The Debate Over Private Equity In Banking

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While the collapse of Bear Stearns and financial industry losses now topping $400 billion, many lawmakers and regulators are calling for increased regulation of the banking industry. But a parallel argument has been pointing in the opposite direction: loosening some regulations to allow private equity firms to invest more in banks.
The losses have forced banks to raise somewhere around $400 billion in new capital (the number changes every couple of days, so we forget exactly how much), much of which is now under water from further losses. With estimates of further losses totaling as high as $1 trillion to $2 trillion, many now wonder where the banking industry will find new capital to replace these holes.
One answer might be the government, although contracting revenues due to a dithering, recessionish economy may limit this option. Others have proposed easing rules that have discouraged private equity firms, which have something like $400 billion of capital on hand, from investing in banks.


Those rules subject investment firms which own more than 25 percent of a bank to the full panoply of banking regulations, basically declaring the owner a bank itself. Holders with between 10 percent and 25 percent are prevented from controlling the banks management.
The practical effect of all this limits outside investment firms to holding less than a 10% stake in a bank if they wish to place a director on a bank's board. Perhaps the greatest barrier to private equity investment, however, isn't these limitations. It's the "source of strength" doctrine, which exposes controlling firms to potentially unlimited liability for bank losses. It's meant to ensure depositors that the owners of the banks holding their deposits stand ready to support the banks with their full faith and credit. But it also helps deter investors, such as private equity firms, from taking large stakes in the firms.
Private-equity firms seem eager to invest in banks, and have been encouraging lawmakers to reform the regulations to make this easier. Proponents of the move, including two managing directors at the Carlyle Group who penned an op-ed in the Wall Street Journal in June, argue that the ideas behind the regulations--the need to prevent conflicts of interest and concentration of economic power--do not apply to private equity firms, who generally would only hold their stakes in banks for limited periods of time.
Opponents of the reforms hardly find this reassuring. Andy Stern, president of the Service Employees International Union, last month wrote that "short-term capital infusions from private-equity funds will only make the banking crisis worse, by encouraging risky behavior and abusive banking practices." Of course, the SEIU has become one of the most prominent opponents of private equity firms in recent years.
The fight between private equity and the unionists played out in an especially messy fashion at Washington Mutual. When the Texas Pacific Group's invested in Washington Mutual, the deal diluted shareholder while delivering $50 million in transaction fees to TPG. A pension fund controlled by the SEIU was one of those shareholders. Washington Mutual is now on almost everyone's list of bank's that might wind up in the hands of the FDIC. Not a week goes by that we don't get asked by a WaMu customer about whether they should withdraw their deposits. (As good citizens we naturally tell them that unless they have over $100,000 in the bank, their deposits aren't in danger.)
Yesterday the New York Times weighed in on the issue, accusing the private equity firms of "exploiting the desperation of banks and regulators." It's not exactly surprising to see the Times taking the union position in this matter but the path they took to reach it is unexpected. After echoing the union argument that private equity firms could do a great deal of damage in the short term, the Times concentrates on the need for greater transparency in the banking industry and the allegedly malignant signaling aspect of the reforms.
"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," the Times editorialists write. "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."

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