The federal government could avoid many unnecessary bank failures by making targeted preferred equity investments in community banks with a Camels 3 rating.

Although both Tarp and the Small Business Lending Fund improved the health of participant banks, the exclusion of community banks with a regulatory rating of three on the five-level system from both programs translates into many missed opportunities to bring greater stability to the banking system and reduce losses incurred by the FDIC insurance fund.

In the three years since Lehman Brothers collapsed, most of the almost 400 bank failures have been community banks.

Tarp investments rescued many distressed financial institutions, most visibly the country's largest institutions, by restoring their capital to safe levels. The Tarp investment model has proven to be profitable to boot, currently estimated to return a $20 billion profit to U.S. taxpayers. Unfortunately, Tarp's successes were not evenly distributed throughout the banking system. It excluded banks with a Camels 3 rating – a sizable portion of the country's banking system, many of which would also have benefitted from capital injections.

Similarly, although the SBLF initially targeted smaller banks the U.S. Treasury limited participation to community banks that were not subject to dividend restrictions. Because federal banking regulators have frequently placed Camels 3 banks under dividend restrictions of some form, again these community banks were effectively denied access to government preferred equity investment.

Few Camels 3 community banks are attractive to the barely functioning public capital markets. Their only options, if they are among the fortunate, are to grant significant price concessions to attract private equity investment or sell bank assets at low valuations.

Unfortunately, without additional capital such banks remain subject to supervisory pressure and enforcement actions to increase capital levels without any realistic options for doing so.

Without additional capital, many are at significant risk to decline into "troubled condition." Once in troubled condition, the bank will likely incur additional losses due to increased regulatory costs and supervisory focus, loss of customer confidence and loss of banking talent. At this point, without the prospect of additional capital or an M&A transaction (which are quite rare these days) the bank becomes a prime candidate for eventual failure – at an average cost to the FDIC of up to 30 to 40 percent of the bank’s total assets.

Many Camels 3 community banks are in financial distress with low capital despite having strong management teams and prudent risk profiles. Capital levels at these banks have decreased due to losses related to faltering local economic conditions rather than from high-risk business models, management and board self-dealing, or unreasonable incentive compensation.

Through seasoned supervision, banking regulators could identify those with strong management and prudent operations that would be appropriate for government investment. By making capital investments in these banks, the federal government could reduce the number of Camels 3 banks that decline into "troubled condition" and eventually fail.

It is worth explicitly noting that Congress has required that the FDIC implement the least costly method associated with the resolution of problem banks. A preferred equity injection of 10 or 15 percent of a Camels 3 community bank's total assets could prevent many bank failures, and such equity investments compare favorably to failure-associated losses of 20 to 40 percent of total assets.

In addition, each community bank saved from failure preserves a primary financing source for local small businesses and an established and stable source of jobs. With much of our current political discourse focused on job creation, a preferred equity government investment program should be able to gain political traction.

Preferred equity investments in these community banks would avoid unnecessary additional bank failures at a cost less than other available alternatives. If structured properly, such equity investments would preserve community lenders and employers, encourage job growth and creation, and reduce the irretrievable financial costs associated with unnecessary and avoidable community bank failures.

Jacob A. Lutz and Thomas O. Powell are partners of Troutman Sanders and lead the law firm’s financial institutions practice.