(Adds reference and link to NYCB's update on Thursday)

By Pete Schroeder, Michelle Price and Koh Gui Qing

WASHINGTON, March 7 (Reuters) - A U.S. banking regulator

could have stopped New York Community Bank from

pursuing a deal that has contributed to its financial woes.

Instead, they signed off on it.

The Office of the Comptroller of the Currency (OCC) approved

NYCB's $2.6 billion merger with Michigan mortgage lender

Flagstar Bank even though other regulators feared the deal could

create problems at the New York bank, according to people with

knowledge of the matter and public records.

When approving the deal, the OCC had concerns about NYCB's

big exposure to the ailing commercial real estate (CRE) sector,

but believed that the tie-up would help diversify its loan book,

according to one person with knowledge of the matter.

The merger pushed the combined bank near a $100 billion

regulatory threshold which imposes stiff capital rules. The

looming new requirements, along with the bank's CRE exposure,

forced NYCB to slash its dividend in January, sending its shares

diving and sparking credit downgrades.

Flagstar also had CRE exposure. Reuters reported in May both

banks were among the top five most exposed, when ranked by a

regulatory concentration measure.

Regulators' deliberations reported here for the first time

are surfacing a year after Silicon Valley Bank's implosion

exposed areas of weak oversight and as policymakers debate the

risks of bank mergers. They help shed light on the missteps that

contributed to NYCB's problems and are likely to increase

pressure on regulators to be tougher on bank tie-ups.

Interviews with a dozen industry officials, merger

experts and regulatory sources, as well as public documents,

show how NYCB for years wanted to grow by pulling off a major

deal, but when the Federal Deposit Insurance Corporation (FDIC)

stood in its way the bank turned to the OCC.

The OCC greenlit the deal even though the FDIC had already

privately vetoed the transaction over concerns about the banks'

lending practices, according to two of the sources.

Additionally, the OCC disclosed when approving the deal that

it was in the middle of an examination into potential

discriminatory lending at Flagstar. Reuters could not ascertain

the outcome of that exam.

As a safeguard, the OCC imposed a special condition that

required the bank to seek its written approval for future

dividend payouts.

With NYCB, now fighting to shore up its balance sheet,

approving the Flagstar deal looks to have been a miscalculation,

say some regulatory and merger experts.

NYCB last week disclosed a far greater loss than previously

stated as well as faults in its lending controls. But on

Wednesday, it said it had raised $1 billion from investors. On

Thursday, the bank disclosed that its deposits fell 7% during

the last month and that it will outline a new business plan next

month. It said it has interest from buyers for some of its

loans.

"If you've got a banking problem, the solution is not to

make it bigger," said Dennis Kelleher, CEO of Washington

advocacy group Better Markets that has analyzed the deal.

"The Flagstar-NYCB merger should never have been

allowed...on the merits at the time."

A spokesperson for NYCB did not provide comment. However,

both banks filed a detailed merger application which the OCC

spent several months reviewing, records show.

RAPID GROWTH, RAPID PAIN

Founded in 1859, NYCB for decades chugged along as a small

lender focused on New York real estate. But the bank wanted to

accumulate deposits to generate more interest income, according

to one person with direct knowledge of the matter who asked to

remain anonymous discussing confidential information.

To grow deposits, former CEO Joseph Ficalora was set on

deals, the person said, but his attempt at a transformative

tie-up with Astoria Financial was scuttled by regulatory issues

in 2016.

After Congress in 2018 relaxed rules for banks with between

$50 billion and $250 billion in assets, it became easier to get

bank deals done.

Then in April 2021, under CEO Thomas Cangemi, NYCB announced

its big move: merging Flagstar into NYCB's New York subsidiary,

creating a lender with $87 billion in assets. Cangemi stepped

down as CEO last month.

Ficalora and Cangemi did not respond to requests for

comment.

The deal had issues from the start.

NYCB was supervised by the New York Department of Financial

Services (NYDFS) and the FDIC. Both regulators, as well as the

Federal Reserve, had to review the deal.

NYDFS approved the deal in April 2022. But officials at

the FDIC had concerns about fair lending practices at Flagstar,

and were also worried about the exposure of some of NYCB's

multifamily loans, according to sources familiar with the

matter. FDIC officials decided they could not approve the deal,

they said.

The sources declined to be identified discussing

confidential regulatory information.

The FDIC's fair lending concerns were previously reported by

media outlet The Capitol Forum.

Before the FDIC could formally block the deal, the banks

announced in April 2022 they were restructuring the transaction

so that NYCB would merge into Flagstar, which was regulated by

the OCC. A national OCC charter was appropriate, the banks said

at the time.

As a result, the OCC and Federal Reserve had to review the

deal, while the FDIC's approval was no longer necessary and the

NYDFS would have no oversight of the new entity.

Flipping charters so late in the merger process is

unusual, according to lawyers who also said the OCC had ample

discretion to block the deal. One of the sources said FDIC

officials were angered by NYCB's move to shop the deal to the

OCC.

But some OCC officials were concerned about NYCB's CRE

exposure, and believed the deal could help diversify the bank,

the source added. For supervisors, diversification is a

positive, said a different regulatory source.

The OCC approved the deal in October 2022. The Federal

Reserve approved it days later.

Months later, NYCB expanded further, buying assets from

failed Signature Bank in a deal approved by the OCC and FDIC.

Combined, the Flagstar and Signature deals doubled NYCB's

balance sheet to $116 billion.

Spokespeople from the NYDFS, the Fed and FDIC, declined

to comment.

MERGER REVIEWS

One sign that the OCC had concerns about NYCB's CRE

concentration was its condition in the approval notice that the

new bank seek the agency's approval before paying dividends.

The OCC imposed those restrictions to ensure the bank had

sufficient resources to address any supervisory issues that

arose post-merger, said a regulatory source, echoing the OCC's

explanation at the time.

While banks often have to seek some approvals around

dividends, such explicit language struck some experts as

noteworthy.

"The OCC is signaling in the order that it's got some

potential concerns about integration," said Jeremy Kress, a

University of Michigan professor who advised the Justice

Department on its ongoing bank merger policy review.

Bank mergers have become a contentious issue in Washington

as left-leaning Democrats push regulators, including the OCC, to

take a tougher stance. They say allowing banks to get bigger

creates systemic risks and increases costs for borrowers.

That debate intensified after lenders including NYCB and

JPMorgan ( JPM ) were allowed to buy failed bank assets and as

analysts expect more struggling banks to consolidate.

The OCC in January proposed overhauling its merger rules. It

is unclear if the NYCB-Flagstar deal would be approved under its

planned changes which would subject deals whereby the combined

entity has more than $50 billion in assets to additional

scrutiny.

"The question is not should we or shouldn't we" allow

mergers, Acting Comptroller Michael Hsu told Reuters in an

interview about the OCC review on January 26.

"The question is, 'How do we get the best ones?"

(Additional reporting by Hannah Lang, Douglas Gillison and Matt

Tracy; editing by Megan Davies and Anna Driver)