ICYMI – Yale Insights Highlights Research Regarding Private Equity’s Role in Stabilizing Banks During the Financial Crisis
Yale Insights: Private Equity Investors Helped Stabilize Failed Banks During the Financial Crisis
Song Ma, Assistant Professor of Finance
Written by Roberta Kwok
March 21, 2022
The researchers found that PE investors tended to acquire banks in poorer health that traditional buyers—that is, other banks—didn’t want. And they seemed to do a reasonably good job of turning these failing banks around. Banks purchased by PE firms fared better than those bought by other banks on measures such as keeping branches open and lending to small businesses.
“They know how to run distressed and risky assets,” says Ma, who collaborated with Emily Johnston-Ross at the Federal Deposit Insurance Corporation (FDIC) and Manju Puri at Duke University on the study. The bank resolution evidence suggests that “they could play a quite positive role in stabilizing the financial system during that specific period.”
PE firms raise money from individuals and organizations and act as a financial intermediary, buying companies and making financial and operational changes. These investors have a reputation for cutting staff and reducing wages in order to increase short-term profits, but some research suggests that the target companies’ operations run more smoothly after PE firms get involved.
During the 2008 financial crisis, private equity played “an overlooked role,” Ma said. Many small community banks failed, and the FDIC allowed other companies to bid on them. Typically these bidders were other banks, but PE firms also were permitted to toss their hats in the ring.
One might expect PE firms to perform poorly in this area, since banks require specialized expertise to run. Perhaps PE investors also would take excessive risks in their attempts to turn around the banks, creating even more problems.
On the other hand, PE involvement could be beneficial if other buyers lacked the capital to bid on these banks or were averse to taking on more risk. Other banks might not have had the resources to take on struggling institutions, Ma says. PE firms, in contrast, like risky projects and could more easily raise money; they have enough “dry powder,” he says.
To investigate, Ma and his colleagues examined FDIC data on the resolution process for 482 failed banks from 2009 to 2014. Among banks that were bought, PE firms acquired 13% of them, the equivalent of 24% of the assets held by failed banks. “It’s a pretty significant amount,” Ma says.
Next, the researchers evaluated the failed banks’ health, based on measures such as the amount of capital they had and how distressed their assets were. They found that PE firms were acquiring banks at “the bottom of the quality ladder,” he says. For instance, a one standard deviation lower in one measure of capitalization was linked to a 3.5 percentage points higher in the chances that a PE firm would buy it. PE investors also were more likely to buy banks with a higher fraction of risky assets, such as real estate loans.
Traditional investors would say “you’re out of your mind” to buy banks in that condition, Ma says. But PE firms are willing to buy them because “if they can turn them around, the returns are bigger.”
PE investors also appeared to acquire banks in areas where nearby banks—the most natural buyers—might not be able to take over. For each failed bank, the researchers examined the financial health of other banks with branches in one or more of the same zip codes. PE firms were more likely to buy banks whose neighbors were also faring poorly.
What would have happened if PE investors hadn’t stepped in? The team calculated that 5.5% more failed banks would have been liquidated. FDIC resolution costs also would have risen by $3.63 billion, or about 5%.
But another question still remained. Did the PE firms do a good job of running these banks? That question proved trickier to answer because the types of banks bought by PE firms and traditional buyers were different. So any variation in performance would be hard to attribute to PE management; it could just be due to underlying differences in the banks.
To circumvent this problem, the team identified a subset of banks that had been bid on by both PE firms and other banks. The FDIC chose the buyer based on small differences in bids—as close to a randomized experiment as the researchers could get.
During the three years after acquisition, the chance that a bank branch run by a PE firm would close was 15 percentage points lower. These banks’ increases in deposits were also 36 percentage points higher. And in counties with PE-acquired banks, small business loans grew 32% faster.
“PEs actually did quite a good job in turning around those banks,” Ma says.
Their success might be partly due to the CEOs they hired to run the banks. Ma’s team found that these executives had an average of 29 years of experience in banking. And 37% of them had previously worked with distressed assets or turning around troubled organizations.