WASHINGTON (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.

"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 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)