A simple fix, sitting right on the shelf in Congress, would make it easier in important ways for the vast pools of capital in private-equity funds to be put to good use in the banking sector.
Of course private-equity firms can and do structure acquisitions of banks within existing legal and regulatory constraints. The recapitalization of Doral Financial and the Federal Deposit Insurance Corp.'s sale of IndyMac's banking operations to a private-equity consortium led by Dune Capital are but two examples of how existing techniques can be adapted to make such acquisitions possible.
Regulators are doing what they can to make bank acquisitions and investments easier for private equity. They have adopted procedures to preclear bidders for failed institutions, and the Federal Reserve has loosened somewhat the "control" rules for private-equity investments in banks.
Still, basic statutory limits designed to separate banking from commerce continue to hamper traditional private-equity investments in banks. Recent experience proves that the obstacles can be cleared, but some private-equity firms have balked at the requirements to structure a consortium deal, form a separately "siloed" bank fund, or make a noncontrolling investment.
As uncertainty persists in the financial markets, and leading private-equity firms stand by with available capital, the time has come to revisit more fundamentally the rules for private-equity investments in banks. And the good news is: A simple solution is just waiting to be adopted.
Nearly a decade ago, in the Gramm-Leach-Bliley Act of 1999, Congress authorized qualifying bank holding companies to make private-equity investments in commercial firms under a new "merchant banking" investment authority. This authority also applied by extension to thrift holding companies and to foreign banks operating in the United States.
As a result virtually all major banking organizations can legally own up to 100% of a commercial firm (whether an automaker, a winery, or a hotel chain). They can elect a majority of the portfolio company's board of directors and can otherwise "control" the company.
But restrictions remain. For example the banking organization generally may not "routinely manage or operate" the portfolio company. It cannot, for example, install one of its employees as CEO of the portfolio company or make routine business decisions. And the investor generally must sell its investment within 10 years (unless it obtains a regulatory extension). Most portfolio companies bought under this authority are treated as "affiliates" for purposes of regulations that limit a bank's ability to lend to or otherwise do business with its affiliates.
These restrictions, promulgated jointly by the Federal Reserve and Treasury, were designed not only to maintain a separation between banking and commerce but also to promote the safety and soundness of insured depository institutions. The restrictions are meant to insulate the insured institution from the risks of merchant banking investments while letting its holding company diversify its investment activities in prudent ways.
Which leads to the simple fix that the current environment cries out for. If banking organizations can make private-equity investments in commercial companies, why not let private-equity funds make investments in banking organizations under exactly the same restrictions? In other words, turn merchant banking investment authority into a two-way street. And in either direction, firewalls still protect the insured depository institution.
In 1999, Congress recognized the benefit of letting well-capitalized banking organizations be a source of equity capital to commercial firms, provided the insured institutions were safe. Ten years later, it is time to recognize that private equity can and should be a source of capital to banking organizations on comparable terms.
All Congress needs to do to implement this reform is to exempt private-equity funds from regulation as bank holding companies or thrift holding companies, so long as their investments in banks comply with the limitations on merchant banking authority established by the Federal Reserve and Treasury — a 10-year holding period (subject to extension), prohibition of routine management or operating involvement, compliance with rules governing transactions with affiliates, etc.
A private-equity fund that acquires "control" of a bank under traditional standards would still be subject to prior review under the Change in Bank Control Act, ensuring that the background of the investor and the terms of the investment would be vetted by the appropriate regulatory agency. The fund's control persons would still be "institution-affiliated parties" subject to regulatory enforcement for any violation of banking laws or unsafe or unsound practices.
But the advantage of the proposed exemption is that the fund and its sponsor firm would not need to be concerned with the activity restrictions, source of strength obligations, etc. that accompany status as a regulated holding company. Private-equity funds would in this sense be regulated much as individuals who own and control banks have long been regulated.
The virtue of adapting Gramm-Leach-Bliley's merchant banking authority (with its restrictions) is not just in its simplicity. Congress is dealing with numerous competing priorities this month, and policymakers are in search of solutions that can be carried out quickly. Turning merchant banking authority into a two-way street for private equity means that neither Congress nor the banking agencies charged with writing regulations would need to reinvent the wheel.
As Congress considers authorizing the Treasury to spend the remaining balance of Tarp, it should consider adopting — and the banking agencies should support — this modest legal reform. Facilitating private equity investments in banks will maximize the use of private capital in promoting lending by healthy institutions, rescuing distressed institutions, and resolving failed institutions with the least cost to the Deposit Insurance Fund.
Neglecting to do so risks leaving hundreds of billions of private dollars on the table while relying on taxpayer funds to finance the recovery of our banking sector.