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Private Equity Still Constrained From Buying Failed Banks

Back in early July, I complained about the Federal Deposit Insurance Corporation (FDIC) proposing rules too harsh for private equity firms interested in buying failed banks. In a climate like this, the more banks that can be saved without the FDIC needing to resolve them, the better. As a result, I think private equity involvement, while not ideal, is certainly better than the alternative -- lots more failures. This week, the FDIC voted on the final rules. They're better, but still probably not good enough to encourage much private equity firm participation.Probably the most major issue at play is the capital cushion required. The prior proposal I wrote about would have required a 15 percent cushion. Instead, the FDIC voted for a 10 percent requirement for private equity firms. Other banks are only required to have 5 percent when purchasing failing banks.

The apparent purpose for this disparity is to encourage private equity firms to partner with banks to make purchases. If they do, then they can enjoy the 5 percent capital cushion as well. That, however, presents another problem because private equity firms probably don't want a partner cutting into their profits. They would also generally prefer to have complete control over the transaction. As a result, it's unlikely that we'll see a whole lot of private equity participation in buying up failing banks.

What's the fear of private equity firms purchasing banks? The New York Times explains:

Some critics feared that private equity buyers might be more prone to gamble on riskier loans in order to bolster their returns or use the banks they controlled to finance their operations. They also expressed concern that private equity buyers would quickly unload their bank investments if they did not turn a quick profit, further destabilizing the industry.

First, what if they do gamble on riskier loans and the bank subsequently fails? Without the private equity's purchase of the bank prior to that, it would have subsequently failed. Notice the similarity. What's the harm in giving the bank a chance to survive through allowing a private equity firm to purchase it?

As for the other two concerns, the FDIC addressed those already through other rules. One requires the private equity firm to hold the bank for at least three years. The other restricts the bank from lending to the private equity firm's affiliates. So those are already taken care of. That means it comes down to worrying that the banks may fail if private equity firms make poor lending decisions. Yet, without such firms' involvement, those banks will fail anyway.