FDIC Adopts Strict Rules for Private Equity Investment in Failed Banks
The FDIC made some compromises, but will continue to hold private investors in failed banks to a higher standard than strategic buyers. The FDIC’s board approved a final policy on private equity investment in troubled financial institutions by a 4-1 vote; Director John Bowman stood alone in opposition to the measure. Even so, the FDIC expressed a commitment to review the policy in six months. The chair of the FDIC Board, Sheila Bair, said that the 61 private comment letters “gave us a lot to think about.” In today’s post, we’ll summarize public comments and the final rules for the policy’s capitalization, source of strength, and cross guarantee requirements.
Capitalization. The majority of comments opposed the FDIC’s proposed rule that private equity investors maintain a 15% Tier 1 leverage ratio in failed banks. Some pointed out – as we did over a month ago – that the suggested ratio was three times that currently imposed on healthy banks. The heightened capitalization requirements, many argued, would place private equity investors at a competitive disadvantage to strategic buyers. Others predicted that private equity firms would be less likely to invest in failed banks and more likely to offer less competitive bids to the FDIC.
Final Rule. Banks owned by private equity investors are required to maintain a 10% Tier 1 leverage ratio for the first three years. The FDIC reserves the right, however, to impose a higher leverage ratio on a particular investor if it determines that the situation warrants special treatment. After three years, private equity-owned banks must remain “well capitalized” (or maintain certain financial ratios specified in FDIC regulations). The FDIC justified the increased capital requirements as a necessary protection against the “higher risk profile” of private investments in troubled financial institutions.
Source of Strength. The controversial source of strength requirement would have required private equity funds to infuse ailing banks with additional capital. Comment letters overwhelmingly objected to this rule, claiming it could create unlimited liability for private investors. Even more to the point, a number of commentators observed that the rule would bar private equity firms from investing in failed banks altogether. By the terms of their organizational documents, private equity funds are prohibited from providing capital support to or making subsequent investments in their portfolio companies.
Final Rule. It’s gone. The FDIC deleted the source of strength provision, noting that it would not be possible for private equity firms “as a practical matter.” (It’s not clear why the FDIC did not take practical matters into account when drafting its initial proposal.)
Cross Guarantee. Commentators complained that the cross-guarantee requirement would place the other investments of private equity investors at risk. They emphasized that different funds – even those managed by the same private equity firm – have different investors and accordingly should be treated separately. Several commentators claimed the rule would impede a private equity manager from investing in two different banks through two different funds with two distinct groups of investors. As we wrote earlier, the rule would also inhibit club deals in failed banks.
Final Rule. The FDIC raised the threshold for the cross guarantee rule to apply. Under the revised rule, if investors own 80% or more of two or more banks, the stock of the banks commonly owned by those investors must be pledged to the FDIC. If one of the banks fails, the FDIC may exercise its pledge to the extent necessary to recoup any losses it incurs.
It looks like the FDIC will have a lot of inventory on hand in the coming months. Every week we witness more and more bank failures. The forecast doesn’t bode well either. According to the Financial Times, Dick Bove of Rochdale Securities predicts that another 150-200 banks will likely fail in the next several months. So far, the FDIC has not been able to get rid of all of the failed banks already on its books. The New York Times reported that of the 77 banks that have failed this year, the FDIC has found buyers for only 69 of them.
We suspect the FDIC hasn’t gone far enough to make investments in failed banks attractive to private equity firms. If banks continue to fail, the FDIC will most likely have no choice but to open the market to as many potential buyers as possible. In six months’ time, it wouldn’t be surprising if we see the FDIC Board revisiting these issues once again.
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