June 13, 2000
My name is Jeffrey Walker. I am the Managing Partner of Chase Capital Partners, and I am a Member of the Executive Committee of The Chase Manhattan Corporation. I am pleased to have the opportunity today to speak on behalf of The Financial Services Roundtable on the merchant banking rules released by the Federal Reserve Board ("Board") and the Department of Treasury ("Treasury").
Chase Capital Partners, the primary equity investment arm for The Chase Manhattan Corporation, has a long-standing and successful history of making merchant banking investments. Chase Capital Partners has been involved in merchant banking activities for over sixteen years. In fact, it has closed over 1000 transactions since its inception. Several companies in which we have invested that may be familiar to you include Star Media, Geocities, Kinkos, 1-800 Flowers, Office Depot, American Tower, Harris Chemicals, Jet Blue Airways, Multex, Telecorp PCS and Triton Cellular. It is a global investment partnership with over $18 billion in assets under management, and has over 140 investment professionals in seven offices throughout the world.
Chase Capital Partners has maintained a successful relationship with the Chase Manhattan Corporation, its primary investor, by maintaining a diversified investment portfolio. At the same time, Chase Capital Partners has consistently exhibited a strong risk management and reporting process and has received satisfactory results from its banking exams for its entire history.
Chairman Grams and Chairman Bennett, thank you for holding this hearing today and for inviting The Financial Services Roundtable to participate. The Financial Services Roundtable is a national association whose membership is reserved for 100 companies selected from the nation's 150 largest integrated financial services firms. The member companies of the Roundtable engage in a wide range of financial activities, including banking, securities, insurance, and other financial service activities.
The Roundtable is pleased that these two subcommittees continue the long tradition of promoting honest and open discussion on topical and important issues such as the one we are addressing today. The Roundtable expects that this hearing will help the Subcommittee evaluate the industry's concerns over the proposed capital charge and other restrictions contained in the merchant banking rules. The Roundtable further anticipates that this hearing will help address solutions for ensuring that banking organizations and securities firms have equal opportunities to engage in merchant banking activities under the Gramm-Leach-Bliley Act ("GLB Act").
Let me begin by stating that Congress authorized merchant banking investments under the GLB Act in recognition of the "essential role" that merchant banking plays in modern finance. The Roundtable strongly believes that the merchant banking rules threaten to restrict this important activity in ways that are plainly inconsistent with the clear intent of Congress. More importantly, the Roundtable believes that these rules will make it a great deal more expensive for FHCs to make merchant banking investments and, thereby, threaten to limit the availability of venture capital funds. Finally, the Roundtable believes that the rules are unnecessary given the long and highly successful history of bank holding companies and securities firms in making, managing, and monitoring venture capital investments in a prudent fashion. Any supervisory concerns of the Board and Treasury over merchant banking investments can be dealt with most appropriately on a case-by-case basis through the traditional examination and supervisory process.
The Roundtable has submitted a comment letter to the Board and Treasury urging them to reconsider the proposed capital charge and other aspects of the merchant banking rules that disadvantage financial holding companies ("FHCs") in the conduct of merchant banking activities. As explained in full detail in the Roundtable's comment letter, the Roundtable has significant concerns about the following aspects of the merchant banking rules.
The Fifty Percent Capital Haircut
One of the most objectionable aspects of the merchant banking rules is the Board's proposal to impose a fifty percent capital haircut on merchant banking investments by FHCs under the GLB Act and equity investments by bank holding companies under other long-standing legal authorities. This extra capital charge increases the amount of capital that a holding company must carry against a covered investment by approximately 800 percent. This is an eight-fold increase in the capital cost of making these types of investments.
The Roundtable strongly believes that this extraordinary capital charge undermines the very competition that Congress concluded was in the public interest when it passed the GLB Act. The capital charge will upset the "two-way street" that permits banking organizations to compete with securities firms and securities firms to own banks by making it more expensive for FHCs to make merchant banking investments. The capital charge also will disadvantage U.S. FHCs as compared to securities firms that are unaffiliated with banks and foreign banks that elect FHC status, neither of which will be subject to similar capital haircuts. This disparate treatment is inconsistent with the spirit of the GLB Act.
The Roundtable further believes that the arbitrarily high capital charge is not necessary. Banks and bank holding companies have engaged for decades in activities that the Board says are identical in risk to merchant banking activities. They have done so without any threat to safety and soundness.
The Board's main justification for the capital charge is that some banking and securities firms apply internal risk models with a high capital assessment to equity investments. The Board's reliance on internal models in this case is inappropriate for two primary reasons. First, internal models usually apply a higher charge to some investments and a lower charge to investments judged as less risky. The Board's rules do not allow such adjustments. Thus, the Board is "cherry-picking" only the part of an internal model that applies a higher charge, while ignoring other parts of the model. Second, the industry's practices are divergent. The Roundtable surveyed many of its members and was itself surprised to learn that there is no common approach to addressing investment risk. Accordingly, the Roundtable does not believe institutions' internal capital models provide support for the application of a uniform 50% regulatory capital charge.
The Board assumes that objections to the capital charge are of no practical significance because FHCs will remain well capitalized even after the capital charge. This assumption is not correct. Institutions typically maintain a cushion above regulatory capital requirements. Such a cushion protects against unexpected events and ensures high ratings, among other things. A mandatory increase in capital will not reduce the need for an institution to maintain such a cushion.
Accordingly, the capital charge will have a real, concrete and significant impact on institutions. It will require institutions to raise additional capital for each equity investment. It will do so for no economic reason. This outcome is unwarranted given that circumstances have not changed and experience does not call for increased capital for merchant banking investments.
The Roundtable believes that an individualized approach to risk management is by far the most effective way of addressing the perceived risks of merchant banking. An individualized approach would not upset the careful balance that Congress sought to achieve in authorizing merchant banking. The Board certainly has ample authority to limit merchant banking activities of particular institutions on a case-by-case basis.
If the Board, nonetheless, decides to impose specific capital rules on merchant banking activities, the Roundtable has suggested some alternatives. These alternatives, which are set out in detail in the Roundtable's comment letter, include excluding unrealized gains on merchant banking investments from an institution's calculation of its capital base or imposing a 200 percent risk weighting for investments made under the new merchant banking authority. Any of these proposed alternatives is an improvement over the Board's arbitrary capital charge.
The Maximum Investment Cap
Another objectionable feature of the merchant banking rules is the maximum investment cap on FHC merchant banking investments. The interim rule generally prohibits a FHC from making additional merchant banking investments if the aggregate value of all merchant banking investments exceeds the lower of $6 billion or 30 percent of the FHC's capital base.
As an initial matter, the GLB Act does not authorize these caps. Furthermore, the Roundtable strongly believes that any artificial investment cap on merchant banking will limit the ability of FHCs to compete in the market. A maximum cap will limit diversification and reduce market presence of FHCs. This will impair FHCs ability to compete for most major deals. In addition, a maximum cap also will punish those firms that invest wisely -- firms whose merchant banking portfolio's have shown significant gains will run the risk of hitting the caps; firms with poorly performing portfolios are less likely to hit the percentage caps.
The Roundtable is perplexed over why the Board and Treasury believe that a specific dollar cap, let alone one based on a fixed dollar amount, is appropriate. The dollar limits do not reflect the industry's past practice in investing in merchant banking. In fact, the dollar limits are so low that securities firms may reach the limits quickly and automatically be precluded from further merchant banking investments. A one-size-fits-all approach to regulating merchant banking simply does not work.
The preamble to the interim rule suggests that the maximum cap is a temporary measure to be revisited as soon as the Board and Treasury adopt appropriate capital rules and gain experience in managing and supervising the risks of merchant banking. If the Board and Treasury are determined to impose a cap, the Roundtable urges them to include a specific "sunset" provision for the cap in the actual text of the rule. Ambiguity over the duration of the cap will have at least three negative consequences: first, it will impair the ability of FHCs to assess properly the viability of potential merchant banking investments; second, it will have a practical effect on the management of FHCs' merchant banking business (e.g., decisions on staffing and recruiting); and, third, it will only add to the competitive advantage of securities and investment firms over FHCs and their affiliates in merchant banking.
Coverage of More Than Merchant Banking
The Roundtable further objects to the unwarranted, broad scope of the merchant banking rules, which encompass much more than merchant banking. In fact, the merchant banking rules are written so broadly that they cover existing equity investments made under long-standing legal authorities, including investments in small business investment companies ("SBICs") and loans to merchant banking clients.
Bank holding companies have made limited equity investments for more than 30 years without any additional capital charge. Moreover, the Board and Treasury have presented no evidence, and the Roundtable submits that there is none, to indicate that these investments have given rise to any safety and soundness risks or other concerns. The inclusion of these types of equity investments in the scope of the merchant banking rules is not necessary or appropriate.
The coverage of SBIC investments is particularly troubling. As you may well recall, small business was intended to be a principal beneficiary of the new merchant banking powers for banking firms. The merchant banking rules, however, now require extraordinary capitalization for investments in SBICs. This treatment disregards the fact that SBICs are licensed, regulated and examined regularly by the Small Business Administration; have a limited partnership structure; and have consistently been regarded as conservative and profitable investments that do not pose a safety and soundness risk to banking organizations.
The Roundtable believes that the high capital cost of SBIC investments will cause a decline in such investments. This decline in SBIC investments may adversely affect essential financing for new and small companies and retard the creation of new jobs by such firms.
Retroactive Application of Merchant Banking Rules
Another troubling aspect of the merchant banking rules is that the proposed capital charge would apply retroactively to all equity investments made under long-standing authorities. The Roundtable strongly believes that this result is an unfair surprise, which penalizes bank holding companies that have made investments in reliance on current law.
Let us be clear about the consequences of this approach. Investments that have been held for many years in a safe and sound manner, without any suggestion of risk supporting additional capitalization, would now be subject to a significant capital hit. This hit applies even though there has been no change in the actual risk profile of the investment. For example, let us assume that a bank holding company holds the very same investments today as it held prior to the GLB Act. The bank holding company has no intention of engaging in any merchant banking activities under the GLB Act or electing FHC status for that matter. As a result of the merchant banking rules, this same bank holding company will have to retain extra capital to support its pre-existing investments. This result makes no sense.
In practice, the retroactive imposition of a capital charge on pre-existing investments will alter the economics of existing investments of bank holding companies. Investments that at one time were cost-effective and sound would suddenly become unprofitable. This result could cause a fire sale of investments that have become too costly to retain. All of this will occur merely because the Board has changed the rules of the game. The nature of and risk posed by these investments, however, has not changed.
The merchant banking rules contain several other provisions of concern to the Roundtable. To summarize a few, the merchant banking rules also impose (1) a maximum holding period on FHC investments, which is inconsistent with the plain meaning of the GLB Act; (2) limitations on managing a portfolio company, which are unduly restrictive in light of the language of the GLB Act; (3) recordkeeping and reporting requirements, which impose substantial and unnecessary burdens on FHCs and may require a FHC to disclose prematurely future divestiture plans; and (4) cross-marketing restrictions and restrictions on private equity funds, which are too broad. The Roundtable has addressed these and other troubling provisions in great detail in its comment letter.
Chairman Grams and Chairman Bennett, in conclusion, the Roundtable appreciates the opportunity to provide our comments on this important topic of concern to banking organizations and securities firms, alike. Thank you again for this opportunity. I would be pleased to answer any questions that the Committee might have on this issue.
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