Oak Harbor-based Whidbey Island Bank will not become Frontier Bank.

Washington Banking Company, the holding company for Whidbey Island Bank, notified Everett-based Frontier Financial Corporation this week that it is terminating an agreement and plan of merger worked out last September.

The problem is that Frontier Financial was unable to secure permission for the merger from the Federal Deposit Insurance Corporation after regulators found concerns in a consumer compliance exam of Frontier. Chief executive officers from both companies said regulators are taking a much tougher line nowadays in the wake of problems in the banking market, largely as a result of insurance claims from Hurricane Katrina and the subprime mortgage crisis.

“We’re disappointed, but at the same time, this gives us more opportunities,” said Washington Banking Company CEO and President Michal Cann. He explained that the company will explore options, which include remaining independent or partnering with a different bank.

In the meantime, Whidbey Island Bank will likely be hiring back support staff who were lost in the merger process. Many of the top administrators would have lost their positions if the merger went through, but now they get to keep working — at least for the time being.

The ultimate fallout from the collapse of the merger may be litigation. Both companies are claiming that the other owes a $5 million termination fee for breaching the merger agreement.

“We would have preferred a joint agreement of termination,” said John Dickson, president and CEO of Frontier Financial, “but they decided to take a little more aggressive action toward us.”

Cann said Frontier broke the agreement by not being able to secure FDIC permission in a timely manner. Also, Frontier represented that it was in compliance with banking rules and regulations, but the regulator’s compliance audit apparently found otherwise.

Dickson disagrees that Frontier breached the contract over compliance issues. He said his company is making a counterclaim that Whidbey Island Bank broke the agreement by not allowing Frontier to have a 30-day period to “cure” the problems.

Cann countered that 30 days of continued uncertainty over the merger would not have benefited either company, or their customers, stockholders or communities.

Both CEOs hope that the disagreement can be worked out amicably.

“We hold Whidbey Island Bank and employees in high regard and we are disappointed that it has come to this,” Dickson said.

Consumer compliance exams, Dickson explained, deal with regulations and rules, such as fair lending practices. He said he can’t disclose the exact issues identified because to do so would be a violation of federal law. The findings have nothing to do with money, he said, and Frontier Financial is financially sound.

“We’ve already resolved 90 percent of the issues they looked at,” Dickson said. “It had nothing to do with the quality of our loans.”

Dickson said regulators told him that the merger would not be approved because of the compliance issues. He said regulators are “being very difficult with consumer compliance right now” because of the recent messes in the banking industry.

“I’m very frustrated with the regulators,” he said. “I don’t think they are really taking into account the impact the lack of approval will have on our communities and customers.”

The permission from the federal government was the last step in the merger process and the denial took everyone by surprise. Dickson said his company spent $1.3 million, before taxes, on the unsuccessful merger process. Much of the money was spent on legal costs and conversion of the computer systems.

Cann said Whidbey Island Bank also lost money, but he wouldn’t say how much.

Shares of Washington Banking fell more than 22 percent Wednesday on news that the merger fell through. Stock in the 19-branch bank closed down $2.81 to $9.69, on more than 34 times its average volume.

Both Cann and Dickson said the stock fell to a level that was more in line with similar companies. The stock price had been buoyed by speculation over the merger, they said.

Cann emphasized that Whidbey Island Bank remains solid financially. In April, the company reported first quarter earnings were up 3 percent to $2.3 million compared to the first quarter a year ago.

“We remain strong, with solid credit, strong loan growth and increasing profits,” Cann said. “In some ways we are running more efficiently.”