UPDATE 1-U.S. FDIC restricts interest rates at weak banks

(Adds action on debt program, background)

WASHINGTON, May 29 (Reuters) - U.S. banks that are struggling to stay afloat will not be allowed to aggressively ratchet up interest rates to attract customer money, a top bank regulator said on Friday.

The Federal Deposit Insurance Corp voted to bar a bank with insured deposits from paying interest rates that “significantly exceed” prevailing market rates if the bank is deemed not well capitalized. The new rule better defines what constitutes normal market rates, the FDIC said.

The agency also finalized a rule that expands the FDIC’s debt-guarantee program to include mandatory convertible debt. The FDIC passed an interim rule in February to expand the program, which is designed to boost confidence in banks.

The interest-rate rule comes as many smaller regional banks are weighed down by bad loans and credit losses. The FDIC said on Wednesday that the number of banks on its “problem list” grew 21 percent in the first quarter to 305 institutions -- the highest number since 1994.

Some of those institutions will likely be nursed back to health, but others will join the ranks of the 36 U.S. banks that have failed so far this year.

The number of seized banks has been consistently creeping upward, with 25 failed banks in 2008, and only 3 in 2007.

FDIC Chairman Sheila Bair said this week that the number of failed banks will continue to grow. (Reporting by Karey Wutkowski, editing by Gerald E. McCormick and Steve Orlofsky)