U.S. banking regulators partially retreated from a much-criticized proposal to impose new rules on private equity investment in troubled banks, aiming to encourage responsible investment in distressed banks.

The 4-1 vote by the Federal Deposit Insurance Corp board was a partial victory for potential investors and some regulators who had warned that an initial proposal unveiled in July threatened to scare away much-needed capital.

The regulators lowered capital requirements and dropped or modified measures that could have required investors to kick in more capital after their initial investment. The rules will be further reviewed in six months.

Even so, FDIC Chairman Sheila Bair said the modified rules could depress investor interest in failed banks, a view shared by a private equity industry group.

The FDIC recognizes the need for additional capital in the banking system, Bair said, but added: We do want people very serious about running banks.

U.S. bank regulators are increasingly looking to nontraditional investors -- such as private equity groups and international banks -- to nurse failed banks back to health as the number of insolvent institutions continues to rise, draining the FDIC's deposit insurance fund.

Regulators have shuttered 81 banks so far this year, compared with 25 last year, and three in 2007.

The Private Equity Council said the rules, at a minimum, would reduce the value of any bids for failed banks, increasing resolution costs for the FDIC.

Given the well-documented track record of private equity firms in turning around troubled companies, it also makes little sense to deprive the banking system of needed expertise, the group said.

Josh Lerner, a Harvard Business School professor, said the FDIC was walking a tightrope given that there was a clear need for outside money due to the number and cost of bank failures.

At the same time there's clearly a sense of reluctance to give too good a deal to the private equity guys, he said.

CAPITAL RATIOS

A capital requirement for private equity investments in banks was lowered to a Tier 1 common equity ratio of 10 percent, from the 15 percent Tier 1 leverage ratio previously proposed.

One private equity executive said their analysis was that on a typical $10 billion bank, a private equity bid would be put at around a $1 billion disadvantage because of the 10 percent capital level.

The regulators also dropped a requirement that investors serve as a source of strength for the bank they buy, which critics said could have put them on the hook for more capital if the institution struggled.

A cross-guarantee proposal -- meaning if an investor owns more than one bank, the FDIC can use the assets of the healthier bank to cut losses from the one that has faltered -- was modified to only include banks that had an 80 percent common ownership.

The FDIC kept a requirement that private equity investors maintain their ownership of a bank for at least three years, unless they get prior approval by the FDIC.

BankUnited Chief Executive John Kanas said it was clear regulators were holding private equity to a higher standard than other investors.

And it will probably result in private equity adjusting their prices downward accordingly for these transactions, Kanas told Reuters. Earlier this year he led a consortium that included private equity giants Blackstone Group <bx.n>, Carlyle Group <cyl.ul> and WL Ross & Co in taking over failed Florida lender BankUnited.

The dissenting vote was from acting director of the Office of Thrift Supervision, John Bowman, who said the revised policy was overly broad and imprecise. He also expressed unease at singling out private equity investors as a separate group.

Voting for the rules were Bair, FDIC Vice Chairman Martin Gruenberg, FDIC Director Thomas Curry and Comptroller of the Currency John Dugan.

Dugan had raised concerns in July about the initial version of the rules, but said he supported the new guidelines, describing them as significantly improved.

The FDIC on Wednesday also voted to extend by six months a program that guarantees transaction deposit accounts, which businesses typically use to meet payroll and pay vendors.

It has improved overall liquidity throughout the banking system, Bair said.

The agency also said it would seek comment on whether to phase in the impact on capital requirements of an accounting change that will force banks to bring $1 trillion of off-balance sheet assets back on their books.

(Reporting by Karey Wutkowski and Steve Eder; Additional reporting by Paritosh Bansal and Megan Davies in New York; Editing by Tim Dobbyn and Simon Denyer)

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