On Sept. 22, the Federal Reserve announced it had relaxed its restrictions on private equity fund investments in banking organizations. While the relaxation is timely, it represents at most tinkering around the edges and is unlikely to entice the huge pools of money that are waiting on the sidelines to jump into the banking industry. The Fed-imposed straitjackets are still there, and the Fed had an opportunity to help private equity capital alleviate the capital shortage at our major banking institutions but failed to do so.

Any company that controls a bank is a bank holding company and as such is subject to the supervision and regulation of the Federal Reserve. Importantly, it is also subject to limitations on its ability to engage in "commercial" (as opposed to "financial") activities. Control is defined as ownership of 25% or more of a class of voting securities, the power to elect a majority of the board or the power to exercise a controlling influence over management or policies.

For years the Fed operated under a series of prophylactic restrictions that limited companies wishing to acquire more than 10%, but less than 25%, of a class of stock to stringent passivity covenants to ensure they could not exercise control. These measures included restrictions on board seats, service on board committees, communicating with and opposing management and other limitations designed to ensure that the investment was truly passive. In the eyes of the board, the best method of ensuring absence of control was to institute severe measures to ensure passivity.

The Fed relaxed each of those limitations. While helpful to those that want to make minority investments in banking organizations, it does nothing for those that wish to make controlling investments. The Fed can do more.

The most dramatic change would be for the Fed to clarify that any private equity fund whose activities are functionally equivalent to the merchant banking activities permitted financial holding companies may become a bank holding company. It seems simple and straightforward. Well-capitalized and well-managed bank holding companies that elect to do so may engage in merchant banking activities functionally indistinguishable from those engaged in by private equity funds. The bank holding companies may own up to 100% of the stock, provide the entire board of directors, select qualified officers and, if their investments are in jeopardy, may become involved in the day-to-day activities of the company. The bank holding company must have a 10-year investment horizon, by which it should realize its investment in the company. It is as good a description of what a private equity fund does as any, yet for some reason the Federal Reserve has been unable to publicly provide any guidance on this point. Clearing up this uncertainty would provide much-needed clarity and at least give private equity firms the option of taking large, controlling stakes in banking organizations. The Fed may have implicitly taken this step when it approved the Morgan Stanley and Goldman, Sachs & Co. applications to become financial holding companies, but if so, it is quite obscure.

The Fed could also clarify that the "source of strength" obligation is simply the prompt corrective action provision embodied in the Federal Deposit Insurance Act. The Fed's "source of strength" doctrine is generally read to require bank holding companies to provide financial strength to their subsidiary banks. The prompt corrective action provisions require an undercapitalized bank to submit an acceptable capital plan to its regulator. To be acceptable, any parent holding company must guarantee the performance of the plan, but the exposure under the guarantee is capped at the greater of 5% of the institution's total assets or the amount that would have brought it back into full capital compliance.

Again, certainty as to the exposure is paramount.

The Federal Reserve need not make special rules for private equity funds; all it needs to do is return to core statutory principles. Clarity and certainty will go a long way toward clearing the roadblocks that have impeded the funds to date. Any private equity fund that wishes to abide by the rules can do so; any that doesn't can go its own way.

We recognize that these proposals are contrary to interpretations by the Fed board and staff dating many years. These interpretations, however, represented a regulatory effort to move beyond the strict confines of the statutory framework to accomplish what appeared at the time to be worthwhile regulatory objectives. Whether the objectives were worthwhile or whether they achieved their objectives is open to debate. However, whatever the merits in the past, they are not required by law and are interfering with the recapitalization of the banking industry. It is time to move beyond them.

John Douglas, a former general counsel at the Federal Deposit Insurance Corp., chairs the banking and financial institutions group at Paul, Hastings, Janofsky & Walker LLP.