion or more only trimmed back by about 4%, says Matt Anderson, managing director at Foresight.

The contrast in the outstanding balance of construction and land loans is greater when comparing the fourth quarter of 2008 with the fourth quarter of 2009. Banks with assets of $10 billion to $100 billion, for instance, held $121.7 billion and $83.4 billion respectively, a 31.5% decline over one year.

“To the extent that they're shedding exposure, it's more through selling off the loans to someone else or potentially through foreclosures,” says Anderson. Buyers of this debt have generally been private equity players seeking to expand into commercial real estate, particularly if there's a discount involved.

Many small banks say the haircuts on sales haven't been as severe as they anticipated. Since the volume of non-performing loans has continued to grow, evidently the ones selling are not causing banks to take a big loss, says Anderson. “They're choosing which ones to sell.”

Loans selected for disposition may be performing or “less bad” non-performing loans. For example, the discount on a loan for rural land may differ from that of an urban project.

Over the past year, small banks have gained a reputation for not only having too many construction loans and mortgages, but also for holding loans of lower quality than larger banks hold.

The Congressional Oversight Panel established to oversee expenditures of the $700 billion Troubled Asset Relief Program points out that of the nation's approximately 8,100 banks, 2,988 are small banks with too much exposure to commercial real estate.

Community and mid-sized banks hold high concentrations of the riskiest loans, according to the panel.

On the plus side, many of these lenders contend that they have significant exposure to owner-occupied properties, which have performed better than income-producing properties. “It's better but not problem free,” says Anderson.

Owner-occupied properties made up 43% of total outstanding loans for small banks at the end of the fourth quarter, and had a 4.8% delinquency rate. In the same period, the 57% of loans for income-producing properties posted a 6% delinquency rate.

But small banks are unlikely to make new commercial real estate loans. “[They are] cleaning up the risk and not planning on coming back anytime soon,” says Anderson.