FDIC Adopts Rules to Attract Private Equity Purchasers of Failed Banks

To date this year, bank failures have cost the FDIC approximately $19 billion and, as of June 30, 2009, the FDIC’s fund that protects more than $4.5 trillion in U.S. bank deposits has shrunk to $10.4 billion, the lowest level since the savings and loan crisis of 1993. As new lenders are added to the list of “problem banks,” the banking industry is faltering due to bad loans, and the FDIC is struggling to clean up the mess left behind by failed institutions.

The New Rules
Against this backdrop, on August 26, 2009, the FDIC voted to adopt rules to allow and encourage private equity firms to buy failed banks¹. In doing so, the FDIC hopes to expand the field of potential acquirers for the shuttered lenders. The rules impose significant restrictions on private equity ownership of banks, but the FDIC backed down from its initial proposal that would have included even more stringent capital requirements. Under the new rules, private equity firms are required to hold on to failed banks for at least three years; investors are required to maintain high-quality capital — commonly called “Tier 1 common equity” — equal to 10 percent of the bank’s overall assets; and private equity owned banks are restricted from extending credit to its investors and some affiliates.

The FDIC did not adopt the proposed rules that would have required the private equity firm to act as a “source of strength” for the purchased bank by covering losses in the event of failure or that would have required private equity owned banks to maintain a 15-percent Tier 1 leverage ratio. Still, the special standards for private equity firms are more stringent than those for traditional banks. For example, traditional banks are required to maintain a five-percent Tier 1 leverage ratio. It should be noted that there is an exemption to the Tier 1 leverage ratio requirement if a private equity firm was to partner with a traditional bank buyer to purchase a failed bank.

The FDIC’s Dilemma
The rules for private equity firms illustrate the tightrope the FDIC is walking. A failed bank costs the FDIC much more if it fails without a buyer ready to move in. The FDIC needs to find new sources of capital. As such, the FDIC must find buyers for failed institutions while ensuring that the investors are not investing for a quick profit, which would serve to further weaken already weak institutions. The FDIC is concerned that the private equity investors might engage in aggressive practices that could put the FDIC deposit insurance fund further at risk. As FDIC Chairman Sheila Bair noted, “We do want people who are serious running banks.”²

Reaction
This year, the FDIC allowed private equity buyers to purchase only two failed banks, IndyMac and BankUnited, and those transactions were subject to heightened scrutiny. The new rules are supposed to provide certainty and encourage more private investment. Still, initial reaction to the new rules shows that private investors feel the FDIC rules treat them unfairly. The industry lobbied hard to weaken the rules initially proposed by the FDIC; to them, the adopted rules do not go far enough. Investors point out that the rules favor existing U.S. and foreign banks at a time when struggling banks are in desperate need of capital that private investors are in a position to offer. At best, the new rules appear to be a mixed result to private equity.

Opportunities
It has been widely reported that more than 150 publicly traded U.S. lenders have non-performing loans of at least five percent of their holdings³. Such a number has, in the past, indicated a lender’s weakness. With the record number of bank failures to date and more on the horizon, the FDIC is looking for non-bank investors to shore up the system and to help defray the costs related to bank failures. The FDIC’s willingness to adopt somewhat weaker rules with regard to private equity investment in failed banks could spell opportunity for investors who are willing and able to play by the rules.

¹ See FDIC Final Statement of Policy on Qualifications for Failed Bank Acquisitions (http://www.fdic.gov/news/board/Aug26no2.pdf).

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