Need To Know: Questions Remain On Fed’s Bank Investments Rules

The Federal Reserve’s decision to ease restrictions on private investment in banks promises to boost activity by buyout firms in the sector. But the changes still leave many questions unanswered, and industry lobbyists hope to push the Fed to ease the restrictions further.

Under the new rules, the Fed is allowing private investors more influence on banks in which they invest. “The rule change does make a non-control investment in a bank or bank holding company more attractive,” said Joseph Vitale, a partner with Schulte Roth & Zabel LLP who works with financial institutions, private equity firms and has practiced before the Federal Reserve Board.

However, industry professionals said that the changes may not be enough to spur a a flood of private equity investment in banks. That’s because the rules remain highly restrictive for buyout firms, most of whom regard control of their portfolio companies as a central tenet of their investment philosophy. And, it should be noted that, even under the prior rules, buyout firms found ways to be active in financial services.

According to a recent report from Freeman & Co., there were 69 private equity investments with a disclosed value of $35.5 billion in the financial institutions group sector in the last 12 months ended with the first half of 2008. This figure, however, reflect deals beyond just banks, such including insurance, financial technology and processing, asset management, business services and specialty finance.

The Fed previously considered an investor as having a controlling stake when it owned 25 percent or more of a bank, though it maintained broad discretion in its interpretation and often found investors held a controlling stake when they owned less than that. In its statement, released Sept. 22, the Fed raised the controlling threshold to a 33 percent interest. It also eased its policy regarding board seats and relaxed rules restricting discussions between equity investors and top officers at the bank.

But the Fed still maintains broad discretion in its application of the rules and could determine that investors with less than a 33 percent stake hold a controlling influence, and hence subject it to rules of the Bank Holding Company Act. “It’s not as cut-and-dry as some journalists would like it to be,” said an industry lobbyist. “It’s interpretation.”

Moreover, the Fed did not address the issue of club equity investments, in which a team of buyout shops partner to invest up to 33 percent, though it did say in a footnote that such investments “often raise questions” about the group’s collective intent. Said David Nissenbaum, another partner at Schulte Roth & Zabel: “The question is, when does a simultaneous minority investment equal control by the group?”

Still, the industry lobbyist we spoke with said the move was promising and noted that buyout firms are sitting on some $400 billion of capital they need to invest. He suggested the industry would push the Fed for more concessions. “I don’t think the discussions are over,” he said.