FDIC concluded its quarterly board meeting earlier this afternoon and the big news is it approved lower capital requirements for private equity shops looking to buy failed banks.*

But the weaker requirements come with a silver lining.

The previous proposal was that banks in the hands of private equity would have to maintain Tier 1 capital of 15%, triple the standard of 5% that is currently considered “well-capitalized.”  [Your humble columnist thinks that threshold is way too low, but that's another discussion].

Under the rule that was adopted, such banks will have to maintain a 10% capital ratio, but the definition of capital isn’t Tier 1, it’s Tier 1 common equity.

Tier 1 common equity is close to tangible common equity, which is a stronger measure of capital than simple Tier 1.

Why does this matter? As I wrote about in my column updating Q2 leverage stats, it’s not just the size of the capital cushion that matters. It’s also the quality of that cushion. (If this post seems a little wonky, I recommend going back to that column.)

Common equity is the best cushion of all because it sits in the first loss position. Preferred equity — which is included when calculating Tier 1 but excluded when calculating Tier 1 common — failed totally last year. Banks had issued a bunch in late ’07 and early ’08 in order to boost Tier 1, but because common was nearly overwhelmed with losses, investors higher up the capital structure panicked.

To be sure, the switch to common won’t have any effect on the day-one economics of these deals. Subordinated debt is wiped out when FDIC takes failed banks into receivership.

But this will discourage private equity guys from polluting the capital structure down the line. Hybrid debt issuance that would qualify as capital under Tier 1 won’t qualify under Tier 1 common.

My hope is that this foreshadows a more general move away from Tier 1 in favor of Tier 1 Common or TCE for all banks. The banking system is still desperately undercapitalized in my view, taking into account the loan losses that are festering on balance sheets.

On another front, I was disappointed to see that FDIC abandoned the “source of strength” requirement, which would have required PE shops to put up more capital if their banks falter.

But they maintained the three year holding requirement, and they say that banks falling under the 10% TCE threshold would be subject to prompt corrective action (ht frog). That means FDIC could force them to boost capital back above the 10% threshold.

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A question for readers: Are there any protections in place preventing PE shops from using insured deposits to fund investments in other areas? What’s to stop them from using the bank to finance their own LBO deals?

*Readers interested in the nitty gritty can read the FDIC’s Final Statement of Policy here (pdf).