Let me say upfront that I have no problem with private equity companies buying an interest in banks. I do have a problem with them buying up a bunch of banks and controlling them. Good private equity funds are great at identifying deals when they see them and see them with many failing banks. What they see is all upside and downside protected by taxpayers.
Private equity firms are putting the Washington money to use by pressuring the Fed, Congress and the White House to change another old banking rule that applied to bank ownership - mainly the Bank Holding Company Act. Current law prohibits mixing banks and commerce
based on a fear that if industrialists own banks, they will dominate — and try to manipulate — the economy, as they did during the early-20th-century heyday of John Pierpont Morgan.
Just another old obsolete rule - kind of like Glass-Steagall.
But there is another important reason why private equity firms should not control banks:
The government also wants the ability to stabilize a teetering bank by drawing on the funds of its parent company. That is hard to do with private equity firms, which have numerous businesses owned by funds, each of which is walled off to protect investors.
Private equity firms operate various funds and each fund has a narrow purpose such as acquiring all banks in Florida. Through legal means that fund, a legal entity, has nothing else behind it other than its investment in the banks. There probably would not be any additional funds for the Fed to go after in the event of bank failure so that means taxpayers would be on the hook for that future bailout.
Guess who the private equity firms enlisted for help: H. Rodgin Cohen - same guy that Secretary Geithner picked to be his Deputy Treasury Secretary. Part of their strategy:
Mr. Flowers said, is to persuade the Treasury secretary, Timothy F. Geithner, to pressure the Fed to back down.
The other risk is that these private equity firms are highly driven on profits and returns on investment. They will drop a struggling bank in a heart beat and leave it the regulators to figure out the mess. If don't believe me, let's examine the example of J. Christopher Flowers, the subject the the NYT Article. Mr Flowers has said:
at one investor forum in New York in January that “the government has all the downside and we have all the upside.”
He is absolutely right. There are two examples of Mr. Flowers handy work in the article: one in Germany and one in Japan. In both cases, the government authorities are considering taking over the trouble banks owned Mr. Flower's private equity firm. Nothing would stop him and private equity firms from doing the same thing here if they are allowed to control banks.
As, Prof. Krugman says, banking needs to be boring. But this is not the way of doing that. Private equity is needed but not to the point where they control banks. Their inherently risky business models would cause a new problem ten years from now.