June 7, 2000

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

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

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

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

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

• How the proposed rules undermine Congressional intent;
• The negative impact that will result if a 50% capital charge is placed on merchant banking activities; and
• The need to eliminate unnecessary and burdensome regulatory restrictions imposed on merchant banking activities conducted through private equity funds.

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

The Proposals Undermine Congressional Intent. 

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

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

1. the depository institution not holding the ownership interests acquired;
2. the ownership interests acquired being held for the purpose of appreciation and ultimate resale or disposition of the investment, and
3. the holding company not engaging in the routine management or operation of the company or entity, except as may be necessary to obtain a reasonable return on the investment upon disposition.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Questions? Please contact Pamela Smith for more information.