BY JONAH CRANE, BRIAN GRAHAM, AND KEVIN STEIN
Once again, the banking system is under stress and banks are in need of additional capital. And once again, a significant portion of that capital will need to come from outside the banking system. The FDIC’s quarterly review of bank performance for Q1 2023 revealed that, in addition to two failures, one self-liquidation, and one rescue acquisition in the first quarter, the number of problem banks has increased to 43, with a total of $58 billion in assets.
Some undercapitalized banks will seek to raise additional capital directly; others, as Treasury Secretary Janet Yellen has suggested, will seek mergers (which, unlike JP Morgan’s takeover of First Republic, will need to be funded by private capital). Meanwhile, private capital has already provided funding to stabilize at least one regional bank, and insurance companies—aided by private equity—are now reportedly eyeing bank assets.
Prior to the global financial crisis (GFC), private equity (PE) funds did not invest frequently in banks. Given the stress on the system that followed, regulators took a number of steps to facilitate and encourage PE to invest in banks, and many funds did. Between 2009 and 2013, institutional investors played an important role in bringing new capital into the banking system. Investor groups, including PE funds, backed credible management teams to acquire and rehabilitate failed banks and recapitalized challenged open banks. In total, private investor groups acquired stakes in nearly 100 banks, saving the FDIC’s deposit insurance fund over $3 billion and generally achieving appropriate risk adjusted returns. (In a follow-up post we will break down the performance of PE investments in banks from 2009-2013, and discuss lessons learned for investors.)
As with every other facet of financial services, the regulatory environment governing investment of capital into banks can be complex, opaque and fraught. Below we highlight some of the key actions regulators took over a decade ago, many of which remain on the books today. We believe private capital will have an important role to play in restabilizing the banking system and regulators will likely revisit their GFC playbook.
More Flexible “Control” Thresholds
One of the primary obstacles to PE investment in banks is the legal requirement that any company deemed to “control” a bank becomes a bank holding company, subjecting its entire business (including other portfolio companies) to regulation by the Federal Reserve, including limitations on non-financial activities. That would be a non-starter for an institutional investor.
In 2008, the Fed loosened and clarified its policy with respect to when investors would be deemed to “exercise a controlling influence” over a bank. The changes enabled a given PE fund to take a more sizable ownership stake in a bank, to exercise commensurate oversight through proportional board representation, and to protect their rights as investors without being deemed to control the policies and operations of the bank.
Even with the relaxed ownership limits, a PE firm seeking to acquire a bank generally must do so as part of a so-called “club deal,” teaming up with several other institutional investors, or through a joint venture with an existing bank, such that no single PE firm trips the control thresholds. The policy changes adopted in 2008 largely remain in place, having been further clarified and formalized by rule in 2020.
During the GFC, the OCC implemented a “shelf charter” program, which allowed a group of private investors to become “pre-approved” to acquire deposits and assets of failed banks. This was necessary because only banks are permitted to assume deposits, and the process for launching a new bank ordinarily takes several months to several years. In 2008, the OCC established a streamlined process pursuant to which a charter would be granted to a private investor group based on the strength of the management team, committed capital, and a simple business plan. The charter would remain inactive, or “on the shelf,” unless and until the investor group was identified as the winning bidder for a failing or failed bank. The OCC granted preliminary approval for six shelf charters organized by investor groups, ultimately approving the acquisition of five banks by two of those investor groups (see here and here). This process remains in place, though the OCC has not issued a shelf charter in many years given the relative scarcity of bank failures over the last decade, and the availability of other structures as discussed below.
The FDIC and OCC also permitted multiple private investor groups to each acquire and recapitalize a small existing bank, with the express intent of using that bank as a vehicle to acquire a much larger failed or troubled bank. These so-called “inflatable” charters were used by several individuals and investor groups to effectuate a number of roll-up transactions. The regulatory innovation was granting approval of the change in bank control even though the precise plans of the acquirer could not be known at the time of approval–because they were contingent on identifying one or more failing banks to acquire.
FDIC’s Modified Bidder Process
As a complementary action to the OCC’s issuance of shelf charters, the FDIC established a modified bidder qualification process to expand the pool of qualified bidders for the deposits and assets of failing banks. Investor groups that had received conditional approval for a charter (including shelf charters) could apply for deposit insurance and also receive conditional approval from the FDIC, thus positioning them to quickly assume the deposits and loans of a failing bank.
Special Conditions for Private Investor Groups
While the FDIC joined the other federal banking agencies in paving a path for PE investments in banks, the FDIC at the time did raise concerns about the risks that might arise from those investments. In particular, institutional investors were viewed as having higher risk appetites, holding investments for a relatively short period, operating with significant leverage, and potentially lacking banking expertise. In addition, such investors tend to ring-fence each of their investments to insulate them from exposure beyond their initial investment—whereas a bank holding company is expected to act as a source of strength for each of the banks it owns, and commonly-owned banks are subject to the FDIC’s cross-guaranty authority (whereby the stock of the commonly-owned banks is required to be pledged to the FDIC for use in recouping losses incurred as a result of the failure of one of the banks).
The FDIC issued a statement of policy in 2009 designed to limit those perceived risks while not discouraging private capital investment into failed or troubled banks. All investors in FDIC-assisted transactions were required to enter into a binding agreement with the FDIC agreeing to adhere to the policy statement, which included the following requirements:
Investors would be required to hold their ownership position for at least three years
The bank would commit to maintaining at least a 10% common equity tier 1 capital ratio
The FDIC’s cross-guaranty would only apply if an investor group were to own 80% or more of two or more banks
The FDIC would not accept applications where the ownership structure included entities domiciled in bank secrecy jurisdictions
This guidance remains in effect, so private investor groups considering bank investments involving FDIC assistance should anticipate requirements to comply with similar conditions (and in the current regulatory environment, the possibility of other conditions).
The FDIC’s guidance appeared designed to encourage PE investors to team up with strategic bidders in joint venture-style deals. Specifically, the FDIC stated that the conditions described above would not apply to private investors that teamed up with an established bank holding company that would own a controlling interest in the acquired bank. With relatively larger banks under stress in 2023, and a limited universe of potential acquirers, this kind of joint venture structure may be a natural vehicle to support the merger activity Secretary Yellen alluded to. Joint ventures between PE and strategic bidders can take many different forms. For example, PNC reportedly teamed up with a PE fund and asset manager to absorb some of First Republic’s assets as part of PNC’s bid for the failed bank.
Another form of joint venture is when the FDIC creates a special-purpose entity to acquire assets from a failed institution, and retains an equity stake in the joint venture as a way to share in the gains realized by the acquirer—in exchange for providing downside protection. This structure was used following the GFC to sell often-distressed asset portfolios from failed banks where the deposits had already been sold to a bank. For example, following the failure of Corus Bank, the FDIC sold a 40% equity interest in a special purpose LLC to a consortium of private investors, provided funding for the deal, and retained a 10% “equity kicker.” The FDIC may opt to use this structure to dispose of the remaining assets in the Signature Bank receivership, as the deposits have all been assumed by Flagstar Bank.
The current banking outlook is different than the post-GFC period in some important ways. Between 2008 and 2013, hundreds of small banks failed, concentrated in the West and Southeast. So far in 2023, a handful of regional banks are under duress, and the opportunities appear more likely to arise as banks respond to the stressful environment by selling assets or businesses, or raising capital to shore up their balance sheets or to support acquisitions. If the much-anticipated commercial real estate crisis materializes, we may face a scenario more akin to the post-GFC period with a wave of community bank failures.
What is clear is that the banking system needs more private capital, and regulators will play an important role in determining which deals can get done, and how. As they often do, regulators will start by consulting their playbook from the last crisis. Bank management teams and institutional investors should do the same to position themselves to be prepared to take advantage of either scenario.