WASHINGTON — As the number of bank failures continues to rise, some industry representatives are making a case that amounts to political heresy: the Federal Deposit Insurance Corp. should prop up dying institutions rather than letting them collapse.

They argue that the constant stream of failed-bank deals — in which the FDIC sells deposits on the cheap and guarantees some of the losses — has scared away potential buyers for open and operating institutions.

If the FDIC were to consider open-bank assistance in just a few cases, this thinking goes, it could slow the pace of failures and save the government money.

"I daresay that in some cases it will be the least-cost solution to provide some kind of open-bank assistance," said Ron Glancz, a partner at Venable LLP.

To say that regulators and Capitol Hill are skeptical about this argument is an understatement. The FDIC faces a high legal bar for providing open-bank aid — and doing so would be politically dangerous.

"Do you bet on a disciplined resolution to a very troubled institution … or do you give the guys who got you into this position a chance to do it again?" said Karen Shaw Petrou, the managing partner of Federal Financial Analytics Inc. "I don't mean to be unsympathetic, but I don't get it."

Still, some industry representatives said the loss-sharing deals the agency is cutting to resolve failed banks are so attractive that private-sector merger activity has all but evaporated.

"There have been some creative deals … but most buyers are just saying, 'I'll wait until it fails,' " said Dan Bass, the managing director in the Houston office of Carson Medlin Co.

A majority of the FDIC's 140 failed-bank resolutions this year have included agreements that the agency and acquirer will share future losses tied to its assets. Typically, the FDIC will cover 80% of losses on a chunk of the assets, and then 95% beyond that level. (The agreements run for 10 years for mortgages, and three years for commercial-related assets.)

The agency says the agreements help draw more competitive bids for failed banks, mitigate the agency's short-term cash needs and help it unload a high volume of assets.

Yet observers say the tactic hurts the FDIC in the long run as it shoulders risks far into the future, bolstering the case for providing assistance to a private-sector recapitalization that would stave off the failure.

"The costs" of assistance "would have been far less than the FDIC is experiencing in connection with the losses that are being sustained going forward," said James Rockett, who co-heads the financial institutions corporate and regulatory group at Bingham McCutchen in San Francisco.

To be sure, the FDIC has little leeway to offer open-bank deals, even if it wanted to.

By law the agency must choose the "least costly" method for resolving a bank, and may only make an exception when the Treasury secretary — after consultation with the president and the Federal Reserve Board — determines a failure would pose a threat to the financial system.

Though the FDIC may choose open-bank assistance if it concludes it would be the cheapest route, a legal provision in 1993 barred the agency from providing any government resources that benefited shareholders of a failing bank.

"If the law basically says you can't benefit shareholders, that's a pretty tough task, because that's who the open-bank assistance group is negotiating with: the shareholders," said John Bovenzi, a former FDIC chief operating officer and now a partner at Oliver Wyman. "What's in it for them? If they're going to get wiped out, why would they negotiate a deal?"

Since the start of the crisis, the FDIC has offered assistance to only some of the industry's largest banks as part of broader government assistance designed to avert economic disaster. In aid packages to both Bank of America Corp. and Citigroup Inc., the Treasury invoked the systemic-risk exception and the FDIC provided protection against losses. The exception also was used to launch the agency's temporary coverage of unsecured debt and zero-interest deposits.

But open assistance for smaller institutions attempting a recapitalization is unprecedented.

Proponents of open-bank deals say that lawmakers should give the FDIC more latitude to save institutions.

"They can't do open-bank assistance under the current law. They would need a change in the law," Glancz said. "I think Congress needs to do it, but I also think that the banking agencies can encourage more private capital investment in banks. What I'm concerned with is" the FDIC is "not weighing the attractiveness of the loss-sharing with the possibility that that's drying up the capital markets."

Tom Vartanian, a former senior official at the Federal Home Loan Bank Board, said the FDIC should use its systemic-risk exception to save some small banks.

"If you add up 500 community banks failing, there's an impact in 500 communities and there's an impact on the FDIC, which loses the money, which then has an impact on the rest of the industry, which then has to fork over the money," said Vartanian, a partner at Fried, Frank, Harris, Shriver & Jacobson LLP.

That argument overlooks the cost savings of failed-bank resolutions, some observers said.

Failed banks "are costly, but they would be costly on an open-bank basis as well," said John Douglas, a partner at Davis Polk & Wardwell and a former FDIC general counsel. "If you compare a closed-bank situation and an open-bank situation, invariably the closed-bank situation will turn out to be less expensive to the FDIC, because you wipe out so many liabilities in the receivership. You wipe out all contingent claims, subordinated debt and other types of debt. … You don't have to deal with it at all."

Bovenzi and Petrou said the mergers and acquisitions market eventually will recover on its own.

"Certainly for any institution that is flatlining, there is not private investment capital out there," Petrou said. "For entities that are weak but viable, there is. There is money out there and there is money moving."

Bovenzi said the pace of deals could pick up after the pace of failures slows.

"Down the road when you get to the point where there are fewer bank failures, you're still going to have winners and losers," he said. But "the winners should be able to buy some of the institutions that wouldn't necessarily otherwise fail, but would have their share price reduced to the point where it would become attractive to those acquirers. While this may not be the time where a lot of that's happening right now, it doesn't mean it won't down the road."

Lawmakers, many of whom have condemned the bailouts of larger institutions, are also highly unlikely to support giving the FDIC more room to assist dying banks. It could also encourage smaller institutions to engage in more reckless behavior, knowing they may be saved by the government.

"You'll have a significant moral hazard issue for smaller institutions to the degree that the FDIC supports institutions and subsidizes investments in entities that should have pulled themselves back from the brink," Petrou said. "If an institution is in need of open-bank assistance, the management that got it to that point is at least open to some question."

For their part, FDIC officials have indicated they are not interested in providing financial help to open individual institutions that are troubled. Chairman Sheila Bair has expressed some interest in using resources left in the Troubled Asset Relief Program to benefit smaller banks, but she has also opposed open-bank assistance, and urged Congress to prohibit it for nonbank firms in the pending legislation to create a resolution regime for those companies.

"We're subject to least-cost. We can't provide assistance of any kind to an open institution absent a systemic-risk determination," Bair said Dec. 2.

Some observers said proponents of open-bank assistance are really just interested in getting FDIC help for deals that would not involve the highly competitive bidding process for institutions that want to acquire failed banks.

"There are plenty of people who want open-bank assistance," Douglas said.

"The reason sellers want it is because it gives their shareholders some hope of recovery in the future. … The reason acquirers want it is they want the institution without having to go through the bidding process."

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