Private Equity and Financial Stability: Evidence from Failed Bank Resolution in the Crisis

Emily Johnston Ross is a Senior Financial Economist at the FDIC Center for Financial Research in the Division of Insurance and Research; Song Ma is Assistant Professor of Finance at Yale School of Management; and Manju Puri is J. B. Fuqua Professor of Finance at Duke University Fuqua School of Business. This post is based on their recent paper.

Private equity (PE) has become an important component in the financial system. An extensive literature explores the effects of private equity buyouts on firm-level outcomes, with some papers arguing that such buyouts positively affect the operations of target companies. At the same time, the private equity industry generates much controversy. Critics often argue that private equity transactions involve heavy financial engineering schemes that introduce a substantial debt burden on the target companies and default risks to the banking sector (Andrade and Kaplan, 1998; Kaplan and Strömberg, 2009). This concern could be exacerbated during an economic downturn due to the cyclicality of private equity investment (Bernstein, Lerner, and Mezzanotti, 2019).

How does private equity interact with and affect the stability of the financial system, especially during periods of crisis? In a recent paper titled Private Equity and Financial Stability: Evidence from Failed Bank Resolution in the Crisis, we investigate this question by examining private equity investors’ engagement in the failed bank resolution process in the aftermath of the 2008 crisis. This is a novel setting in which to study private equity and financial stability. Bank failures and resolutions are a salient feature of financial crises, and have a significant real effect on the economy (Bernanke, 1983; Granja, Matvos, and Seru, 2017). Indeed, banks are central to the functioning of financial markets and have important externalities (Gorton and Winton, 2003). Our setting allows us to examine private equity investors’ role in one of the most crucial steps in stabilizing the financial system in a crisis.

The role of PE in failed bank resolution is a priori unclear. There are concerns that PE investors could exert negative influences on financial stability. They may take advantage of the fragile banking sector and target high-quality assets under fire sales. Banks have safety nets and backstops that may also be exploited by PE investors. Further, PE acquisitions may be value destroying if PE investors are not well prepared to operate a bank. On the other hand, PE investors could have a unique advantage in stabilizing the financial system through acquiring failed banks. First, PE investors have a higher risk appetite, which may allow them to target riskier and lower quality failed banks that are less appealing to traditional bank acquirers. Under this line of reasoning, PE investors complement bank acquirers through the “selection” of failed banks. Second, during those financial downturns, PE investors may have relatively more stable funding (Bernstein, Lerner, and Mezzanotti, 2019), bringing in new capital in times of capital scarcity. Third, PE investors have expertise to turn around distressed firms in adverse economic situations (Hotchkiss, Smith, and Strömberg, 2011; Jiang, Li, Wang, 2012; Cohn, Hotchkiss, Towery, 2020).

PE acquisitions are significant, totaling about a quarter of all failed bank assets acquired in the period 2009–2014. We find PE investors bid for, and eventually acquire, failed banks that are of poorer quality and higher risk compared to those that were acquired by banks. PE-acquired banks, on average, are larger and more undercapitalized. They tend to have a lower ratio of core deposits (measuring a stable source of funds for the bank). PE-acquired failed banks also have lower profitability prior to failure, captured by the net interest margin, and hold larger proportions of riskier loans. PE investors focus on banks that are less likely to immediately synergize with healthier existing banks. Granja, Matvos, and Seru (2017) show that bank acquirers are more interested in purchasing failed banks that are geographically close to themselves to realize informational benefits and economies of scale. Hence, the natural acquirers of failed banks are healthy local banks. We show that failed banks whose neighboring banks are in worse health are more likely to be acquired by PE investors.

This evidence points to a sorting pattern of failed banks with their plausible acquirers: PE acquirers complement banks in this market by bidding and ultimately acquiring lower-quality and higher-risk failed banks. In doing so, PE investors help channel capital that can fill the gap left by a weak, undercapitalized banking sector and help meet the huge needs for new capital. This allows more failed banks to avoid being liquidated and the local financial system to be preserved. Comparing our data with a simple counterfactual world without PE investors acquiring any banks, we estimate that PE acquisitions allowed the FDIC to reduce resolution costs by $3.63 billion.

Filling the gap left by undercapitalized bank buyers is valuable, yet if PE interventions introduce excessive risks and long-term underperformance into the financial system, the overall impact of PE would have to be viewed with caution. Our empirical strategy leverages proprietary FDIC failed bank bidding data to generate a quasi-random sample, focusing on a set of banks that were bid on by both PE investors and by banks (i.e., selectable to both PE investors and banks) and whose bidding values were close (below five percent of the total bank assets). Essentially, the exercise compares banks that were (marginally) won by bank acquirers and those (marginally) won by PE investors. We explore several different performance metrics. First, PE-acquired failed bank branches are less likely to close than bank-acquired failed bank branches. In fact, we also find a higher probability of exiting a county altogether in bank-acquired banks. Next, we find that PE-acquired banks experience a significantly higher increase in branch-level deposits compared to other failed banks. Given deposits are the base for profits, lending capacity, and market power, we interpret this as a positive indicator for PE-acquired banks.

To investigate effects of PE-acquired failed banks on regional economic recovery from the crisis, we adapt the quasi-random framework in a county-level analysis. Those counties with PE acquisitions experience stronger recovery from the crisis—faster employment growth and increased total and per capita income. Compared to bank-intervened counties, PE-intervened counties witness higher growth in small business lending, both in the number and amount; those loans are also made at a lower interest rate. The positive performance may be partially attributable to the expertise of the management team that PE investors bring into failed banks. We show PE investors hire ex-bankers who, on average, have nearly 30 years of experience in the banking industry, and more than half of them were CEOs of other banks before being appointed at the failed banks. More than 60 percent of the CEOs had experience in the local area of the failed bank, more than a third specialized in turnaround management and troubled and distressed assets, and about a third had previously founded a bank that eventually merged with a larger buyer.

Taken together, our results suggest that private equity plays an important role in failed bank resolution in a time of crisis. PE investors provide much needed capital in acquisitions, which helps fill the gap of a weak banking sector at a time when the natural potential acquirers—local banks—are themselves in distress. PE acquirers also help turn around the acquired failed banks, preserving their branch structure, helping deposit growth, and managing the loan portfolio losses, with positive effects for the real economy. While there are natural policy concerns in allowing PE firms to form bank holding companies and in bringing in non-banks into banking in general, our results suggest that, despite these concerns, private financial investors can play a positive role in resolving distressed banks in a crisis.

The complete paper is available for download here.

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