By Matthias Rieker Of DOW JONES NEWSWIRES NEW YORK -(Dow Jones)- A new rule to cap interest rates paid by weak banks is forcing them to shrink and get healthy faster - or may, in some instances, accelerate their demise. In January, the Federal Deposit Insurance Corp. will limit the interest rates paid by banks that don't have strong capital, like New South Federal Savings Bank, of Irondale, Ala., First Federal Bank of California, of Santa Monica, and Royal Palm Bank of Florida, the Ft. Lauderdale subsidiary of Mercantile Bancorp Inc. (MBR) of Quincy, Ill. All three banks are deemed by regulators to be less than "well capitalized." FDIC standards restrict those banks' deposit rates to 75 basis points above either the national average or local market rates, which can be considerably higher. The new rule simplifies things by pushing banks to use only the national average. For most weak banks, the measure will force more drastic reductions of bad loans that weigh on their capital rather than luring depositors with high interest rates. "Hot money is not a strategy for survival," said Terry Moore IV, a managing director with consulting firm Accenture. The measure intends to reduce costs for other banks that compete for deposits with weak banks. Current rules are "allowing weak banks to drive up costs for the rest of the industry," FDIC Chairman Sheila Bair said in a press release in May after the news rule was finalized. But the consequences in some instances may be severe. Lawrence Kaplan, a lawyer with Paul, Hastings, Janofsky & Walker LLP, said it may push some banks over the edge - either into the arms of stronger banks, or into FDIC receivership, the banking industry's version of bankruptcy. Banks deemed to be "less than well capitalized" by regulators "will feel liquidity pressure" and will be forced to compete "with one hand tied behind their back," Kaplan said. "This will cause deposit outflows" among the banks that need deposits most, and subsequently might speed up the rate of bank failures. As of June 30, 307 of the nation's 8185 FDIC insured banks were not well capitalized. According to FDIC data, New South Federal is one of them. New South Federal, through its UmbrellaBank.com division, offers 2.2% for a 12-month certificate of deposit; First Federal, the banking subsidiary of FirstFed Financial Corp. (FFED) pays 1.99%; according to the FDIC, the national average is 1.01% for a 12 month CD. Royal Palm offers 1.62% interest on a savings account; the national average is 0.2% for savings accounts. The restriction "is another nail in the coffin" of banks suffering due to the real estate meltdown rather than bad management, said Greg Murphy, Royal Palm's chief executive. He said the new rules are overly harsh: "I don't think there is a lot of logic to it." Royal Palm hopes to avoid the interest-rate cap by merging its Florida bank charter into the Illinois charter of another Mercantile bank, which is "well capitalized." The new rules "are another factor that tells us we do the right thing" in consolidating charters, Murphy said. Calls to the CEOs of New South Federal and First Federal remained unanswered. The new rule won't affect brokered deposits - from investors like pension funds, for example - because banks that are not "well capitalized" usually cannot accept deposits through brokers. But it will limit rates on deposits from branch customers and on Internet deposits, which often pay particularly high interest rates. Ally Bank, the subsidiary of struggling GMAC Inc., often pays top rates on CDs nationwide on Internet deposits. The FDIC is already reining in those rates, according to The Wall Street Journal. FDIC rules allow some flexibility in local markets where pricing is competitive. Kaplan said exceptions will likely be a tough sell to the FDIC. Greg L. Lee, the chairman and chief executive of Nexity Bank, said he is "not alarmed by the change," because he is confident he can convince the FDIC that Nexity needs to pay higher rates to keep up with the competition. Nexity was ordered by the FDIC in March to increase capital and therefore the new deposit rate restrictions will apply to it. Nexity pays 1.83% for a 12-month CD; the average of the rate for the four banks listed on bankrate.com in Birmingham, including New South Federal, is 1.39%. Customers of Nexity's competitors often negotiate higher rates than those advertised, Lee said. Supporters of the new restrictions want banks to have trouble paying high rates. "I applaud the FDIC's rule to put some limit on what troubled banks can pay for deposits," said Christopher Whalen, the managing director of Institutional Risk Analytics. "If a bank has a capital deficiency it should be shrinking," he said, rather than expanding through high priced deposits. -By Matthias Rieker, Dow Jones Newswires; 212-416-2471; matthias.rieker@dowjones.com
