These investors typically buy private companies and overhaul their operations to boost profits. 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. During the 2008 financial crisis, private equity played an overlooked role, Ma said. For each failed bank, the researchers examined the financial health of other banks with branches in one or more of the same zip codes. Study: Margin Trading Causes Stock Prices to Drop in Concert. 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. Perhaps PE investors also would take excessive risks in their attempts to turn around the banks, creating even more problems. The FDIC chose the buyer based on small differences in bidsas close to a randomized experiment as the researchers could get. PE firms raise money from individuals and organizations and act as a financial intermediary, buying companies and making financial and operational changes. PE firms have generated controversy, with critics arguing that they extract value from the companies they buy and even destabilize the financial system. But a new study co-authored by Song Ma, an assistant professor of finance at Yale SOM, suggests that these investors may have played a positive role in turning around banks that failed during the 2008 financial crisis. Their success might be partly due to the CEOs they hired to run the banks. The team calculated that 5.5% more failed banks would have been liquidated. Among banks that were bought, PE firms acquired 13% of them, the equivalent of 24% of the assets held by failed banks. When the next crisis hits, policymakers will need to decide whether PE investors should be allowed to join the fray again. PE firms were more likely to buy banks whose neighbors were also faring poorly. Typically these bidders were other banks, but PE firms also were permitted to toss their hats in the ring. PE firms took on banks in poor health that other buyers didnt want, and those banks performed relatively well under their new management. Its a pretty significant amount, Ma says. PE investors also were more likely to buy banks with a higher fraction of risky assets, such as real estate loans. But another question still remained. And 37% of them had previously worked with distressed assets or turning around troubled organizations. FDIC resolution costs also would have risen by $3.63 billion, or about 5%. 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. Is the Fed Ready for the Next Financial Crisis? The question of whether PE firms help or hurt the economic system is too big to answer comprehensively, says Song Ma, an assistant professor of finance at Yale SOM. FDIC resolution costs would have risen by $3.63 billion, or about 5 percent. 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. 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. Can We Reduce Risk from the Shadow Banking System? That question proved trickier to answer because the types of banks bought by PE firms and traditional buyers were different. And in counties with PE-acquired banks, small business loans grew 32% faster. And they seemed to do a reasonably good job of turning these failing banks around. 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.

But some people argue that PE investors maneuvers, such as loading these companies with a lot of debt, introduce risk into the financial system. Did the PE firms do a good job of running these banks?

But based on how the situation after the 2008 crisis unfolded, Ma says, letting private equity play a role shows some promise., Yale Insights is produced by the Yale School of Management. 2007-2022 Yale School of Management, Patrick Fallon/Bloomberg via Getty Images, Private Equity and Financial Stability: Evidence from Failed Bank Resolution in the Crisis, Women Arent Promoted Because Managers Underestimate Their Potential, In a First, Randomized Study Shows That Masks Reduce COVID-19 Infections, Inside the CDO Market That Catalyzed the Financial Crisis. During the three years after acquisition, the chance that a bank branch run by a PE firm would close was 15 percentage points lower. They found that PE firms were acquiring banks at the bottom of the quality ladder, he says. 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. But in a recent study, his team zeroed in on one example of PE involvement: when PE investors bought banks that failed during the 2008 crisis, a period when financial stability is extremely important and also extremely fragile, Ma says. So any variation in performance would be hard to attribute to PE management; it could just be due to underlying differences in the banks. The teams study was limited to one time period, and they cant say whether one policy will fit all scenarios. We are looking at a very high-stakes moment.. To circumvent this problem, the team identified a subset of banks that had been bid on by both PE firms and other banks. The researchers found that PE investors tended to acquire banks in poorer health that traditional buyersthat is, other banksdidnt want. A sign outside a Jefferson, Missouri, branch of Premier Bank, which failed in 2010. PE investors also appeared to acquire banks in areas where nearby banksthe most natural buyersmight not be able to take over. The researchers calculated that without private equity investments, 5.5 percent more failed banks would have been liquidated. These banks increases in deposits were also 36 percentage points higher. Mas team found that these executives had an average of 29 years of experience in banking. Other banks might not have had the resources to take on struggling institutions, Ma says. One might expect PE firms to perform poorly in this area, since banks require specialized expertise to run. Traditional investors would say youre out of your mind to buy banks in that condition, Ma says. Many small community banks failed, and the FDIC allowed other companies to bid on them. Private equity firms have attracted plenty of criticism. But PE firms are willing to buy them because if they can turn them around, the returns are bigger.. The bank resolution evidence suggests that they could play a quite positive role in stabilizing the financial system during that specific period.. PEs actually did quite a good job in turning around those banks, Ma says. What would have happened if PE investors hadnt stepped in?