Will new FDIC rules spark bank buys?

Last Wednesday, the Federal Deposit Insurance Corp. (FDIC) approved a softer set of investment requirements to help bring in more investments by private equity firms that previously were uninterested in purchasing failed banks due to required capital levels.

But two questions remain: How many firms are interested in buying a failed bank, and will the new rules agreed upon by the FDIC last week help draw in banks?

If billionaire investor Wilbur Ross is any indication, PE firms remain cautious but are still interested in buying failed banks for the time being.

Ross, who runs WL Ross & Co., says that he plans to invest further in banks, but revised capital requirements for private equity investment in the sector are still too tight. Ross said last week in an interview with Reuters Television: “We will now be able to be a bidder. … We’ll be in the game, but not as aggressively as we had been.”

The FDIC provoked a backlash when it proposed strict guidelines in July outlining regulations related to PE firms investing in banks. The proposed policy would have forced private equity firms to maintain high capital levels and put a large amount of their own money at stake when investing in failed banks.

After a much-anticipated meeting last week, however, the FDIC agreed in a 4 to 1 vote to a softer set of guidelines.

Private equity investors will have to meet a Tier 1 capital ratio requirement of 10%, which is down from 15% proposed earlier by the FDIC. The Tier 1 capital ratio, also known as a bank’s corporate worth, refers to shareholders’ equity, or the amount paid to purchase shares the bank, plus any retained profit or loss. Put simply, if a firm purchased bank stock at $100 per share, and the bank makes $10 in profit a year, pays no dividends and makes no losses, then after 10 years the bank’s tier one capital would be $200.

The capital ratio shift to 10%, required to be maintained by a bank buyer for a minimum of three years, are meant to ensure a bank can sustain a reasonable amount of losses, without jeopardizing its solvency.

Ross says that he would have preferred a ratio of 7.5 percent. He adds that he is particularly interested in possibly acquiring banks in the Sun Belt states, including Florida, Arizona, Texas and potentially Nevada, where he says that retail deposits are strong.

“The [new policy] strikes a thoughtful balance to attract non-traditional investors in insured depository institutions while maintaining the necessary safeguards to ensure that these investors approach banking in a way that is transparent, long term and prudent,” said FDIC Chairman Sheila Blair in a prepared press release after the vote.

David Panton, partner and co-founder of Atlanta-based Navigation Capital Partners, says he’s pleased that the FDIC has provided greater clarity on the issue.

Panton says that Navigation, a mid-market firm that typically invests in B2B services, has been considering bank investment opportunities in the Southeast. The original requirement of 15% would have provided a financial disincentive to private equity firms, he says.

“But we believe the most prohibitive proposed requirement was the additional source of strength requirement, especially to the extent it penalizes firms that clearly are passive, minority investors in banks.”

However, the FDIC removed that source of strength requirement.

The main points of the FDIC rules for private equity investments in banks include:

• Capital Requirements: The FDIC will enact a Tier 1 leverage ratio of 10% for the first three years of ownership, lower than the 15% proposal.

• Source of Strength: Removed. Proposal basically said that a PE firm would be liable for a bank’s losses.

• Cross-Guarantees: Only will apply to a PE firm that owns 80% or more of a bank. The proposal was for all owners of 5% or more, and would have required a firm with multiple banks to use a stronger one to help support a weaker one.

• Continuity of Ownership: PE owners will be precluded from selling any of their securities for a three-year period. This is unchanged from the original proposal. Also mostly unchanged are certain disclosure and transparency requirements.

All of these rules are effective immediately, but are not retroactive for already-agreed upon deals. Also, these rules are subject to review in six months.

“In the interim, many banks will likely fail and time will show if the FDIC’s actions in revising the [rules] fulfilled their statutory mandate towards least-cost resolutions,” says Lawrence Kaplan, a former bank regulator at the Office of Thrift Supervision, and now an attorney in the Banking and Financial Institutions Group at law firm Paul Hastings.

Kaplan says that the key metric to evaluating the appropriateness of the revised rules will be to see, in the next six months, if private equity firms return to the bargaining table and buy troubled banks.

“Unfortunately, a continued adverse reaction will mean a rapid depletion of the FDIC insurance fund, resulting in higher costs to the banking industry and the FDIC,” he says. “It’s a dangerous game to play with the industry’s or taxpayer’s money.”

Indeed, the Deposit Insurance Fund was reported to have $13 billion at the end of the first quarter. Since then, three large failures—BankUnited Financial Corp., Colonial BancGroup Inc. and Guaranty Financial Group Inc.—have collectively cost the Deposit Insurance Fund roughly $10.7 billion. Such bank failures has prompted some to speculate the fund will fall into the red before the end of the year.

Meanwhile, the number of troubled banks reached 305 for the first quarter, the highest level since 1994. The number also marked quite a jump from the 252 reported for the fourth quarter of 2008.

Banking analyst Richard Bove of Rochdale Securities says that perhaps another 150 to 200 banks will fail on top of 81 so far in 2009, adding stress to the FDIC’s deposit insurance fund.

The Private Equity Council, which represents the 11 largest buyout firms nationwide, issued a statement last week expressing criticism of the 10% capital requirements for banks under the ownership of private equity firms.

Doug Lowenstein, president of the Private Equity Council, says that it is counterproductive to impose measures that could deter investors who are willing to provide capital.

“Given the well-documented track record of private equity firms in turning around troubled companies, it also makes little sense to deprive the banking system of needed expertise,” he said.

Reuters contributed to this story.