[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
PROMOTION OF CAPITAL AVAILABILITY
TO AMERICAN BUSINESSES
=======================================================================
JOINT HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE, AND
GOVERNMENT SPONSORED ENTERPRISES
AND THE
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND
CONSUMER CREDIT
OF THE
COMMITTEE ON
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
__________
APRIL 4, 2001
__________
Printed for the use of the Committee on Financial Services
Serial No. 107-9
__________
U.S. GOVERNMENT PRINTING OFFICE
71-863 WASHINGTON : 2001
_______________________________________________________________________
For sale by the Superintendent of Documents, U.S. Government Printing
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice BARNEY FRANK, Massachusetts
Chair PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska MAXINE WATERS, California
RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma KEN BENTSEN, Texas
ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut
BOB BARR, Georgia DARLENE HOOLEY, Oregon
SUE W. KELLY, New York JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio MAX SANDLIN, Texas
CHRISTOPHER COX, California GREGORY W. MEEKS, New York
DAVE WELDON, Florida BARBARA LEE, California
JIM RYUN, Kansas FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio JANICE D. SCHAKOWSKY, Illinois
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina CHARLES A. GONZALEZ, Texas
DOUG OSE, California STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin HAROLD E. FORD, Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSELLA, New York JOSEPH CROWLEY, New York
GARY G. MILLER, California WILLIAM LACY CLAY, Missiouri
ERIC CANTOR, Virginia STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
SHELLEY MOORE CAPITO, West Virginia BERNARD SANDERS, Vermont
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
Terry Haines, Chief Counsel and Staff Director
Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises
RICHARD H. BAKER, Louisiana, Chairman
ROBERT W. NEY, Ohio, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
CHRISTOPHER COX, California NYDIA M. VELAZQUEZ, New York
PAUL E. GILLMOR, Ohio KEN BENTSEN, Texas
RON PAUL, Texas MAX SANDLIN, Texas
SPENCER BACHUS, Alabama JAMES H. MALONEY, Connecticut
MICHAEL N. CASTLE, Delaware DARLENE HOOLEY, Oregon
EDWARD R. ROYCE, California FRANK MASCARA, Pennsylvania
FRANK D. LUCAS, Oklahoma STEPHANIE TUBBS JONES, Ohio
BOB BARR, Georgia MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, North Carolina BRAD SHERMAN, California
STEVEN C. LaTOURETTE, Ohio GREGORY W. MEEKS, New York
JOHN B. SHADEGG, Arizona JAY INSLEE, Washington
DAVE WELDON, Florida DENNIS MOORE, Kansas
JIM RYUN, Kansas CHARLES A. GONZALEZ, Texas
BOB RILEY, Alabama HAROLD E. FORD, Jr., Tennessee
VITO FOSSELLA, New York RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
GARY G. MILLER, California RONNIE SHOWS, Mississippi
DOUG OSE, California JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania STEVE ISRAEL, New York
MIKE FERGUSON, New Jersey MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
MIKE ROGERS, Michigan
----------
Subcommittee on Financial Institutions and Consumer Credit
SPENCER BACHUS, Alabama, Chairman
DAVE WELDON, Florida, Vice Chairman MAXINE WATERS, California
MARGE ROUKEMA, New Jersey CAROLYN B. MALONEY, New York
DOUG BEREUTER, Nebraska MELVIN L. WATT, North Carolina
RICHARD H. BAKER, Louisiana GARY L. ACKERMAN, New York
MICHAEL N. CASTLE, Delaware KEN BENTSEN, Texas
EDWARD R. ROYCE, California BRAD SHERMAN, California
FRANK D. LUCAS, Oklahoma MAX SANDLIN, Texas
BOB BARR, Georgia GREGORY W. MEEKS, New York
SUE W. KELLY, New York LUIS V. GUTIERREZ, Illinois
PAUL E. GILLMOR, Ohio FRANK MASCARA, Pennsylvania
JIM RYUN, Kansas DENNIS MOORE, Kansas
BOB RILEY, Alabama CHARLES A. GONZALEZ, Texas
STEVEN C. LaTOURETTE, Ohio PAUL E. KANJORSKI, Pennsylvania
DONALD A. MANZULLO, Illinois JAMES H. MALONEY, Connecticut
WALTER B. JONES, North Carolina DARLENE HOOLEY, Oregon
JUDY BIGGERT, Illinois JULIA CARSON, Indiana
PATRICK J. TOOMEY, Pennsylvania BARBARA LEE, California
ERIC CANTOR, Virginia HAROLD E. FORD, Jr., Tennessee
FELIX J. GRUCCI, Jr, New York RUBEN HINOJOSA, Texas
MELISSA A. HART, Pennsylvania KEN LUCAS, Kentucky
SHELLEY MOORE CAPITO, West Virginia RONNIE SHOWS, Mississippi
MIKE FERGUSON, New Jersey JOSEPH CROWLEY, New York
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
C O N T E N T S
----------
Page
Hearing held on:
April 4, 2001................................................ 1
Appendix:
April 4, 2001................................................ 49
WITNESSES
Wednesday, April 4, 2001
Grauer, Peter A., Managing Director, Leveraged Corporate Private
Equity Group, on behalf of Credit Suisse First Boston Private
Equity, the Securities Industry Association and the Financial
Services Roundtable............................................ 35
Hawke, Hon. John D., Jr., Comptroller of the Currency, Department
of the Treasury................................................ 10
Kabel, Robert J., Partner, Manatt, Phelps and Phillips, LLP, on
behalf of the Bank Private Equity Coalition.................... 30
Meyer, Hon. Laurence H., Member, Board of Governors, Federal
Reserve System................................................. 7
Whaley, John P., Partner, Norwest Equity Partners and Norwest
Venture Partners, on behalf of the American Bankers Association
Securities
Association.................................................... 33
APPENDIX
Prepared statements:
Baker, Hon. Richard H........................................ 50
Bachus, Hon. Spencer......................................... 52
Oxley, Hon. Michael G........................................ 57
Kanjorski, Hon. Paul E....................................... 54
Kelly, Hon. Sue W............................................ 56
Waters, Hon. Maxine.......................................... 58
Grauer, Peter A.............................................. 137
Hawke, Hon. John D., Jr...................................... 101
Kabel, Robert J.............................................. 115
Meyer, Hon. Laurence H....................................... 60
Whaley, John P............................................... 120
Additional Material Submitted for the Record
Hawke, Hon. John D., Jr.:
Written response to questions from Representatives Bachus,
Baker and Kelly............................................ 113
Meyer, Hon. Laurence H.:
Written response to questions from Representatives Bachus,
Baker and Kelly............................................ 79
The Securities Industry Association, prepared statement.......... 153
PROMOTION OF CAPITAL AVAILABILITY
TO AMERICAN BUSINESSES
----------
WEDNESDAY, APRIL 4, 2001
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises,
Joint with the
Subcommittee on Financial Institutions
and Consumer Credit,
Committee on Financial Services,
Washington, DC.
The subcommittees met, pursuant to call, at 10:04 a.m., in
room 2128, Rayburn House Office Building, Hon. Richard H.
Baker, [chairman of the Subcommittee on Capital Markets,
Insurance and Government Sponsored Enterprises], presiding.
Present for the Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises: Chairman Baker;
Representatives Bachus, Biggert, Ose, Toomey, Ferguson, Ryun,
Bentsen, J. Maloney of Connecticut, Mascara, Inslee, Ford,
Hinojosa, Lucas, Shows and Ross.
Present for the Subcommittee on Financial Institutions and
Consumer Credit: Representatives Bachus, Roukema, Baker, Kelly,
Ryun, Biggert, Toomey, Grucci, Ferguson, Tiberi, Waters, C.
Maloney of New York, Bentsen, Mascara, Moore, Kanjorski, J.
Maloney of Connecticut, Ford, Hinojosa, Lucas, and Shows.
Also Present: Representatives LaFalce and Oxley.
Chairman Baker. Good morning. I would like to call this
joint hearing of the House Subcommittee on Capital Markets and
the House Subcommittee on Financial Institutions of the House
Financial Services Committee to order.
This morning Chairman Bachus and myself have joined
together for the purpose of again reviewing the rules proposed
pursuant to the enactment of Gramm-Leach-Bliley with regard to
merchants' banking activities. Chairman Bachus and I both,
along with Ranking Member Kanjorski, realize the significance
of these proposals and do appreciate the modifications made
from the earlier proposals submitted last summer to the status
of the proposals currently. Certainly all Members perceive
Gramm-Leach-Bliley to be a significant step toward unleashing
the power of markets to facilitate economic development,
utilize new technologies and create market opportunity
heretofore not possible.
It would appear to me and I am perhaps aware that others
still have remaining concerns with regard to certain aspects of
the implementation of the proposed regulations. Certainly we
should not preclude activities which are currently authorized
by law under the name of modernization and make managerial and
cross-marketing decisions more difficult which are customarily
utilized in the marketplace today.
In the course of the hearing today we will hear not only
from regulators, but from market participants, and I am advised
that there are a series of competitive meetings ongoing so our
membership here today, gentlemen, will be continually changing
I am told. But it does not in any way lessen the committee's
interest in this matter, nor our attention to your testimony
here today.
At this time, I would like to recognize Ranking Member
Kanjorski, then come back for opening statements.
[The prepared statement of Hon. Richard H. Baker can be
found on page 50 in the appendix.]
Mr. Kanjorski. Thank you, Mr. Chairman, for the opportunity
to speak before we begin today's hearing on the promotion of
capital availability to American business.
As the Ranking Democratic Member on the Capital Markets
Subcommittee, I want to maintain the competitiveness of our
Nation's capital markets. These resources help American
businesses compete in the international marketplace. They also
strengthen our domestic economy by helping our Nation to remain
productive, providing better jobs at higher wages for American
workers, and improving the quality of life for American
families.
It is therefore appropriate and constructive for us to hold
hearings at this time on the revised merchant banking rules
issued by our Nation's financial regulators earlier this year.
These proceedings will help us determine whether these
regulations run counter to the purposes of the Gramm-Leach-
Bliley Act or whether they capture the essence of the law's
intent.
During the debate over the modernization law, one of the
most highly contentious issues debated was the extent to which
we should break down the legal barriers separating banking and
commerce. In Japan, the intermingling of these sectors via cozy
kieretsu combinations probably contributed to the great
inefficiencies that first produced the economic disorder in
their banking system in the 1990's and which continues today.
Ultimately, Congress learned from these concerns and we enacted
a law maintaining a firewall between banking and commerce.
A closely related issue examined in the overhaul of the
financial services industry concerned merchant banking. This
term refers to equity investments by commercial banks in non-
financial firms. In our deliberations, we recognized the
importance of merchant banking in providing equity capital to
the private sector, but decided that for at least 5 years only
units of financial holding companies could engage in such
activities. Consequently, the law permits these units to
acquire equity investments in non-financial companies and to
sponsor equity funds, providing that they limit their ownership
positions and do not retain day-to-day management control of
these investments.
In March of 2000, the Federal Reserve and the Treasury
Department issued interim and proposed regulations to implement
the merchant banking provisions of the modernization act. These
proposals generated considerable debate among affected parties
and in the press. Of particular concern to me, along with many
of my Democratic colleagues, was their effect on small business
investment companies, which bring important capital resources
to small businesses in the communities in which they operate.
Because commercial banks represent the largest source of
the SBIC program's private funding, concerns arose that
provisions contained in the merchant banking rulemaking, such
as the proposed 50 percent capital charge on all equity
investments, would have constricted the availability of
financial resources for small businesses. During our
subcommittee's prior hearing on the interim rules, I expressed
concerns about the effect of the proposal on SBICs, and urged
the regulators to create a limited carve-out under their
merchant banking rules for such investments. To their credit,
the regulators responded to many of my concerns when issuing
their revised capital proposal for non-financial equity
investments in January, 2001.
As I noted earlier, in passing the Gramm-Leach-Bliley Act,
we maintained the firewalls preventing the indiscriminate
mixing of banking and commerce. From my perspective, it remains
very important that our Federal financial regulators strike an
appropriate balance between allowing financial holding
companies to engage in merchant banking activities and
insulating commercial banks, which carry Federal deposit
insurance, from the associated risks.
In closing, Mr. Chairman, my colleague in the other body,
Senator Paul Sarbanes of Maryland, perhaps said it best when he
noted that the financial modernization law gave the Federal
Reserve and the Treasury the ability to jointly develop
implementing regulations on merchant banking activities ``to
define relevant terms and impose such limitations as they deem
appropriate to ensure the new authority does not foster
conflicts of interest or undermine the safety and soundness of
depository institutions or the act's general prohibitions on
the mixing of banking and commerce.'' Although I generally
agree with his assessments, I believe it equally important to
learn more about the views of the parties testifying before us
today and, if necessary, to further refine and improve merchant
banking regulations in the future.
Thank you Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 54 in the appendix.]
Chairman Baker. Thank you.
Chairman Bachus.
Mr. Bachus. Thank you, Chairman Baker, for your leadership
on this issue and for convening this joint hearing.
One of the committee's chief central responsibilities in
this Congress will be overseeing the implementation of the
historic Gramm-Leach-Bliley financial modernization
legislation. Among the issues that need to be addressed are the
far-reaching financial privacy regulations scheduled to go into
effect July 1 and a more recent regulatory proposal that would
permit banks, through financial holding companies and financial
subsidiaries, to engage in real estate brokerage and management
activities.
Though the privacy and the real estate rules are of greater
interest to individual American consumers, the merchant banking
rules first proposed in March of last year have enormous
consequences for the financial services industry and for
capital formation processes that help fuel our economy. Private
equity placements and venture capital investments provide
critical seed money for American entrepreneurs whose creativity
and energy have helped make the U.S. economy the envy of the
world.
I was one of the Members that felt that, as originally
proposed by the regulators last March, the merchant banking
rules were deficient in important respects. Particularly
troublesome was the requirement that financial holding
companies hold 50 cents in capital for every dollar of equity
investment in non-financial companies. By setting the capital
threshold so high, the original capital rule served as a huge
disincentive for any investment banking firm thinking of
partnering with a depository institution under the financial
holding structure established by Gramm-Leach-Bliley.
To their credit, the regulators took the criticism of the
original proposal to heart and have come back this year with
rules that clearly move in the right direction. Most
importantly, the revised proposal replaces the rigid 50 percent
capital requirement with a more flexible sliding scale, an
approach that increases or decreases the capital charge imposed
on merchant banking investments in direct proportion to the
concentration of such investment in an institution's portfolio.
But acknowledging that a bad proposal has been made better
is not the same thing as concluding that the proposal was a
good idea in the first place. In my mind the Federal Reserve
and the Treasury have simply not met their burden of proof in
demonstrating that additional requirements are needed in the
merchant banking arena. Banking organizations have been making
private equity investments pursuant to other statutory
authorities since well before Gramm-Leach-Bliley was enacted,
and have done so profitably and seemingly without loss to
individual institutions, depositors or the system as a whole.
This track record strongly suggests that bank regulators
already have the legal tools needed to effectively supervise
merchant banking activities of financial holding companies and
bank holding companies without these new rules.
With the welcome improvements made by the regulators, the
revised merchant banking rules still place financial holding
companies at a decided competitive disadvantage in relation to
firms that choose to operate outside of that structure. Such a
result cannot be squared with the congressional intent
evidenced by Gramm-Leach-Bliley, which was to encourage, not
actively impede, affiliations between securities firms and
banks. This regulatory initiative before us greatly concerns
me.
I yield back the balance of my time.
[The prepared statement of Hon. Spencer Bachus can be found
on page 52 in the appendix.]
Chairman Baker. Thank you Mr. Bachus.
Ms. Waters, do you have a statement?
Ms. Waters. Yes, I do, thank you. Thank you very much.
Good morning, Mr. Chairman. I am pleased to have the
opportunity to speak about the promotion of capital
availability to American businesses.
As the Ranking Member of the Financial Institutions
Subcommittee, I believe we have a duty to oversee the
regulations implementing the merchant banking provisions of the
financial modernization legislation that became law last
Congress. I also believe that it is important for us to monitor
the expansion of merchant banking activities themselves, to
ensure that the regulations are important, to carry out the
intent of the Gramm-Leach-Bliley Act.
I understand that the final revised rules address a number
of industry concerns that were voiced about their original
interim rules. I am pleased that the provisions governing the
small business investment companies will ensure the continued
ability of banks to invest in SBICs, benefiting small business
as well as the communities they serve.
Regarding the larger issue of merchant banking in general,
there must be sufficient oversight of these activities. We have
a responsibility to limit the risk inherent in merchant banking
and not sacrifice safety and soundness in the haste to expand
these activities too rapidly. This intent is crystal clear in
the statutory language of the Gramm-Leach-Bliley Act.
The legislation did permit financial holding companies to
engage in merchant banking activities. Moreover, the bill
imposed a series of prudential restrictions on the conduct of
the merchant banking activity. It required that the merchant
banking activity be conducted in an affiliate of the depository
institution rather than in the depositary institution itself or
a subsidiary of a depository institution.
It also required that merchant banking investments be held
only for a period of time long enough to enable the sale or
deposition of each investment on a reasonable basis.
Furthermore, the legislation restricts the ability of financial
holding companies to routinely manage or operate companies held
under the merchant banking authority.
Finally, the legislation specifically granted the Federal
Reserve and the Treasury Board authority to issue joint
regulations implementing the merchant banking activities.
Merchant banking was singled out, appears the only one of nine
activities listed in the legislation as financial in nature to
receive an explicit grant of authority to the regulators to
issue regulations. Moreover, the Federal Reserve retains this
authority under the Bank Holding Company Act to set capital
standards for bank holding companies which include financial
holding companies.
The legislation also explicitly prohibited cross marketing
between the depository institution and merchant banking
portfolio companies acquired under the new authority. I
understand that there are some members of the industry that
would want this provision changed, but the law is clear on this
point and should not be undermined through additional changes
in the regulations.
While I understand that the industry is concerned about the
ability of American banks to compete in the global marketplace,
we certainly do not want to model our banking policy after the
Japanese system, which serves an example to all of what can
happen when the separation between banking and commerce is
breached.
I believe these regulations will not prove to be
unreasonably burdensome and will fullfil the congressional
intent to ensure adequate oversight of merchant banking
activities.
During the consideration of the financial modernization
legislation, Federal Reserve Board Chairman Alan Greenspan
testified that, of the nine banking activities permitted in
various versions of H.R. 10, merchant banking should be viewed
as the most risky of those activities. With that in mind, I
look forward to hearing the views of the witnesses and thank
you in advance for your testimony.
[The prepared statement of Hon. Maxine Waters can be found
on page 58 in the appendix.]
Chairman Baker. Thank you, Ms. Waters.
Are there additional opening statements?
Mrs. Kelly.
Mrs. Kelly. Thank you, Mr. Chairman. I want to thank both
you and Mr. Bachus for agreeing to hold the hearing on the
promotion of capital availability to American businesses.
The issue revolves around a large source of capital to many
businesses; and, as we know, capital is the lifeblood of
industry. As the Chairman of the Oversight and Investigations
Subcommittee, the issue is very high on my list of priorities;
and I am very pleased that we all share this interest.
As we are aware, in March of 2000 the Federal Reserve and
Treasury issued two rules for financial holding companies which
contain provisions that run contrary to the language Congress
agreed to as part of the Gramm-Leach-Bliley law. In particular,
I was concerned about the 50 percent capital charge on all
merchant banking activities and I believe that the cross
marketing restrictions were too severe. I feared that the
capital charge would force divestment from some banks of sound
investments which could, in turn, have negative effects on the
economy.
I was pleased to see that the final rule issued in January
of 2001 eliminated the hard dollar cap, removed some of the
automatic penalty associated with holding investments over the
time limits set by the rules and relieved some of the cross-
marketing restrictions. While it was a good step in the right
direction, I believe the Federal Reserve should go farther.
The rule seems to neglect to take into account the
sophisticated internal risk modeling mechanisms banks employ to
accept the risks inherent in merchant banking activities and
the new and existing powers for bank examiners analyzing
merchant banking activities. While I strongly believe we must
ensure safety and soundness, we must also ensure the law as we
wrote it in Gramm-Leach-Bliley is implemented as we intended.
I want to thank the witnesses for joining us here today to
share their considerable knowledge on these issues, and I look
forward to the testimony and discussing the issues with them.
I thank you again for holding this hearing, and I yield
back the balance of my time.
[The prepared statement of Hon. Sue W. Kelly can be found
on page 56 in the appendix.]
Chairman Baker. Thank you, Mrs. Kelly.
Does any Member wish to give an opening statement?
If not, I would suggest that we are just under 8 minutes or
so on the matter pending on the floor, that we would recess
momentarily, come immediately back, keep you about 10 minutes,
and we will reconvene our hearing at that time.
[Recess.]
Chairman Baker. I would like to reconvene the hearing.
Members are on their way, returning from the vote. I am
told we will have about an hour before we are interrupted
again, so at this time I would like to proceed with recognition
of our first panel of witnesses.
The Honorable Laurence Meyer, Governor, Board of Governors
of the Federal Reserve, we welcome you here and look forward to
your testimony. Your comments will be made part of record, as
well as that of Mr. Hawke. Please proceed.
STATEMENT OF HON. LAURENCE H. MEYER, GOVERNOR, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. Meyer. Thank you, Chairman Baker, Chairman Bachus and
subcommittee Members.
When I last appeared here to address the topic of merchant
banking, the Board and the Department of the Treasury were
considering comments on rules we had proposed only recently
before the testimony. As I indicated at that time, our
experience has been that public comments generally provide us
with valuable insights and information.
That is, in fact, what happened in this case. The Board and
the Treasury received a significant amount of useful
information that led us to revise our rules that implement the
merchant banking powers in the Gramm-Leach-Bliley Act. We have
also consulted with our fellow banking agencies regarding the
appropriate capital treatment for equity banking activities. As
a result, we have significantly revised and again sought public
comment on a proposed capital approach.
Let me provide some background that I hope will put both
what we did and what we have proposed in context.
The Bank Holding Company Act reflects a long-held concern
of Congress that mixing banking and commerce could result in an
adverse effect that may reduce the availability of credit to
unaffiliated companies and create a greater risk to deposit
insurance funds and, ultimately, the taxpayer.
As part of the consideration of the GLB Act, Congress
considered and rejected the idea of allowing banking
organizations to affiliate broadly with commercial firms. At
the same time, Congress recognized that merchant banking
represents a form of ownership of commercial firms by banking
organizations that is functionally equivalent of financing for
small businesses.
To distinguish merchant banking from the more general
mixing of banking and commerce, the GLB Act requires that
merchant banking investments be held only for a period of time
to enable the resale of the investment and prohibits the
investing financial holding company from routinely managing or
operating a commercial firm except as necessary or required to
obtain a reasonable return on resale of the investment.
The final rule adopted in late January of this year focuses
on defining these important restrictions. Generally, the rule
permits a 10-year holding period for direct investments and a
15-year holding period for investments in private equity funds.
Many commenters acknowledged that merchant banking investments
are rarely held beyond these periods.
The final rule also contains several safe harbors and
examples of routine management. For example, the final rule
allows representatives of a financial holding company to serve
on the board of directors of a portfolio company. In addition,
a financial holding company may enter into agreements that
restrict extraordinary actions of the portfolio company. On the
other hand, a financial holding company would be considered to
be routinely managing a company if an officer or employee of
the financial holding company is also an executive officer of
the portfolio company or if the financial holding company
restricts decisions made in the ordinary course of business of
the portfolio company.
In response to commenters, the final rule provides a
mechanism for allowing specific employee and junior officer
interlock in the limited situation where the interlock does not
rise to the level of routine management of the portfolio
company.
The GLB Act allows an investing financial holding company
to routinely manage a portfolio company in special
circumstances. The final rule adopts statutory language in this
area.
The final rule also contains several provisions that are
designed to encourage the safe and sound conduct of merchant
banking activities. The Board recently issued supervisory
guidance that outlines some of the best practices employed by
merchant bankers for managing the risks of equity investment
activities. That guidance has been well received by the
industry as useful and flexible.
In addition, the interim rule contained two thresholds that
triggered agency review of the financial holding companies that
devote significant amounts of capital to merchant banking
activities. The final rule eliminates the absolute dollar
threshold and contains a sunset provision that automatically
eliminates the entire threshold review process once the banking
agencies have implemented final banking rules governing
merchant banking activities.
I should note that the thresholds may be exceeded with
Board approval, and one experienced investment firm has already
received Board approval to exceed the thresholds.
The GLB Act contains provisions that prohibits cross-
marketing activities and restricts credit and other funding
transactions between a depository institution and a portfolio
company controlled by the same financial holding condition.
Both are contained in the GLB Act to reinforce the separation
between banking and commerce and are mirrored in the final
rule.
An integral part of our original merchant banking proposal
involved the regulatory capital that would be required to
support merchant banking activities. This proposal attracted
quite a bit of comment, and it is an example of an area where
we learned from the public comments.
Together with the other agencies we have developed a new,
revised capital proposal. In developing this new capital
proposal, the banking agencies were guided by several
principles. First, equity investment activities in non-
financial companies generally involve greater risks than
traditional bank and financial activities. I have explained in
much greater detail our analysis of the risk associated with
equity investment activities in my testimony last June. If
anything, the activity in equity markets since last June has
confirmed this analysis; and few of the commenters on that
original capital proposal disagreed with the substance of that
analysis or our conclusion.
A second and related principle is that financial risks to
an organization engaged in equity investment activities
increase as the level of investment accounts for a larger
portion of the organization's capital, earnings and activities.
The grant by the GLB Act of merchant banking authority to
financial holding companies with its promise of increased
equity investment activities was an appropriate time to
reevaluate whether existing capital charges were adequate to
account for this risk.
A third principle guiding the agencies' efforts is that the
risk of loss associated with a particular equity investment is
likely to be the same regardless of the legal authority used to
make the investment or whether the investment is held in the
bank holding company or in the bank. In fact, the agencies'
supervisory experience is that banking organizations are
increasingly making investment decisions and managing
investment risks as a single business line across legal
entities.
In light of these principles, the Board and the other
agencies issued a revised proposal that would apply
symmetrically to equity investment activities of bank holding
companies and banks.
The revised proposal would apply a series of marginal
capital charges that begin with an 8 percent capital charge and
increase to a 25 percent charge as the level of the banking
organization's overall exposure to equity investment activities
increases relative to the institution's Tier 1 capital. These
charges are regulatory minima, and financial holding companies
are expected to hold capital based on their assessment of the
nature and risk of their investment activities.
Commenters, including a number of Members of the
subcommittee, strongly urged the agencies not to impose a
higher capital charge on investments made through a small
business investment company. These commenters argued that SBICs
serve the important public purpose of encouraging investment in
small businesses, are already subject to investment limitations
imposed by the Congress and the Small Business Administration,
and have generally been profitable to date.
Commenters made similar arguments in support of an
exception for investments made by State banks under the special
grandfathering authority preserved by Section 24 of the Federal
Deposit Insurance Act. These investments also have been
reviewed and limited by Congress and are subject to further
review and limitation by the FDIC.
The agencies recognized substantial merit in these
arguments. Accordingly, we revised the capital proposal so that
it does not generally impose a higher capital charge on
investments made through SBICs.
The proposal also includes an exception for investments
held by State banks under the special grandfather rights in
Section 24 of the FDI act.
One of the comments made most often in response to our
original proposal was that internal risk-based models for
assessing capital adequacy better reflect the individual risk
profile of individual organizations than the more general
formulas that currently underlie the agencies' regulatory
capital requirements. We have been working with the Basel
Capital Committee on a proposal, recently published for public
comment, that would focus regulatory capital requirements at
least at large banking organizations on internal risk models
developed by the organization and verified by the regulatory
agencies.
But neither the banking agencies nor most banking
organizations are at the stage where we can rely on these
models as a replacement for regulatory minimum capital
requirements. We view our revised capital proposal for equity
investment activities as a bridge to a robust internal model
approach.
The invitation for public comments on the revised capital
proposal will remain open until April 16. We will carefully
review all of the comments that we receive so that we may
develop a final rule that will be workable and, importantly,
will enhance safety and soundness.
[The prepared statement of Hon. Laurence H. Meyer can be
found on page 60 in the appendix.]
Chairman Baker. I thank you, Governor Meyer.
Our next witness is the Honorable John Hawke--no stranger
to the committee as well--Comptroller of the Currency. Welcome,
sir.
STATEMENT OF HON. JOHN D. HAWKE, JR., COMPTROLLER OF THE
CURRENCY, DEPARTMENT OF THE TREASURY
Mr. Hawke. Thank you, Mr. Chairman.
Chairman Baker, Chairman Bachus, Chairman Oxley and Members
of the subcommittees, thank you for inviting the Office of the
Comptroller of the Currency to participate in this hearing on
the new and proposed rules relating to the merchant banking
investment activities of banking organizations.
Our written testimony focuses principally on the
performance of national bank equity investments made through
small business investment corporations--SBICs--and the OCC's
involvement in the February 2001, capital proposal, which
addresses the regulatory capital requirements for those
investments. Because the OCC was not a party to the final rule
adopted jointly by the Federal Reserve Board and the Treasury
Department specifying the conditions under which the newly
authorized merchant banking activities can be conducted, we do
not address issues relating to that regulation.
Merchant banking is a term with no fixed definition that is
generally used to describe a range of financial activities,
many of which have long been permissible for national banks.
For example, national banks for many years have engaged in the
business of buying and selling securities for the accounts of
customers, they have advised customers on mergers and
acquisitions, and they have represented customers in connection
with the private placement of securities--all of which might be
considered part of traditional ``merchant banking'' activities.
The Gramm-Leach-Bliley Act--GLBA--did not affect the ability of
national banks to engage in any of those activities.
The rules we are discussing today address only one aspect
of the business referred to as merchant banking, namely, the
making of private equity investments in non-financial firms, in
particular, equity investments having a venture capital
character. In this regard, as well, it is important to
recognize that banks and bank holding companies have long had
the authority to make such investments through SBICs and
through explicit permission granted under the Bank Holding
Company Act.
Prior to the enactment of GLBA, no significant public
policy or safety and soundness concerns were raised by bank
regulators concerning the ability of either bank holding
companies or banks to make private equity investments under
existing investment authorities. In fact, the clear intent of
Congress in that far-reaching new law was to expand the ability
of banking organizations to make such investments in excess of
the limits contained in prior law, even where such investments
might constitute control of the company in which they were
made.
As part of a compromise negotiated in the final stages of
the GLBA legislative process, this new merchant banking
authority was limited to bank holding companies for a period of
5 years. Given the experience of banks in a broad range of
merchant banking activities and the safety and soundness
protections included in GLBA for financial subsidiaries of
banks, we did not believe it was necessary to so limit the new
authority. Prudent bank supervision has been emphasizing the
need to diversify the revenue streams of banks so as to reduce
the dependence of banks on net interest margins. Non-interest
income has become an increasingly important component of bank
earnings, and permitting banks to provide expanded venture
capital financing to customers, within prudent limits, would
serve to lessen the concentration of bank earnings in
traditional loan income. The OCC believes that the elimination
of the disparate treatment for banks and bank holding companies
in this area is appropriate certainly no later than the end of
the GLBA-imposed moratorium.
The OCC's primary objective in the development of
regulatory capital rules for merchant banking activities was to
protect the existing capital and regulatory infrastructure
surrounding SBICs, which reflects the long-standing
congressional preference for these entities. Many commenters
did not believe that the original Federal Reserve Board capital
proposal was consistent with that objective. That proposal
would have assessed, at the holding company level, a 50 percent
Tier 1 capital charge on the carrying value of private equity
investments in non-financial companies held directly or
indirectly by a holding company, and would have applied this
capital charge to a variety of existing investment authorities
for banks and bank holding companies beyond the new GLBA
banking merchant authority.
One of the OCC's principal concerns about the proposal was
that any consolidated holding company capital requirement that
would apply a charge to assets held by or under a bank that was
more stringent than the charge that was fixed by the primary
regulator of the bank would undermine the congressional mandate
that bank capital requirements be set by the primary Federal
bank regulator. Since the primary purpose of holding company
capital is to protect the subsidiary bank, the OCC saw no basis
for the judgments of the primary bank regulator to be
supplanted through the establishment of more strict
consolidated holding company capital requirements.
I am pleased to say that the revised capital proposal is a
significant improvement over the original proposal in several
respects. First, the scope of the proposal is much narrower
than the earlier version. It limits the scope of the regulation
to specified equity investment activities of a character
similar to those that might be engaged in by financial holding
companies under Gramm-Leach-Bliley.
Second, the new capital proposal is more consistent with
the experience that national banks have had with regard to SBIC
investment activities for over 40 years, during which there
have been no safety and soundness concerns. In view of this
record of performance, the safeguards placed on these
activities, and the important public purpose of encouraging the
development and funding of small businesses, the recent
proposal accords SBIC investments preferential treatment.
The banking agencies have recognized, however, in light of
the substantial growth in SBIC investments in recent years,
that significant concentrations of private equity investments
could potentially result in safety and soundness concerns, just
as with any heavy concentration of assets. The OCC favors the
approach adopted in the recent proposal, that is, requiring
stepped-up capital charges when aggregate equity investment
levels exceed specified concentration thresholds. Thus, we
believe that the revised capital proposal promotes the
continued conduct of private equity investments, while
maintaining safety and soundness principles and preserving the
intent of Congress to promote bank investments in small
businesses through SBICs.
I would be pleased to respond to any questions.
[The prepared statement of Hon. John D. Hawke Jr. can be
found on page 101 in the appendix.]
Chairman Baker. Thank you very much, Mr. Hawke.
I would like to start our questions with you, Governor
Meyer.
Oh, excuse me, I would be reminded Chairman Oxley has
joined our committee, and I would like to at this time
recognize the Chairman for any opening statement he may wish to
make.
Mr. Oxley. Thank you, Mr. Chairman; and I will submit my
formal statement for the record.
Let me just welcome our witnesses, Mr. Meyer from the Fed
and Mr. Hawke from the Comptroller's Office. We have had a
number of opportunities to work together over the years,
particularly on the Gramm-Leach-Bliley bill.
I would say to both you, Chairman Baker, and to Chairman
Bachus I thank you for having this hearing. I think we need to
explore some of these merchant banking issues, particularly in
light of the recent changes that were made in the regs; and I
guess the old admonition about doing no harm from the
Hippocratic oath probably has some reference here as well.
We look for a modern financial marketplace based on the
tenets of the Gramm-Leach-Bliley Act, and to a large extent all
of us are working our way through this major change that was
made in the statute from almost 70 years ago. It is important
to have this kind of hearings so that the members can get our
arms around these kinds of issues that in many cases were just
simply not issues before the passage of Gramm-Leach-Bliley. The
merchant banking issue is clearly one of them, and how the
regulators and how the Congress deals with this will have a
great deal to do with how successful we are in moving toward
that modern financial services marketplace. So, again, Mr.
Chairman, thank you for these instructive hearings. I yield
back, and I ask unanimous consent that my statement be made
part of the record.
Chairman Baker. Certainly, without objection. Thank you,
Mr. Chairman, for your interest and your participation here
this morning.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 57 in the appendix.]
Chairman Baker. Governor Meyer, under current law, the
Credit Suisse First Boston now manages, on behalf of Louisiana
State Teachers Pension Fund, approximately a half a billion
dollars at the Teachers Pension Fund direction and from time to
time will make minority investments in firms and as a condition
of that investment establish a restrictive covenant which would
allow Credit Suisse First Boston, for example, but not
exclusively, to make managerial changes they deem in the best
interest and in accordance with their fiduciary area
responsibility to the pension plan.
As I am understanding the rule as now promulgated, they
would no longer have the unconditioned right to do--they could
do it, but it would come only in consultation with the Fed's
approval. Is that correct?
Mr. Meyer. No, I don't think that is correct. The final
rule makes clear that the financial holding companies can
engage in what would be considered routine management in
exceptional circumstances, and you gave one example. When it
comes to changing senior management, for example, because of a
change in the strategic direction of the firm or performance of
the firm, the final rule recognizes that explicitly as one of
the situations in which it would be appropriate to have that
involvement.
Chairman Baker. Let's explore further what constitutes
exceptional circumstances. That is the trigger then that would
allow the third party to make strategic changes. Is there a
blueprint that you can go down and say here's what we can do
under certain circumstances?
Mr. Meyer. We have tried to provide a list of examples,
although we do not claim it is exhaustive, because you can't in
advance think of all the situations that would be relevant, but
to reduce uncertainties and give guidance. So we have talked
about situations where there was a change in management, where
there was a sale of some business line or where there was a
significant acquisition, where there were significant losses
that had to be remedied. It was a long list, but I think it is
a very good list of the circumstances in which it is important
to give the financial holding company the opportunity to
intervene to protect its investment.
Chairman Baker. Well, my point is that this appears, at
least from an outside reading of the regulation, to restrict
conduct which prior to the January promulgation may have been
in the course of ordinary business an acceptable practice which
now, at the very least, may be subject to a second look before
you proceed to determine if the Fed's approval may be
necessary. Is there anything in market practice from your view
that warrants this divisional level of concern?
My view is that the modernization proposal was to enable
more relationships with less regulatory oversight to occur to
facilitate economic growth. It would appear that this, at the
very least, if I agree with your view that there is a list of
things that you are allowed to do as illustrative but not
exclusive, that there may be things that you can't do now that
you could do previously without Fed's approval, is that a
correct summation?
Mr. Meyer. Let me try to work on that.
First of all, the examples that we gave in the
modifications we made in the revised rule reflected careful
discussions with commenters; and we put into the final rule
examples that they gave us that reflected what is considered to
be best practice in the industry.
Before we even wrote our interim rules we sat down and we
interviewed large security firms and large banks that were
heavily involved in merchant banking to get an idea of what
industry practice was, and we thought of ourselves as codifying
best practice in these areas. Where we found we had overstepped
and hadn't gotten it right, we tried to do a better job in the
final rule.
Now, let's see, I have lost----
Chairman Baker. Principal point was, are there things which
historically you could engage in which pursuant to the
promulgation you may not?
Mr. Meyer. I think the other point that you were making is
a very, very important one. It goes to the tension between
Gramm-Leach-Bliley, making a determination that shouldn't be a
broader mixing of banking and commerce and then on the other
hand providing authority for merchant banking activities. And
the key point in the legislation, mirrored in the regulation,
is that there are certain restrictions on merchant banking so
that it is not the same as the broad mixing of banking and
commercial.
We did not put into the legislation such things as holding
periods and prohibitions on routine management. You have put
them in there. But I presume the Majority put them in there
because they wanted to assure that this won't become a broader
mixing of banking and commerce. So we are simply mirroring what
you did.
Chairman Baker. Let me, before I recognize Mr. Bentsen,
make one declarative statement. I wouldn't have done it, but
some Members did it on the direction of expert financial advice
from somewhere.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
I apologize for having to step out during both of your
testimonies. And, Mr. Hawke, I don't want you to think I missed
your testimony altogether, that that is any indication of where
I think you might be or not be.
Chairman Baker. Mr. Bentsen, can you pull your mike up,
please?
Mr. Bentsen. Looking at the proposed capital requirements,
which I guess was the most controversial aspect of the proposed
rule, how did the Board and the Treasury come up with this new
sort of sliding scale? Is that modeled after anything or was
that just something you all came up with internally?
Mr. Meyer. Well, after the comments came in, we thought
that they justified a total reassessment of our approach to the
capital rule. We began with the proposition that equity
investments are riskier than traditional banking activities and
required some additional capital treatment.
As we worked further on that, we determined that the risk
to the banking institution from the equity investments depended
very critically on how large those equity investments were
relative to the total organization. So, for example, if you
have an SBIC that is 5 percent of the Tier 1 capital, that
doesn't impose much risk on the banking organization because it
is so small relative to the total. So we decided that what that
would justify would be a sliding scale, where the capital
charge would be quite low for low concentrations of merchant
banking activity but get progressively larger as the
concentrations rose. This came out of very careful analytical
thinking.
The staff member who led the effort is sitting behind me,
and we think it was a major contribution to an improved capital
rule.
Mr. Bentsen. I don't know if you want to comment on that or
not.
Mr. Hawke. Just briefly, Congressman Bentsen. During the
discussions that we had with the Federal Reserve, we made our
position very strongly known that we wanted a preference for
SBICs, and that was our overwhelming concern about the capital
reg. The Fed staff expressed the view that they were concerned
about concentrations, and we recognized that at some point
concentrations could become important. But the stair-step
formulation that appears in the final regulation protects SBIC
investments up to a level that matched the outermost limits of
the experience that we had had with our banks in terms of SBIC
investments. A bank can only invest up to 5 percent of its
capital in an SBIC, so anything over 5 percent of total capital
has to come from appreciation in the investments.
Mr. Bentsen. Let me ask you also, because my time is
running out. The way I read this, on top of the scale the Board
and the Comptroller have the authority to subsequently go back
in and look at financial holding companies' equity investment
in their merchant banking operation and apply other criteria.
Am I reading that correct? Is that only after you exceed a
certain threshold or is that in any case?
Mr. Meyer. Well, in general, the capital rule is about a
regulatory minimum. Banks are expected to hold economic capital
in excess of that regulatory minimum. So in general you would
be expecting to see banks hold more than that amount of
capital, and we would be assessing their economic capital
allocation through the supervisory process.
Second, once their concentration got up to a level of 50
percent of Tier 1 capital, then we have indicated that their
merchant banking activities would come under more intensified
scrutiny. Since we are already up to the highest marginal
capital charge of 25 percent, when they get up to 25 percent of
Tier 1 capital, when it gets up to 50, we would intensify our
supervisory review; and depending upon the risk management and
the nature of the equity investments, we could ask for
additional capital.
Mr. Bentsen. You state in your testimony with respect to
internal risk models that you all are reviewing that, but at
this point in time--if I understand that, that means whether or
not the internal risk models of the institution itself, not the
Fed or the Comptroller, but at this time you all intend to
still rely on your own risk molding, risk assessment.
Mr. Meyer. We intend to rely on this capital charge for the
purpose now. But, as we have indicated, we do think it is a
bridge ultimately to the use of internal risk models by banking
organizations overseen by their regulators.
Mr. Bentsen. With the Chairman's indulgence, you referenced
the Basel reviews are ongoing discussions about this. With
respect to internal risk models, would the idea be that there
would be some standard, some international standard that
regulators would use for what is a qualified risk model versus
what anybody comes up with?
Mr. Meyer. Yes. What the Basel approach is now working with
in the new proposed rule is an approach whereby the banks could
use their internal systems for their banking books, for
example, to determine the appropriate capital charge in
relationship to risk. But that would be overseen and validated
by their supervisors.
I should note that banks are much more advanced in their
measurement and management of risk in the banking book than
they are in their equity investments in their merchant banking
portfolios. Very frankly, I don't know of a single bank at this
point that has a model sophisticated enough to put it before us
and have any hope that it would be appropriate for determining
their capital charges.
Chairman Baker. Mr. Bentsen, your time is expired.
Mr. Bachus.
Mr. Bachus. Thank you.
First of all, the committee has prepared about 15
questions, some of which may not be covered today in oral
questions. We would like to submit those to you, those that are
not answered today.
My first question is about process; and, Governor Meyer, I
am going to direct this to you. You had an interim rule in
March, and then 9 days before the change in Administration you
issued a final rule. Didn't that preclude the new
Administration from weighing in on these rules?
Mr. Meyer. When the law was passed, first of all, we needed
to move quickly to reduce uncertainty in the industry. So
within a day or two after the powers became effective we put
out an interim rule. We certainly wouldn't have wanted to wait
longer to reduce that uncertainty. There were a lot of comments
about that rule and we wanted to move as quickly as we could to
make revisions in that rule, again to reduce uncertainty and to
improve it.
Now, you will undoubtedly recall that one of the reasons
that this law was passed was because the Federal Reserve and
the Treasury had worked together to bridge their differences
and to reach agreements to allow it to go through, and we were
partners in that process. It seemed only natural that these
partners worked together to do the regulations, which we did.
Now if we had waited, for example, for the new
Administration, we would not have yet had our first meeting.
The Under Secretary for Domestic Finance has not been
officially nominated, to my understanding; and we would still
be waiting for our first meeting with the new Administration on
this topic. I don't think that would have been a prudent thing
to do.
Having said that, I expect to have as exceptional a
relationship with the new Treasury as we did with the previous
Treasury; and I look forward to sitting down with the Under
Secretary for Domestic Finance at the earliest convenience and
reviewing all of the implementation we have done with Gramm-
Leach-Bliley and getting feedback on that.
Mr. Bachus. Thank you. I hope that you will do that.
I have several concerns, and I noted this is what you said
in response to Congressman Bentsen: Equity investments are more
risky than traditional activities. Now a lot of what you have
done here is premised on that fact. But, in fact, is that true?
I mean, a lot of your merchant banking activities historically
have been high profit, maybe some would argue not as risky as
commercial lending. So did you all make a determination that
this premise was, in fact, correct?
Mr. Meyer. We have indeed studied it very carefully. And,
frankly, when we had meetings with trade associations, and so
forth, to give us feedback on the original capital proposal,
oftentimes the very first thing they would say is, these are no
riskier than traditional banking assets. But when I confronted
them and we had a full discussion on it, few held on to that
position very long. Very frankly, few of the commenters made
that point. Most agreed that equity investments are riskier.
Mr. Bachus. We are talking about a percentage. Say they
invest five times and two of them go flat but three of them are
highly profitable. What I am talking about is an average here.
Mr. Meyer. Absolutely. There is an iron law of economics
that when a particular activity or instrument has very high
risk, it has to offer higher expected returns to get people to
hold it. It is very fundamental.
Merchant banking activity is a very good example of an
activity that has a very high expected rate of return, and it
must be high because of the risk that it holds. We did a study
of 25 years of experience with venture capital firms, and we
found that, for example, one-third to one-quarter of individual
investments suffered losses and that 20 percent of these firms
went out of business.
Mr. Bachus. Are these bank holding companies and financial
holding companies?
Mr. Meyer. No, these are firms that had 100 percent capital
backing them, no leverage. Why no leverage? Because these
activities were viewed as so risky to begin with that they
backed them 100 percent with capital. Leverage is a way to
increase your expected return by taking on more risk. But these
investments were already very risky to begin with. So I really
do not think that this is a reasonable concern or an issue.
Let me say one more thing. If you have a list of banking
organizations that have told you that they can't tell the
difference between the riskiness of their merchant banking
investments and their loan portfolio I would like their names.
Mr. Bachus. One more thing. You have put--the merchant
banks often have minority investments in their portfolio
companies and then they require restrictive covenants to make
those investments safer, but in fact, if a final rule prohibits
or restricts their ability to make these restrictive covenants,
doesn't it, in fact, have the perverse effect of making that
investment more risky? And what do you say to the critics who
say that the final rule restricts their ability to manage and
protect their minority rights in the companies they invest in?
Mr. Meyer. Well, as I indicated earlier, in the final rule
we have made revisions and clarified the terms under which
financial holding companies can engage in routine management in
those exceptional circumstances. I think what we have done has
mirrored what is industry practice.
One has to make a distinction between routine management on
a day-to-day basis and interventions in those special
circumstances when the threat to the investment is there, such
things as losses being taken by the firm, when there has to be
a change in management, when there is an important sale of
another company or when you might be selling off a line of
business. So these are precisely those critical junctures when
intervention and routine management is allowed, and I think we
have clarified that we have done something which is consistent
with the best practice in the industry.
Mr. Bachus. Let me simply close by saying I would think
that any restrictions that you allow the merchant banking
company to have would be a good thing as far as protecting
their own interest and the more management they do would be the
best. So I would hope these rules do not limit them in any way.
Mr. Meyer. I appreciate that point. I think what we are
trying to do is that delicate balancing act, making those
distinctions between merchant banking and the broader mixing of
banking and commerce; and, quite frankly, we are hearing from
some Members of this committee that they would prefer that
there was a broader mixing of banking and commerce. We are
restricted by what you did in the bill.
Mr. Bachus. Remember, as a regulator, your duty is to
protect the bank, not to protect the company that is being
invested in.
Mr. Meyer. We certainly understand that. But also
understand that when you put something into the legislation,
expect it to show up in the regulation. Don't expect a
regulation to undo what the Majority did in their legislation.
Mr. Bachus. If you could identify those areas, it would be
helpful.
Chairman Baker. Thank you, Mr. Bachus.
Mr. Hinojosa.
Mr. Hinojosa. Thank you, Mr. Chairman. I am going to pass
and come back with some questions.
Chairman Baker. Certainly.
Mr. Lucas.
Mr. Lucas. Pass.
Chairman Baker. Mr. Ford.
Mr. Ford. Since I just walked in, I am definitely going to
pass.
Chairman Baker. That is OK.
Mrs. Roukema.
Mrs. Roukema. Mr. Chairman, I didn't think I had a
question, but I do want to make a statement, and then I guess I
will ask a question.
I am one of those that was very concerned in Gramm-Leach-
Bliley regarding the safety and soundness and the mixing of
banking and commerce. And I believe we did the right thing. I
have no regrets about that. And I am deeply concerned as to
whether or not you are following through consistent with the
law.
But you have both made the case that what you are doing is
enforcing the law. Now, your statement--I am going to go over
them--but it sounds to me you have hit the proper balance here
consistent with Gramm-Leach-Bliley.
But I do want to ask a question, and maybe it is obvious,
but it may be a good example of how you are translating through
regulation the meaning of Gramm-Leach-Bliley. And I am not sure
but why you have indicated that the FHCs have to wait, as I
understand it, ``for an extraordinary corporate event prior to
being permitted to intercede in the management of the portfolio
company.''
Now this is evidently a good example of how you have to
translate the legislation into your regulation. I don't quite
understand it. How do you do that? Wouldn't it be better to
serve the interests of safety and soundness if there were
action before the fact rather than after the fact? And I am not
quite sure how you would address it after the fact, after there
is significant evidence. Could you use that as an example of
how you translate the legislation and your regulations into
practical action?
Mr. Meyer. Well, I think you made the point very well. The
issue here is balance, and it is a difficult balance to strike.
I think I would agree with that.
The question here is, how do you carry out the statute's
prohibition on routine management? And simply by saying that
you can intervene any time you want with no restrictions would
seem to go against the spirit of the prohibition of routine
management. So we had to find a way to balance that, and so
what we did was to say that, no, in the ordinary course of
business you can't have covenants which restrict the ordinary
course of business, day-to-day routine management, but you
could in these critical cases. And we laid out a series of
examples, as I noted before.
We don't mean that that list is exhaustive, and we will
gain more experience with this regulation over time. But I
think that is the only way we could do it that on the one hand
would be consistent with the prohibition on routine management
and on the other hand would allow opportunities for
intervention at critical junctures when it is necessary to
protect the investment.
Mrs. Roukema. What is an example, however, of the
extraordinary corporate events?
Mr. Meyer. Change in senior management, a significant loss
that the firm was incurring, a purchase of a new business, sale
of an existing business line. There are many, many other
examples.
Mrs. Roukema. You would automatically take that under
review.
Mr. Meyer. We have given guidance so there would be no
uncertainty. If a financial holding company found a portfolio
company in one of those circumstances, it doesn't have to come
back to us and ask permission. They have the authority to
intervene. Now it has to be temporary.
Mrs. Roukema. I am sorry?
Mr. Meyer. They can't do it forever.
Mrs. Roukema. Temporary?
Mr. Meyer. Temporary.
Mrs. Roukema. All right. Well, I hope this is working well.
Mr. Meyer. Well, we will find out.
Mrs. Roukema. Thank you.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mrs. Roukema.
Mrs. Maloney.
Mrs. Maloney. I would like to, first of all, welcome you.
Good to see you. Thank you for having this hearing.
First of all, I would like to ask the Honorable John Hawke
and Governor Meyer, how does the proposed merchant banking
capital rule compare with the new proposed Basel capital
standards? How do they compare?
Mr. Hawke. Mrs. Maloney, the Basel proposal is very much a
work in progress right now and----
Mrs. Maloney. They came out with preliminary guidelines,
did they not?
Mr. Hawke. The Basel proposal is out for comment--similar
to a proposed rule.
To try to simplify a very complicated process, the Basel
proposal is divided into two parts. One is the standardized
approach, which is very simple. The other is a complicated
approach.
In the simple standardized approach, the current proposal
is that equity investments of this sort would have 150 percent
risk weighting, which I think works out to be something not
terribly different from what the Federal Reserve proposal is.
As far as the more complicated proposal, that is still up in
the air. There hasn't been a specific proposal yet for the
treatment of equity in the more complicated part of the
proposal.
Mrs. Maloney. But if the committee completes its work and
the United States signs on for uniform global capital
standards, wouldn't any additional merchant banking capital
charges and changes be repealed? I mean, would the Basel
Committee, if we sign on, would that then become the capital
standard that we are going to use in this country and in
foreign countries?
Mr. Hawke. I think that is a very good, very pertinent
question; and it applies to a number of aspects of the Basel
proposal. I would certainly hope that when the dust all settles
our domestic capital requirement would be consistent with what
Basel comes out with. But we are still quite a ways from the
end of the line on that.
Mrs. Maloney. When do you expect them to complete their
work?
Mr. Hawke. The Basel Committee is hoping to have a final
proposal out by the end of the year, and it would not
essentially take effect until 2004.
Mrs. Maloney. Now, are the capital standards basically the
same for domestic operations as for foreign loans? Is there any
difference now?
Mr. Hawke. In the Basel proposal?
Mrs. Maloney. Not in the Basel. I am just talking about now
in the United States.
Mr. Hawke. At present, the existing Basel Accord applies to
internationally active banks, but the existing accord is much
simpler in its contours than the proposed accord will be. So,
essentially, it has been applied up and down the line
domestically.
Mrs. Maloney. But are the capital standards higher for
loans domestically or for foreign or are they the same?
Mr. Hawke. For individual loans, they are the same.
Mrs. Maloney. The Fed is, as I understand, heading the
Basel Committee. Do you have any comments on it?
Mr. Meyer. The Federal Reserve does not head the Basel
Committee. The president of the Federal Reserve Bank of New
York is chairman of the Basel Committee. But the Federal
Reserve participates, as the OCC does, as a member of the Basel
Committee.
Mrs. Maloney. So do you have any further comment on it? Do
you see it, likewise, that what they are proposing is basically
what you are proposing? Is it basically the same, and once it
becomes complete then that will be the standard? Is that how
you see it, too?
Mr. Meyer. I see it working the following way: First of
all, right now the treatment of equity is really one of gaps
that hasn't been completely worked through at Basel. We are in
discussions about what that will be, particularly for the more
advanced approaches; and we are hopeful that the final Basel
rule will be flexible enough that it will be consistent with
our rule. We will be trying to move it in that direction, but
we can't guarantee that.
Whatever happens at Basel will require us then to review
our capital proposals in light of the Basel treatment. It
should be understood, however, that national authorities always
have the opportunity and the authority to impose higher, more
conservative capital requirements than Basel. They just can't
be more liberal than what Basel comes out with. So we will have
to look over the Basel rule, we will have to look over the
nature of the equity investments that are typical in merchant
banking investments in the U.S. compared with equity
investments that are undertaken abroad and reach a final
determination at that time.
Mrs. Maloney. So, in other words, you see a higher capital
standard for our domestic----
Mr. Meyer. Not necessarily.
Mrs. Maloney. I find it interesting there is more default
on our foreign loans than on our domestic loans, and I read a
report on that from some of our private banks. Why do you
believe that is?
Mr. Meyer. Well, I would presume that if one took a poll
and one asks about the default rate as the loans were given
further and further away from where that banking organization
was located that the default rates would go up. That is fairly
typical. It reflects the greater knowledge that banks have with
respect to domestic conditions and laws, and so forth, then
what is going on in other countries. So I don't find that
particularly surprising.
Mrs. Maloney. But then, because of the outcome, should we
have higher standards for foreign loans or capital requirements
possibly so that we would not have such a great default?
Mr. Meyer. Under the new Basel approach the capital
requirements against individual loans would depend upon the
risk assessment by the bank. That couldn't take into account
all of these kinds of considerations, so I think it is
perfectly consistent.
Chairman Baker. Mrs. Maloney, your time is expired.
Mrs. Kelly.
Mrs. Kelly. Thank you, Mr. Chairman.
Gramm-Leach-Bliley prohibits the depository institution
controlled by a financial holding company from cross-marketing
any product or services with or through any company in which
the financial holding company or a bank holding company hold an
equity interest through the merchant banking authority.
However, a depository institution generally may cross-market
the product or services of non-financial companies held by
insurance affiliates of the financial holding companies through
statement stuffers, internet sites, portals, things like that.
Would the Fed support an amendment to Gramm-Leach-Bliley that
would correct that kind of inequity and allow the same kind of
cross-marketing abilities to be extended to products or
services of portfolio companies that are held under the
merchant banking authority?
Mr. Meyer. The Board hasn't taken a position on this.
As you well know, this asymmetry in Gramm-Leach-Bliley is
probably not one of its greatest virtues, and we would agree
with that. However, in correcting it, one has to make a
decision as one makes it more symmetrical whether one wants to
have the same restrictions on cross-marketing everyplace or
reduce those restrictions everyplace.
Again, clearly the restrictions on cross-marketing were one
of the vehicles that the Congress used to make the distinction
between merchant banking activities and the broader mixing of
banking and commerce. That is an issue you may want to
reconsider, but we haven't taken a position on it.
Mrs. Kelly. I want to jump to the committee statement that
talks about the fact that depository institutions should be
able to compete on an equal basis with Section VI(C)(3)(h) of
the Gramm-Leach-Bliley Act. Do you think that the joint rules,
even in their current form, given their numerous restrictions,
satisfy the congressional intent which talks about the fact--
and I can read it for you. It says, ``the Board shall take into
account that investment banking firms affiliated with
depository institutions should be able to compete on an equal
basis for principal investments with firms unaffiliated with
any depository institutions so the effectiveness of these
organizations and their investment banking activities is not
compromised.''
Do you believe that the joint rules, even in their current
form, satisfy the Congressional intent?
Mr. Meyer. We do believe so. Remember that what we did, as
I indicated earlier, is that we sat down with large securities
firms and large banks to try to determine how they conduct
their merchant banking activities and to put in our regulations
what constituted best practice. In that way we thought we would
ensure that the two-way street which is so important in the
Gramm-Leach-Bliley Act remained open.
If you take a look, for example, at capital treatment, we
did find out that the large securities firms tend to hold more
capital relative to their merchant banking investments than
banking organizations did. So we don't really think that the
capital rules are going to provide an obstacle for securities
firms to affiliate with banks.
I will also note that a very large number of the major
securities firms are already affiliated with banks, and we have
had two others that have become affiliated with banks, with
foreign banking organizations, and another sizable securities
firm with merchant banking activities has recently elected to
become a financial holding company. So I don't see this as an
obstacle, and we tried very hard in our rules to keep that two-
way street open.
Mrs. Kelly. Mr. Chairman, I am going to run out of time
here, but I would like to ask one more question. What is the
statutory authorization for the aggregate cap on merchant
banking investments?
Mr. Meyer. For the caps?
Mrs. Kelly. Yes.
Mr. Meyer. I think the authority that we would use would be
the authority for overall safety and soundness that comes from
the Bank Holding Company Act for bank holding companies. After
all, what it is is not a strict cap, but it is a threshold that
requires us to do a careful review of the safety and soundness
and risk management of those financial holding companies that
have devoted a very high amount of their capital to these
activities.
Mrs. Kelly. So there is no statutory authorization as far
as you know.
Mr. Meyer. No. Just as we are given the authority for
capital in general, in order to protect safety and soundness,
it is that authority that we are using in this case.
Mrs. Kelly. Thank you. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mrs. Kelly.
Mr. Grucci.
Mr. Grucci. Thank you, Mr. Chairman. I have no questions at
this time and yield back my time.
Chairman Baker. Mrs. Biggert.
Ms. Biggert. Thank you, Mr. Chairman. I have no questions
either.
Chairman Baker. Mr. Hinojosa, if you do not have a question
at this time, we will start the second round at this point.
Mr. Hinojosa. Go ahead.
Chairman Baker. Governor Meyer, I want to return to the
presumption on which much of this has been constructed,
something subsequent to the line Mrs. Kelly was pursuing. The
explanation for many of the determinations is based on the
predicate that Congress acted; therefore, the regulator
implemented. But the law did not require a 50 percent capital
offset, nor did it require a 20 percent offset, nor did it
require a sliding scale. Those were all determinations made
under the broad directive, as I understood your answer to Mrs.
Kelly, that you have the responsibility to provide for capital
adequacy, that is correct.
Second, with regard to the modifications made since the
earlier addition, we now have the--and this is a summary. I
don't believe this to be the rule. I didn't get that clarified.
With regard to managerial relationships, the final rule was
modified to clarify that the holding company may be considered
routinely managing if they provide investment advisory services
and management consulting services to the portfolio company so
long as the holding company does not exercise managerial
discretion of decisionmaking authority. To me, that reads, I
can sit in a room and say we think you might ought to look at
this, but I cannot say I recommend that you do this. What is
the distinction? I see a differing view behind you there.
Mr. Meyer. The final rule does indicate that you can
provide consulting services and give advice, and that does mean
giving recommendations.
Chairman Baker. How does that--is distinguished from making
a managerial----
Mr. Meyer. It is not a decision. It is advice. There is a
difference between advice and a dictate that says, this is what
you are going to do in the ordinary course of business. Do it
because we are the financial holding company and we own a share
of this firm. You can't do that.
Chairman Baker. But clearly the law didn't make a provision
as to doing either A or B. That is a recommendation of the
regulation.
Mr. Meyer. We are trying to strike the balance.
Chairman Baker. I understand.
Mr. Meyer. There is no precise way of doing it. So these
questions are all reasonable ones, but we had to try to strike
a balance between the Majority in Congress' view that we should
do something to prohibit routine management. That was a
difficult task. We have done our best to try to draw that
balance.
Chairman Baker. I am not questioning the credibility of
your decisionmaking acumen. I am merely pointing out that much
of the earlier explanations to questions was that Congress
dictated certain courses of action to which you responded, and
in my view there was a broad discretionary grant of authority
given in which the Fed found it appropriate to act.
My view is that I have some philosophic disagreements with
the exercise of the discretion as provided by the final rule.
But if wasn't clearly marked, it wasn't I-66 that you are on--
this is more David Copperfield--first you see it, then you
don't--and somebody has got to make a decision about what the
final illusion looks like. Were it to be our judgment, and I am
speaking a little in advance with final agreement with Mr.
Bachus, and I may wish to speak to this later, to provide more
clarification in the formulation of these rules by way of
further congressional deliberations.
I noted in your comment that Gramm-Leach-Bliley was not
symmetrical in its market consequence. To the extent you could
help us provide for symmetry I would very much appreciate your
direction in order to better understand where those inequities
exist. The underlying philosophy that I think many members of
this committee have adopted is whatever A can do in the
marketplace to B, B ought to be able to do in the marketplace
to A. And from what I am getting from much of the presentation
this morning and the questions, that does not appear to be the
current circumstance. Do you agree with that observation?
Mr. Meyer. Mr. Chairman, I was responding to the asymmetry
that was introduced at the last minute into Gramm-Leach-Bliley
with the special preference for insurance affiliates with
respect to cross-marketing activities. So that was a very good
example of a place in which the law became asymmetrical at the
last minute, and I could understand why there might be some
questions about that. But, again, the rule mirrored that. As I
say, we have not taken a position on that, on how that should
be corrected.
Chairman Baker. That is my point. If there are identifiable
areas of market distortion, we very much are interested in not
wanting to provide arbitrage or preference or anything else.
One might choose to try it, but I want to make sure if we
provide in that manner we are correcting it and not making it
worse.
Mr. Meyer. We would look forward to working with you in
those areas.
Chairman Baker. Thank you very much.
Mr. Bentsen, you would be recognized for a second round, if
you would like.
Mr. Bentsen. Thank you, Mr. Chairman. I keep trying to read
the rule. Every time, you are interrupting me. But I do have a
question.
Chairman Baker. At least I am not waking you up.
Mr. Bentsen. No, no, it is really fascinating. But I do
have a couple of questions.
Mr. Hawke, and this may be more of an agency or political
question, but in reading this, as I now recall some of the
details of Gramm-Leach-Bliley that I have forgotten, national
bank subsidiaries are precluded for 5 years from engaging in
merchant banking above the current 5 percent rule or the civic
rule, is that right.
Mr. Hawke. As I said in my direct testimony, merchant
banking is a very broad term. What banks were not given was
authority parallel to what holding companies got to make
private equity investments beyond what they can already do,
say, with respect to SBICs.
Mr. Bentsen. Until?
Mr. Hawke. Until 5 years.
Mr. Bentsen. Four years or five years, I guess.
Would it be the position of the Comptroller's office that
what is being proposed right now--the capital standards that
are being proposed right now--would apply to national bank
subsidiaries as it does to holding companies? And I would ask
the same question of the Fed as well, or is that too
prospective in nature?
Mr. Hawke. You mean, would it apply 5 years out?
Mr. Bentsen. Right.
Mr. Hawke. We would hope that if 5 years out the Fed and
the Treasury see fit to extend the new merchant banking
authority to financial subsidiaries of banking organizations,
we would have an opportunity to examine then what the
appropriate capital requirements were under those
circumstances. There is certainly going to be some momentum
behind the existing rule that the Treasury and the Fed adopted
in this area. I would think that it would likely become a
standard for what banks might be able to do 5 years out.
Mr. Bentsen. Governor Meyer, would that--I mean, again,
obviously, this is some ways down the road and you would have
to take into consideration civic investments and other issues,
but would it be fair to assume that if these standards go
through and the Fed find them to be workable and prudent, that
if and when a petition is made to open up merchant banking
activity for national banks, which I would bet would probably
be made, that the Fed would view these rules as being
commensurate for a national bank subsidiary.
Mr. Meyer. Congressman, I would not like to see you lose
money, so I would just say this. There is no presumption one
way or another. That is a decision that would be made within
the 5-year time. There is no presumption one way or another
which way it will go at this point as to whether or not this
will be extended.
Second, I think the important principle in the capital rule
which I hope would be preserved would be one of symmetry. That
is, the capital treatment of merchant banking investments
should be independent of whether they are held in the bank
holding company or in the bank; and I hope that principle would
be one which would continue if the new merchant banking
authority were then extended to banks.
Mr. Hawke. We would certainly support the symmetrical
extension of new authority to national banks.
Mr. Bentsen. I appreciate that.
If I could ask one or one more question on symmetry. If I
read this correctly, Mr. Hawke, in your testimony, the ongoing
Basel proposal would apply a risk weight standard of 150
percent for venture and equity, and I think you all are looking
at it using a factor of 100 percent. But you perceive there is
symmetry because, I think, of what Governor Meyer said. You are
trying to establish minimums, and you have regulatory
discretion which would allow you to go higher. Is that a
correct interpretation?
Mr. Hawke. The Basel proposal is awfully complicated, but
under the simplified Basel approach there would be a 150
percent risk weighting that could be applied at the regulator's
discretion to equity investments. They did not particularly
characterize the type of equity investment, whether it is
speculative or venture capital, but equity investment
generally.
I should say that is a very controversial issue within the
Basel Committee, because there are banks in the home countries
of many members of the committee that have long had the ability
to be invested in equity.
Mr. Bentsen. Thank you.
Chairman Baker. Mr. Bachus.
Mr. Bachus. Thank you.
Governor Meyer, why should a financial holding company have
to wait for what we have called extraordinary corporate events
prior to being permitted to intervene or intercede in the
management of one of their portfolio companies?
Mr. Meyer. I would answer as I have before. Because you
have, the Congress, put into the bill a prohibition.
Mr. Bachus. Under risk management.
Mr. Meyer. That is the higher reason.
Mr. Bachus. So if we amended that----
Mr. Meyer. Absolutely. If you eliminated the restrictions
on the mixing of banking and commerce, of course, a lot of
other things would be possible, too.
Mr. Bachus. We are talking about the risk management
provision.
Mr. Meyer. OK.
Mr. Bachus. As the routine management----
Mr. Meyer. If you eliminated the routine management, that
is one of the protections that make merchant banking different
from the mixing of banking and commerce, but obviously you
could change that.
Mr. Bachus. Don't you agree that we would all be better
served if these companies that have expertise were allowed to
intercede before, say, their investment got in trouble.
Mr. Meyer. You are perhaps not talking to a sympathetic
party here, because I do support the provisions and the spirit
of Gramm-Leach-Bliley that at this point we shouldn't move
ahead to a broader mixing of banking and commerce, and I
appreciate the restrictions that were put into the law to make
that effective.
Mr. Bachus. But to me, anytime you allow one to assist in
the management of something they have invested in, it would
obviously improve the safety and soundness of their investment.
Mr. Meyer. I appreciate that point, and it is a valid one.
But you understand as well the balance that we are trying to
strike here.
Mr. Bachus. I think our main concern is safety and
soundness of the investment. And if these companies have
expertise and management I would think we would want to
encourage----
Mr. Meyer. In terms of risk management, that is always
something that a financial holding company can intervene in, in
terms of the process of risk management but not the day-to-day
activity. Risk management is a process, and that process
definitely comes under the review and intervention of the
financial holding company. It has to be satisfied with the risk
management.
Mr. Bachus. I am thinking about Warren Buffett, for
example, going down and firing the CEO, which he does and is
very successful.
Mr. Hawke. Mr. Bachus, if I could add a note to that. It is
very traditional for banks that have extended loans to a
company to exercise some involvement in the affairs of the
company when the loan gets into trouble. I would hope that the
rule that the Fed and the Treasury have adopted would not
interfere in any way with the ability of a bank, whether it is
in a holding company that made a merchant banking investment or
not, to exercise the normal rights and authorities of a bank to
take remedial steps with respect to a company it has made a
loan to.
Mr. Bachus. Otherwise, if they do it in a commercial loan
then they will start----
Mr. Meyer. But it is perfectly appropriate to do that, and
I think there is considerable effort to do just that, prepare
for a financial holding company to intervene to protect its
investment.
Mr. Bachus. I would just say I think they ought to be free
to assist management any way they see proper.
But let me ask you another question. Why is a carrying
value of merchant banking investment used to determine the
aggregate merchant banking investments instead of the actual
cost of the investment? The reason I ask that, it seems the
more successful the investment the more they are penalized.
Mr. Meyer. As the carrying value goes up, the capital to
the firm goes up. As the carrying value goes down, the capital
of the firm goes down. So that is the real exposure to the firm
from that merchant banking investment. When the firm reports
its balance sheet and its financial statements, its merchant
banking activities, it is going to report its carrying value.
Mr. Bachus. Because of that, the more successful a
financial holding company's investments are, the less ability
they have to make other investments.
Mr. Meyer. Not at all. The more successful they are, the
more they can make investments. But they have to hold capital
against their carrying value, because that carrying value
reflect the exposure of that organization to the risks.
OK, if you have a 10 percent or a 20 percent or a 50
percent decline in the value of the firm, the risk depends upon
the current carrying value.
Mr. Bachus. Mr. Hawke.
Mr. Hawke. Mr. Bachus, I think a great many investments,
particularly made by SBICs, are carried at historical cost, and
they are not written up. This is particularly true of
investments in privately held venture capital--in companies
that don't have a public trading market. Any assets held in the
available-for-sale account of an institution will be carried at
what may be a higher value, but the unrealized appreciation
will not count toward Tier 1 capital. So the big difference is
whether the increase in value that is unrealized can be counted
toward Tier 1 capital.
Mr. Bachus. All right. I have got 47 seconds, right.
Chairman Baker. No, you are 47 seconds over, but I am not
counting.
Mr. Bachus. I will ask a real short one.
Chairman Baker. Good.
Mr. Bachus. Has the Fed considered excluding investments
from the rules once a portfolio company has gone public?
Mr. Meyer. No. Once a portfolio company goes public those
now publicly traded equities are held under the merchant
banking authorities and are subject to the same rules. We have
made no distinction between the private equity investments and
the publicly traded ones. That is something that, over time--
for example, if banks develop internal risk models that are
more sophisticated and can make that distinction--we would
certainly be willing to consider.
Mr. Bachus. Thank you.
And I just want to make a comment. Oftentimes--you talked
about market volatility and what the market has done since you
came out with these rules. But I think you might agree that
since you have shown the merchant banking investments are more
stable than some of your publicly traded equity which have
really gone down in value.
Mr. Meyer. Well, the difference between publicly traded
equity and private equity investments is that the latter are
not regularly marked to market, so you wouldn't know right now
to what degree losses are incurred. If the market stays as it
is right now, then we will find out over time.
Chairman Baker. Thank you, Mr. Bachus.
I just want to make a quick observation. It has always been
a matter of mystery to me--Mr. Bachus and I used to know the
citations when we were in the depths of the Gramm-Leach-Bliley
debate--why a holding company can have up to a 24.9 percent
interest equity in a domestic corporation non-voting but you
can have up to a 40 percent position in a foreign corporation.
And I never have ever had a successful explanation as to why
that appears to be a less risky position than a 24.9 percent in
the domestic corporation. So there are a lot of apparent
inconsistencies, to me at least, in providing opportunity as it
relates to risk in the markets.
I think this committee has a lot of work to do, and I look
forward to working with Mr. Bachus and Mrs. Maloney and others
on this matter.
I am informed that we have a series of votes. Do we know
how many? I am told two, two votes; and I make this
announcement for the benefit of our next panel. We would
conclude this panel of witnesses, express our appreciation for
your courtesy and long participation this morning. It is an
important matter to the committee. We do look forward to having
further informational exchanges and follow-up with our written
questions and look forward to working with the gentlemen.
Mr. Bachus. Could I?
Chairman Baker. Sure.
Mr. Bachus. One thing that we would like you to do, we have
identified the routine management provision within the Act that
is problematic. Would you work with us to identify other areas
in which you might inadvertently work against us?
Mr. Meyer. I think perhaps we would like to communicate
with you a little further to clarify the routine management
aspects.
Mr. Bachus. Not only that, if there are other provisions
that you are mandating, some of these regulations, we would
like to sort of identify it. Because it is sort of my
understanding that it did not mandate any of these regulations.
Mr. Meyer. We are looking forward to working with you.
Chairman Baker. We have a follow-up question.
Mrs. Maloney. The Chairman raised an important point, and I
would like to hear from both of you. What is the explanation
that you can have 40 percent in a foreign company but only 24
percent here? What is the explanation?
Mr. Hawke. We pointed out that anomaly a number of times
during the Gramm-Leach-Bliley.
Chairman Baker. I think you and I have been doing this for
a decade.
Mrs. Maloney. I would like to hear why.
Mr. Hawke. I would rather not try to justify that.
Mrs. Maloney. Can you, Mr. Meyer, justify it?
Mr. Meyer. The only thing I can say is today you can have a
100 percent ownership in a U.S. firm under the new merchant
banking authority, but I really can't comment on the previous
rules. I don't know why they exist as they do.
Chairman Baker. It is an area where we really do need to do
some work. We tried unsuccessfully in Gramm-Leach-Bliley to
address that concern. You can only have up to a 5 percent
voting interest with a 24.9 percent equity position. To me, it
seems, along the lines of Mr. Bachus' questioning, if you have
your financial resources at risk or worse, where you have a
fiduciary responsibility to the Louisiana Teachers Fund and you
see something going on, you ought to be able to exercise your
discretion to improve the operation, safety and soundness of
that enterprise for the benefit of teachers, much less the
shareholders of the underlying management.
Mr. Meyer. Mr. Chairman, if you see something going on that
is a threat to your investment, you can. It doesn't mean you
can manage the firm on a day-to-day basis.
Chairman Baker. I understand that. If you can smell the
smoke and see the fire, you can grab a fire extinguisher. But
if you see a guy piling rubbish in the corner with matches in
his pocket, you can't say a word. I think that is the
distinction that troubles me.
With that explanation, I would conclude this panel. We will
reconvene as quickly as possible. Hopefully, no more than 20
minutes.
[Recess.]
Mr. Bachus. [Presiding.] At this time, we will reconvene
our hearing with our second panel. They are: Mr. Robert J.
Kabel, Counsel for the Bank Private Equity Coalition,
representing Manatt, Phelps and Phillips; Mr. John P. Whaley,
Partner, Norwest Equity Partners and Norwest Venture Partners,
on behalf of American Bankers Association Securities
Association; and Mr. Peter D. Grauer, Managing Director,
Leveraged Corporate Private Equity Group, representing Credit
Suisse First Boston Equity, on behalf of the Securities
Industry Association and the Financial Services Roundtable.
We welcome you gentlemen to the hearing. Did you all have
an opportunity to hear the first panel? All right. All of you
did.
At this time we will start, and we will go from my left to
right with opening statements.
STATEMENT OF ROBERT J. KABEL, PARTNER, MANATT, PHELPS AND
PHILLIPS, LLP; ON BEHALF OF THE BANK PRIVATE EQUITY COALITION
Mr. Kabel. Thank you, Chairmen Baker and Bachus, Members of
the subcommittee.
I am Robert Kabel and, just to correct the record, I am a
partner at the law firm at Manatt, Phelps and Phillips, but I
have been outside counsel to the Bank Private Equity Coalition
for some years.
On behalf of BPEC, I want to thank you for your continuing
interest in the regulatory implementation of the merchant
banking authority enacted as part of the Gramm-Leach-Bliley
Act. BPEC appreciates your convening of this important hearing
and the opportunity to present our views on the implementation
of the merchant banking provisions of GLBA.
BPEC was formed in early 1995 by the direct investment
subsidiaries of several large commercial bank holding companies
to address various statutory and regulatory issues that
prevented them from competing effectively with non-bank direct
investment firms.
Prior to the enactment of GLBA, BPEC members had been
involved for many years in direct investment activities. These
direct investment subsidiaries have many years of direct
investment experience and excellent earning track records.
BPEC worked in the 104th Congress with then House Banking
Committee Chairman Jim Leach on the merchant banking language
included in the first financial modernization bill he
introduced early in 1995. Identical merchant banking language
was included in every subsequent version of financial
modernization legislation, including the legislation that was
signed into law in November of 1999. The purpose of the
merchant banking provision was to expand the existing direct
investment authority of commercial bank holding company
subsidiaries so they could compete more effectively with
securities firms and insurance companies who were not subject
to Glass-Steagall and Bank Holding Company Act restrictions.
Prior to the enactment of GLBA, the SBA regulated SBICs,
and the Federal Reserve regulated all other direct investments
made through bank holding companies. The regulation of merchant
banking activities was burdensome and often unpredictable. The
Federal Reserve examinations varied widely in regard to several
critical issues. Therefore, BPEC and others in the industry
advocated the enactment of the merchant banking provisions in
GLBA as a means by which to streamline the regulation of
merchant baking activities as well as provide for greater
competitive equality.
Since enactment of GLBA, BPEC has worked with the Federal
financial regulators on implementation issues through a series
of meetings and comment letters.
Chairman Baker, we appreciate the attention you and the
Capital Markets Subcommittee have given to this important issue
since enactment and look forward to working with both
subcommittees in the future. BPEC strongly believes that the
appropriate regulatory implementation of the GLBA merchant
banking provisions in accordance with congressional intent will
determine whether with this new statute leads to the
modernization of our financial industry as Congress had
intended. Nothing less than that is at stake here. If GLBA is
not properly implemented, the two-way street concept that
Congress worked toward for so many years will fail to be
achieved.
In view of the intense scrutiny given merchant banking
issues during the development of GLBA, BPEC was surprised and
disappointed when the Federal Reserve Board and Treasury issued
their interim merchant banking regulations on March 17 of last
year and the Board issued its proposed capital rules.
The interim rule established an extensive set of complex
rules for merchant banking which BPEC members, and many other
members of the financial community, thought to be exceedingly
restrictive. We are pleased the regulators took into account
many of the extensive comments submitted regarding the interim
rule and modified several of its provisions so that the final
rule provides some greater flexibility and certainty of its
provisions.
We remain concerned, however, that the final rule imposes a
series of restrictions on the financial holding company
merchant banking operations that our non-FHC merchant banking
competitors are not required to follow. In particular, BPEC
remains troubled by the cross-marketing restrictions included
in the final rule. The GLBA explicitly provides insurance
companies involved in merchant banking with authority to cross-
market products and services. This apparent disparity is unfair
and unwarranted and should be changed. If regulatory relief is
not forthcoming, BPEC recommends amending GLBA to permit
financial institutions to cross-market products and services.
BPEC, like almost everyone in the financial services
industry, also was disappointed by the Federal Reserve's
original proposed capital rule for merchant banking activities.
During the several year debate which led to the enactment of
GLBA, none of the regulators ever publicly suggested that there
should be the prospect of special capital rules for merchant
banking activities. Congress rightly did not impose an
excessive capital requirement because it recognized that
existing merchant banking firms had a long history of making
prudent investments and therefore did not require a separate
capital rule.
BPEC is pleased that the Federal Reserve carefully reviewed
the substantial industry comments submitted in regards to the
proposed capital rule and made significant changes in the
revised proposal now out for comment. Comments made by this
committee and others in Congress were very constructive, and we
appreciate the committee's leadership on this issue.
While BPEC appreciates the fact that the Federal Reserve
carefully reviewed and responded to many of the comments
submitted on the original proposed rule, we continue to object
to singling out any individual class for discriminatory
treatment. BPEC believes that the Federal Reserve should
utilize the internal capital allocation models of those
financial holding companies with merchant banking operations.
The Federal Reserve should review those models during the
normal examination process and impose specific capital
requirements only if the internal models are deemed inadequate
to protect against the inherent risk in the institution's
merchant banking portfolio.
Again, I want to thank you for this opportunity to present
the views of the Bank Private Equity Coalition on the final
merchant banking regulations and the revised proposed merchant
banking capital rule; and I would be happy to answer any
questions.
Mr. Bachus. Thank you.
Mr. Kabel, before you stop, we are going to correct the
record to show that you are actually testifying--you are a
partner in Manatt, Phelps, but you are testifying on behalf of
the Bank Private Equity Coalition.
Mr. Kabel. That is correct, Mr. Chairman.
Mr. Bachus. Also, Mr. Grauer.
Mr. Grauer. Yes, sir.
Mr. Bachus. You are also testifying on behalf of Financial
Services Roundtable as well as the Securities Industry
Association.
Mr. Grauer. Correct.
Mr. Bachus. Thank you.
[The prepared statement of Robert J. Kabel can be found on
page 115 in the appendix.]
STATEMENT OF JOHN P. WHALEY, PARTNER, NORWEST EQUITY PARTNERS
AND NORWEST VENTURE PARTNERS, ON BEHALF OF AMERICAN BANKERS
ASSOCIATION SECURITIES ASSOCIATION
Mr. Whaley. Messrs. Chairmen, my name is John Whaley. I am
a partner of Norwest Equity Partners and Norwest Venture
Partners.
I am here today on behalf of the ABA Securities
Association, or ABASA, and the American Bankers Association.
Many of ABASA's members regard the merchant banking authority
as the most important feature of the Gramm-Leach-Bliley Act. We
want to ensure that we may exercise that authority to the
fullest extent allowed under the law.
ABASA strongly opposed the original capital proposal as
well as the interim rule. Subsequently, both of these were
revised, and we are pleased that the regulators chose to
address many of our concerns.
Today, I will highlight three issues: the proposed special
capital charge on equity investments, the rules on private
equity funds and legislative relief from certain cross-
marketing limits.
Regarding capital charges, bank regulators have proposed a
three-tier system for assessing capital against equity
investments made by financial and bank holding companies.
Specifically, the proposed rule would assess an 8, 12 or 25
percent capital charge deduction on an organization's Tier 1
capital as the level of equity investments increase. This
graduated capital charge is a significant improvement over the
one-size-fits-all 50 percent capital charge originally
proposed.
We remain concerned, however, that any special capital
charge will exacerbate the inequity between financial holding
companies, or FHCs, and non-FHCs engaged in merchant banking
activities, thereby undermining congressional intent that all
investment banking firms engaged in these activities operate on
a level playing field.
The special capital charge, even as reduced under the new
proposal, would preclude FHCs from engaging in merchant banking
activities on the same terms and conditions as their non-bank-
affiliated competitors. It also might discourage the securities
and insurance firms from becoming FHCs because the price may be
too steep.
For these reasons, we earlier advocated and continue to
maintain that a supervisory approach would be the optimum way
to address this issue. Further, the capital charge would apply
not only to newly authorized merchant banking equity
investments but also to the four pre-Gramm-Leach-Bliley types
of investments which are listed in my written statement.
Of these four types of investments, only SBICs are given
special treatment under the proposal. No special capital charge
is applied to any SBIC investment unless the total amount of
such investments exceeds 15 percent, and then only the excess
amount above 15 percent is subject to the capital charge.
ABASA opposes any special capital charge on equity
investments authorized prior to Gramm-Leach-Bliley. The banking
industry has a long history of engaging in such activities, and
there is simply no evidence that additional capital is
warranted. At the very least, all investments through SBICs
should be excluded from the special capital charge.
If the regulators do not exclude all pre-Gramm-Leach-Bliley
authorities or at least SBICs from the special capital charge,
at the very least all equity investment made prior to March 13
of 2000 should be grandfathered. Without such grandfathering,
many investments made before March 13 will become uneconomic,
not because of any change in inherent worth but solely because
of a change of regulatory treatment.
With respect to private equity funds, merchant banking
equity investments may be made through pooled funds or directly
in portfolio companies. The interim rule properly recognized
that investments made through a private equity fund in which an
FHC, by definition, may only be a minority investor should have
fewer restrictions than investments made directly in portfolio
companies. Nevertheless, the interim rule needlessly imposed
many of the same restrictions on portfolio investments made
through private equity funds that it imposed on direct
portfolio investments. That is, the rule's restrictions applied
to the FHC's investment in the private equity fund itself and
then looked through the equity fund and applied it to the
portfolio investment made by the fund as well.
ABASA strongly objected to these look-through provisions.
The restrictions deterred FHCs from investing private equity
funds and created a significant disincentive to include FHC
investors in many private equity funds. We are pleased that the
final rules on private equity funds have been simplified and
clarified to address many of ABASAs concerns.
Regarding the need for relief from cross-marketing limits,
under the cross-marketing limitation a bank cannot market any
product or service of a portfolio company in which its FHC has
made a merchant banking investment; and the portfolio company
in which the FHC has invested may not market the banks products
and services. A limited exception is provided, however, for
banks that are affiliated with insurance companies. That kind
of bank can market its product through internet websites and
statement stuffers to a portfolio company in which the
insurance company has made a merchant banking investment.
Products and services offered by the portfolio company in which
the insurance company has invested also may be marketed through
internet websites and statement stuffers via the insurance
company's affiliated bank.
Nearly all of ABASAs members are FHCs that may make
merchant banking investments because of their affiliation with
securities firms. Very few own insurance companies. As a
result, our FHC members cannot take advantage of the website
statement stuffer exception. There is simply no rationale or
public policy reason for this competitive inequity.
The ability to cross-market through internet websites and
statement stuffers is an important tool. As Representative
Kelly stated and Governor Meyer confirmed and was mentioned by
Chairman Baker, there is not a great deal of symmetry in how
Gramm-Leach-Bliley is applied. Therefore, we urge the
subcommittees to fix this inequity by expanding the website
statement stuffer exception to all FHCs engaged in merchant
banking activities.
Thank you, and I will be happy to respond to any questions
you have.
[The prepared statement of John P. Whaley can be found on
page 120 in the appendix.]
Mr. Bachus. Mr. Grauer.
STATEMENT OF PETER A. GRAUER, MANAGING DIRECTOR,
LEVERAGED CORPORATE PRIVATE EQUITY GROUP, ON BEHALF OF CREDIT
SUISSE FIRST BOSTON PRIVATE EQUITY, THE SECURITIES INDUSTRY
ASSOCIATION AND THE FINANCIAL SERVICES ROUNDTABLE
Mr. Grauer. Thank you, sir.
I am Peter Grauer, Managing Director and Senior Partner of
Credit Suisse First Boston's private equity business, which is
the largest manager of private equity assets in the world.
Credit Suisse First Boston as a financial holding company
commends the Federal Reserve and Treasury for the significant
improvements that the joint rules reflect from the original
interim rules put out in March of 2000. We appreciate the
Federal Reserve and Treasury's willingness to be open-minded
and work with the industry to improve these rules. In the same
spirit, we look forward to further refining the rules as the
agencies gain greater expertise in private equity activities.
While we recognize how far the agencies have come, we still
believe that the joint rules present an unnecessarily
burdensome array of restrictions that are neither mandated by
safety and soundness concerns, nor in keeping with the language
or spirit of Gramm-Leach-Bliley. In fact, the changes in our
view do not correlate with the way successfully run merchant
banking business have conducted their activities over the last
15 years. Indeed, we believe that more than any factor the
merchant banking restrictions have impeded non-bank financial
firms from becoming financial holding companies.
In our view, the unwillingness of these firms to elect
financial holding company status serves to underscore both the
continuing difficulties that the joint rules raise and that
financial holding companies are operating at a significant
disadvantage in the marketplace.
It is important to start from this premise, entirely borne
out of our experience in the business, that active merchant
banking, properly managed, poses no greater risk to financial
holding companies than any other activities that regulated
financial institutions are permitted to engage in without
restrictions.
Today I would like to highlight three specific problem
areas under the rule. The first I will address are the
restrictions on routine management or operation of a portfolio
company for minority investors. Second, I would like to
underscore what my colleagues have stated with regard to the
aggregate limit on merchant banking investments causes
operational difficulties. And, thirdly, restrictions on a
maximum holding period for merchant banking investments are not
customary in the private equity market and will increase the
risk of those investments without any countervailing benefit.
In my view, these restrictions significantly diminish an
important business opportunity for financial holding companies
and undercut the intent of Congress under Gramm-Leach-Bliley
without adding in any material way to the regulatory goals
referred to in the joint rules.
First, in general, the joint rules' restrictions on routine
management or operation of a portfolio company appear to
presume that an investment can be protected from bad or
improper management through control of a portfolio company's
board of directors. However, where an investor is a minority
investor and therefore does not have the ability to control the
portfolio company's board, the need for additional contractual
and operational protections become significantly greater than
in the majority-investment context.
The joint rules' prohibition on the use of many traditional
covenants that dictate prudent business practices or controls
increase the risk associated with a minority investment and
cause minority investors to lose an important tool to protect
value.
Based on our experience at Credit Suisse First Boston
Private Equity, I would strongly recommend that the Federal
Reserve and Treasury revise the joint rules to permit financial
holding companies making minority investments to retain the
right to use a wide range of restrictive covenants. These
covenants are intended to ensure prudent management and
operating practices.
While we recognize that the joint rules do provide limited
examples of covenants that, if granted to a financial holding
company, would not be considered to be routine management or
operation, the regulatory list is limited and incomplete.
I believe that the current restrictions on routine
management or operation of a portfolio company are unnecessary
and could result in a significant handicap to our business.
Accordingly, I believe that a far broader range of events and
business developments should expressly be subject to a private
equity investor's approval without such approval being deemed
improper participation in routine management or operations.
Examples should expressly include: all matters affecting
the financing of a portfolio company; matters affecting the
regulatory tax or liability status of a portfolio company;
approval of capital expenditures and major expense items;
policies regarding the hiring, firing, or setting or changing
the compensation of non-executive employees; any transactions
with affiliates or related persons; negative covenants relating
to any material operations; and the creation of any subsidiary,
partnership or joint venture to conduct any part of a portfolio
company's business.
These rights are typical of those that private equity funds
routinely seek in connection with a minority equity investment
in a portfolio company. Indeed, most of them are little
different from a covenant that a lender would require. While
the joint rules have left the door open that these items may be
acceptable on some type of case-by-case basis, the facts are
that market circumstances will not wait for regulators to make
these determinations; and if we are unable to negotiate for
these types of controls on behalf of our managed funds this
will undercut our ability to participate most effectively in
private equity market.
Another aspect of the way in which the joint rules address
routine operations or management that we find particularly
troubling is the prohibition on any officer or employee
interlock between a financial holding company and a portfolio
company at the executive officer level. From time to time, it
has been important for us to provide our direct expertise to a
portfolio company in a variety of different contexts. Certain
situations can require full-time senior assistance in building
or restructuring a management team. Investors count on our
ability to provide this assistance when choosing to invest in
our funds. There is no reason in my judgment why flexibility
should not be brought to bear in respect to appropriate senior
officer interlocks, and such flexibility would be entirely
consistent with the way in which non-financial holding company
merchant banking and private equity operations are currently
conducted.
The second area I would like mention briefly is the
aggregate percent of capital-based investments and related
capital charges imposed on merchant banking investments. In
light of the fact that my colleagues next to me have addressed
this item in substantially more detail than I did, I would like
to join in their remarks on these important issues.
My third point, holding periods for private equity
investments should be eliminated. The recent amendments to the
joint rules should reduce, but will not eliminate, the fire-
sale mentality by creating these limits. A simple look at the
market circumstances over the past several weeks demonstrates
why forced sales and formally limited holding periods could be
problematic from an investment as well as a safety and
soundness viewpoint.
Private equity is the ultimate buy-and-hold experience, and
the profitability of merchant banking activities come from the
ability to develop companies over a substantial time period,
waiting for the appropriate market windows for exit and
liquidity purposes. It seems particularly inappropriate to
require prior Federal Reserve staff review of every proposed
merchant banking investment holding which exceeds the
regulatory maximum and to impose a capital charge for longer
term investments. Requiring such a process will only provide an
unfair degree of leverage to portfolio companies in dealing
with their merchant banking investors if such companies know
that an investor could be forced to dispose of its interest or
suffer adverse regulatory consequences.
It also dramatically changes the negotiating between the
financial holding company seller and the potential buyer who
would be smart enough to know the consequences to the seller if
it fails to compete the sale. We submit that any abuses
associated with holding investments beyond some regulatory
benchmark be addressed through the normal supervisory and
examination process.
In closing, I very much appreciate the opportunity to raise
these points with you. As a senior officer of an entity that
until recently functioned outside the Gramm-Leach-Bliley
framework, I can appreciate perhaps more than most the
significant and potentially harmful impact of the imposition of
rules and limitations which, for all of their good and well-
appreciated intention, simply do not translate well to the
actual operations of the merchant banking bills.
While we greatly appreciate the efforts of the Federal
Reserve and Treasury staff to improve the joint rules, we still
believe that, even in their current form, they give significant
advantages to other non-financial holding company competitors.
We do not believe that this was your intention, and we look
forward to further dialogue to remedy this situation.
Mr. Chairman, thank you.
[The prepared statement of Peter A. Grauer can be found on
page 137 in the appendix.]
Mr. Bachus. I thank the panel.
Mr. Kabel, one problem on the cross-marketing we have is
the Gramm-Leach-Bliley Act does prohibit some of the cross-
marketing, but in that I think we have created an inequity, and
I think Mr. Baker and I plan to offer an amendment or some
legislative proposal to amend Gramm-Leach-Bliley to allow the
same cross-marketing abilities to be extended to products or
services of portfolio companies held under merchant banking
authorities. We are going to address that.
Mr. Kabel. Well, thank you, Mr. Chairman. We certainly
support that and would like to work with you on that and
promoting it.
Mr. Bachus. Thank you. We are not sure whether that will
fix the problem, but it should, and they say it is a
prohibition in the bill. Also, you heard what Mrs. Kelly, you
noted that she had questioned Governor Meyer about that.
Mr. Kabel. Actually, the Bank Private Equity Coalition
would actually encourage a look again at the statute. I know
that it has been stated rather explicitly that there is no
discretion, but frankly it would be better if the regulators
would look at it again and perhaps review that, and we would
ask--we are going to encourage them to do that.
Amending a statute is difficult, and I think people
certainly on the panel understand that better than anyone else,
but we would hope they would do that. And it has created some
difficulty. I think these gentlemen could address that better,
but there are certain relationships that they would like to
have with online companies and so forth which they can only
have if they are an investor, and the cross-marketing
restrictions has prevented them from having those
relationships.
Mr. Bachus. Thank you. I think these are the usual kinks
that you have with a new act, so I think we will hopefully work
through that.
Mr. Grauer, I understand your analysis insofar as it
applies to large merchant banking operations such as CS First
Boston, but should--or maybe I will ask it, shouldn't we be
concerned that loosening up the joint rules in the manner you
suggest would be inappropriate for comparatively small
financial holding companies of which, by my count, there are
more than 400, including 12 in Alabama?
Mr. Grauer. To the contrary, Mr. Chairman. I think that our
suggestions are even more relevant as it relates to the smaller
financial holding company operations in their merchant banking
operations, that they should be given the same latitude as the
larger funds have to be able to conduct their activities
regardless of whether they are operating out of a major money
center or anywhere else in the country. We think that is both
sound investment judgment and also basically good for the
economy.
Mr. Bachus. In fact, the view that I posed is sort of
prejudicial toward your smaller companies. Many of them do have
that expertise. I do agree with your answer.
I guess the last thing I will say, I have got a minute, Mr.
Whaley, one of the things that we have asked the Fed and
Treasury to respond to is why aren't all merchant banking
investments grandfathered so that financial holding companies
and bank holding companies do not have to reconfigure their
internal capital allocations for existing activities. We think
that is appropriate, so we are responding to that.
Mr. Whaley. Well, I appreciate that that would be very
beneficial to everyone. I mean, it is kind of an issue of
fairness in equity, but to have a capital charge after the fact
is like a retroactive tax increase, and so I think that it
would just be a fairer way to implement the regulation to
grandfather existing investments.
Mr. Bachus. And it could cause profitable investments to
become unprofitable. So I would agree with you. I would be
interested in their response to that request.
At this time, I would recognize the gentlelady from New
York.
Mrs. Maloney. Thank you, Mr. Chairman.
I understand you were not pleased with the original rules
that came out as they affected SBICs in the revised standard.
What are your comments on it? Are there any remaining concerns
affecting SBIC merchant banking investments of which Congress
should be aware, and your comments on their current rules on
SBICs.
Mr. Whaley. The new rules do go a long way with respect to
SBICs. They still assess a capital charge to the extent there
is more than 15 percent of capital base. In a SBIC, there isn't
an incremental charge, and SBICs are also counted in the
aggregate total as to whether--as to which level of capital
charge is appropriate. So they have improved it quite a bit,
but there still is some implicit additional capital charge with
larger SBICs.
Mrs. Maloney. I asked the first group this question, but I
would like to hear from the industry what you think about the
proposed merchant banking capital rule and how it compares with
the new proposed Basel capital standards. Do you have any
comment on that?
Mr. Kabel. Mrs. Maloney, if I could comment by way of
background, I think all of our institutions have taken the
position that we don't feel there is a need for special capital
rules period for merchant banking, that existing capital rules
standards for the bank holding companies were sufficient to
take into consideration the risk. Because we simply do not
agree with the proposition that merchant banking investments
are riskier. We just simply do not agree with that.
Frankly, I am not an expert of capital of any kind, much
less the new Basel, but our position has been, BPEC's position,
and it will be again in our comment letter to the Federal
Reserve Board on the revised proposed rules, that they should
simply utilize internal capital models to the maximum extent
possible, which I think most people would agree are very well
done. The purpose of these capital models is to reflect the
actual risk inherent within the merchant banking portfolio. And
then if through the examination process those models are viewed
to be inadequate then impose specific capital with the inherent
regulatory authority.
Mrs. Maloney. OK. Thank you very much.
Mr. Whaley. We would share that view, by the way.
Mrs. Maloney. Thank you.
Mr. Bachus. Mr. Baker.
Chairman Baker. Thank you, Chairman Bachus.
I would like to suggest, Mr. Chairman, that we consider on
the principal elements that have been mentioned here today that
perhaps you and I and other interested Members, perhaps Mrs.
Maloney, consider, although the final rule has been
promulgated, a letter of comment concerning some of the obvious
deficiencies in the current reg, which would include the
routine management definitions, comment on the aggregate
limits, certainly including the holding period.
I have before me what the Gramm-Leach-Bliley provisions are
with regard to holding period. It is, quote, to enable the
deposition thereof on a reasonable basis consistent with
financial viability. Now to take that and to translate it into
a specific term, as we were repeatedly told earlier that the
Congress legislated with regard to these matters, seems to be a
bit at contravention with what the language says.
There are a couple of other additional elements I would
like to throw on the pile, one of which, with regard to a
holding company forming a private equity fund, and you start
out with the plan to have only a 20 percent stake and, because
of the way the fund is structured, the holding company winds up
with a 25 percent stake, that fund then no longer qualifies as
a private equity fund. Then you have got to go back to your
investors and tell them they are no longer part of a qualifying
fund, and you are now subject to these restrictions.
It is just sort of common-sense business formation issues
that have no consequence with regard to safety and soundness or
risk to the markets.
Second, the area where I have the most difficulty on all of
this is things that were previously permissible which now
appear to be in contravention of the new rule, under Section
4(c)(6) of the Bank Holding Company Act, bank affiliated firms
have made investments under that provision without any risk to
safety and soundness historically, that now the agencies have
determined or the Fed has determined to apply the new capital
charge to those investments which previously had no capital
charge against them.
So we have--in my view of the world, we have gone backward,
Mr. Chairman, instead of forward in promulgating rules which
enable cooperative ventures to benefit the economy and
investors. We are now taking a business practice previously
authorized that has not presented market risk to my knowledge
and saying you will now be subject to the new capital charge
which did not previously exist.
I would suggest, Mr. Chairman, that certainly all other
matters which you deem appropriate to include in such a letter,
that we will try to get Members of both subcommittees to join
together in this, I think there are bipartisan concerns that
the consequences of this action will deter what this Congress
tried to do over longer than a decade to modernize our
financial regulatory system.
Mr. Grauer, particularly with regard to your firm's
responsibility with the Louisiana State Teachers Pension Fund--
you caught my attention when the word Louisiana got thrown in--
where you have historically managed minority interest
investments for the benefit of that fund, am I understanding
that the total assets available to your organization is equal
to or exceeds $5 million?
Historically, you have been able to enter into restrictive
covenants that had certain restrictions which would enable you
to take appropriate actions--``appropriate'' being defined as
whatever you think it is in order to protect the interest of
the individual investing teacher. Am I understanding the rule
modification properly, that you would either have that ability
now significantly limited or eliminated in making such
covenants or agreement with minority investments of the sort
you have engaged in?
Mr. Grauer. We believe the rules have been significantly
limited.
Chairman Baker. Would there be cause of concern for the
Teachers Fund to rethink their investment strategy, or what is
the outcome of this?
Mr. Grauer. Each investor, and particularly the Teachers
Fund, goes through an extensive due diligence process before
they ever commit equity to any capital funds. One of the
aspects of that due diligence is to go through and evaluate our
track record, both with successful investments and less
successful investments; and I think they have satisfied
themselves that, as is a professional manager such as ourselves
and others, we are not alone in this world by having the
ability to move quickly and exercise discretion over these
investments. It has gone a long way not only to protecting
their investments but maximizing their returns.
I think in the absence of that flexibility we would be
looked upon by them much less favorably than perhaps someone
who is not subjected to the financial holding company
limitation under Gramm-Leach-Bliley.
Chairman Baker. So you probably feel some obligation
henceforward to advise your customer--your client that we have
had these changes in law which do not enable us to take certain
actions. Consequently, we want you to be aware of this. As a
result of our due diligence process that here--now are the
rules under which we operate, and it could potentially steer
the teachers investment guidance in a different direction.
And, for the record, I am not promoting anyone's private
profitability at the expense of the teachers. What I am
concerned about is getting the best return for the teachers
with the best possible return available.
I don't know if you'll say it, but my summation is the rule
unintentionally precludes them from getting the best
professional management advice for the return for the teachers.
Mr. Grauer. We would agree with that.
Chairman Baker. Thank you. Thank you very much.
Mr. Chairman, I yield back my time.
Mr. Bachus. Thank you.
Chairman Baker. I had one other question. There was
testimony provided by the SIA which I don't think has been made
part of record, Mr. Chairman. It is here. I would like to ask
that be made part of the record.
Mr. Bachus. Without objection, that testimony or letter
will be included in the record.
Chairman Baker. Thank you, Mr. Chairman.
[The information can be found on page 153 in the appendix.]
Mr. Bachus. Mr. Grauer, the holding period also concerns
Chairman Baker and me. You mentioned the necessity of a forced
sale or having to unload the investment when equity markets are
depressed. I would ask the other two gentlemen, can you see any
justification for having a holding period, other than just the
broad language of the Act which basically says as long as it is
justified?
Mr. Whaley. I cannot see a reason for having an absolute
time limit to hold an investment. It is true that most
investments are made and then liquidated within a 10-year
period, but there are many circumstances where it makes sense
to continue to hold them. Sometimes it is market circumstances
that require you to hold them, and sometimes it is in the very
best interest of the company that we have invested in for us--
it is very disruptive if we go to the company and say, you know
what, we have all got to sell our positions because of this
regulation. And it is a problem.
Mr. Bachus. I can see where Uncle Sam would want it so,
particularly if it has been successful and it would generate
tax revenues. Other than that, I can't imagine.
Mr. Kabel. Mr. Chairman, I think that is an excellent
example of using this issue of time period. It is really an
issue that should be dealt with through the examination
process, as opposed to providing regulatory time periods,
whereby, if you bump up against the 10-year period, then you
are required to divest. Why not have the regulators look at
these investments and ask why an institution is holding an
investment for a certain period of time.
There are some investments where there is no market for
them. I am not sure what we should do with these investments
when the subsidiary bumps up against the 10-year period. There
may be absolutely no market for these investments. Often, they
have already been written down to zero, and that is part of the
process. The advantage of portfolio investing is that the
institution invest in a lot of companies and a lot of different
industries, and that is why the direct investment subsidiaries,
on balance, have been extremely successful.
You can say on an individual basis that an individual
investment may be risky, but it is important to remember that
these are banks who are doing the investing. These subsidiaries
have to report to the bank holding companies, and they are
prudently managed. I am not suggesting that the direct
investment folks outside of banks are not prudently managed,
because they are. It is a very successful business. These are
people who really understand what they are investing in, and
they understand how to add value to the companies in which they
are investing.
Chairman Baker. Mr. Chairman, can I jump in on that point?
Mr. Bachus. Yes.
Chairman Baker. I just want to make sure I understand the
operative conditions under which the 10-year disposition rule
works.
Let's assume you have a holding you have had for 9 years
and 4 months. You know the rule requires to dispose. So you go
into the market. The other guy figures this out. Maybe he is
not quite so anxious to close. Maybe the terms change.
Something happens. It is not to your best financial interest.
You then procedurally could go to the Fed and apply for an
extension, but even if the extension were granted you would
then have to have a 25 percent capital charge against the
holding until you disposed of the asset. So that then drives
down your margin or you have got to increase your price in
order to dispose of the asset on the terms in which you
originally contemplated. Are those facts close?
Mr. Kabel. It is my understanding that is correct.
Mr. Whaley. That is correct.
Mr. Kabel. That is exactly what happens.
Chairman Baker. So at the end of the day you have an
arbitrary window. If it is a profitable center, you probably do
not want to get rid of it. But yet if you are going to the
market any time near the duration is coming to an end--if I was
on the other side I would certainly like to have you in that
position, knowing that if you didn't take my deal on the terms
I suggested you will take the capital hit and then we will talk
then. I love that.
Mr. Grauer. Mr. Chairman, just as a point of clarification
I think that capital charge could be as high as 100 percent.
Chairman Baker. I am told it was at 100, but it was reduced
in the modification. It could go down to as low as 25.
Apparently, this is another one of those David Copperfield
things. We don't know where it is.
Mr. Bachus. Thank you.
I will ask a general question of the panel, and it may give
you an opportunity to expound on some of the comments of the
first panel, too.
I think underlying all this is the continuing debate on how
safe are your activities and do they threaten the safety and
soundness of your institution. Given the current economic
conditions, how do you respond to the regulators' concern that
merchant banking activities, if not subjected to close
regulatory scrutiny and stringent capital requirements, could
jeopardize the safety and soundness of those institutions that
conduct such operations? How have merchant banking investments
generally fared in comparison with other types of banking
activities during tough economic times?
We will just go from right to left.
Mr. Grauer. I will make a stab, and my colleagues will
elbow me if I am talking too long or perhaps getting off the
point.
One of the things that we do, and I think all of us in the
private equity business do, is when we--prior to making an
investment we do an extensive amount of research on how we
think the portfolio company will behave in different economic
environments. And as we see those environments develop, either
we are in them or we expect that they will occur, we try to
capitalize our companies so they can weather the storm that
occurs as a result of their business suffering through an
economic downturn.
So invariably there are some companies in all of our
portfolios that don't do as well as others, but, by and large,
most of them have been capitalized, particularly if those are
businesses that are subject to economic cycles such that they
will be able to come through those cycles with solid cash flow,
the ability to service their debt, meet their payroll and
fulfill all the various obligations to their constituents.
So, number one, we try to plan for that ahead of time as we
do the evaluation for each new investment that we look at.
Number two, we also, once we are in an investment, try and take
considerable care as we go through each annual operating plan
cycle to look at the more macro-economic events that are in
front of us and again try to batten down the hatches to the
extent we need to by downsizing the expense base to the extent
we have to, shutting down our capital expenditure programs to
preserve cash and do various other things to ensure that we can
get through the economic cycle.
So those of us who have been in the business for a long
time, such as firms as my own, we have been doing this for over
16 years, we have been through a number of economic cycles, and
I think we have prepared our portfolio to go through those
economic cycles successfully. I think that is one of the
factors that is not brought to bear in the kind of broader
analysis that occurs in preparing legislation like Gramm-Leach-
Bliley where perhaps the level of professional investment
expertise that each one of the major merchant banking firms
have exercised and developed over the years is not necessarily
taken into account. It is a business that clearly has risks
associated with it, but certainly as professional managers we
do our darnedest to be able to take those risk out of the
equation day-in and day-out.
Mr. Bachus. Thank you. I would note for the record that we
have your resume, and it firmly establishes that you have been
very successful in making these investments and that you
certainly have the background to testify and to be an expert
witness.
Mr. Grauer. Thank you, Mr. Chairman.
Mr. Whaley. That was very well said, Peter.
I would just add to that the fact that, at Norwest, we have
been in the private equity investment business for close to 40
years now, which includes a number of upcycles and downcycles,
and you learn to manage through those cycles really doing the
kind of things that Peter alluded to. How that performs
relative to other banking assets, I can't really respond
succinctly to that, other than to say that there was a lot of
discussion earlier today about risk and how you manage that
risk. And it isn't the riskiest class of assets that banks
have. I think risk is only half the equation.
You have to look at the risk return situation, and I think
we would be much more interested in managing a portfolio of 25
equity investments, as opposed to 25 senior loans that are
fully collateralized. Because you have less risk in the loan
that is fully collateralized. You don't make a lot of money on
a loan. You make a net interest margin, whereas in the private
equity business you have the opportunity to make a number of
times on your investment; and, on balance, I think that it
affords the opportunity to make more money and make a more
meaningful revenue stream for the bank holding company.
Mr. Kabel. Mr. Chairman, I don't have much to add. These
gentlemen have been in the business for many years.
But each member of the Bank Private Equity Coalition is
similarly situated in that they have all been in the business
for many, many years. They have well-diversified portfolios,
and they do understand how to manage risk. That is why they
have been so successful.
The regulators often during the course of the lengthy
process--during the process leading up to Gramm-Leach-Bliley
and certainly subsequently would say to my members, we are
really not concerned about you. We are concerned about people
entering the business.
I can appreciate that. But, again, I fall back--the Federal
Reserve examiners are excellent regulators. They understand how
to look at portfolios. They understand how to talk to the
executives of the organizations about what they see.
So, again, I think we fall back on the fact that there was
a system in place that was working. We promoted the specific
merchant banking language in the Gramm-Leach-Bliley Act because
we wanted in the statute a section that talked about classic
portfolio investing that is exactly what the Gramm-Leach-Bliley
provisions provide. That is why when we get into the
definitional issues is where we are clearly running into
problems. But we wanted that statutory provision because of
some of the problems we have seen through the examination
process over a period of years where examiners had different
views as issues.
The classic example that was often brought up was,
depending on where you were situated in the country, you either
could or could not have a member of a board of directors if you
were an investor. I think anyone who looks at that objectively
for safety and soundness would say, of course you want to have
a member of the board of directors. The board of directors
members are the ones who learn of the information first to know
whether there is a problem.
So that has been taken care of. Clearly, that is one of the
advantages of having this provision enacted as part of Gramm-
Leach-Bliley. And I think just over a period of time hopefully
we will be able to work our way through a lot of other issues
hopefully in dealing with the Congress and hopefully in dealing
with the regulators.
Mr. Grauer. Mr. Chairman, if I could add one other thing.
That is, particularly as it relates to some of the restrictions
that I talked about under the new legislation on our ability to
act in both majority and minority investments, in addition to
the analytical framework that I described that we applied both
before and as we look at investments, we monitor our portfolio
companies literally on a monthly basis and in some instances on
a weekly basis, depending on what they are doing, what kind of
capital they are spending and what we think the cash flow
implications of that are.
We oftentimes will make changes. We will move in very
quickly to do things. That is largely because we have
consummated over the last 16 years over $50 billion worth of
acquisitions. We have put to work over $5 billion worth of
equity capital, over $7 billion of equity and no capital. We
have dealt with some 160 investment opportunities over that
period of time where we have had a portfolio shareholder
interest.
As a consequence, the same way you and your colleagues
structure the legislation and other things that you do day-in
and day-out both for your constituents and for our country, we
do the same thing with our portfolio companies. And having
either one hand or two hands tied behind our back and limiting
our ability to do that we are not serving our constituents,
people like the Louisiana teachers and the retirees that exist
in that system, properly.
I want to say one other point before we give up our time.
We in your number of the 29 States that are represented on your
two subcommittees, we manage a retirement system capital for 10
of those States. We manage today--of the $22 billion of assets
that we have under management--roughly 50 percent of that
capital comes from the public pension fund retirement system,
either public employees in the case of Utah--excuse me, in the
case of Louisiana, it is the teacher system. In the case of
Utah, who we manage over $800 million for, it is the public
employee retirement system.
We do the same thing for the States of Arkansas,
Connecticut, California, Illinois, Massachusetts, Michigan,
North Carolina, Pennsylvania, just so mention some of the
representatives who are in your committees.
We have to have the ability to make decisions and make
those decisions on an unfettered basis not only to protect your
constituents but also to generate the kind of rates of return
that we expect our investors have put their monies with us as a
fiduciary to accomplish.
Mr. Bachus. Thank you.
Chairman Baker.
Chairman Baker. Mr. Chairman, I have no further comments.
Thank you for your courtesy.
Mr. Bachus. Ranking Member Waters had indicated she had no
questions.
Ms. Waters. No, I have no questions. I thank you. I did not
have an opportunity to thank you for making sure that your
subcommittee joined in to have this combined hearing, and we
got a lot of information from it. Thank you.
Mr. Bachus. Thank you.
Finally I will just conclude, Mr. Kabel, we appreciate your
comment about whether or not Gramm-Leach-Bliley does, in fact,
prohibit cross-marketing that we have talked about. I know Mrs.
Kelly's question presupposed that it did. We will go back and
take a look at that. She had suggested that a regulation could
possibly take care of that interpretation, that concern.
So, with that, if any of you gentlemen want to make a final
comment, we would invite it. But I think we have a wonderful
record. I think we will close at this time.
Mr. Kabel. Thank you very much.
Mr. Whaley. We appreciate your leadership on this whole
process. It has been very helpful from our end.
Mr. Bachus. Chairman Baker particularly has expressed his
concerns for over a year, which you all have concerns, and has
alerted me to these concerns. So this won't be the end of the
story. Thank you.
Mr. Whaley. Thank you.
Mr. Bachus. The hearing is adjourned.
[Whereupon, at 1:20 p.m., the hearing was adjourned.]
A P P E N D I X
April 4, 2001
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