The Banks and Private Equity

by Dollars and Sense

The Banks and Private Equity

Many banks are ailing, lamed by hundreds of billions of dollars in bad loans and poor investments and hamstrung by the prospect of continued multibillion- dollar losses.

There is no painless solution. If banks retrench by making fewer loans, families and businesses are hurt and with them, the broader economy. If banks cope by building bigger cushions against losses, shareholders take the hit in the form of lower dividends, lower earnings per share, lower stock prices or some combination.

Yet, for the past month, some private equity firms have been promoting what they claim would be a relatively pain-free fix of the nation’s banks. And the Federal Reserve — which must know that if it sounds too good to be true, it probably is — has yet to say no, as it should.

Private equity firms say they are ready to invest huge amounts in ailing banks — provided the Fed eases up on the regulations that would otherwise apply to such large investments. The firms’ desire to jump in makes perfect sense. Bank shares are cheap now, but for the most part, are likely to rebound when the economy improves. The firms’ push for easier rules, however, is a dangerous power grab, and should be rejected.

Under current rules, if an investment firm owns 25 percent or more of a bank, it is considered, properly, a bank holding company, subject to the same federal requirements and responsibilities as a fully regulated bank. If a firm owns between 10 percent and 25 percent of a bank, it is typically barred from controlling the bank’s management. To place a director on a bank’s board, an investor’s ownership stake must be less than 10 percent. The rules exist to prevent conflicts of interest and concentration of economic power. They protect consumers and businesses who rely on well-regulated banks, as well as taxpayers, who stand behind the government’s various subsidies and guarantees to banks.

To maximize their profits, private equity firms want to own more than 9.9 percent of the banks they have their eye on and they want more managerial control — and they want it all without regulation. They argue that because they tend to be shorter-term investors, problems that the rules address are unlikely to occur on their watch. That is a weak argument. It does not necessarily take a great deal of time to do damage. And as the financial crisis demonstrates daily, decisions and actions taken by unregulated and poorly supervised firms can prove disastrous years later.

Worse, the private equity firms are exploiting the desperation of banks and regulators. They know that banks are desperate to raise capital and that doing so is a painful process bankers would rather avoid. They also know that regulators and other government officials, many of whom where asleep on the job as the financial crisis developed, want to avoid the political fallout and economic pain of bank weakness and failure.

Federal regulators would be wrong to cave. Now, when there is great uncertainty about which institutions are too big or too interconnected to fail, is exactly the wrong time to allow less transparency and less regulation. And with confidence in the financial system badly shaken, it would be a mistake to signal to global markets and American citizens that the government is willing to put expediency above long-term stability.

Held to the same rules as other investors, private equity firms may choose to invest less. Some banks may have a tougher time repairing the damage to their institutions. Some banks will fail. That, unfortunately, is what happens in a financial crisis.

Labels: banking regulation, New York Times, private equity, The Fed

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8/03/2008 08:30:00 PM