Mr. Robert E. Feldman, Executive Secretary
Attention: Comments/OES
Federal Deposit Insurance Corporation
550 17th Street, NW
Washington, DC 20429

Ms. Jennifer J. Johnson, Secretary
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, NW
Washington, DC 20551

Communications Division, Third Floor
Office of the Comptroller of the Currency
250 E. Street, SW
Washington, DC 20219

Re:     Leverage and Risk-Based Capital Guidelines:  Nonfinancial Equity Investments; FDIC RIN 3064–AC47; FRB Docket No. R–1097; OCC Docket No. 01-03; 66 Federal Register 10212; February 14, 2000

Dear Mr. Feldman, Ms. Johnson, Sir or Madam:

The ABA Securities Association ("ABASA") appreciates the opportunity to comment on the proposed new rules issued by the Federal Deposit Insurance Corporation ("FDIC"), the Board of Governors of the Federal Reserve System ("FRB") and the Office of the Comptroller of the Currency ("OCC") (collectively referred to as the "Agencies") that would impose special minimum capital requirements on equity investments in nonfinancial companies. The proposal replaces a prior proposal issued by the FRB.

ABASA is a separately chartered subsidiary of the American Bankers Association ("ABA") that develops policy and provides representation for those holding companies involved in securities underwriting and dealing, proprietary mutual funds and derivatives activities.

Background

Initially, the FRB sought to impose special capital requirements on nonfinancial equity investments by requiring a 50 percent deduction from Tier 1 capital of the total carrying value of these investments. The FRB rule also would have defined those investments to include not only investments made under the newly authorized merchant banking powers but also investments under previously authorized and exercised investment authorities: Section 24 of the Federal Deposit Insurance Act, Regulation K, Sections 4(c)(6) and 4(c)(7) of the Bank Holding Company Act and statutes allowing investments in Small Business Investment Companies ("SBICs").

ABASA strongly opposed the original capital proposal issued by the Board in March of 2000, [1]arguing for a supervisory approach that would consider the individual bank's holding company's internal controls, systems and models. Even if such a supervisory approach were not adopted, ABASA stated that the proposed 50 percent deduction was clearly excessive and that any such special capital charge should not apply to investments made pursuant to the investment authorities that pre-existed the Gramm-Leach-Bliley Act (GLBA).

The new proposed rule would adopt a three-tier or sliding scale approach for assessing capital against equity investments made by financial holding companies ("FHCs") and bank holding companies ("BHCs").  The capital charge would be in addition to the capital otherwise required to be held under bank holding company capital requirements.  This separate capital charge would take the form of a deduction from the organization's Tier 1 capital. The size of the deduction would increase as the equity investment portfolio increased relative to the organization's Tier 1 capital, as described below. 

Specifically, if equity investments in nonfinancial companies make up less than 15 percent of an organization's Tier 1 capital, an 8 percent Tier 1 capital charge would be assessed against all such equity investments (except, as noted below, those made through small business investment companies ("SBICs")).

The second tier provides that if equity investments in nonfinancial companies make up 15 percent or more but less than 25 percent of an organization's Tier 1 capital, a 12 percent capital charge would apply to the amount of such investments exceeding the 15 percent threshold. 

Under the third tier, a 25 percent capital charge would apply to the amount of equity investments in nonfinancial companies that equal or exceed 25 percent of an organization's Tier 1 capital. 

In addition to the new, merchant banking equity investments that may be made under Gramm-Leach-Bliley, there are four other pre-Gramm-Leach-Bliley types of banking organization equity investments in nonfinancial companies that also must be counted in determining whether the 15 percent and 25 percent thresholds have been exceeded:

1.      Equity investments made through SBICs;

2.      Non-controlling equity investments made under sections 4(c)(6) and 4(c)(7) of the Bank Holding Company Act;

3.      Portfolio equity investments made under Regulation K; and

4.      Most equity investments by state banks under section 24 of the Federal Deposit Insurance Act.

Although SBIC equity investments count towards the aggregate 15 percent and 25 percent calculations, no capital charge or deduction is applied to any such SBIC investment unless the total amount of such SBIC investment by itself exceeds the 15 percent threshold.  To the extent that the separate 15 percent SBIC investment threshold is exceeded, such "excess" SBIC equity investments are subject to the aggregate capital charge.

ABASA's Views

ABASA is pleased that the Agencies significantly reduced the 50 percent blanket capital charge originally sought to be imposed on all equity investment activities.  However, ABASA maintains that the optimum method for dealing with nonfinancial equity investments would be to adopt a supervisory approach as we originally advocated in our comments to the Board. As we suggested, a supervisory approach would require FHCs to meet appropriate qualitative standards for managing merchant banking risk in order to qualify for the supervisory approach.  In assessing where an FHC is appropriately managing risk under this approach, we had proposed that the regulators would look at all relevant facts and circumstances, including internal capital allocation models, valuation policies, reporting systems, equity investment risk management policies, and so forth.  An FHC's internal capital allocation model could be used to measure and "backtest" capital adequacy with respect to merchant banking investments in a manner that could be readily monitored and validated by the regulators.  Significant failures of the model could result in additional capital requirements for merchant banking investments, on a case-by-case basis.

ABASA remains concerned that any special capital charge assessed against FHCs engaged in merchant banking activities will further exacerbate the inequities between FHCs and non-FHCs engaged in merchant banking activities. The legislative history describing the merchant banking provisions of the Gramm-Leach-Bliley Act indicates that Congress intended that those investment banking firms affiliated with securities firms and insurance companies that opt to become FHCs should be permitted to continue to engage in merchant banking activities in substantially the same manner as had always been permitted.[2]  Conversely, Congress also intended that bank and financial holding companies should not be placed at a competitive disadvantage relative to investment banking firms not affiliated with any depository institution, but should be allowed to engage in merchant banking activities to the same extent as those other firms.[3]

Despite Congress' stated intentions, the newly proposed special capital charge against merchant banking activities, even as reduced under the revised proposal, would preclude FHCs from engaging in merchant banking activities on the same terms and conditions as their non-bank affiliated competitors.  These provisions also might discourage securities and insurance firms from becoming FHCs, because the price, in terms of limits on merchant banking activities, may be too steep.  The result:  financial holding companies will be precluded from engaging in merchant banking activities on the same terms and conditions as their non-bank affiliated competitors. If they choose to engage in merchant banking it will be with a capital charge not borne by their non-bank competitors.

Nevertheless, ABASA recognizes that a special capital charge ranging from 8 to 25 percent of Tier 1 capital is a significant improvement over "the one size fits all" 50 percent capital charge originally proposed. The newly proposed sliding scale approach addresses, in large part, many of our concerns by assessing capital according to the level of nonfinancial equity investments made by an organization.  Thus, as the level of such investments increases, so too, would the required Tier 1 capital deduction.

However, ABASA continues to oppose any assessment of a special capital charge on non-merchant banking equity investments, which have been permissible for banking organizations for many years preceding the Gramm-Leach-Bliley Act.  The banking industry has a long history of engaging in such equity investment activities through SBICs,[4] under Regulation K,[5] and under the authority of sections 4(c)(6) and 4(c)(7) of the Bank Holding Company Act and Section 24 of the Federal Deposit Insurance Act.[6]  To date, those activities have produced strong returns with minimal losses and have taken place over a relatively long period of time, involving both up and down markets. There is simply no evidence that additional capital is warranted for equity investments authorized for banking organizations prior to passage of the Gramm-Leach-Bliley Act. At the very least, investments through SBICs should be excluded from both the activity-level calculation and special capital charge.

Should the regulators insist on going forward with their proposal to assess capital against merchant banking activities authorized for banking organizations prior to passage of the Gramm-Leach-Bliley Act, ABASA would strongly encourage the regulators to grandfather all equity investments made prior to March 13, 2000.  Without such a determination, many of the investments made previously will be rendered uneconomic – not because of any change in inherent worth but solely because of an unanticipated change in regulatory treatment that results in greater unexpected cost.

Moreover, grandfathering these investments avoids the burdens associated with implementing a phase-in of the special capital charge over a period of time for those equity investments made prior to March 13, 2000.  As the proposal notes, these investments involve only modest amounts at most banking organizations and will be liquidated over time.  Modest investments liquidating over time would tend to argue against a phase-in of capital charges.

ABASA appreciates your willingness to review our comments. We would be happy to answer any questions that may arise.

Sincerely,

Beth L. Climo