Subcommittee on Financial Institutions
Subcommittee on Securities

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

Testimony of
John P. Whaley

On Behalf Of
The ABA Securities Association
The American Bankers Association

June 13, 2000

Chairman Bennett, Chairman Grams, and members of the subcommittees, my name is John P. Whaley. I am a partner of Norwest Equity Partners and Norwest Venture Partners, both of which are merchant banking firms based in Minneapolis, Minnesota, and Palo Alto, California, respectively. Norwest Venture Partners makes equity investments in early stage and emerging growth businesses focused in information technology related industries. Norwest Equity Partners makes equity investments in companies with traditional and emerging business models with a focus in media and telecommunication industries. Norwest Equity Partners also invests in management-led buyouts of more mature businesses. Together, these firms comprise the private equity investment business of Wells Fargo & Co., a $218 billion financial holding company based in San Francisco, California.

I appear here today on behalf of ABASA, the ABA Securities Association. ABASA is a separately chartered trade association subsidiary of the American Bankers Association ("ABA"), formed in 1995 to develop policy and provide representation for those bank and financial holding companies involved in, among other things, merchant and investment banking activities. My testimony today also reflects the views of the ABA. 1

I commend you for holding this hearing to focus on capital markets developments after passage of the Gramm-Leach-Bliley Act ("Act"), particularly the merchant banking rules recently issued for comment by the Board of Governors of the Federal Reserve System ("Board") and the Department of the Treasury ("Treasury"). 2 Many of ABASA's members regard the authority to engage in expanded merchant banking activities as the single most important feature of the Act. As a result, ABASA has a strong interest in ensuring that its members are able to engage in merchant banking activities to the full extent allowed under the law.

As you know, one of the clearly stated purposes of the legislation was to create a two-way street among all financial services providers. Unfortunately, the proposed merchant banking rules undermine, in many important respects, Congressional intent. In fact, we believe that the proposed rules, in effect, rebuild many of the barriers among financial services firms that Congress sought to eliminate through passage of the Act. Accordingly, ABASA is strongly opposed to the proposed rules, as currently drafted.

In my statement today, I would like to highlight three issues:

As we discuss in our comment letter to the Board and Treasury, a copy of which is appended to this statement, ABASA has many additional concerns and comments with respect to other aspects of the proposals. However, our opposition to the proposals is chiefly grounded upon the three issues outlined above.

The Proposals Undermine Congressional Intent.

New Section 4(k)(7) of the Bank Holding Company Act authorizes the Board and Treasury to issue regulations implementing the merchant banking authority granted to financial holding companies ("FHC") under new Section 4(k)(4)(H). It is our position that the proposed rules extend well beyond implementing the merchant banking provisions of the Act.

The Act conditions an FHC's ability to engage in merchant banking activities on:

  1. the depository institution not holding the ownership interests acquired;

  2. the ownership interests acquired being held for the purpose of appreciation and ultimate resale or disposition of the investment, and

  3. the holding company not engaging in the routine management or operation of the company or entity, except as may be necessary to obtain a reasonable return on the investment upon disposition.

These three conditions were included in order to maintain the separation between banking and commerce.

Neither the capital charge nor the restrictions on private equity funds implement the statute's objective of ensuring that FHCs may engage in merchant banking activities but not in commerce. Rather these restrictions, in all likelihood, will unduly interfere with the ability of FHCs to engage in merchant banking - an activity specifically authorized as financial-in-nature by the Congress.

The legislative history describing Section 4(k)(4)(H) indicates that the Congress intended that those investment banking firms affiliated with securities firms and insurance companies that opt to become financial holding companies should be permitted to continue to engage in merchant banking activities in substantially the same manner as had always been permitted. 3 Conversely, Congress also intended that bank holding companies should not be placed at a competitive disadvantage to investment banking firms that are unaffiliated with any depository institution; but should be allowed to engage in merchant banking activities to the same extent as non-bank affiliated investment banking firms.4

Despite Congress' stated intentions, the regulatory restrictions imposed by the proposed rules, particularly the 50% capital charge against merchant banking activities and the aggregate investment limits,5 will effectively guarantee that the two-way street is unattainable. Securities firms will opt not to become FHCs because the price, in terms of limits on current and future merchant banking activities, is too steep. Foreign banks will conduct their merchant banking operations from offshore locales in order to avoid the draconian effects of the proposed rules. Bank and financial holding companies will be precluded from engaging in merchant banking activities on the same terms and conditions as their non-bank affiliated competitors.

The statutory provisions generally prohibiting FHCs from routinely managing portfolio investment firms and from holding these investments indefinitely more than adequately address the separation between banking and commerce. It is ABASA's position that in issuing these proposals, the Board and Treasury have gone way beyond effectuating congressional intent, but rather undermine that intent.

Nor are these provisions necessary to protect the safety and soundness of depository institutions or to control risk as the Board and Treasury would seem to claim. Congress believed it more than adequately addressed any safety and soundness concerns by authorizing merchant banking activities to be conducted only through holding companies for the first five years. Additionally, in authorizing merchant banking activities, Congress recognized the essential role merchant banking plays in modern finance and determined that any risk associated with these activities was acceptable. After all, only firms with well-capitalized and well-managed banks can exercise these new activities. It is inappropriate for the Board and Treasury now to second-guess that determination and raise additional barriers to full entry into merchant banking.

Furthermore, no evidence exists that FHCs cannot control risks associated with merchant banking activities. The banking industry has a long history of engaging in merchant banking activities through small business investment company firms ("SBICs"), 6 through Regulation K firms,7 and under the authority of sections 4(c)(6) and 4(c)(7) of the Bank Holding Company Act and Section 24 of the Federal Deposit Insurance Act. 8 To date, those activities have produced strong returns with minimal losses and have taken place over a relatively long period of time, involving both up and down markets.

Finally, merchant banking activities serve an important function in providing needed capital to corporations. While it is true that some of the target companies are "start-up," early stage firms, many others are not. For example, many banking organizations anticipate using the new merchant banking powers to facilitate the transfer of family-owned businesses from one generation to another or to take equity kickers as consideration for loans to established corporations. It is ABASA's strong belief that the proposed rules, if adopted, will have a very negative impact on the flow of capital to firmly established operating companies, as well as small and medium-sized start-up companies. Such a result is good neither for corporate America nor for the consumer.

The Fifty- Percent Capital Charge Will Have a Strong Negative Impact on Merchant Banking Activities.

The proposed rule amends the regulatory capital guidelines applicable to merchant banking activities conducted by both FHCs and bank holding companies ("BHCs"). Specifically, the proposal would impose a 50% capital charge (deducted from Tier I capital of the holding company) on all investments made by a holding company, directly or indirectly, in nonfinancial companies. This onerous capital treatment would not be limited to only the new expanded merchant banking authority granted to FHCs by the Gramm-Leach-Bliley Act, but rather would extend as well to all merchant banking investments made under existing authority, including equity investments authorized under the Small Business Investment Act.

First and foremost, ABASA is opposed to the 50% capital charge as it is excessive and bears no resemblance to the BIS-approved risk-based capital guidelines. Under those capital guidelines, a banking organization must hold a total of 10% or more in risk based capital in order to be considered well capitalized. To achieve that 10% risk based capital ratio, the organization must hold a minimum of 6% Tier I capital against every $100 million in investments, plus 4% or more in Tier II capital. 9 Thus, under current regulations, a holding company would have to maintain $6 million in Tier I capital for every $100 million in investments.

The proposal turns all this on its head by requiring the holding company to deduct from its Tier I capital $50 million for every $100 million in investments in order to maintain its same well-capitalized position. Thus, the proposal would require eight times more capital for merchant banking activities than is currently required for existing merchant banking activities.

This sea change in regulatory capital requirements will not only have a significant negative impact on the ability of holding companies to engage in new merchant banking activities authorized under the Gramm-Leach-Bliley Act but also on the ability of holding companies to engage in those specific merchant banking activities authorized for banking organizations prior to passage of the Gramm-Leach-Bliley Act, including banking organizations' ability to make equity investments through an SBIC. No grandfather of equity investments previously made is contemplated by the proposal, leaving banking organizations in the untenable position of having to raise their overall capital requirements-quite significantly in some circumstances-without contributing even one additional dollar toward an equity investment.

It should be understood that, if allowed to stand, the 50% capital charge will render uneconomic many of the investments previously made through SBICs, Regulation K firms, or under authority of the Bank Holding Company Act or the FDIA. These investments will become uneconomic not because of any change in inherent worth but solely because of an unanticipated change in regulatory treatment.

Second, it is not completely accurate for the regulators to suggest that the 50% capital charge is drawn from the internal capital allocation models employed by those investment banking firms, both bank and non-bank affiliated, that are engaged in merchant banking activities. While it is true that investment banking firms internally allocate capital to merchant banking activities and that that allocation generally ranges between 25 and 100 percent of capital, it is equally true that these firms allocate significantly lower amounts of capital to other activities than is currently required under the risk based capital rules. For example, 6% capital is required to be held against commercial loans, yet many firm models distinguish between blue chip borrowers and other less creditworthy firms and allocate less capital against the better credit. 10 Economic internal capital models and regulatory capital requirements are, however, aligned when all capital allocated under the internal models averages out to equal to or better than the 6% of Tier I capital requirement.

What, in fact, the Board has done is to "cherry pick" or select only the high capital allocations from internal capital allocation models and ignore all the lower capital allocations assigned under these same models. It is unfair for the regulators to suggest that they are following industry precedent set by internal models when they ignore all other capital allocations set by these very same models.

Third, the regulators are wrong to suggest that the proposed capital charges will have no meaningful impact on both FHCs and BHCs. In fact, the proposal will have a significant practical impact on holding companies. Specifically, holding companies will be forced to replace capital depleted as a result of the 50% capital charge in order to maintain opportunities to grow their business and to satisfy both regulatory and market demands and expectations for large capital cushions at the holding company level.

For all the above reasons, ABASA believes that the proposal to impose a "one-size-fits-all" 50% capital charge on all merchant banking investments is wrong-headed, not in accordance with Congressional intent and, in fact, counterproductive. Such a special capital charge is particularly inappropriate when applied to organizations that have experience managing the risks of such investments and have appropriate internal mechanisms, processes and controls to handle, and hold appropriate capital against, such risks. The Board as a supervisory matter has the tools to review the internal controls of such organizations to validate the fact that they appropriately manage the risks of such activities.

An across-the-board 50% capital deduction is unreasonable even for those organizations that do not yet have internal controls that pass the Board's supervisory muster. In those instances, if the Board sees the need for a standard regulatory capital requirement, something much more reasonable should be considered. First, special merchant banking capital requirements should only apply in those instances where an FHC's merchant banking investments constitute a significant portion of the FHC's portfolio, for example where the investments exceed 20% of Tier I capital. Then, they should be imposed at a more measured level than the 50% deduction and should blend with the current risk-based capital framework.

If any regulatory capital is adopted by the Board, in no case should it apply to equity investments that are permissible under the Bank Holding Company Act for all bank holding companies or their subsidiary institutions. SBIC investments, non-controlling investments, and investments under Regulation K have all been conducted prudently and profitably by BHCs for many years. There is simply no evidence that additional capital is warranted.

Finally, on a related matter, ABASA strongly objects to the interim rule's aggregate investment limits. The limits are neither supported by the plain language of the Act nor its legislative history. Erecting yet another barrier to an FHC's ability to engage in merchant banking activities ignores congressional intent that FHCs be able to participate in this important activity to the same extent and on the same basis that non-bank affiliated firms engage in the same activities. Moreover, we note that fixed dollar limits as opposed to percentage limits make no sense in today's consolidating markets. Since we are led to believe that the aggregate investment limits are likely to be eliminated once the Board has addressed the capital rules applicable to merchant banking, we do not comment extensively on those limits here. Of course, we strongly support their elimination.

Unnecessary and burdensome regulatory restrictions should not be imposed on merchant banking activities conducted through private equity funds.

The proposal recognizes that merchant banking investments may be made directly in portfolio companies and through the use of pooled funds. The proposal further provides that investments made through a specially-defined type of pooled fund, "a private equity fund," in which an FHC, by definition, 11 may only be a minority investor (no more than 25 percent) should have fewer restrictions than those made directly.

This distinction is most appropriate, because equity fund investments inherently raise fewer regulatory concerns than do direct investments in portfolio companies. Proportionally less of the FHC's own capital is at risk. The majority participation by unaffiliated investors imposes significant market discipline on investment decisions. The unaffiliated investor participation also helps ensure that the FHC's investment is made for bona fide investment purposes, rather than made to allow the FHC to engage in prohibited commercial activities. Finally, the 25 percent limit establishes a strong presumption that the FHC's minority position will prevent it from exercising meaningful "control" over portfolio companies in which the fund invests. The equity fund investments reinforce the banking and commerce separation.

Having recognized these legitimate reasons for less restrictive treatment, the proposal imposes fewer restrictions on portfolio investments made by these specially-defined private equity funds - but only in very limited circumstances. For example, under the proposed aggregate investment limits, an FHC may hold a greater amount of investments in private equity funds than it may hold directly in portfolio companies.

In a number of other instances, however, the proposal needlessly imposes the same burdensome restrictions on portfolio investments made by a private equity fund as on portfolio investments made directly. That is, the proposal's restrictions apply to the FHC's investment in the private equity fund itself, and then "look through" the equity fund to the portfolio investments made by the private equity fund and impose many of the restrictions on the fund's investments.

It is to these "look through" provisions that ABASA strongly objects. We believe these restrictions will needlessly deter FHCs from investing in private equity funds and create a significant disincentive to the inclusion of FHC investors in many private equity funds.

Two extreme examples of these "look-through" restrictions are the proposed rule's "routine management" and holding period restrictions. When an FHC makes an investment in a private equity fund, no matter how small or passive, neither the FHC nor the fund may "routinely manage" a portfolio company in which the fund has made an investment. Similarly, each of the fund's portfolio investments is subject to holding period limits. 12

Moreover, where the FHC's investment in the private equity fund is deemed to be "controlling" - even though it may never exceed 25 percent of the fund's equity - additional "look-through" restrictions are imposed. Again, these restrictions, listed below, apply not just to the FHC's investment in the private equity fund, but also to the private equity fund's investments in portfolio companies:

ABASA believes that all of the look-through restrictions are unnecessary, misguided, and counterproductive. Let me explain why.

We recognize that it is appropriate to impose the proposed rule's restrictions on an FHC's first-level investment in a private equity fund since that is itself a direct merchant banking investment. But we strongly oppose the restrictions "looking through" to the underlying portfolio investments made by the private equity fund. These "look through" restrictions are unnecessary to ensure that the FHC does not operate the underlying portfolio company. They are unnecessary because of the limits that the proposed rule already imposes on the FHC's investment in that specially-defined private equity fund. Specifically, the fact that the FHC's interest in the private equity fund is limited to a minority participation of less than 25 percent means that unaffiliated, arms-length investors will hold the remaining 75 percent (at least). In addition, the fund is prohibited from becoming an operating company, must hold diversified investments, and must establish a plan for the resale of investments. And perhaps most importantly, the fund may not be formed or operated for the purpose of making investments that are inconsistent with the merchant banking statutory provision or for evading any of the proposed rule's limitations.

All of these limits ensure that a private equity fund may not be used as a vehicle for the FHC to operate a portfolio company as opposed to merely investing in it. As a result, investments made under such limits simply do not raise the same banking-commerce regulatory concerns as would an FHC's direct investment in a portfolio company.

As described above, in many instances the proposed rule expressly recognizes the force of this logic. Except with respect to the "routine management" and holding period restrictions, the proposed rule does not impose look-through restrictions on private equity fund investments where an FHC's investment in a private equity fund is not "controlling." But there is another significant concern here in that the "control" standard is established far too conservatively. The proposed rule's 25 percent cap and various related limits for the specially-defined private equity fund could themselves have been established as the "control" threshold. Any FHC investment meeting these restrictions could have been deemed a "non-controlling" investment in the private equity fund, with none of the proposed rule's restrictions looking through to the fund's portfolio investments.

However, instead of this straightforward, common sense result, the proposed rule imposes a cumbersome distinction between "passive" investments below the 25 percent limit that are not controlling, and "non-passive" investments below the 25 percent limit that are controlling. Using "passivity" as the touchstone will import into the merchant banking context the complex precedent that the Federal Reserve has used in very different contexts, e.g., for purposes of determining whether a company's investment in a bank should make it a regulated bank holding company. Such precedent is needlessly restrictive in the very different circumstance of a merchant banking investment made through a private equity fund.

In short, ABASA believes that the very limitations that apply in the proposed rule's definition of "private equity fund" ensure that the FHC will not be able to use an investment in such a fund to operate a portfolio company in violation of the continued separation of banking and commercial activities. In truth, the proposed definitional restrictions impose sufficient distance between the FHC and actual "control" of a portfolio company. The resulting separation makes unnecessary all of the proposed rule's "look-through restrictions" on portfolio companies held by specially defined private equity funds in which an FHC invests.

Moreover, ABASA believes that the statute provides clear legal authority to establish the control threshold in this manner. The merchant banking provision does apply to an FHC that uses the merchant banking authority to directly or "indirectly" acquire ownership of the shares of a portfolio company. But as the proposed rule expressly recognizes, "[w]here control exists [of a private equity fund by an FHC], the financial holding company is deemed by the BHC Act to indirectly own the shares of the portfolio company held by the private equity fund." 13 The corollary is also true: where an FHC does not control a private equity fund, the FHC is not deemed to indirectly own the shares of the portfolio company. The issue is therefore the definition of "control."

Accordingly, ABASA urges that the control threshold be deemed to be the proposed rule's definitional limits on an FHC's investment in a private equity fund. The proposed rule's current distinction between "passive" and "nonpassive" investments in a private equity fund should be eliminated, and "look through" restrictions should not be applied to any portfolio company investment made by a specially defined private equity fund that by definition cannot be controlled by an FHC.

Indeed, ABASA believes that, even if an FHC's investment in a private equity fund were to exceed 25 percent, it should not trigger the look-through restrictions unless the FHC were also the general partner of the fund. Put another way, the type of "control" that warrants the look-through provisions does not exist unless the FHC is both a general partner and has a significant equity stake in the fund. ABASA urges that this change to the rule's proposed definition of "private equity fund" be adopted as well.

One final point. The proposed rule's cross-marketing restriction clearly applies between a bank and a portfolio company (under certain circumstances). It has been suggested that the restriction also applies between a bank and a private equity fund itself, so that an FHC might not be able to provide fund investment opportunities to a bank customer. Such a strained interpretation of the statute is fundamentally at odds with the purpose of the restriction, which was to separate banks from commercial activities, not to separate bank customers from financial investment opportunities. ABASA strongly opposes such a restrictive reading of the statute.


In conclusion, we are opposed to the proposed merchant banking rules and fervently hope that the Board and Treasury will limit their activities to effectuating Congressional intent and addressing the fundamental concerns raised by the many commentators. ABASA appreciates the opportunity to air its concerns regarding these proposals and their impact on merchant banking - an activity that is of fundamental importance to the financial services industry, corporate America and consumers.

1 - ABA brings together all elements of the banking community to best represent the interests of this rapidly changing industry. Its membership-which includes community, regional, and money center banks and holding companies, as well as savings institutions, trust companies, and savings banks-makes ABA the largest banking trade association in the country.

2 - Although the merchant banking proposals are actually two separate proposals, i.e., an interim merchant banking rule proposed by both the FRB and Treasury (Docket No. 1065) and a proposed capital rule issued by the FRB (Docket No. 1067), the proposals are strongly intertwined and, accordingly, for ease of reference, we refer to them generally as the proposed rule or as the proposal.

3 - House Rep. No. 106-74, 106th Cong., 1st Sess. at 123; S. Rep. No. 106-44, 106th Cong., 1st Sess. at 9.

4 - Id.

5 - The interim rule establishes two aggregate limits on merchant banking investments: an FHC is prohibited from making additional merchant banking investments if the aggregate carrying value to the FHC of all merchant banking investments exceeds either the lesser of 30 percent of the FHC's Tier I capital or $6 billion, or the lesser of 20 percent of the FHC's Tier I capital or $4 billion excluding investments made by the FHC in private equity funds.

6 - Since 1958, commercial banks have, through their SBIC corporations, provided equity capital, long-term loans and management assistance to new and established small business firms. Bank-owned SBICs generally provide the largest proportion of financed dollars to small businesses. For 21 of the last 22 years, bank-owned SBICs have made a profit on their venture capital investments, averaging an annual rate of return of 13%.

7 - Many banking organizations engage in merchant banking activities abroad through a variety of vehicles. Limits on these activities include no more than 40 percent of the equity of a company, with no more than 20 percent of which consists of voting equity.

8 - Bank holding companies may make passive noncontrolling investments under authority of Sections 4 (c )(6) and 4(c )(7) of the Bank Holding Company Act. In addition, state nonmember banks may, under certain circumstances, engage in merchant banking activities under Section 24 of the Federal Deposit Insurance Act.

9 - Well-capitalized under the risk-based capital guidelines also requires a minimum leverage ratio of 5%.

10 - Board staff has freely acknowledged that the current risk-based capital guidelines are inadequate: they overestimate the capital required for some assets and underestimate the capital required for others.

11 - As more fully described in our attached comment letter, we also believe that the requirement to have at least 10 investors other than an FHC is both needlessly large and counterproductive.

12 - ABASA recognizes that the holding period for portfolio investments by private equity funds is longer than the holding period for direct merchant banking investments. ABASA believes, however, that no holding period limits should be placed on portfolio investments by private equity funds.

13 - 65 Fed. Reg. at 16468.

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