Subcommittee on Financial Institutions
Subcommittee on Securities


Joint Hearing on Merchant Banking Regulations Pursuant
to the Gramm-Leach-Bliley Act of 1999


Testimony of Joseph S. Bracewell
Chairman and CEO
Century National Bank
Washington, D. C.

On Behalf of the
Independent Community Bankers of America

June 13, 2000

Good morning, Chairmen Bennett and Grams, and other members of the Financial Institutions and Securities Subcommittees. I am Joseph S. Bracewell, Chairman and CEO of Century National Bank, a $220 million community bank based here in the nation's capital. I am testifying on behalf of the Independent Community Bankers of America ("ICBA"), which appreciates this opportunity to provide its views on merchant banking matters.

The ICBA is the only national trade association that exclusively represents the interests of community banks. The 5,500 ICBA-member banks can be found at nearly 16,700 locations across the country. The ICBA's members hold more than $491 billion in insured deposits, $589 billion in assets and more than $344 billion in loans for consumers, small businesses and farms. ICBA-member banks employ nearly 232,000 citizens in the communities they serve.

Overview

As noted in our June 6 letter regarding today's hearing, many ICBA-member bankers hold strong feelings about merchant banking issues because of their implications for the mixing of commerce and banking. In late March, the ICBA submitted a comment letter to the Federal Reserve Board ("Fed") and the Treasury Department ("Treasury") on their joint interim rule 1 governing merchant banking investments made by financial holding companies ("FHCs"). The comment letter also addressed the Fed's supplemental proposed rule, 2 issued in consultation with Treasury, on the regulatory capital treatment of merchant banking investments. In general, we found the interim rule and the proposed rule to be consistent with provisions in the Gramm-Leach-Bliley Act ("GLB Act") concerning merchant banking activities.

Last year, the ICBA, working with House Banking Committee Chairman Leach, Representative Largent and Senators Sarbanes and Johnson, among others, successfully fought the banking and commerce issue as part of the debate over the GLB Act dealing with unitary thrifts. The Congress also did not adopt proposals to permit banks to own a "basket" of commercial firms. The merchant banking language in the new law should not be construed to permit activities that the Congress clearly rejected or failed to authorize.

In our judgment, it was the clear intent of the Congress that banking and commercial activities remain separate to protect the integrity of insured deposits, to promote the safety and soundness of financial institutions, to preserve the banking system's role in the payments system, and to maintain the stability of our nation's financial system.

There are serious safety and soundness implications for going beyond what the Fed and Treasury have proposed on merchant banking. We find ourselves in an era of major changes in the financial services industry, many of these changes the direct result of the GLB Act. Broadened financial activities open new doors, but they also raise questions for both financial competitors and their regulators. It would be hard to imagine a better example of this situation than issues surrounding private equity investing by FHCs, particularly as related to the ever-burgeoning (and potentially volatile) technology sector.

In addition, structural changes in the industry have regulators grappling with the "challenges of global financial institution supervision," to quote the title of a speech given by Fed Governor Laurence H. Meyer on May 31. These emerging large complex banking organizations ("LCBOs") do present a systemic risk to our economy. 3 As Governor Meyer noted late last month, "These entities are becoming increasingly difficult to supervise and evaluate because of their complexity and opaqueness."

Certainly, no one can deny that taking equity positions in technology firms without positive earnings records -- as would be permitted by the new merchant banking authority -- is a risky business. Such investments can contribute to the increased systemic risk posed by LCBOs that Governor Meyer has warned about.

Again, it is ICBA's judgment that the Fed and Treasury have struck a very careful balance in the merchant banking proposals that weighs financial innovation with safety and soundness considerations. We understand that some of the industry's largest players don't share this view, which is being made in the broader context of how LCBOs should be regulated.

Basis for Fed and Treasury Actions

During June 7 testimony before the Capital Markets Subcommittee (House Banking Committee) on the merchant banking proposals, Treasury Under Secretary for Domestic Finance Gary Gensler noted that the "Congress provided joint rule-writing authority to the Treasury and [Fed] to ensure that merchant banking activities would be conducted in a safe and sound manner and would preserve an appropriate separation of banking and commerce." Governor Meyer echoed this point, testifying that the interim rule, for example, "is designed to implement the provisions of the GLB Act that were enacted in order to prevent merchant banking activities from being no different than a mixture of banking and commerce."

The legislative history of the GLB Act buttresses the Fed and Treasury's stance. Senate Banking Committee Ranking Member Sarbanes and House Banking Committee Chairman Leach both said in separate floor statements during debate on the S. 900 conference report that under this rulemaking authority the Fed and Treasury "may define relevant terms and impose such limitations as they deem appropriate to ensure that this new [merchant banking] authority does not . . . undermine the safety and soundness of depository institutions or the Act's general prohibitions on the mixing of banking and commerce."4

Interim Rule on FHC Merchant Banking Activities

The joint interim rule implements provisions of the GLB Act that permit an FHC to own up to 100 percent of a nonfinancial company as part of a bona fide securities underwriting or merchant or investment banking activity. The rule notes that the "GLB Act contains provisions that are designed to help maintain the separation of banking and commerce by limiting the time period that a merchant banking investment may be held by [an FHC] and the circumstances under which the [FHC] may routinely manage or operate a portfolio company." Accordingly, the rule generally limits merchant banking investments to 10 years (with flexibility as circumstances may warrant), and generally prohibits an FHC from operating a portfolio company on day-to-day basis (again, with flexibility in certain circumstances). The ICBA fully supports these prudential limits, which conform to the clear intent of the Congress in the GLB Act to maintain the historical separation of banking and commerce in the United States, and to the specific requirements in the GLB Act limiting holding periods and prohibiting routine management or operation of the portfolio company by an FHC.

As Undersecretary Gensler testified on June 7, the new merchant banking authority provided by the GLB Act "significantly expands the ability of bank affiliates to invest in the private equity market." He pointed out that the "most important thing to understand about [merchant banking] is that these investments are generally higher risk, longer term, illiquid investments" than traditional banking investments. Governor Meyer's testimony noted that U.S. banking organizations have doubled their private equity investing over the last five or so years. He stated that "holdings of stock - mainly private equities - [at some large banking organizations] already were large and rising before merchant banking was authorized by the GLB Act." Governor Meyer added that this development "had clearly gotten our attention [as supervisors] well before last November," when the new merchant banking authority was enacted.

Clearly, the dramatic recent growth in private equity investing by banks, or to be more accurate, a small number of very large banks, is closely related to the economic boom and bull stock market which the U.S. economy has enjoyed over most of the last decade. As Governor Meyer's testimony notes, the "attraction of banking organizations to the high returns and growing buoyancy in stock prices . . . has matched the growth in the entire private equity market," where more private equity financing has been undertaken in the last three years than in the previous thirty.

There can be no doubt that expansion of merchant banking activities will produce increased risks for those banks choosing to exercise this newly-expanded authority, as risk is both the greatest danger and the greatest benefit of private equity investing. These heightened risks may lead to heightened returns in certain instances, but the bottom line remains that banks will be increasing their presence in a field of endeavor where the risks are both potentially greater and different from the vast bulk of their traditional operations. This situation naturally calls for caution, and the Fed and Treasury have prudently embarked on such a course.

The ICBA supports other necessary safeguards in the interim rule that require an FHC to: (1) establish policies and systems to monitor the risks of its merchant banking investments; and (2) establish policies for assuring the corporate separateness of companies held under the rule and limiting the potential that the FHC or its affiliated depository institutions may be legally liable for the financial obligations or operations of those companies. Likewise, we support provisions in the rule that implement cross-marketing restrictions from the GLB Act and impose the affiliate transaction restrictions of Sections 23A and B of the Federal Reserve Act to dealings between a bank and a portfolio company controlled by the same FHC. All of these provisions, particularly the risk-monitoring standards, are related to the evolving process of harnessing market discipline and increased public disclosure as both an operational tool for LCBOs and a supervisory aid for the regulators charged with overseeing these emerging conglomerates.

In addition, the interim rule wisely sets aggregate investment limits for an FHC involved in merchant banking activities, including a limit of the lesser of 30 percent of Tier 1 capital or $6 billion. The ICBA agrees, as the rule notes, that "these limits are necessary until appropriate capital rules are put in place and experience is gained in managing and supervising the risk of this activity." Governor Meyer aptly described these limits in his testimony last week when he said regulators "view the caps as a safe and sound way to allow merchant banking activities to begin and fully expect to revisit the need for caps as we review the interim rule and the capital proposal." Emphasis needs to be given here to the words "to begin," as that is the case with these expanded merchant banking activities. These caps do not apply to or limit in any fashion the pre-GLB Act investment authority of banks.

Proposed Rule on Regulatory Capital Treatment of Merchant Banking

The ICBA also fully supports the Fed's supplemental proposed rule that a bank holding company be required to deduct from its Tier 1 regulatory capital an amount equal to 50 percent of the total carrying value of all merchant banking investments it holds. Large bank representatives have publicly criticized the proposal as too harsh, and have claimed that commercial banks will be at a competitive disadvantage to foreign banks, as well as investment banks and insurance companies that do not own a bank and are not subject to the FHC rules. The Fed and Treasury note, however, that the proposal reflects existing "industry practices in conducting merchant banking activities," with internal capital charges already ranging from 25 percent to 100 percent depending on the firm or type of investment.

The ICBA agrees that this capital proposal is a necessary precaution to prevent buildup of excessive risk within banking organizations from merchant banking activities, especially with the expansion of the activities under the new GLB Act authority. The ratings firm Standard & Poor's has expressed a similar view, issuing an analysis agreeing with the proposed 50 percent capital charge for private equity investments by banks, provided that "the bank's portfolio is mature and diversified; less diversified portfolios could need up to 100%." 5 Standard & Poor's went on to note that there will be no ratings implications from these new regulatory requirements because the firm has historically allocated this level of capital for bank private equity investments. Moody's, the other major ratings firm, has issued a similar analysis, saying that the venture capital activities are "capital-intensive . . .[and] it is prudent for venture capital activities to be funded with a high equity component." Moody's also described the 50 percent capital plan "as being supportive of bank ratings." 6

During the question-and-answer session at the June 7 hearing in the Capital Markets Subcommittee there was an interesting exchange on this issue. A witness representing Chase Capital Partners told Subcommittee Ranking Member Kanjorski that this Chase Manhattan unit's annual rate of return on its realized investments might be closer to 60 percent (rather than the stated 40 percent) if a 50 percent capital charge was applied, rather than the 100 percent capital charge already applied by Chase. Not surprisingly, Rep. Kanjorski then asked the witness how he could possibly be opposed to the 50 percent capital proposal -- which the witness had earlier testified was "[o]ne of the most objectionable aspects of the merchant banking rules."

Some of the large banking and securities organizations opposed to the 50 percent capital standard have also claimed that the Fed is engaged in "cherry picking" by setting a higher capital charge for risky assets, such a private equity investments, without providing capital relief for lower-risk assets. Among other things, they have suggested that the Fed wait for broader reforms to capital rules under the Basle Accord, changes that would perhaps make bank regulatory capital charges more risk-sensitive and more reflective of actual economic risk at individual institutions.

While these suggestions have some level of validity in that capital standards should be updated to deal with LCBO-related concerns, the underlying premise of these arguments is faulty. The simple fact is that regulators, and the entities they supervise, must deal in the here-and-now. Private equity investing by banks has grown dramatically in recent years and is poised to grow even faster under the new merchant banking authority. The capital standard which has been proposed will help ensure these activities are undertaken prudently, and, more importantly, help cushion any losses stemming from either normal problems (e.g., bad investments) associated with private equity holdings or a general economic downturn, which is inevitable at some point.

Additional Issues

Some commenters have objected to applying the proposed capital rule to certain other pre-GLB Act authority, such as private equity investments by Small Business Investment Companies ("SBICs") and state-chartered banks. The Federal Deposit Insurance Corporation ("FDIC"), for instance, has commented that the capital proposal places undue regulatory burden on state-chartered banks already engaging in private equity investment under section 24 of the Federal Deposit Insurance Act. In a May 22 letter to the Fed, FDIC Chair Tanoue wrote that her agency's "section 24 review process has already addressed [merchant banking-risk] concerns with respect to investments covered by the section 24 aspect of the [Fed's] proposed rule . . . [and the FDIC will impose] increased capital requirements as necessary to protect the state bank and the Bank Insurance Fund."

As for SBICs, commenters have noted, among other things, that they are subject to licensure, regulation and examination by the Small Business Administration in order to address risk and safety and soundness issues. In addition, bank investment in SBICs is already limited. A bank may not invest more than five percent of its capital and surplus in SBICs.

In general, the ICBA believes that similar activities should be treated in similar ways, unless the activities can be distinguished from one another. The Fed and Treasury should reexamine certain pre GLB-authority to determine whether prudential limits already in place for these activities are adequate to address concerns associated with these investments. That being said, it is critical that pre-GLB authority and business structures not become a convenient basis or location for cloaking the newly expanded merchant banking authority and stretching the prudential limitations set on these powers.

Conclusion

The business of community banking is to provide finance for consumers and small businesses. The financial support that community bankers provide to their customers is a staple for continuing economic development and well being in the communities that they serve. The stability of the financial system and the integrity of the deposit insurance system are critical to community banks' ability to continue to fulfill this role. Activities that may put the stability of the financial system or the integrity of the deposit insurance system at risk -- such as the growing systemic risk posed by the largest financial institutions -- must be carefully controlled and managed. The Congress has charged regulators with overseeing this task -- and using their expertise and experience to make appropriate judgments. Sometimes this may involve using an ounce of prevention to avoid a painful and expensive pound of cure.

The Fed and Treasury have embarked on the right course with their actions thus far on merchant banking. Those FHCs that choose to exercise this newly-expanded authority can do so. But let's be certain that we take on this process carefully. We have seen the dangers of unfettered mixing of banking and commerce in other countries, most notably in Asia in recent years. The U.S. economy is the most vibrant and dynamic in the world. In order to keep it in this condition, prudential safeguards are necessary for newly-expanded authority. This is particularly important as it relates to the activities of emerging LCBOs, which pose safety and soundness concerns on a scale which regulators have just begun to confront.

Thank you for considering the ICBA's views on these matters.

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