The U.S. Senate Banking Committee will remove a provision from the financial reform bill that bank regulator Sheila Bair said could allow for backdoor bailouts, a panel spokeswoman said on Friday.

Sheila Bair, chairman of the Federal Deposit Insurance Corp, told a conference of community bankers earlier on Friday that the agency had serious concerns about a provision in the bill that seems to allow the Federal Reserve to rescue Wall Street firms if their functions were critical to the markets.

That provision will be removed in an amendment as the Senate Banking Committee debates the draft bill, committee spokeswoman Kirstin Brost told Reuters.

If the Congress accomplishes anything this year, it should be to clearly and completely end 'too big to fail,' Bair said at a conference of the Independent Community Bankers of America.

Bair said small banks deserve an even playing field and that larger institutions are still enjoying benefits from an implicit government guarantee.

She said the largest banks have much lower funding costs than community banks and are attracting more deposits.

These signs all point to a presumption in the marketplace that the largest banks are, indeed, too big to fail, Bair said.

The FDIC chief, a critic of some of the government's massive rescues of Wall Street firms, has been one of the strongest advocates of creating a resolution mechanism that would allow the government to dismantle a failing financial firm.

That government power, she has said, would help remove the notion that some firms are too big to fail.

But she said the bill before the Senate Banking Committee, unveiled on Monday by the panel's chairman, Senator Christopher Dodd, appeared to have loopholes.

We do have serious concerns about other sections of the Senate draft which seem to allow the potential for backdoor bailouts through the Federal Reserve Board's 13(3) authority, she said.

In Dodd's bill, the Fed's emergency lending authority is changed to prevent it from propping up individual institutions.

However, it still allows the Fed to extend systemwide support for healthy institutions or systemically important market utilities with sufficient collateral to protect taxpayers from loss during a major destabilizing event.

Bair said that loophole could mean that practically all Wall Street firms could still receive bailouts.

It's time that the big players understand that they sink or swim on their own, she said.

Dodd's bill will change as the committee starts to debate and amend it, a process scheduled to begin Monday. The removal of the provision, if agreed to by the committee, would mark another win for Bair. She also successfully lobbied lawmakers to pre-fund a resolution mechanism, instead of collecting fees from financial firms after an institution collapses.

THANKING THE SMALL BANKS

Bair praised community bankers for the role they play in extending credit to borrowers. Bair, a Kansas native who once worked as a bank teller herself, received a standing ovation at the ICBA's annual conference.

The conference -- five days at a plush resort in Florida -- brought together hundreds of small bankers seeking exemptions from sweeping new financial rules being drafted by Congress.

Community banks have already succeeded in being largely spared the burdens of consumer protection and fee proposals.

You kept this nation going when it slid into the heart of financial darkness, ICBA President Cam Fine told the bankers in a fiery speech that included a montage of his television appearances.

The recovery of small banks, however, is lagging big institutions, largely because of concentrations in commercial real estate loans that took longer to unravel. Bank failures will likely peak in the third quarter of this year, Bair told CNBC Television on Friday on the sidelines of the conference.

Despite the industry's troubles, Bair said community bankers are continuing their tradition of being a critical source of lending. She said large banks have pulled back on credit more than smaller institutions, and this is hampering the economic recovery.

Last year, banks' loan balances fell by 7.5 percent, the steepest decline since 1942.

Bair noted that the largest banks accounted for more than 90 percent of the total drop in bank lending in the 2009 fourth quarter. Small banks, on the other hand, increased their loans by more than 0.5 percent, she said.

While so many big banks keep pulling back, you are hanging in there, doing your best to support the credit needs of our struggling economy. That deserves recognition in Washington, and all of our thanks, Bair said.

(Reporting by Karey Wutkowski; editing by John Wallace)