WASHINGTON — Federal regulators' decision to fail $1.38 billion-asset Community Banks of Colorado was premature and ill-advised, according to Fred Joseph, the state banking commissioner.

In an interview, Joseph said he favored allowing the critically undercapitalized bank to sell branches and have more time to solve its problems. But the Federal Deposit Insurance Corp. opposed the branch deal, he said, and the Federal Reserve Board — the primary federal regulator — had a strict timeline for dealing with the bank. On Friday, Community became the first bank ever closed by the Fed, overruling Colorado, which had hoped to keep the bank alive.

"I believe what was best for the bank was the sale of the branches," Joseph said Sunday. "We looked at the bank and thought it was best for the consumers and the state of Colorado to let the deal go through."

The failure was not only historic — in that the Fed instead of the state regulator played the role of executioner — but it also revealed a rare instance of state and federal regulators disagreeing over when to the pull the plug.

"It's a judgment call about whether the state or federal government or any agency wants to take the calculated risk that an institution is going to make it on its own," said V. Gerard Comizio, a partner at Paul, Hastings, Janofsky & Walker, LLP. "It's a tough call and there is a lot of disagreement. Many state banking commissioners really don't want to be in a position to have banks go out of business on their watch if they can avoid it."

Joseph called the case of Greenwood-based Community Banks "a very unique situation."

Community Banks had agreed to sell 16 of its 40 branches to Boston company NBH Holdings Corp. (The Kansas City institution, MidWest Bank, that ultimately bought Community's operations from the FDIC is also owned by NBH.)

Joseph said the branch sale would have increased the bank's status to "adequately capitalized", making its condition less dire, and given it more time to deal with its losses. A heavy dose of construction loans had left the bank with a high amount of assets in nonaccrual status. At June 30, its leverage ratio was a meager 1.92%.

"They still would have to retain the poor assets that they had and had to work through them, but they would have more capital and more time to do it," Joseph said.

But federal regulators blocked the branch sale. Joseph said the FDIC, which becomes involved whenever a bank is "critically undercapitalized", objected to the deal because it would not meet the so-called "least cost" resolution test. The FDIC is bound by law to pursue resolution options for failing or failed institutions that result in the least cost to the Deposit Insurance Fund.

"They did the least cost analysis and they don't explain to anybody how they do it," Joseph said.

The Fed, meanwhile, had subjected Community Banks to prompt corrective action, an accelerated regulatory process for dealing with troubled institutions. After finding that the bank had become "critically undercapitalized" on July 29, the central bank said the Colorado institution had 90 days under prompt corrective action to right the ship or face potential failure. The seizure occurred on the last Friday — typically the day when banks are closed — before that deadline.

"The Prompt Corrective Action statute required the Federal Reserve, as the bank's federal supervisor, to appoint the FDIC as receiver not later than 90 days after the bank became critically undercapitalized, or to take other supervisory action, with the FDIC's concurrence, that would cause the least possible long-term loss to the deposit insurance fund," the Fed said in a press release Friday.

While it is unclear why the pending branch deal ran afoul of the regulators' least-cost test, some observers said the FDIC may have concluded the sale was not a sufficient cure for the bank's problems, and would have hurt the institution's franchise value in receivership if the failure still occurred at a later date.

"The analysis the FDIC uses is: Is the bank just cherry-picking assets when it has one foot in the grave?" said Douglas Faucette, a partner at Locke Lord LLP. "If the bank can buy a little time, but it has sold its best assets and isn't viable, then the FDIC isn't going to approve the sale.

"If the FDIC made the determination that the bank was not anymore viable with the branch sale than without it, then they acted properly."

Yet Faucette added that the standard for what makes a troubled bank viable has become somewhat murky in the stricter regulatory environment following the crisis.

"When there used to be fixed capital requirements, it was easier to make the argument" for more time, but "regulators have not been shy that they do exercise authority to oppose an individual bank's capital levels based on its peculiar risk," he said. "Where is the bright line test? At what point does the agency have the absolute authority to say: 'We've determined that you're not viable.' … It is subjective and based on assumptions, and assumptions vary."

Comizio said a bank nearing failure has to make a particularly strong case for its survival.

"Can the government … decide to stay the execution at the last minute? The answer is: yes," he said. "But especially for a significantly undercapitalized shop, it really depends on whether there are compelling circumstances."

Other past recent branch-sale proposals for troubled community banks did not necessarily lead to recovery.

In June 2009, Peoples Community Bank in West Chester, Ohio, announced it would sell 17 of its 19 branches to First Financial Bancorp in Cincinnati. The next month, however, the Office of Thrift Supervision closed the thrift and said it did not approve the branch sale because it would not have cleaned up its battered portfolio. The regulator said at the time that the failure of the intact institution was the least costly resolution. In early 2010, TierOne Corp. in Lincoln, Neb. tried to sell 32 of its 69 branches to Great Western Bank in Sioux Falls, S.D. TierOne failed in June of that year while still holding its 69 branches.

Similarly, Community's branch sale "would have made the situation somewhat better, but it wouldn't have resolved the issues," said Wesley A. Brown, a managing partner at St. Charles Capital, a Denver investment bank.

Joseph said there were other reasons Colorado could not fail Community Banks.

Under Colorado law, the banking commissioner can close an institution with negative capital without having a public hearing. But when a damaged bank is still technically solvent — which Joseph said was the case with Community Banks — he needs to go through a different procedure in which the bank can argue for its preservation before the state's banking board.

That process had not been completed before the Fed was forced to act under the PCA requirements, Joseph said.

When federal regulators said it was time to close the institution — which would typically be a job that fell to the state regulator — Joseph said he had to follow the state's process.

"I said I have to go through the administrative procedures act if you want me to do that," he said. "It's been very clear in the previous cases that a bank was insolvent. In this case the bank actually was not insolvent. It would have required a hearing in front of the banking board in order to take a action. … The FDIC and the Fed obviously have the 90-day requirement in the PCA rules."

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