Fed Reviews Bank Investment Rules to Channel Capital to Lenders

By Craig Torres

June 27 (Bloomberg) -- Federal Reserve officials are reviewing regulations that limit investment firms' stakes in banks, aiming to channel more capital into the U.S. banking system.

``We are looking at ways we can make those things more workable and gain from the experience we have had over the past few years,'' said Fed spokesman David Skidmore, citing a statement by the central bank's general counsel, Scott Alvarez.

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson have urged lenders to raise capital to compensate for almost $400 billion in writedowns and credit losses from the collapse of the subprime-mortgage market. Concern about rising loan losses has sent the Standard & Poor's 500 Banks Index into a 21 percent dive this month, putting it on course for its worst monthly return in almost a decade.

``The biggest ingredient that is missing in the banking system is capital,'' said David Kotok, chairman and chief investment officer of Cumberland Advisors Inc., a Vineland, New Jersey firm that manages $1 billion. ``The more they liberalize, the more they attract'' capital, he said.

Currently, Fed guidelines limit funds to a 9.9 percent voting stake in banks, and funds or individuals have to commit to the Fed that they will remain passive investors if they go above that level, up to a cap of 24.9 percent. If they don't make that commitment, they then would have to form a bank holding company.

Seeking Clarity

More than 100 mortgage companies have been forced to close, halt operations or sell themselves since the beginning of last year. Among larger firms, Citigroup Inc. and Merrill Lynch & Co. had their second-quarter earnings estimates cut by analysts at Goldman Sachs Group Inc. yesterday, spurring declines in their shares.

Fed officials are reviewing the history of their legal interpretations and responses to investors to see if they can summarize their views into a clear set of guidelines. Regional lenders would benefit most from any change, said Kotok.

The central bank ``is taking a look at these rules with an eye toward whether there are any provisions that can be modernized,'' said Mark Tenhundfeld, senior vice president of regulatory policy at the American Bankers Association in Washington. ``We would certainly favor the Fed looking at its control regulations to see if there are any barriers to investment.''

Carlyle Meeting

Fed officials have met with Washington-based buyout fund Carlyle Group, said Ellen Gonda, a spokeswoman for the firm. ``There is an ongoing dialogue,'' she said. ``It's not unusual for regulators to seek private-sector input on policy.''

Central bankers have also spoken with J.C. Flowers & Co., Kohlberg Kravis Roberts & Co. and Warburg Pincus, the Wall Street Journal reported yesterday, citing unidentified people familiar with the matter. KKR spokeswoman Ruth Pachman declined to comment.

Lifting the legal cap on non-banks' purchases of bank shares ``would be a very major step,'' Fed Vice Chairman Donald Kohn said in answer to questions at a June 5 Senate Banking Committee hearing. ``It would be a huge change from where we are today and I'm not sure it's necessary in order to get capital.''

Defaults and delinquencies on mortgage loans and related credit products have hit the financial system with $400 billion of losses and writedowns since the start of last year and resulted in tighter credit conditions for consumers. Financial institutions have raised more than $321 billion of capital over the same period, including through sales of stock and stakes to sovereign wealth funds.

`Important Role'

``In the last few recapitalizations where balance sheets have been strengthened for financial institutions, private equity has played an important role,'' Treasury Undersecretary Robert Steel said in an April interview. Changes to the current limits on bank capital purchases is ``certainly something worth considering and looking at,'' he said.

Fifth Third Bancorp, Ohio's second-biggest bank, said June 18 most of its quarterly profit will evaporate after already posting nine consecutive declines.

Cleveland-based KeyCorp doubled its forecast last month for charges on debts unlikely to be repaid to as much as 1.3 percent. The bank, whose profit fell 38 percent in the first quarter, cited its effort to reduce vulnerability to homebuilders and ``elevated'' net charge-offs for education and home loans.

``At the very least the rules need to be simplified and probably can be liberalized,'' said Bill Isaac, chairman of the Federal Deposit Insurance Corp. between 1981 and 1985, and now head of the Secura Group LLC, a financial consulting firm in Vienna, Virginia.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net