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CAPITAL MARKETS AND THE NEW ECONOMY

WEDNESDAY, JUNE 7, 2000
U.S. House of Representatives,
Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises,
Committee on Banking and Financial Services,
Washington, DC.

    The subcommittee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives Lucas, Biggert, Terry, Toomey, Kanjorski, Bentsen, C. Maloney of New York, J. Maloney of Connecticut, Capuano, and Waters.

    Chairman BAKER. I would like to call this hearing of our Capital Markets, Securities and Government Sponsored Enterprises Subcommittee to order and note that we do have several Members who have indicated they are on their way and they should be here momentarily.

    I would like to express my appreciation to all of our witnesses who will appear during the course of the hearing this morning for their attendance, given the length of notice that was provided, particularly to those of our first panel. I appreciate your courtesy in appearing here today.
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    In response to inquiries from a number of the media, and I am sure our first panel will also be appreciative, there will not be discussion of any matters related to Government-sponsored enterprises during the course of this hearing today for the public record.

    It is, however, to discuss the ramifications of proposed regulations pursuant to the passage of the Gramm-Leach-Bliley Act of this Congress. Certainly, every Member of Congress was greatly relieved, after two decades of very difficult work, to see the passage of this important legislation and hoped that it would not only reconcile disputes of long-standing proportion, but, as well, create new opportunities for business expansion for creation of employment opportunities and better service to consumers.

    Our reason for conducting the hearing today is to understand more fully the implications of the proposed regulation and to ensure that the two-way street that the Congress envisioned being constructed will not be limited to a one-way street or, perhaps worse, converted to a parking lot.

    I am confident at the same time, however, regulators have carefully come to the conclusions that warrant the proposal before the subcommittee today, and that there are sufficient reasons to be concerned about the new business risk, whether it be management risk or credit risk, that may be created by the partnering of activities not historically engaged in a relationship.

    However, the application of the proposed capital provisions are of particular concern in that it would appear to increase the cost for many enterprises that have been successfully engaged in business conduct for many years without the necessity of such capital adequacy requirements. The subcommittee simply wants to understand the reasons.
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    Mr. Kanjorski and I have, in our efforts of the modernization of the Federal Home Loan Bank, been particularly concerned about the flow of capital, the adequacy of capital, to all regions of our country, and to ensure that capital markets can function efficiently and take full advantage of the technologies that are available in the market today.

    Whether it is a coffee shop or an internet IPO, having access to financial resources is the hub and core of continuing the enormous economic prosperity this country has enjoyed. It is the subject matter of this subcommittee and certainly of the Banking Committee to have a full understanding and make full inquiry into any regulatory intervention that might impede, unintentionally or not, in that continued expansion.

    For these reasons, the subcommittee is conducting this hearing this morning, and I want to, again, express my appreciation to the Federal Reserve and to the Treasury for their courtesies in working out their schedule to appear here today. We fully understand the controversy surrounding the proposal, and we want to be constructive in this hearing and fully understanding, and giving the opportunities for parties to be heard, but certainly do not wish to, in any way, inhibit appropriate steps necessary to protect taxpayers from unwarranted loss. Thank you for your courtesies.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you, Mr. Chairman.

    Mr. Chairman, I would like to ask unanimous consent to enter into the record Mr. LaFalce and Mrs. Jones statements.
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    Chairman BAKER. Without objection.

    Mr. KANJORSKI. Mr. Chairman, I thank you for the opportunity to speak before this hearing today. I will submit my full statement for the record, and I will try to speed up my remarks, because we have some very important witnesses from whom we want to hear.

    We are familiar with the fact that last year, when we passed the Financial Services Modernization Act, we tried to keep separate banking and commerce. It is very important, as these rules and regulations are promulgated, that this intent of Congress be adhered to.

    As we go through this hearing today, I am particularly interested in the effect the new regulations will have on small business investment companies that are presently in existence, and the new ones that are being created in the New Markets Initiative of the President.

    It is very important that we work to limit the risk and provide for safety and soundness in the banking system, but we also have a commitment to our communities, and to particularly our distressed economic communities, to make funds available through these new vehicles that the President has set forth in the New Markets Initiative. As a matter of fact, toward that end, shortly before we began our Memorial Day recess, I joined President Clinton, Speaker Hastert and Ranking Member LaFalce at the White House to announce a bipartisan compromise agreement on legislation that would enact the best elements of the New Markets Initiative and the Renewable Communities proposal. Thanks to the efforts of Chairman Leach, our committee has already marked up and favorably reported the America's Private Investment Companies Act, one piece of the New Markets Initiative.
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    I hope, although we have in the last few weeks seen some contentiousness, both in the other body and in our own body, that we can put this to rest for a few moments to enact this absolutely necessary legislation. This bill will help the lower 40 percentile of the distressed economic communities of America that have not necessarily shared in the success of our economic system in the last eight years.

    With that in mind, looking forward to the testimony of this distinguished panel, Mr. Chairman, I thank you.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    Mr. Lucas.

    Mr. LUCAS. Nothing.

    Chairman BAKER. Does any other Member wish to make an opening statement?

    Mrs. Biggert.

    Mrs. BIGGERT. Mr. Chairman, this really isn't an opening statement, but I would just like to say that last week, the Federal Reserve Board lost Nancy Goodman to an accident. She has been with the Board for many years in Chicago and I think she will be a great loss to the Federal Reserve and to the City of Chicago and the suburbs. Thank you.
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    Chairman BAKER. Thank you very much.

    Any other Member wish to make opening remarks?

    If not, at this time I would like to call on our first witness, the Under Secretary for Domestic Finance, Department of Treasury, Mr. Gensler. Welcome back, Mr. Gensler.

STATEMENT OF HON. GARY GENSLER, UNDER SECRETARY FOR DOMESTIC FINANCE, DEPARTMENT OF THE TREASURY

    Mr. GENSLER. Thank you, Mr. Chairman, Ranking Member Kanjorski, Members of the subcommittee. I thank you for the opportunity to appear here today, and if I could submit the full testimony for the record and summarize.

    Chairman BAKER. Absolutely. Without objection.

    Mr. GENSLER. I am also pleased, if I might say on a personal note, that my daughter is out of school, my eldest daughter, and so Anna Gensler, behind me, is here to see a little bit about how Congress works and a little bit of what her daddy does.

    On a more serious note that the subcommittee has come together on, the Administration strongly supports the financial modernization legislation that moved forward, and I don't think that anyone doubts how hard we all worked, together with this committee across both sides of the aisle and with the Senate, to get that balanced bill forward to allow for greater innovation and greater service to communities, to consumers and to the economy at large.
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    One of the key pieces of that legislation was to allow banking organizations to compete with securities firms and securities firms to buy banks, what has been called sometimes the two-way street. We fully support that concept.

    At the same time, however, Congress intended to limit the mixing of banking and commerce and to assure that merchant banking activity, when conducted, would be conducted in a safe and sound manner. So, the legislation was intended to promote this new activity, but at the same time there was a recognition of not mixing banking and commerce and promoting safety and soundness.

    The new merchant banking authority under the Act significantly expanded the ability of banks to conduct investments in what I will call private equity investing, which is a little broader category than the term ''merchant banking,'' which would also include venture capital investments.

    When we looked at the rules, we recognized that Congress' intent is clearly to allow also venture capital investing.

    We are in the midst of rule writing right now, and the staffs are still analyzing the comments, so this hearing is a constructive step for the Federal Reserve and Treasury in terms of finalizing those rules, but at this juncture, we are really still considering many of the comments, and there have been very important comments that were received.

    So today I think that we can provide a background, if that would be helpful, on how we came to the rules, and a little bit about private equity investing itself.
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    Private equity investing has been a feature of capital markets for centuries. Private equity investments generally are understood to be investments usually by professional investors, not retail investors, in private companies. Often they are startup companies like venture capital, or in leveraged buy-outs or other middle market companies. The market itself has grown dramatically. In the last twenty years, it has grown from about $5 billion to now over $400 billion in size in terms of the market. So it is a significant and important market to the economy that we wish to continue to foster.

    The most important things to understand, though, about these investments in this market is that: One, they are higher risk. They are equity investments to start with, but even amongst those, they are higher risk. Two, they are long-term investments. And three, they are generally illiquid. They don't trade. You can't open up the newspaper and see where these investments trade.

    While we are in the midst of the rule writing, we think that it is important to be careful that in the longest running economy we not let today's confidence lead to complacency about the fundamental risk of these higher-risk, longer term, illiquid investments.

    Now, by its nature, when I say that it has these risks, I would add also some, or risks, just to comment. In terms of being illiquid, they tend to be unregistered shares in private companies. Sometimes they are public companies, but even when they are public companies, they tend to be controlled investments, and by ''controlled investments,'' that means they are not readily sold 100 shares or 1,000 shares at a time.

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    They also tend to be held for a long period of time, looking to be sold in the public market or the merger market. So they largely depend on the future state of the stock market or the future state of the merger market.

    In terms of financial institutions' role in this sector, they have been engaged for several decades. In fact, with the passage of the Small Business Investment Act in the late 1950's, banks, and then later investment banks, got into this business, and in a limited way in the 1960's and 1970's. They have had a much more dramatic involvement, both investment banks and commercial banks, in the last two decades, with various changes in laws in the late 1970's.

    Today, if one looks at the involvement, particularly of commercial banks, they had some authorities. Even before the Gramm-Leach-Bliley Act, they had some authorities called Edge Act corporations, 5 percent holdings at the holding company, and also the Small Business Investment Act that we talked about earlier.

    Banks today have roughly $35 billion to $40 billion of investment in this area. Investment banks, from our statistics, seem to be a little bit higher than this. But each of these combined represent in aggregate only about 20 percent of the overall pie. So about 80 percent of these investments are outside of banking and investment banking organizations today, with a little less than 10 percent of the overall market currently in banking organizations.

    Now, financial modernization removed many of the restrictions of the Glass-Steagall Act, and one of the important restrictions allowed the two-way street we talked about earlier. The Administration fully supports this. As I said earlier, Congress enacted this bill with two caveats: First, that private equity investment would be undertaken in a way that was not a backdoor way into banking and commerce. It is very difficult to say you can't own the factory, but you can own shares in the factory as long as you hold it for resale in the future. I mean, that is the sort of blurry line in between.
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    The United States has the most efficient capital markets in the world. The allocation of capital in our market, and the allocation of risk in that market, are not confused by the affiliations or relationships between financial and commercial enterprises. We separate those who allocate capital from those who compete for capital in this Nation, and when we look at the history of finance in other countries, even in G–7 industrialized countries, we see, oftentimes, there are banks that can have long-term, many decades' holdings in major corporations in their countries.

    We think our capital market is deeper and more efficient, in part, because we have had that separation; and Congress shared that view in passing the Act last year.

    The second caveat was around safety and soundness. So, accordingly, the Act itself had a series of steps to assure that merchant banking was not this backdoor roll into banking and commerce, and also assured safety and soundness. In terms of the rules, the Federal Reserve and Treasury published two rules, one jointly called the interim rule, which assessed the intent of Congress and put in place five or six key areas that are outlined in the testimony; these five or six key areas really are designed to assure, for example, separation related to risk management, and related to the involvement in day-to-day management of these companies.

    A lot was involved, including setting the board of directors up, being involved in hiring and firing the major participants in the company and the major corporate decisions, but not the day-to-day decisions of running the corner grocery store or even the big factory.

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    The second rule, which was actually under the Federal Reserve's authorities, but which Treasury was consulted on and supported, relates to capital. That is the area that has gotten really many more of the comments than the first of the two rules.

    In terms of capital, it was really a focus on safety and soundness recognizing these investment are higher risk, longer-term, illiquid investments, and what is the appropriate level of capital for an institution to have to back these investments?

    The rule says 50 cents. Just to comment on what that means, that means that for a dollar of equity investment—and I want to clarify, that the rule is only about equity investment, it is not generally about loans—for a dollar of equity investment, you can have 50 cents of your own money and actually borrow 50 cents from outside. This contrasts, I would say, to the predominant way to finance these investments in about 75 or 80 percent of all private equity investments in this country.

    So of the $400 billion, something a little over $300 billion is invested by private, limited partnerships. And when pension funds and endowment funds put money with the leading venture capitalists, with the leading leverage buy-out folks, they say we don't want you to borrow money against this. We will give you a dollar of equity, and you put that dollar of equity to work in portfolio companies. That would be, in essence, 100 percent capital for 100 percent investments.

    What the Federal Reserve here is saying, you can have 50 cents of borrowing for 50 cents of your own money and then put it to work.

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    In contrast, the current Federal Reserve capital rules say that you could actually have $24 of borrowing for every dollar of your own money and put $25 to work.

    I don't think there is anyone who will testify today who will say that is economically what they see this business to be. There is some debate about whether the regulatory capital number should be changed.

    Again, we have received a lot of comments. The Federal Reserve has received a lot of comments. We are going to be looking at all of those seriously. There tend to be more comments with regard to the capital rule, but there are comments on both rules.

    We look forward to this hearing to help us move forward and try to finalize these rules in a thoughtful way and express the intent of Congress.

    Chairman BAKER. Thank you very much, Mr. Under Secretary. I very much appreciate your daughter being with you today. She apparently is keeping you in very good behavior today so I am glad she is here with you.

    Mr. GENSLER. She often does.

    Chairman BAKER. Thank you.

    Our next participant this morning is a member of the Federal Reserve Board, Mr. Laurence Meyer. Welcome very much. We appreciate your courtesy in facilitating our hearing this morning.
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STATEMENT OF HON. LAURENCE H. MEYER, MEMBER, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM

    Mr. MEYER. Thank you. Chairman Baker, Mr. Kanjorski, other Members of the Subcommittee on Capital Markets, I appreciate the opportunity to be here today.

    I hope you will understand that with the comment period just over last month, members of the Board now have and must have an open mind regarding our proposals and the comments. We will reserve judgment until we have seen a summary and analysis of the public comments.

    In addition, the Federal Financial Institutions Examination Council will be discussing bank capital requirements on equity investments. That discussion, of course, will be considered by the Board in developing its final rule on holding company capital requirements on these assets.

    Clearly, the most important, but also the most controversial aspect of the proposal is the capital treatment of equity investments for regulatory purposes. Given that Under Secretary Gensler discussed the private equity market and the involvement of banks and bank holding companies in that market so thoroughly, and also explained many of the other proposed rules in his opening statement, I will focus on the proposed capital rule in my oral statement.

    In focusing on capital, let me underline that in developing our proposal and considering the public comments, we were and are mindful of our responsibility to balance the need for safety and soundness for banking organizations with other aspects and goals of the Gramm-Leach-Bliley Act, the Small Business Investment Act, and the Bank Holding Company Act. The tradeoffs involved will no doubt be central to your questions and our future deliberations.
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    While most banking organizations have not used their pre-GLB Act authority to purchase equities, the size and growth of private market equity holdings at a small number of large banks has been quite substantial. Indeed, equity investments by banking organizations had begun to attract our attention as supervisors well before last November. The banks significantly engaged in equity investing have been quite successful in the business, but our analysis highlighted the potential riskiness of highly levered equity investment.

    Our analysis, summarized in my statement, suggests that the risk of a portfolio of private equity securities is quite significant, with high hurdle rates required to make a commitment, and substantial losses on individual parts of the portfolio. Returns have been very good in the recent years of economic expansion and strong growth, but one of the iron laws of finance is that high nominal returns mean high risk. The high returns are compensation for taking the high risk.

    It is important to note that commenters do not generally disagree with these observations about the risk of equity investment. Nor do they disagree that the economic role of equity capital of the owners of any business is to absorb risk, in other words, to absorb loss.

    Well, what is the banking organization's ability to absorb risk? In short, depository institutions and bank holding companies are required to hold only as little as 4 cents of equity for every dollar of risk assets, although the largest U.S. banks and bank holding companies have equity-to-risk asset ratios, that is tier 1 ratios, of 7 to 9 percent.

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    If assets contract in value by these amounts, the entity is insolvent. Let me underline this point. A dollar contraction in asset values produces a dollar contraction in equity capital. Banking organizations have very little tolerance for loss because they hold such modest equity. Small declines in asset values would therefore eliminate large proportions of their small equity base.

    In addition, you should understand that banking organizations engaged in equity investment have the option to count as income a substantial portion of the increase in value of their equity investments, even if the firm does not realize this profit by selling the securities. This increase in value, even though unrealized and subject to decline, is then permitted to count as capital for the firm and can be used to support its growth.

    In effect, under our current capital rules, a banking organization could leverage these paper gains 25 times. The existing regulatory capital structure, which permits equity assets to be funded with over 90 percent borrowing and permits paper profits to increase the equity base for additional leverage, does not appear consistent with the risks associated with private equity investments.

    Virtually all of our research supports that conclusion. We interviewed banking and securities organizations to determine best practices in the private equity markets, and now have supplemented that information from other sources. All of the information suggests that banking and securities organizations allocate very high levels of internal or economic capital to their private equity business, between 25 and 100 percent, with the median above 50 percent—a clear testimony to the high risk that these firms associate with private equity investments.
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    We also learned that virtually all of the rest of the participants in the private equity market, in contrast to banking and securities organizations, fund their equity investments dollar for dollar with their own equity.

    Based on the cumulating evidence, we proposed a 50 percent capital requirement on portfolio equity investments held under any authority at any location in a bank holding company. This proposal reflected our judgment that the nature and extent of the risk of holding private equities was the same, regardless of the authority used or where the securities were held.

    Since publishing our proposal, each of the two major rating agencies, Standard & Poors and Moody's, have issued reports discussing banking organizations' private equity activities. Both supported our capital proposal.

    Moody's report said that, ''it was prudent for venture capital activities to be funded with a high equity component.'' And Standard & Poor's felt that a 50 percent equity allocation was ''about right if the bank's portfolio is mature and diversified; less diversified portfolios could need up to 100 percent.''

    Such positive support generally has not been the case with those organizations to which the higher capital charge would apply, despite their general agreement about the riskiness of private equity investments.

    They stipulate that, in fact, they impose high internal or economic capital charges on equities, but banking commenters argue that they would have considerably less difficulty with the proposed regulatory capital treatment for their equity holdings if we treated the rest of their assets in the same way. That is, base regulatory capital charge on all assets on their economic or internal capital allocations.
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    They argue that the regulatory capital requirement on a significant volume of banking organization assets exceeds the economic charge. Therefore, the sum of the proposed higher regulatory capital on equities, and the existing regulatory capital on all other assets, would exceed the total economic capital on all the assets.

    The commenters that have raised this issue have argued that the Federal Reserve is engaged in cherry-picking, picking out the risky assets for higher capital charges without providing relief for lower risk assets. Thus, they urge the Board to wait until there is broader reform in the Basel Accord that would address these concerns.

    However, the practical problems we face are that here and now, private equity holdings are large, growing rapidly, and the restraints on further growth are being relaxed, while practical reform of the Basel Accord is at least three years in the future. A difficult set of tradeoffs and choices are thus created.

    When the time comes to make those choices, a factor we must consider is the effect of ongoing capital arbitrage that is undermining the existing regulatory capital structure. Banks in recent years have developed methods to move off their balance sheet those assets whose economic risk, as determined by the market, implies an economic capital charge that is less than the regulatory capital requirement, retaining those assets whose economic capital is equal to or higher than the regulatory requirement.

    Recognizing the realities of the economic pressures, the banking agencies have permitted these kinds of transactions when banking organizations can meet the market test. It is difficult to estimate the capital savings made by these institutions from capital arbitrage and compare it to the potential cost of the higher regulatory capital on equities.
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    The cost of the additional capital charge on equities may exceed measurements of the effective arbitrage on capital requirements. Nonetheless, capital arbitrage is surely one of the variables we will have to consider in the final decisionmaking.

    A related issue in interpreting distinctions between economic and regulatory capital is the desire of banking organizations for excess regulatory capital. It appears clear that banking organizations want to hold a level of capital above regulatory minimums, in part, to obtain the imprimatur of being classified as well capitalized and, in part, to receive higher ratings from the rating agencies and a lower cost of funds from the market.

    Thus, an underlying theme of commenters is the concern that the proposed capital charge would reduce the margin by which they would be well capitalized for regulatory purposes, implying that they may be required to raise additional equity capital to retain the desired excess.

    Stepping back from the detail, the commenters have raised important questions about the merchant banking capital proposal and have also offered a number of suggestions. The Board will carefully evaluate these comments and suggestions and modify the proposal, where necessary, and in the public interest. The subcommittee would expect nothing less.

    Chairman Baker, that is the end of my statement.

    Chairman BAKER. Thank you very much, Governor Meyer.

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    I appreciate both of your comments.

    Mr. Gensler, if I am, in the very large picture, understanding the concern, it would not be with regard to a particular institution's investment, that investment being ill-advised causing that particular bank to have financial difficulty, but it would be, in a broader market sense, that many institutions would engage in a lot of new activities, and perhaps our concern is focused on the consequences of deposit insurance costs as a result of ill-advised new activities.

    Is that sort of the big picture view of what our concerns are?

    Mr. GENSLER. I think that the broader view is these new activities can be very profitable and can be very beneficial to our economy, and they have been these last twenty years. In part, this growth in private equity capital is very constructive, but the broader picture is this is a risk business. I was on Wall Street for eighteen years. I saw some of these deals that worked and some that didn't work, and that risk must be supported by equity behind it; and second, that it must be done in a way to separate banking and commerce, that is, not a backdoor way. You wouldn't own a factory, but you can invest in a factory as long as it is held for resale. And so those are the two bigger picture points.

    Chairman BAKER. If we took the banking and commerce issue off to the side, because some of us have different views on some of these subjects, and stuck only to the question of insulation of risk, that ultimately what is causing the concern is not whether a particular institution fails or has losses, but the implication of a broad-based set of losses, for whatever reasons, may be totally unrelated, that create pressures on the insurance fund as a result. I mean, ultimately, I think we are not in the regulatory business to save individual institutions. We are here to keep the system working; is that fair?
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    Mr. GENSLER. I think that that is absolutely right, and certainly the Federal Reserve would comment on this as well. But this approach to safety and soundness regulation of banking organizations relates ultimately back to protecting the taxpayers, if—hopefully an event doesn't occur, but if an event were big enough to erode the FDIC insurance fund standing behind those various organizations.

    Chairman BAKER. This would be viewed perhaps as sort of an early intervention mechanism so that there are resources to preclude losses from trickling down to an area where we don't want them to go, which leads me to the conclusion, since you have identified apparently significant risk with your regulatory conclusion, it is not appropriate to be talking about significant adjustments in deposit insurance coverage in light of these potential risks that you are discussing. That is just a conclusion I am reaching.

    Second, I think what I find problematic—two things. One is that in order for the institution to engage in the equity activity in the first place, you must be well capitalized. Then you must deduct the value of the investment from your capital and still maintain the well capitalized status. So we are, to some extent, requiring that you be fully capitalized before you engage in this activity; is that correct?

    Mr. MEYER. That is true with respect to well capitalized. The deduction applies only to the securities subs of the bank, but it doesn't apply to the financial holding company.

    Mr. GENSLER. Right. So it only applies actually to the depository institution.
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    Mr. MEYER. Right, the depository institution, exactly.

    Mr. GENSLER. These new activities, the new authorized activities that Congress authorized, at least for the first five years, would not be conducted under a bank. So the well capitalized is the bank.

    Chairman BAKER. OK. Great.

    Second, with regard to currently authorized activity, which institutions have engaged in for many years, and I have always had a problem, Mr. Meyer, in understanding—Governor Meyer—the legitimacy of allowing up to the 25 percent equity holding in a domestic corporation while we allow up to 40 percent in a foreign corporation. I have never understood the risk measurement in that structure.

    What has been demonstrated in market history? Are there broad-based losses or is there something going on that, from your view, that has been missed and why the new rules would now apply to what has been, I believe, a very successful and important part of our economic history with the pre-Gramm-Leach-Bliley activities in merchant banking? Can you explain to me what warrants this new capital requirement in light of the history of that provision?

    Mr. MEYER. Sure. When we began to think about the new activities, we asked ourselves whether there was any fundamental difference between the riskiness of new merchant banking activities and some of the existing merchant banking activities under existing authority—in the SBICs, under the Edge Act and the 5 percent investments in the bank holding companies. In our surveys we found that there really wasn't any difference.
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    Now, the fact of the matter is that with respect to these existing authorities, banks have been managing them prudently because they allocate such high amount of internal capital to these activities. So what you want to think of our approach as doing is identifying industry best practice: establishing that as a foundation for our regulatory treatment, in part, to ensure that new organizations which come into this activity, will be bound to the same prudent behavior that we have seen so far in the industry.

    There is really no basis for a different treatment of the new activities, as far as we can tell. There shouldn't be any differentiation in how they are treated from existing activities.

    Chairman BAKER. That is my final concluding point, because we do have Members wishing to ask some questions.

    It would appear to me there is an extraordinary difference in the risk associated with various enterprises. If it is an internet IPO, which has no history of profitability, no likelihood of profitability, and a significant investment in that activity, given the mania that exists today for those investment opportunities, as opposed to a light industrial firm that has been in business for some number of years who simply wants to expand its capacity, the identifiable risk with those is markedly different, yet the capital criteria would be the same.

    That is the last element of concern, is that it—perhaps there should be some mechanism to have the capital adequacy related to the underlying business risk as opposed to a hard and fast rule, and then to separate that from existing enterprise or investment activities for which there is a long-standing history of no risk to the taxpayer.
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    I don't expect you to comment. I just was expressing that.

    Mr. MEYER. It is a very good point. The commenters have raised points like this. That suggests going down a road somewhat like what we are talking about in Basel with respect to loans, some kind of internal risk-rating approach.

    The problem is that, at this point, the underlying methodologies that banks use to allocate internal capital aren't that sophisticated and don't completely allow, I believe, banks to make all of those distinctions. So I think at the beginning we need some simpler framework, but that is something that we will have to explore as we think about the proposals, whether or not there is any basis for any differentiation between different types of private equity investments.

    Chairman BAKER. Well, I know it is not intentional, but I really worry about the consequences of this on the SBIC side of the ledger. I think it is potentially significantly adverse, and that gets to activities that may otherwise not have access to capital.

    I have run over my time significantly.

    Mr. Kanjorski.

    Mr. Bentsen.

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    Mr. BENTSEN. Thank you, Mr. Chairman.

    Mr. Gensler, Governor Meyer, I apologize for having to step out during your testimony.

    I just want to focus further on the capital, on both the aggregate investment limit and the capital proposal.

    On the capital proposal, it would appear that the prior law, prior to the GLB, or the Gramm-Leach-Bliley Act, bank holding companies were allowed to make an investment of about 5 percent of assets in merchant banking activities, equity investments, and there was a time limit on the holding period, but it was a relatively longer holding period.

    According to your testimony, Governor Meyer, at that time the capital requirement was 4 cents on the——

    Mr. MEYER. That is the minimum.

    Mr. BENTSEN. The minimum was 4 cents. And between the bank and the regulators they were given some latitude above that 4 cents, whether or not the regulators felt that the investment required additional capital?

    Mr. MEYER. Well, two things. Although the minimum is 4 percent, most of the large banks hold between 7 and 9 percent. They tend to hold above the minimum. One of the aspects in the supervisory process is making sure that the appropriate capital is held relative to the risk of the asset, and banks have been holding considerably above that in relationship to their merchant banking assets as part of their internal capital allocation processes.
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    Mr. BENTSEN. But this new proposed rule by both Treasury and the Fed would set an across-the-board 50 percent capital requirement?

    Mr. MEYER. As a minimum.

    Mr. BENTSEN. As a minimum?

    Mr. MEYER. A minimum requirement.

    Mr. BENTSEN. That seems like a fairly substantial increase over 8 percent. In looking at the testimony, I realized that a recent survey of the market demonstrated capital ratios were somewhere between 25 and 100 percent, and so you came up with 50 percent. I mean, why would you go from 8 to 50 and not 8 to 25 with regulatory deference in terms of pressing larger financial holding companies to maybe lift capital requirements—or set aside additional capital if the regulators felt that there was greater risk?

    Mr. MEYER. Well, the median of firms we surveyed was well above 50 percent. We had to look at those cases. There were some cases when they were lower than 50 percent, and sometimes those were not in banks and the firms who had those lower capital requirements tend to be concentrated in the nonventure capital portion, not startups, but more established firms that are less risky, and therefore would require less capital.

    So we did think that best practice, for the kinds of activities that banks have predominantly engaged in, would be, as a minimum, the 50 percent, based on the survey.
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    Mr. GENSLER. Maybe if I can say a few words. One, at Treasury, and I know throughout the Administration, we share the goal of this committee to promote the economy through this very important part of the equity capital markets. It helps promote venture capital. It helps promote, in many regards, the regeneration of many companies.

    We share this goal as it relates to small business investment and the importance of the small business investment company.

    We are in a bit of a new environment in that banking organizations have new authorities, and that those new authorities, particularly, will bring them into broader and more extensive investments in these activities. As we said in the testimony, you add up all of the banks today, they are engaged in their current authorities and they represent about 9 percent of this overall market in the economy, an important, but still modest area.

    We would envision that will grow with the new authorities going forward, and trying to address that growth moving forward is this capital rule, which is actually a Federal Reserve capital rule, but we have been engaged with them to try to do it. And I think the third observation is, because so much of this relates to the economy and relates to the level of the merger market and the stock market, it is hard to see forward when we have had such a strong economy for ten years and a strong stock market for twenty years.

    Mr. BENTSEN. My time is up. I want to get one quick question in.

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    I appreciate that fact, and obviously we are going to have ups and downs in the economy in the future, and it is going to affect the merchant banking activity, and mergers and acquisitions. It would seem to me that capital ratios—you would want capital ratios to fluctuate, or the regulators to have flexibility to adjust capital ratios with respect to fluctuations in the economy, just as regulators do within the banks, rather than setting some set level.

    The only other thing, I don't know if the Chairman will indulge me with this or not, there has been concern raised that these new rules will impede the ability of a two-way street, and that some who are engaged in this activity who might create a financial holding company now would feel that they would be further restricted than the current rules apply to them in merchant banking. Do you see it that way or do you think that is just the price of admission?

    Mr. GENSLER. What I would say is that we fully share the goal of the two-way street. We are going to look at all of these comments closely. There are some very detailed ones that will probably not come up at this hearing about the interim rule and the effect of how private equity funds are managed. We are going to look at that, really to promote the goal that I think we all share of the two-way street, that investment banks could buy banks and banks could be engaged in this activity.

    Mr. MEYER. Yes. We spent a lot of time surveying security firms, particularly because we had a lot of experience with banks under existing authority, but we—at the Federal Reserve—didn't have the same experience with best practices at security firms. And we came away with a view that, again, we were establishing a capital treatment that would be consistent with best practices in terms of economic capital allocations of the security firms, and therefore, we would not be discouraging a two-way street.
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    We will be reviewing this to be sure as we consider the comments, because we certainly do not want to interfere with the two-way street.

    Mr. BENTSEN. Thank you.

    Thank you, Mr. Chairman.

    Chairman BAKER. Mr. Lucas.

    Mr. LUCAS. Thank you, Mr. Chairman.

    Gentlemen, along the lines of what we have been discussing, has the Treasury or Fed done any potential impact studies on these rules? I come at that from the vein of, if you are on the margin of the portfolio, what kind of potential bank divestitures from certain of these activities will these rules promote? Have you done any of that kind of forward analysis?

    Mr. MEYER. Well, it is our view, because we have proposed a capital treatment consistent with internal capital allocations, that it would not have any adverse impact on the activities under any of the existing authorities, in particular, and would allow the expansion of merchant banking activities along the lines that Congress intended when they passed the Act.

    Mr. GENSLER. Again, the interim rule that has a series of risk management practices was meant to be wider than the market today. When many of these investments today are sold in three, four, five, maybe seven years, the holding periods were meant to be wider than that. In terms of engagement in the day-to-day management, to put into practice the ability to appoint the board of directors and to hire and fire senior management and the like were all meant to be wider than industry practice.
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    In terms of our sense in moving forward, it is not to lead anyone to divest any of these businesses. In fact, if you look at the public market analyst reports on this rule, since it has been published, there are no public experts who think that one of the five to ten major banks in this business is going to have to divest its businesses, but you would have to speak to them directly on that.

    Mr. LUCAS. Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Lucas.

    Ms. Waters.

    Ms. WATERS. Thank you very much. Governor, I would like to ask you to continue the discussion of the multibank initiatives in relationship to affordable housing.

    It is my understanding that these investments have been very low risk and enormously successful in States like California and New York and other States. What now does this 50 percent requirement do to the opportunities for investment in housing?

    Mr. MEYER. I am not sure exactly what specific investments you are talking about. To the extent that they are lending activities, they don't come under this. To the extent that they are some of the community development activities that are under the public welfare rules, they are not covered by this.

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    We only cover specific authorities. There are only three that we cover, SBICs, Edge Act and 4(c)(6) authority in the holding company. There are other kinds of activities, many of them related to community development activities, that are simply not covered by these rules. It has no implication for those.

    Ms. WATERS. So as far as you know and understand it, to this point, there would be no great change or risk involved with affordable housing?

    Mr. MEYER. No, but I think I would need something more specific. I don't think so. Could you be more specific about the particular programs you are looking at? If you could communicate those to me, I would look into that more directly.

    Chairman BAKER. Would the gentlelady yield on that point?

    Ms. WATERS. Yes.

    Chairman BAKER. One area that I think you might like to focus your attention, because it does come under the purview of the reg, would be activities conducted with an SBIC where there certainly could be housing impact that would be the subject of her concern.

    Mr. MEYER. Sure. Yes. I think that is absolutely true.

    Ms. WATERS. Well, I suppose you could have small business activity for development, housing development.
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    Chairman BAKER. Even management services, for example.

    Ms. WATERS. Or management services that could be impacted by this.

    Mr. MEYER. Right. Once again, with respect to the SBICs, we didn't see that either the risks in SBICs were different than the risks in these other authorities or in the new activities, or that they were treated differently in terms of how banks currently manage the risks.

    We don't believe that this new rule, as it applies to SBICs, will undermine this activity or discourage it in any way. It was not our intent to do so.

    We recognize that SBICs have played a very important role in promoting small business financing, and that banks have played a very important role in that process. It was certainly not our attempt to undermine this.

    Again, we will be looking over the comments carefully to make sure that we have not inadvertently done so.

    Ms. WATERS. Thank you.

    Chairman BAKER. Thank you, Ms. Waters.

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    Mrs. Biggert, would you be prepared for a question?

    Mr. Toomey.

    Mr. TOOMEY. Thank you, Mr. Chairman.

    Thank you, gentlemen, for testifying today.

    I would like to explore a little bit further this question of the capital requirement and the other limitations that are imposed on this activity.

    Clearly, the intent of Congress was to limit this, restrict this, activity to the holding company and not the depository institution. Right? I mean, that is acknowledged and there are rules that require that. These investments have to be disposed of within a certain period of time. There can't be any active management. So it is truly a merchant banking activity. It is truly happening at the holding company level, not at the depository institution. It can only be done with firms that are already adequately capitalized in the first place.

    So I guess I am just hoping to explore a little bit the question of whether it is really necessary to impose both what seems like a fairly onerous capital charge of 50 percent, and I know you don't believe that is onerous, but in addition, we have this limitation on the total amount of activity that can occur as well as a percentage of the capital. My concern is that perhaps we are making it too expensive to engage in this business. Is it worth looking at different kinds of investments and weighting the capital requirement differently based on some measure of the quality of the company being held or the security being held?
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    Is there not a danger that by imposing these restrictions on the holding companies that we really are establishing, at significantly different levels, burdens on holding companies versus securities firms and we really have not achieved the intent of reducing that?

    Could you comment on those points?

    Mr. MEYER. Well, first of all, with respect to a level playing field between activities conducted within banking organizations and those in unaffiliated security firms, once again we did a very careful survey. We looked at what was the practice among banking organizations with respect to their existing merchant banking activities, and we looked very carefully at how those activities were managed within security firms and we found, for the most part, a considerable commonality in that. So the kind of capital charge that goes into the regulation, the 50 percent charge, is consistent with internal capital allocations at both banking organizations and at unaffiliated security firms. I don't believe that the proposed capital charge will interfere with the level playing field.

    Again, I think it is really important to look at this as an attempt to identify best practice and spread it throughout the banking industry, particularly as new entrants come in to this particular business.

    Mr. TOOMEY. Can I just follow up on that particular point, though? That sort of goes back to the point the Chairman made earlier. If we are confident that the industry generally maintains adequate levels of capital, then why is it necessary to impose that on every player? It would seem to me if an individual player were to have an inadequate level of capital, then they have a risk of loss to their shareholders and that shouldn't be our primary concern. Our primary concern should be systemic risk; right?
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    Mr. MEYER. Absolutely, but I think there is a role for minimum capital requirements. We have imposed minimum capital requirements throughout our banking organizations today.

    Second, there is a role for risk-sensitive capital requirements and we see, indeed, in Basel, that there is a trend throughout to make capital requirements more risk sensitive.

    So I think the issue is not whether we need capital requirements, and not whether they should be risk-sensitive, but, did we get the risk sensitivity right? That is a legitimate point. Is the capital charge appropriate in light of the risks?

    We tried to do a careful survey to make sure that that was the case, but we will be reviewing this in light of the comments.

    Mr. TOOMEY. You mentioned it is appropriate to ask the question, you know, is the capital climate right for the risk? Is it appropriate to distinguish between the different kinds of risks that can be taken even in a merchant banking activity?

    Mr. MEYER. That is a very good point, and part of the problem is whether or not current banking organizations, as they manage these risks and as they do their internal economic capital allocations, have the ability to make those differentiations today. I think ultimately we want to go in that direction. Is that the first step we want to take, or do we want to evolve in that direction as the methodologies improve within banking organizations for getting that job done?
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    It is still a very good point. We will be looking at that as we consider the comments.

    Mr. TOOMEY. If I have time for one last brief question if you could comment on. Again, given that we have restricted this to holding companies, we have said there has to be a 50 percent capital requirement, is it also necessary to limit the amount, the total amount, that can be done? If it has only been done in these institutions, if it is a well-capitalized business, historically it has been profitable and a safe business, why do we also have to say you can't do more than X of that?

    Mr. MEYER. Another very good question.

    When we imposed that aggregate cap requirement, one of the reasons we did so was that we did not yet have in place a capital rule, even as the financial holding companies are allowed to begin these new activities immediately. So we saw this as at least a transitional measure that gave us some comfort as we were moving ahead with the capital proposal.

    In addition, we did mention in our announcement and in our proposal that we also thought it might be prudent to get some experience with supervising these new activities and to have an aggregate cap that limited the explosive growth in these investments during this transitional period. But the aggregate and cap is likely to be transitional.

    Mr. TOOMEY. Thank you, Mr. Chairman.

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    Chairman BAKER. Thank you, Mr. Toomey.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you very much.

    Mr. Meyer, I missed just a part of the ending of your testimony when I had to leave, but I think you make a good argument, and you may have made a convert as to safety and soundness of the system. But, I have some reservations. I question the 50 percent rule as it would apply to SBICs, because I can not see how it could really cause a safety and soundness problem. And, I question why it would not be possible to exclude them from the final rule and allow them to operate as they do now, directed and constructed to perform a public purpose.

    Mr. MEYER. We certainly recognize that important public service through the SBICs, but we also recognize, and I am sure Congress does, too, the importance of promoting safety and soundness with respect to those activities.

    Indeed, one might argue that by doing so, we ensure that those activities will continue to thrive within the banking organizations and will continue to make the important contribution they do to financing small business.

    Mr. KANJORSKI. If I could please just interrupt you there. That argument would work, but SBICs have such flexibility that they can either buy into a startup organization on the equity side or on the credit side. If they make loans and do it on the credit side in order to accomplish the same purpose, they avoid your rule.
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    Mr. MEYER. Yes.

    Mr. KANJORSKI. But, they do a second thing. They weaken that new structured organization to have a very poor balance sheet, very low equity and very high debt.

    Mr. MEYER. We do believe there is a very considerable difference between the riskiness of the typical private equity venture capital component that goes into SBICs and the typical loans that firms make in their lending activities, and this is demonstrated by the fact that banks, in their internal capital allocations, allocate such high economic capital to these private equities.

    Mr. KANJORSKI. I would like the Federal Reserve and Treasury to really look at the ability to carve out the new SBICs that we will be creating under the New Markets Initiative that are targeted to distressed communities.

    Chairman BAKER. Would the gentleman yield on that point? I want to ask you a question to further understand your last line of questioning.

    The response was we believe that the traditional lending process is far less risky than the equity position with the SBIC. That is because the traditional loan is well collateralized. The trouble is the SBIC doesn't have the collateral to post for the loan, and the consequence will be the reduction in risk, I believe, but it will also mean a reduction in capital to the SBIC, because they won't be able to participate. They normally don't participate in the lending process adequately. I think that is the point the gentleman is raising.
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    Mr. KANJORSKI. And, they are so small in size. We are talking about a couple of billion dollars here in the total market that Mr. Gensler is talking about.

    In addition, taking all this into consideration, how does your rule impact on the amount of obligation the banks had in Long-Term Capital Management? Are they still able to go into that organization full force with their limited reserves of, what, 6 or 8 percent? I am not sure of the total capital structure, but I do not think there was more than 4 percent in actual equity in the organization. The rest were loans, maybe $4 billion in capital and $96 billion in loans, a lot of which were made by banks.

    Mr. MEYER. Most of the direct involvement of banks was not, in fact, in loans, but was in derivative positions that banks thought were pretty secure, because they were marked to market and collateralized, and they found out otherwise. They did not do adequate risk management with respect to those positions. As you know, we put out supervisory guidance after that and have worked very hard, and the banking industry has worked very hard to tighten their risk management with respect to HLIs.

    But might I point something out, because you bring up a very interesting point. How did Long-Term Capital Management get into trouble? Maybe one of the ways they got themselves into trouble was they were so highly leveraged. How highly leveraged were they? 25-, 30-to-1? Well, let's go back to see for banks. Four percent capital? That is 25-to-1 in terms of the minimum capital requirement. Is that the way you want banks to be involved in private equity investments?

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    Mr. KANJORSKI. No, I started my comments by noting that you had persuaded me.

    Mr. MEYER. OK.

    Mr. KANJORSKI. I used to play the role of a judge. I would always say to a lawyer, ''Look, when you won your point, maybe you should not push it.''

    Mr. MEYER. We will take it.

    Mr. GENSLER. If I might, Congressman, just to try to answer one of the questions that you asked, the proposed capital rule, as written, does not cover the new markets activities that you mentioned. So I just wanted to clarify. It is very specific that it covers certain authorities and it only covers those authorities. It does not cover those new ones.

    Mr. KANJORSKI. So we are only really worried about the 400 or 500 licensed SBICs that are in existence, and we could probably analyze what total risk is out there, looking at safety and soundness. I would suggest that it is probably less than a $2 billion risk area. If that is the case, why do you move that up to 50 percent when, in fact, we are not really doing anything? The banks can turn right around and get into playing the market with Long-Term Capital Management?

    Mr. MEYER. Just one point. It is true that banks are limited with SBICs to 5 percent of their capital, but that is at cost. If you look at it in terms of their carrying value, and you take into account the unrealized gains, there are banks that have three times as much as that exposure relative to their capital. So it is not that small. At least in a couple of the really largest banks, it is a fairly large activity. It is very concentrated.
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    Mr. KANJORSKI. I am not worried about the banks and SBICs, because I tend to think that they really have not carried out the intent of the SBIC to begin with. They are really just funding until you get to the IPO, and they are really playing the market. But I am really worried about the actual economic development SBICs in the little areas that are trying to develop communities. These are the ones in which I would not care if you instituted a ceiling. I know there is one major bank in New York that derives a major part of their return from their SBIC just by playing the financing before the IPO.
In contrast, I am worried about a small $8- to $10-million SBIC in Hazard, Kentucky, that sometimes needs loans. It needs the capacity to go on either side of the transaction and have a bank follow up. Those would be the problem areas.

    Well, I appreciate it. You may have won a convert. I am not sure.

    Mr. MEYER. Thank you.

    Chairman BAKER. Mrs. Biggert.

    Mrs. BIGGERT. Thank you, Mr. Chairman.

    To follow up on the 50 percent capital that Mr. Toomey had brought up, internally the banks weigh capital requirements for each investment differently. For example, a mezzanine financing investment would carry a lower capital allocation than a new e-business venture, because of its lower potential risk and return. So doesn't the 50 percent capital charge—would that force the holding companies then to steer away from the less risky ventures with the lower return and then toward the higher return, albeit risky, ventures to justify that type of capital allocation?
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    Mr. MEYER. Two things there. That wouldn't be the case if 50 percent were truly the minimum, and, for example, for the riskier venture capital startup kinds of activities, that the internal capital allocations were well above that 60 percent, 80 percent, 100 percent, as we sometimes find. That is one point.

    Second, you, I think, indicated that banks regularly internally allocate different capital charges against mezzanine and startup, and so forth. That wasn't entirely what we found in our surveys. We did find one bank that did that, but we didn't find that practice was all that common. I think that is where banks will be headed, and when banks head in that direction, and develop the methodologies and the internal capital allocation systems to a more sophisticated degree, then I think the capital regulations can go in the same direction.

    Mrs. BIGGERT. But that is true with security firms, that there is a wider range, what, 25 percent to 100 percent?

    Mr. MEYER. There was a range from different security firms, and to some extent it can reflect the considerations that you have indicated, but we do have a problem right now in that not many organizations are prepared to implement that kind of a system with that degree of differentiation across the merchant banking assets.

    Mrs. BIGGERT. Well, what about a range of capital requirements based on risk? Is that a possibility?

    Mr. MEYER. I think all of this has to be considered as we review the comments, and as I indicated, I think it is plausible to believe that that is a direction which we would evolve toward even if we didn't begin first off with such a system. But we will have to consider that.
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    Mr. GENSLER. If I might just add, the nature of what we call the private equity market or merchant banking market is higher cost finance. Companies turn to other forms of finance generally before this, because it costs more. So there is something in the marketplace itself that brings companies that tend to be a bit riskier, whether they be startups or leveraged buy-outs where there is a great deal of debt.

    So there are different levels of risk, but by the nature of private equity, it is always a bit more risky than, for instance, public equity. This overall market, again, is largely financed by pension funds, endowments and the like, and largely outside of investment banks and commercial banks. And investment banks and commercial banks have a great deal to add, and we want to promote that, but when Henry Kravitz gets money from a pension fund, it is a dollar of equity for a dollar of investments.

    Now, in this case the Federal Reserve has found another level, which is the 50 cents level. We are going to consider all the capital rule's comments. Congressman Kanjorski mentioned hedge funds earlier. It is interesting, pension funds and private endowment funds, and so forth, generally look at their investments in this area as what they call alternative investments. They put them usually in the same basket as their investments in hedge funds. Just to give you a context of the risk parameters that most pension funds look at, not always, but generally they put them in the same basket.

    Mr. MEYER. One other point. If we got it right, and that is what we have to continue to look at, if we got it right, and the 50 percent is legitimately an appropriate minimum, and there are investments that are riskier, then in the supervisory process we would have to work to make sure that banks were allocating, hopefully, more capital to the riskier projects. So the question is, did we get the minimum right? That is the real issue.
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    Mrs. BIGGERT. But then what about the less risky? It seems to me that you want them to—that they will go to the more risky and not to the lower risk.

    Mr. MEYER. What you are saying is if we didn't get the minimum right, that there are many assets that have even lower risk, and if that is the case, then the point is exactly right, that will prevent banks from being able to take on those investments and earn a competitive rate of return and we will get the same kind of capital arbitrage that we are worried about with respect to the loan portfolio. So that is exactly what we will have to consider.

    Mrs. BIGGERT. Thank you.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mrs. Biggert.

    Mr. Maloney.

    Mr. MALONEY. Thank you, Mr. Chairman. I want to thank Governor Meyer and Secretary Gensler. Thank you for being here.

    Governor Meyer, this question really is—two of them are for you and follow-up on several of the other questions that have been asked. I want to look at this merchant banking rule from the perspective of distinguishing merchant banking from some of the strategic investments and strategic alliances that banks have already made and are arguably going to continue to make.
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    Under the Financial Modernization Act, there are three different sources of authority for them to do that. One is in the Act itself, the merchant banking provisions for financial holding companies, and this conversation has touched on that already. But the Act also has, ''financial incidental or complementary statutory authorities for financial holding companies,'' and the underlying National Bank Act contains the ''losely-related or incidental to banking authority for banks, and State banking laws have similar provisions.''

    So the two questions are, one, can the Board agree that strategic investments and joint ventures in high-tech and e-commerce activities already approved by the OCC for banks, and banks subsidiaries pursuant to the National Bank Act or by State banking authorities, will not be considered merchant activities, merchant banking activities? And the second related question is, can the Board further agree that holding company strategic investments in high-tech and e-commerce activities—companies that have already been approved under the Bank Holding Company Act or that will be approved now for financial holding companies under the Financial Modernization Act's financial incidental or complementary statutory authorities are, again, not merchant banking activities and should not be treated as such for examination or other regulatory purposes?

    Mr. MEYER. As you know, the merchant banking rules, including the capital proposal, do not apply to investments in financial firms, and that is part of this.

    Mr. MALONEY. Right.

    Mr. MEYER. So it does not apply to those activities that have been ruled incidental to banking, closely related to banking or financial. And the idea is, therefore, not to interfere specifically with those strategic investments that banking firms make, that are integral to their operations and to the financial services that they provide to clients and other financial institutions.
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    Now, when you talk about more generally e-commerce, we can get into kind of a murky and a little blurry area. I have tried to indicate it is not certainly the intent to interfere with those very important strategic investments that banking firms are making in these areas.

    Mr. MALONEY. Just to follow up, Mr. Chairman, I think that is the heart of the issue, and as you review these regulations, I think that is what—I would ask that you take a very close look at that, because if you hold it too close to the vest, certainly some of the activities that banks do now in that incidental category are going to be covered, but the issue is will they have the freedom to take advantage of the changes in the market, the changes in what really is banking as the high-tech field and the e-commerce field evolve.

    So I would encourage you to make sure there is adequate room there for the banking industry to move in that direction without those movements and without that activity being considered merchant banking.

    So, there is a question of a murky or gray area, and my reading, as it stands now, is that it is probably too tight and does not provide adequate flexibility.

    Mr. GENSLER. We will certainly take a look at that, because it is a very important area. Our goal is clearly that if it is financial in nature, it does not come under this. The word ''strategic'' is sometimes used in a broader sense, like having a close relationship with a client sometimes is strategic. And that is where we feel that it was Congress' intent not to have this mixing of banking and commerce. But clearly where it is financial, it is not meant to be under this rule.
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    Mr. MALONEY. Thank you very much.

    Chairman BAKER. Thank you, Mr. Maloney.

    Since all Members on our side have been recognized, Mr. Capuano, you are next.

    Mr. CAPUANO. Mr. Chairman, I just want to echo a few comments that have already been made. First of all, I am really, really thrilled to be back here talking about the financial modernization bill so quickly. I just can't wait to do this for about twenty or thirty more years.

    I guess I wonder in many ways how many people in this room would have had different thoughts about that bill had they known that these regulations were going to be written the way they were, but so be it.

    I have heard a lot of talk today about safety and soundness to the system; great stuff, interesting, important stuff. I have heard a lot of stuff about risk-sensitive capital requirements. I love that term, risk-sensitive capital requirements. That is great. That is your job, possibly my job.

    I am also here to be interested in socially sensitive capital requirements, such as making capital available to nontraditional areas of the economy that otherwise don't have access to capital, such as affordable housing, such as minority-owned businesses, such as businesses located in distressed areas, which is one reason why I am so involved with empowerment zones, with APICS, with the New Market issues. I think that stuff is great stuff. I also want to make sure that we don't do anything to discourage that, and I actually take a lot of encouragement from the comments that I have heard today already that you will review this to make sure that those types of activities are not adversely affected, because I do think that even if they are riskier, even if they are put in the same basket as hedge funds and the like, they are more important to our economy, to individual members of the system than to the greater economy, because it doesn't make a whole lot of difference to me if the whole world is financially well-off if I have a significant segment of the population that is left behind. And a significant segment of the population would be if we walk away from affordable housing, minority-owned businesses, and so forth, and so forth.
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    So I really don't have a question. I did, but those questions have been asked and answered, and I appreciate them. My comment is to emphasize as strongly as I can that you take those issues into account when you review these requirements, particularly the 50 percent capital requirement.

    Mr. Gensler, I look forward to you coming forward with a 50 percent requirement on hedge fund investments by banks. I hope that day comes soon. Thank you.

    Mr. GENSLER. Congressman, we share your philosophy and your goal about promoting all the activities, and that is why we have worked so hard with this committee on so many activities around the Community Reinvestment Act, and around new markets activities, and we look forward to continuing that.

    We don't think that this proposed rule does impinge in the community reinvestment field, as was answered earlier, or on these potentially new legislative initiatives that the President and Congress are working closely on.

    Chairman BAKER. Thank you, Mr. Capuano.

    We do have a couple of Members who want to do a follow-up question, I being one. Just as a matter of clarification, Governor Meyer, and you may want to get back to me on this if it is not something right off the top of your head, I understand that as a supervisory practice, not as a regulatory—or potentially not part of the rule, but the Fed has already begun to treat community development corporations as a merchant banking activity. Can you affirm for me that that has been the practice, or is that not yet the practice?
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    Mr. MEYER. I am not aware of that. Indeed, I think most of the things that I think fall into that community development corporation have this public welfare connotation to them, and those are not covered. That is not part of the activities that are covered by the merchant banking rules, because those are not part of SBICs. They are not in the Edge Act kinds of investments, and they are not in the 4(c)(6).

    Chairman BAKER. Right. I was clear that in the proposed reg that it was not contemplated, but that as a matter of supervisory field practice it was a way in which this analysis was done.

    Mr. MEYER. I will look into that.

    Chairman BAKER. And I have a series of other rather specific questions. I will get those to you within a few days.

    Mr. MEYER. All right. I appreciate that.

    Chairman BAKER. Further, I don't know that it is the appropriate way to state this, but I think you can perceive from Members' participation today that there is a sincere interest in doing something right. Now, defining right in this particular instance is very difficult. There seems to be a lot of hues of gray in this issue, and we don't want to assist an effort that results in losses to taxpayers. At the same time, we felt like, as Mr. Capuano expressed, we had finally resolved the issue of financial modernization, and we appear to be sort of back in the discussion again.
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    To that end, if appropriate, either a report, a briefing, a hearing, some other follow-up step to this hearing at the appropriate time before final promulgation of the regulation would be something we would request, and we can talk about the mechanism that is most appropriate. We don't want to be in the business of rule writing, but we—generally, I think there is a consensus. We would like to know where this is going before we read it as the final step, because there is extraordinary interest in seeing that the system works properly.

    So just as a matter of communication, you let me know what you would be comfortable with as a process, but we very much would like to have a follow-up meeting or something to this hearing once determinations have been close to being finalized.

    Just some housecleaning business. Ms. Waters left a statement for the record, and to note all Members' statements will be included in the record for those who choose to leave them.

    Chairman BAKER. National Venture Capital Association and the FDIC both have comments they would like to be included in the record.

    Chairman BAKER. That concludes my business.

    Mr. Kanjorski.

    Mr. KANJORSKI. Mr. Chairman, just for emphasis purposes, in the statement I entered into the record for Mr. LaFalce today, he enclosed a letter from Aida Alvarez, the Administrator of SBA, dated June 7. I just want to read one of the paragraphs so that we can make sure our witnesses listen to it. ''Today, commercial bank investment represents a major component of the SBIC program. Banks participate in the program through SBIC subsidiaries, bank-owned SBICs, and also provide a significant portion of the capital for independent SBICs. Currently, there are 101 bank-owned SBICs with $5.3 billion of capital. This represents 28 percent of the program's licensees and 62 percent of its total private capital. While large relative to the SBIC program, the banks' investments are still minuscule in terms of the banking industry's capital resources.''
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    I just want to highlight that this type of activity represents, if I am correct in remembering Mr. Gensler's testimony, about 1.5 percent of all the venture capital involved with the banks. That is pretty small as far as safety and soundness is concerned.

    I want to make sure that taking this into consideration, we do not do something to disarm the small army we currently have to help develop some of these distressed communities and areas. Thank you.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    Mr. Lucas, do you have a follow-up?

    Mrs. Biggert, do you have a follow-up?

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman. I have a couple of quick questions.

    Governor Meyer, I had a chance to read through your testimony. As I understand the cap, the limitation, it is 30 percent or $6 billion; and net of private equity investment, it is $4 billion. But the gross cap is $6 billion, the lesser of 30 percent or $6 billion, 30 percent of Tier 1 capital or $6 billion. Is that correct?

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    Mr. MEYER. That is right.

    Mr. BENTSEN. In your testimony, you said there really are a limited number of banks engaged in this activity right now, maybe 10 or so banks of any significance of investment.

    Mr. MEYER. Right.

    Mr. BENTSEN. And the investment range is from $1 billion to $8 billion. If you had a bank, a financial holding company that was at $8 billion, would they then have to ramp back, or would they be grandfathered under this?

    Mr. MEYER. No, because these caps only apply to the new activities under the new act.

    Mr. BENTSEN. But if you are at $8 billion, you would in effect be frozen at where you were?

    Mr. MEYER. No, because those are existing activities. There are no caps on those. They can grow without reference to these caps in the future.

    The only thing that counts are the new activities that are expressly permitted in the holding company by the Gramm-Leach-Bliley Act.

    Mr. BENTSEN. Would only the new activities be subject to the new capital requirements as well?
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    Mr. MEYER. Yes. Oh, no, no. What we did for the capital requirements was different. We said that since the risks appear to be the same for existing activities, the capital requirements should apply to all merchant banking activities.

    Part of this is because increasingly banks manage their risk on a consolidated basis and across legal entities. They manage their merchant banking assets in a similar way, and they ought to be regulated in a similar way.

    Mr. GENSLER. Part of it actually was just really the nature of the rules. There is one rule that we are doing jointly that was put out on an interim basis in March, and then there was the capital rule. The interim rule is only on the new activities, only on the new activities, and that cap that you referred to was seen as in a transitional basis, one, until the capital rule was in place and we learned more about this, and possibly, two, we gauged the experience.

    So it was really of a transitional nature in that first rule in part to get to the second rule.

    Mr. BENTSEN. I had another question on this, but I appreciate what you all are trying to do, and I don't know where I come down on this. I appreciate the fact that you see growth in this sector as part of the new bill, the new act, and the fear of some systemic risk occurring. I mean, the venture business and the merchant business is all up, and at some point it will be down, even though there is long-term growth. So I don't want to sound overly critical of this.
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    Governor Meyer, further in your testimony you go into a rather fascinating discussion of regulatory capital arbitrage that only the Federal Reserve could write.

    Mr. MEYER. Thank you, I think.

    Mr. GENSLER. Interesting words, fascinating and regulatory capital arbitrage.

    Mr. BENTSEN. I guess it is arbitrage throughout life, but if I understand it correctly you are saying that currently you could argue that regulatory arbitrage, capital arbitrage, results in the movement of stronger assets, lower-risk assets off the balance sheet, possibly to the detriment of the capital ratio as a result.

    Could one make the argument that if you impose a new higher capital ratio in merchant banking that you might be forcing institutions to take advantage of arbitrage to make up for that higher capital cost and thus creating perhaps a worse situation?

    Mr. MEYER. If we didn't set that capital charge appropriately, and set it too high so that there were many merchant banking activities for which economic capital allocations would be well below that, that would be the danger.

    Mr. BENTSEN. So you believe that——

    Mr. MEYER. But we tried not to do that. We tried not to do that, but that is a legitimate issue to raise. That is what we have to think about to make sure that we got it right.
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    Mr. BENTSEN. Mr. Chairman, one more thing, with your indulgence.

    Mr. Gensler, I know a number of your staff from Treasury, some of your staff seems to be getting much younger. I didn't know if you would want to introduce who your staff member is with you today.

    Mr. GENSLER. She is the lead of my junior staff at home. It is Anna Gensler, my eldest daughter, who is ten and who is out of school and wanted to see a little bit of how Congress worked.

     Mr. BENSTEN. You are a very good father for bringing her here today.

    Thank you, Mr. Chairman.

    Chairman BAKER. And she is a very nice child for putting up with lengthy testimony.

    Mr. Capuano.

    Mr. CAPUANO. I just think that that is close to getting pretty close to child abuse, so I think you should be aware of that.

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    Chairman BAKER. Gentlemen, Mr. Gensler, we certainly appreciate your participation here today. We hope our hearing is constructive in your efforts, and we certainly want to continue our communication on this important subject. Thank you very much.

    I am advised that we still have some time before we expect the first vote to occur, and hopefully if we can move along we can get all the testimony concluded before the hearing is disrupted.

    I wish to welcome all the participants in our second panel to this hearing. I certainly appreciate your responsiveness, given our lead time in putting the hearing together. Each of you and your organizations have been very cooperative in providing yourselves to be available.

    In the order I have been presented this morning, our first witness would be the President of the Securities Industry Association, Mr. Marc Lackritz. Welcome, Mr. Lackritz.

STATEMENT OF MARC E. LACKRITZ, PRESIDENT, SECURITIES INDUSTRY ASSOCIATION

    Mr. LACKRITZ. Thanks, Mr. Chairman. It is a pleasure to be here before the subcommittee today, although I must tell you that I have a sense, kind of like Yogi Berra used to say, of ''deja vu, all over again.''

    Very quickly after the Gramm-Leach-Bliley Act was passed, we are back here again arguing about what, in fact, it actually said and what it, in fact, intended to say. So it is deja vu all over again in the sense also that we now are dealing with regulatory agencies that, in fact, are proposing regulations vastly outside, far outside, the scope of the legislation that was passed; far outside the legislative intent that was passed, and, frankly, that will have the effect of shutting down one lane of the two-way street that the legislation was supposed to provide for.
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    Just to summarize, we really believe that the merchant banking rules send a powerful signal now to the securities industry that the regulators are still taking a pre-Gramm-Leach-Bliley view of the financial services marketplace in which bank affiliated securities firms will continue to be treated differently from firms that are not part of financial holding companies. These rules will have a significantly adverse impact on the ability of securities firms within financial holding companies to make merchant banking and other permissible investments on the same scale and to the same extent as securities firms that are not part of a financial holding company family. And, because merchant banking is a such a very important part of the business of many securities firms, the existence of these rules will deter securities firms from becoming financial holding companies, because of the roadblocks on one lane of the so-called two-way street.

    The three aspects of the rules that are most troubling are the 50 percent capital charge, the total cap on merchant banking investments and the holding period restrictions.

    Gramm-Leach-Bliley was historic, we think, because it was supposed to enable securities firms and banks to affiliate freely with each other and to ensure that securities firms, once they became partners with banks, would not be artificially restricted in their activities.

    I would just note that in the legislative history of the Act, specifically on both reports, on both sides of the aisle—on both the House and the Senate, the conference report stated that the merchant bank provisions are intended to permit securities firms, ''to continue to conduct their principal investing in substantially the same manner as at present.''
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    We think these new rules go well beyond what Congress authorized in the Act and destroy the two-way street that is the core of the Act. For example, the 50 percent capital charge and the aggregate investment limit on merchant banking investments are artificial restrictions not found anywhere in the Act and never contemplated by Congress in your extensive deliberations on merchant banking.

    Other aspects of the rules, such as the rigid holding period limitation, are plainly at odds with the more flexible approach that Congress specifically directed the Fed and Treasury to take.

    Moreover, these limits on merchant banking activities are entirely foreign to securities firms that are not affiliated with banks. As a result, these limits place securities firms that are part of the financial holding company families or that become financial holding companies at a competitive disadvantage by artificially restricting their activities—artificially restricting their merchant banking investments, and making it prohibitively more expensive for them to provide venture capital to entrepreneurs and growing companies.

    For this reason, many securities firms will be discouraged, if not effectively barred, from acquiring banks and becoming financial holding companies, which was at least a significant part of the objective of Gramm-Leach-Bliley. In short, rather than opening this two-way street, the merchant banking rules recreate the very sorts of roadblocks to an efficient and integrated financial services industry that the Members of this subcommittee and others in Congress worked so hard to eliminate in the enactment of the Gramm-Leach-Bliley Act.
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    Now we heard earlier that Fed and Treasury both testified that these rules are really supposed to formalize existing industry practice. This is not the case, and let me be clear on this point. These rules do not reflect prevailing securities industry practice. Our own experience is that merchant banking practices are far more diverse than the Fed and Treasury have asserted, and that, as a consequence, the rules don't accurately reflect these varied and prudent activities. The capital charge is the very best example of this.

    The Fed is proposing across the board a 50 percent capital charge on all merchant banking investments, because it believes that securities firms and others typically maintain higher internal capital positions to support their merchant banking activities.

    Our experience is that while some securities firms do maintain higher levels of capital for merchant banking positions as opposed to other assets, these levels vary quite significantly from firm to firm and, even within the same firm, from investment to investment depending on an array of factors.

    Furthermore, even if it is correct that some securities firms have higher capital levels for equity investments as part of their internal models, these internal models also apply lower capital charges to other assets; and this sort of cherry-picking, which is what the Fed has sort of done, we think is totally inappropriate, because it doesn't allow for those kinds of adjustments.

    The Fed and Treasury also indicated in their rulemaking that they believe that the restrictions they placed on merchant banking activities are warranted due to the risks posed by this business, but the record of the securities industry participating in the merchant banking business has been very, very good. A successful record was achieved precisely because firms have developed extensive internal controls and management information systems for making, managing and monitoring their venture capital investments.
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    Such established, prudent and time-tested policies and systems should not be disturbed by new rules that inflict arbitrary limits on the amounts firms may invest, on how long firms may hold their investments, and on how these investments may be counted against regulatory capital.

    We think actually there are alternative approaches that are much more effective, but we think the best approach would be for the Fed, which has ample supervisory authority over financial holding companies, to utilize flexible standards and to rely on the very internal capital models that it cites in the rulemaking. Such a course would allow the Fed to differentiate poorly managed firms from others and would encourage and reward institutions that develop sound internal merchant banking practices and risk management models.

    In conclusion, Mr. Chairman, we believe these regulations are totally unwarranted by the legislative history, totally unsupported by the facts and very anticompetitive in their impact. We believe that merchant banking authority is one of the most important powers in the Gramm-Leach-Bliley Act for securities firms affiliated with financial holding companies. We look forward to working with this subcommittee, the Congress and the regulatory agencies to craft new merchant banking rules that advance the goals of financial services reform and safeguard safety and soundness to financial holding companies and their affiliated depository institutions. Thank you, Mr. Chairman.

    Chairman BAKER. Thank you for your participation this morning and your comments.

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    Our next participant would be Mr. Harry Alford, President of the National Black Chamber of Commerce. Welcome, Mr. Alford.

STATEMENT OF HARRY C. ALFORD, PRESIDENT/CEO, NATIONAL BLACK CHAMBER OF COMMERCE, INC.

    Mr. ALFORD. Thank you, Mr. Chairman.

    Chairman Baker, Ranking Minority Member Kanjorski, subcommittee Members, thank you for allowing me, Harry C. Alford, President and CEO of the National Black Chamber of Commerce the opportunity to speak before you concerning the proposed rule changes R–1065 and R–1067 for merchant banking capital requirements.

    The National Black Chamber of Commerce was incorporated in Washington, DC., in May of 1993. Today we have established an infrastructure of 185 affiliated chapters located in thirty-six States and six nations. We have direct reach to 64,000-plus business owners and are the largest black business association in the world. Having completed the task of building a large and viable infrastructure, we are now focusing on key issues that affect entrepreneurs in our communities.

    All surveys and studies reveal that the key issue concerning small businesses and black-owned businesses are no exception. It is capital access. There is a great lack of capital access for small businesses and the need to increase the channels or opportunity pools is ever present. We need more capital. It is the lifeblood for business startup and business development. Any action or conditions that lessens capital access is a threat to jobs, health care, education, and even national security. Small business drives this economy, and the nutrient of capital access is always the great variable in the success ratio of such entities.
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    On March 17, 2000, the Board of Governors of the Federal Reserve System and the Secretary of the Treasury issued joint regulations relating to the merchant banking provisions of the Gramm-Leach-Bliley Act. The proposed rule relating to the capital adequacy of bank holding companies, BHCs, and financial holding companies, FHCs, if enacted, would limit the overall amount of merchant banking activities BHCs and FHCs might engage in, including investments in small business investment companies, SBICs.

    SBICs were created by Congress to provide venture capital financing for small businesses. In addition to Congress, this Administration has supported SBICs as an instrument for job creation in low- to moderate-income areas. These two rules could counter the intent of Congress and the vision of this Administration by significantly slowing down the activity and the amount of investment in such venture capital pools.

    The proposed rule changes would unjustly require BHCs and FHCs to deduct 50 percent of the total carrying value of their merchant banking investments, including SBIC investments, from their Tier 1 regulatory capital for purposes of calculating both their risk-to-capital ratio and their leveraged capital ratio. The net result of the proposed capital adequacy rules would be to increase the percentage of equity capital BHCs and FHCs must have to support SBIC investments from 8 percent to 50 percent. This would be a 525 percent increase in the equity capital charge BHCs have traditionally incurred when making investments to SBICs. The proposed stringent capital requirement will work as a strong deterrent for FHCs and BHCs who might otherwise continue to invest in SBICs.

    Traditionally, regulators have used such requirements to deter bad practices such as predatory lending. Significantly raising the charge-off scares investors. Thus we are shocked, quite shocked, at this practice now being applied to mainstream investment pools that fuel the development for small business and create jobs by the thousands.
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    The 106th Congress will be recorded as the session that promoted small business investment and inner-city renaissance. In the era of New Markets Initiative, American Renewal Act and other new pieces of ingenuity, these proposed rule changes have the effect of being the sole fly in the buttermilk.

    We strongly urge this subcommittee and the 106th Congress to use its powers to squash this direct threat to the SBIC program.

    In addition to the SBIC threat, the proposed rule changes would greatly decrease opportunities that banking institutions may have in meeting their Community Reinvestment Act, CRA, obligations. The rules would take away a key tool to investment in low to moderate-income areas, which the SBIC program provides.

    In conclusion, we feel these rules would undermine congressional intent and cause great harm to our constituency. All who believe that capital access is important to business development and job creation should oppose them.

    Thank you so much for your time, and let me say that from a small business perspective these rules are mean-spirited and onerous. They are antibusiness.

    Chairman BAKER. Thank you very much, Mr. Alford; very good statement.

    I welcome next Mr. Lee Mercer, President of the National Association of Small Business Investment Companies. Mr. Mercer.
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STATEMENT OF LEE W. MERCER, PRESIDENT, NATIONAL ASSOCIATION OF SMALL BUSINESS INVESTMENT COMPANIES

    Mr. MERCER. Thank you. Mr. Chairman, after Mr. Alford's statement, I am not sure what I am going to add to it, but I will try to add a couple of points, and so to you and Mr. Kanjorski and other Members of the subcommittee, I thank you for the opportunity to be here on behalf of the SBIC program.

    We are appearing with respect to the capital adequacy proposal. That is what I will comment on. And I will summarize my testimony and just ask that the full testimony appear in the record.

    Chairman BAKER. Without objection.

    Mr. MERCER. I mean, you have heard it said already that the bank investment in SBICs is a significant source of capital, over 60 percent of the private capital and over 24 percent, I think, now over the past two years of capital invested in independent SBICs.

    So the rule, which has a potential to have a significant negative impact on that, will be substantial.

    Now, I have heard Treasury and Fed allude to the fact that it is a small amount of money in the overall scheme of things, and that is true. SBIC venture capital is probably, at most, 10 percent of the venture capital under management, depending on what you characterize as venture capital.
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    But in terms of numbers of transactions, SBICs, according to SBA's estimates last year, represented about 50 percent of the transactions. So if you view the private small business community in our country as a pyramid, where very small companies need smaller amounts of capital, the SBIC program is supporting the base of that pyramid upon which the balance, the huge balance, of this private equity industry, which is so successful, relies, because most small businesses can't start off digesting a $7 million or $10 million investment. They need $250,000, $300,000, $500,000, a million dollars, and that is the heart of the SBIC program. So for our small businesses, it is a substantial source of capital in this country, and nowhere is there an impact analysis done on that.

    For the reasons stated in our testimony, we believe the SBIC program should be exempt from the rule, or at the very least that there is a lot more homework that has to be done before a capital requirement change is applied to the SBIC program. I won't recite them all, but I do want to make some points which relate to some of what I have heard here today.

    I am not sure that it is true to say that banks have new authority. At least with regard to venture capital, they certainly have expanded authority, but they have been operating venture capital activities in the SBIC program for many years, and quite profitably. And the significance between expanded and new is quite important, because according to what we heard here today they have been managing those activities in a very prudent way.

    So I guess I would ask Treasury and the Fed what exactly has changed to suggest that they will not be managing them prudently in the future as they go forward?

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    Second, some of the statements made in the published rule, in my mind at least, indicate either a lack of understanding this or an unwillingness to accept that constraints, other than their own arbitrary rule, can have an effect on risk. And I quote: ''Risks associated with''—and we will insert 'merchant banking activities'—''do not vary according to the authority used to conduct the activity.''

    That is simply just a ridiculous statement. It assumes, quite frankly, that no other regulation can have an effect on risk.

    In the SBIC program, there are regulations regarding the licensing requirements and the criteria for becoming an SBIC. There are restrictions on the percentage of capital that can be invested. There are examinations by SBA. So to suggest that other authority can have no effect on risk is to probably suggest that we ought to throw out all of the regulatory agencies that have any impact on this.

    All of these things address risk, and risk would be greater without them.

    The proposed rule also treats equity and convertible debt as the same. And I guess I would ask, how can that be? It implies, if you will, carried to its logical conclusion, that an investment in a convertible instrument, a debt from IBM, would subject me to as much risk as it would be if I bought the stock of IBM. It just does not follow.

    Certainly there are—and others have commented on the fact that there are different categories of risk associated within activities that are considered, ''merchant banking activities.''
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    Finally, I guess I would say that there is no discussion of what I will call portfolio management—or what others called portfolio management theory and its impact on risk. That basically talks to the diversification of a portfolio and how that has an impact on risk, and, you know, for leveraged SBICs there are definitely diversification requirements, and bank SBICs impose their own diversification requirements on themselves, but it would seem to me that that ought to be addressed as well.

    I will close with just a question. What will be the final result if the rule were to become final today? What would the impact on the SBIC program be?

    My feeling is that less money would be invested in SBICs by banks. Why? There are several reasons, but one of the reasons would be banks having to allocate capital between an SBIC and what I will call a Gramm-Leach-Bliley activity would probably allocate it to a Gramm-Leach-Bliley activity. Why? The SBIC is subject to more regulation than the Gramm-Leach-Bliley activity for the same type of investment. The SBIC has to be licensed. Its managers have to be subject to qualification requirements. It undergoes examinations. It is subject to the restrictions to invest only in U.S. companies, only in small companies, only in U.S. companies that have 50 percent of their assets and 50 percent of their employees are over 50 percent in this country. So if it were—if for no other reason, you would say the capital is going to go where there is the least amount of restriction, and I think that would be a fair result if I were managing a bank. That is probably what I would do.

    So I guess I would close by saying we are of the opinion that one size does not fit all. For reasons that have been articulated perhaps better than I can here today, by several Members of the subcommittee, we believe that the SBIC program ought to be exempt from this capital requirement. Thank you very much.
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    Chairman BAKER. Thank you, Mr. Mercer.

    Our next witness is Mr. John P. Whaley, who is Partner in Norwest Equity Partners and Norwest Venture Partners, Wells Fargo, and testifying today on behalf of the American Bankers Association and the American Bankers Association Securities Association. Welcome, Mr. Whaley.

STATEMENT OF JOHN P. WHALEY, PARTNER, NORWEST EQUITY PARTNERS, NORWEST VENTURE PARTNERS, WELLS FARGO, ON BEHALF OF THE AMERICAN BANKERS ASSOCIATION AND THE AMERICAN BANKERS ASSOCIATION SECURITIES ASSOCIATION

    Mr. WHALEY. Thank you, Mr. Chairman. Norwest Equity Partners and Norwest Venture Partners are both merchant banking operations, and they comprise the private equity investment business of Wells Fargo & Company.

    As you mentioned, I appear on behalf of ABA Securities Association, or ABASA, and the American Bankers Association.

    Mr. Chairman, many of ABASA's members regard the merchant banking authority as the single most important measure of the Gramm-Leach-Bliley Act. We oppose the recently proposed regulations of the Fed and Treasury. They raise many issues. I will highlight three of them: how the proposed rules undermine congressional intent, the negative impact of the 50 percent capital charge, and the unnecessary and burdensome restrictions on merchant banking through private equity funds.
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    The first of these three points is that the Fed and Treasury have gone far beyond effectuating congressional intent. One of the clearly stated purposes of the law was to create a two-way street among financial services providers. The proposed merchant banking rules undermine that intent. The restrictions, particularly the 50 percent capital charge and the aggregate investment limits, effectively guarantee that there will not be a two-way street.

    Securities firms will not become financial holding companies. Foreign banks will conduct their merchant banking activities from offshore locations. Bank and financial holding companies will be precluded from engaging in merchant banking activities on the same terms and conditions as their competitors.

    These regulatory restrictions, beyond those delineated by Congress, are not needed. Statutory provisions prohibiting routine management of and unlimited holding periods for investments ensure the separation between banking and commerce.

    Congress also adequately addressed risk concerns by authorizing merchant banking activities only through holding companies for the first five years, and by permitting them only to financial holding companies with well-capitalized and well-managed banks and by requiring financial holding companies to have appropriate risk management systems.

    Furthermore, the banking industry has a long history of merchant banking. Those activities have produced strong returns with minimal losses over a relatively long period of time, involving both up and down markets.

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    For all these reasons, it is inappropriate for the Fed and Treasury to raise additional barriers that Congress never intended. Let me give you two prime examples. The first is the proposed 50 percent capital charge on all merchant banking investments, which would apply not only to new merchant banking authority, but to all such investments, including those made under existing authority.

    The 50 percent capital charge is plainly excessive. It would require eight times more capital for merchant banking activities than is currently required. This will negatively impact not only the newly authorized merchant banking activities, but also those authorized prior to Gramm-Leach-Bliley.

    There is also no grandfathering of existing investments. Thus, organizations will have their overall capital requirements raised without contributing one additional dollar of equity investment.

    A 50 percent charge could render uneconomic many existing investments, not because of any change in inherent worth, but solely because of an unanticipated change in regulatory treatment.

    The Fed suggests that the 50 percent capital charge is drawn from internal capital allocation models used by investment banking firms. In fact, however, the regulators have cherry-picked the high capital allocations from internal models and ignored all the lower capital allocations assigned these same models.

    The capital proposal also will have a significant practical impact. Holding companies will be forced to replace capital depleted as a result of the 50 percent charge. This will be necessary to maintain growth opportunities and to satisfy regulatory and market demands for large capital cushions.
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    The second example of undermining congressional intent is the unnecessary and burdensome restrictions on merchant banking through private equity funds. The proposal recognizes that merchant banking investments when constituted of a less than 25 percent interest in a private equity fund should have fewer restrictions than those made directly. This is appropriate because investments made through a minority interest in a fund inherently raise fewer regulatory concerns than do direct investments.

    Having recognized this distinction, however, the proposal does not go nearly far enough. Most of the restrictions that apply to direct merchant banking investments apply to investments made through minority interests in private equity funds. That is, restrictions apply not just to the financial holding company's minority investment in the private equity fund, in most cases they also look through to the fund's investment in portfolio companies.

    ABASA strongly objects to these look-through restrictions. They are evidently intended to prevent the financial holding company from using a private equity fund to operate a commercial company as part of the financial holding company's business, but that will not happen because of the limits that the proposed rule already imposes on a financial holding company's investment in a private equity fund.

    Specifically, in addition to the 25 percent limit on the financial holding company's investment, the fund may not become an operating company, must hold diversified investments, must establish a plan for the resale of investments and must not be used to make investments that evade or are inconsistent with the merchant banking statutory provisions.

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    With these restrictions in place, there is simply no need to have any of the proposal's restrictions look through to another fund's investments. These restrictions will needlessly deter financial holding companies from investing in private equity funds and create a real disincentive to include financial holding companies as investors in many such funds.

    In conclusion, ABASA appreciates the opportunity to voice its strong objections regarding these proposals and their impact on merchant banking, an activity that we believe is of fundamental importance to the financial services industry, corporate America and consumers. We urge Congress to tell the regulators that the proposed rule as presently drafted undermines congressional intent. Thank you.

    Chairman BAKER. Thank you, Mr. Whaley.

    Our next participant is Mr. Jeff Walker, General Partner, Chase Capital Partners, who is here today in his capacity representing the Financial Services Roundtable. Welcome, Mr. Walker.

STATEMENT OF JEFFREY WALKER, MANAGING PARTNER, CHASE CAPITAL PARTNERS, ON BEHALF OF THE FINANCIAL SERVICES ROUNDTABLE

    Mr. WALKER. Thank you, Mr. Chairman.

    Chase Capital Partners is the primary private equity investment vehicle for Chase Manhattan Corporation. We started our business—in fact, I started in 1984. We have invested in over one thousand companies, such companies as Star Media, and Geocities, and 1-800 Flowers, and La Petite Academy, a minority-oriented fund called Quetzal, which we just raised to $250 million, to focus on the minority community and the entertainment and media space. We are a global, integrated partnership with 160 professionals investing through seven offices around the world.
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    We have a diversified portfolio across industry and across stage of investment. We see everything and see a lot. We have been through many different cycles.

    We have earned over 40 percent rates of return on our investments over the last sixteen years compounded per annum. At the same time we have been very consistent in our use of strong controls within our own organization, and we have enjoyed good relationships with the regulators over the last sixteen years.

    With respect to the Gramm-Leach-Bliley bill, you can describe me as happy and frustrated; happy, because after sixteen years of working to try to get a two-way street going between ourselves and our competition, I thought we were there. We have competition of the investment banks, the foreign banks, the private partnerships, but we still have been able to achieve in our firm 40 percent rates of return, in the overall industry excellent rates of return even with one hand tied behind our back. I am frustrated, because just as we got to the finish line, the Federal Reserve and the Treasury saw fit to add rules and regulations that put commercial bank private equity groups back again at a disadvantage. I don't think that was Congress' intent.

    Fifty percent capital requirements, maximum exposure restrictions, holding period limitations and changing the rules covering investments that were booked in the past will cause banks like ours to possibly cut back our commitment to the area. We are talking about doing it already.

    With a higher capital allocation and portfolio limitations, fewer dollars will be allocated to the private equity and venture capital areas by commercial banks. If we had operated under the current proposed regulations over the last sixteen years, I believe a number of the companies that our industry financed would never have received funding. Also, the commercial banks would have been significantly less profitable, because our activity has been extremely profitable for them.
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    We need to be careful of regulations that cause unintended negative consequences. We talked a lot recently, this panel, about capital allocation and focusing on and cherry-picking one particular area of capital. When you don't focus on how much should we allocate to credit cards, how much should we allocate to loans—we have had arguments within our own organization about are loans more risky in our portfolio than a set of private equity investments? Private equity you can make two, three, four times your money. On a loan, you can make interest rate. So what really is appropriate risk-taking? It is still something that we are all discussing in our organizations. There is no one right answer right now.

    Commercial banks have led private equity and venture capital business for forty years investing through the SBICs and other vehicles, in companies all over the country. We have developed organized business investment systems and sophisticated portfolio management tools; stringent due diligence standards and synergistic networks that add value and help our portfolio companies grow to succeed. We bring more to the table than just money, and people come to us for that reason.

    If the Federal Reserve and the Treasury are concerned that new entrants might use the Gramm-Leach-Bliley Act to enter the private equity business and not run their activities with the appropriate safety and soundness in mind, then I suggest that they look at the Small Business Administration. They spent the last forty years figuring out what the appropriate standards are, and we live under them. You can apply the same entrance and operating standards like the SBA does, such as evaluating backgrounds of professionals running the business, operating procedures that are currently in place and length of time in the business.

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    If the regulators are concerned that there might be overconcentration of private equity assets in a bank's portfolio, then I submit they are not focusing on the correct issues. Quality of the professionals running the operation and diversification of the portfolio are more relevant to a successful private equity enterprise limiting losses, and those issues can be better addressed on a firm-by-firm basis through appropriate periodic reviews rather than using a blunt instrument of capital requirements and portfolio size limitations.

    Many groups in the private equity industry, from commercial banks to investment banks to SBICs and private partnerships, are concerned about the negative consequences of these regulations. Chase and the Financial Services Roundtable have submitted letters urging the Federal Reserve and Treasury to reconsider the proposed regulations and have suggested alternatives.

    Financial Venture Capital Association, of which I am a member, just submitted a letter last night to you, Mr. Chairman. It supports our views, and I would like to quote one relevant paragraph: ''The association concurs with the view that regulatory actions which impose unnecessary burdens on venture capital and private equity investing are not in the best interests of the U.S. capital markets and are not consistent with the spirit, if not the letter, of Gramm-Leach-Bliley. The Association also questions the assumptions apparently underlying the joint regulatory actions, which, in its experience and that of its members, do not accurately reflect the character and risks of this investment business. We further question the need for artificial uniform limitations on the conduct of these activities. To the extent that the Board and Treasury actions are prompted by regulatory concerns about the risks associated with these investments, properly managed venture capital and private equity investment and portfolios historically have not presented excessive risks, the sort warranting the potentially drastic capital charges proposed by the Board, or potentially significant operating restrictions contained in the interim rules.''
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    Our industry and Chase has a long track record, through many economic cycles, of successfully investing in private equity, from supporting startups of companies that are building the pipes that support the internet, like the Digital Island; companies that are analyzing the human DNA, like Genomic Solutions; companies that are one of the largest employers in Harlem, like Urban Box Office, which we have invested in. We actually helped create internet business in New York City five years ago by doing the initial startup for the incubators there.

    Using this blunt sword of the proposed Federal Reserve regulations will decrease the chance that companies like these will be financed. Allow us to compete on a two-way street with the investment banks, foreign banks and private partnerships.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Walker.

    Before I ask my first question, I perhaps should give a little background on my perspective. I have been a very strong advocate for the most bold approach under Gramm-Leach-Bliley discussions possible and feel like we moved from the 1930's to about 1986 with its passage, and I had really hoped to come back and move us to about maybe 1998 or somewhere in there.

    Having said that, I have gotten the feeling from letters, and certainly testimony this morning, that we all passed Gramm-Leach-Bliley and, in transportation terms, thought we had provided resources to four-lane every two-lane bridge in America. When the regulations came down, they not only said we should not four-lane these bridges, because you know that is going to increase the amount of traffic and activity, which means more risk, but we really ought to think about taking out the two-lane bridges and get rid of the risk altogether and just build parking lots. It is very frustrating.
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    On the other hand, I want to be the first to acknowledge—and I made that background statement, so my question is properly understood—we have inherently opened the door to new business relationships, that there will be new entries into the market who do not have the track record of your organization, Mr. Walker, and who may be engaged in IPO startups as opposed to equity participation and business activities simply wishing to expand with a proven track record of profitability. There are varying degrees of risk that exist with these decisions.

    Now, I make the assumption that financial management always goes into a question of investment with the idea that we want it to be profitable. I have not met anyone yet who says we do this to lose money, and that would be a unique way of approaching this. So if you have internal risk management tools to make the correct judgment about profitability, then you have a layer of regulatory standards which hopefully protect the public from ill-advised investments.

    What value does the proposed regulation provide to that procedure?

    The only conclusion I can come to at this point, after listening to everyone, is that there are, or will be if we don't have this regulation, new entries into new fields of business without a history of activity that may invest in activities we can all agree are at the outside of the risk curve.

    Can't we give the regulators that and say that the current regulations are not sufficient to gauge that particular type of activity and request some alternative? For example, rather than say, ''Go away,'' and, ''This doesn't make sense,'' what can you recommend, Mr. Walker, to me to say to the regulators?
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    We recognize there are some areas of concern that perhaps current regulation would not properly constrain; or is it your view, based on your experience, that the current regulatory structure is sufficient for post-Gramm-Leach-Bliley?

    Mr. WALKER. I have been dealing with SBA, the Federal Reserve and OCC, and Price Waterhouse and internal auditors for sixteen years, and we go through extensive analysis of our systems, our support, our evaluation procedures, our portfolio management tools, the backgrounds of all of our professionals; and I suggest that those standards are very high and should stay high.

    And I think they should, as I said a little earlier on the new entrants, maybe adopt some of the Small Business Administration's guidelines and standards which are pretty good; maybe add a few more if they would like to make sure that those entering the business have the qualifications so that they can make reasonable financial investment decisions.

    Chairman BAKER. Let me put a finer point. As profitability gets pressure and a bank that is not of the sophistication of your shop, a regional or smaller institution, I think the view of the regulators is not that a particular bank creates a holding company that enables them to facilitate investments that don't work, but on a broad economic basis there are lots of people entering into this activity who don't have the internal risk management tools and are being pressured to do so as interest rate returns narrow. So they are going to look for new fields of business. With the old savings and loan problem, you had to find ways to get that rate of return up, and so there were a lot of things going on with deposits in the 1980's.

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    That is the focus. They don't want to open the doors to unbridled investment opportunity and find themselves with a lot of folks doing a whole variety of things that they have no experience in conducting.

    Is there any legitimacy to that concern?

    Mr. WALKER. Absolutely. The SBA has turned down people who were not qualified.

    Chairman BAKER. Is there any response to the rule—and I fully understand the market's perspective on this rule, but what can we tell the regulators that is responsive to their concerns; or is it ill advised?

    Mr. LACKRITZ. One approach is that the Fed has ample supervisory authority over financial holding companies. From that standpoint, it does have the power on a case-by-case basis to deal with these kinds of situations. I think that is one very important power that they should use, because it is more flexible than a blunt instrument of a regulation that, as you said, Mr. Chairman, there are varying degrees of risk so why should everything have a 50 percent capital haircut.

    The second issue is the firms. Generally speaking, financial services are developing—as Mr. Walker and Mr. Whaley said—internal risk management models now. The right way to go is to have the regulators relying on the internal risk management models that the firms are developing with the regulators' role being assuring themselves that the models are appropriate models and that they work right.
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    The problem, according to the regulators, is that we are not far enough along in terms of implementing those, and new firms that come in may not have the capacity to set up the sophisticated risk management models. The firms that have that in place, that is a good way to go.

    Chairman BAKER. Does anybody else want to make a comment?

    Mr. MERCER. Just to concur and maybe expand a little bit, certainly they have the authority to go into any bank and apply a different capital requirement depending on the qualifications of those managing the activity, according to the type of subset of merchant banking activity that that particular bank is going to be involved in, and certainly by adopting, as Mr. Walker suggests, some of perhaps the SBA's criteria in doing some of that examination.

    I think one of the risks involved in an arbitrary allocation of 50 percent is to give comfort, if you will: I have allocated 50 percent, therefore, I am safe. I mean, that is the worst kind of comfort that one should take from being involved in this activity.

    I am sure neither Mr. Whaley nor Mr. Walker would say, just because we have 50 percent capital, we are safe and we don't have to have diversified portfolios, we can take it to Atlantic City and let it ride on double zero. That is not going to happen, but that is the risk you get if one becomes convinced that 50 percent equals safety.

    Chairman BAKER. Mr. Alford.
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    Mr. ALFORD. I think Governor Meyer's concern about the leverage of 25-to-1 certainly deserves debate and concern, but, 2-to-1 is a bit extreme.

    Mr. WHALEY. I echo Jeff's comments that we have dealt with the regulators for many years at Norwest and have done so very effectively; and that I think to have the Fed oversee this activity as a continuation of what has been done in the past would make some sense.

    I just also add that we have been a very significant contributor to Wells Fargo's profits, and we really are operating under a 6 percent capital allocation as Wells Fargo does it. So I think there has been a lot of discussion about risk, and I would tell you that a single investment in a single early stage company has a lot of risk, but history has shown that a professionally-managed portfolio of investments over time dramatically decreases that risk and that you can look at the financial results that have come out of the bank-affiliated venture firms and you can see that it is, I think, overblown in terms of concern.

    Chairman BAKER. My experience on new ventures is that you get the loan if you don't need it; otherwise, it is tough to find.

    Mr. Kanjorski.

    Mr. KANJORSKI. I am sort of awed by your testimony, Mr. Whaley, and by Mr. Walker's testimony. Did you assume when we passed the Financial Services Modernization Act that nothing would change in terms of the requirements? You seem so surprised. As a legislator, when I supported the Act, I realized that we were changing the playing field, but we were going to rely on Treasury and the Federal Reserve to redefine the requirements so that safety and soundness would be protected. Do you not think that was the intent of Congress?
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    Mr. WALKER. I can't read into the intent of Congress. What I was hoping for was that we would be given a level playing field and put on the exact same competitive level with investment banks and foreign banks and our potential merger partners, so they would be motivated to combine with us. And we were still operating on a fairly sound and safe basis. So we would not change the way we operated our business, which was safe and sound, and we continue that process.

    Mr. KANJORSKI. I accept that. With a 40 percent return over sixteen years per annum, I am jealous.

    Did you do an analysis of what your profit actually would have been over the sixteen-year period if, instead of having an 8 percent reserve, you had a 50 percent reserve? I think you would only have had a 37 percent profit.

    Mr. WALKER. We actually report our number assuming 100 percent capital, so that 40 percent is just the return on our gross investment number. So if you leveraged it, it was a much higher rate of return, actually.

    Mr. KANJORSKI. You had a higher return than 40 percent?

    Mr. WALKER. Yes.

    Mr. KANJORSKI. If you were required to put a 50 percent reserve to the 40 percent, the best quick calculation I can make is that you only would have had a 37 percent return per annum. Is that about correct?
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    Mr. WALKER. I am not sure that calculation——

    Mr. KANJORSKI. Well, what would it cost you? If you had to put a 50 percent reserve instead of 8 percent on the leveraged side of the bank's money that was invested, it must be a very small fraction.

    Mr. WALKER. If we financed our deals with 100 cents on the dollar capital, we are at a 40 percent rate of return. If it was 50 cents of capital and 50 cents of debt, we would actually earn a higher rate of return; so it would be a 50 or 60 percent. Leverage would help the return.

    Mr. KANJORSKI. So with the rule that they are propounding, you would have made 60 percent return?

    Mr. WALKER. If on the number that I talked to you about, absolutely. If you evaluate it.

    Mr. KANJORSKI. Why 60 percent instead of 40 percent?

    Mr. WALKER. I don't think that is the appropriate analysis. I think the analysis is, what amount of capital should the Federal Reserve and the Treasury deem appropriate for Chase.

    Mr. KANJORSKI. They are deeming 50 percent reserve for the safety and soundness protection. If, in fact, you are so successful that they required that instead of making a 40 percent return, you make a 60 percent return, I can not understand why you are arguing against it.
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    Mr. WALKER. Because our business is stand-alone, that is my point. You can't evaluate our business stand-alone if we are part of Chase. The Fed ought to look at Chase's capital needs and how much capital they should have in their 150 different businesses and then analyze that for risk.

    In our business, we have to pay taxes. I am quoting a pretax number.

    Mr. KANJORSKI. Do you think that the Federal Reserve is sophisticated enough at this period of time to have a model established to really test what you are talking about? Can't test what Chase is doing and what all of these new banks are doing under this Act?

    If they have to make a judgment of reserve in the nature of a rule, should they not make it on the conservative side rather than making the mistake of not requiring a sufficient amount of reserve? Then you have some companies that are not as successful or do not have the track record that you have. They are going to get in there and see this opportunity as a potential bonanza, and we are going to drive an extraordinary amount of venture capital that is going into less sophisticated investments, because of the mass amount that is out there. Will they not eventually get a risk?

    Mr. WALKER. My personal opinion is that the Federal Reserve ought to focus, instead of on the micro aspects of managing a bank, on safety and soundness for the financial institutions that are out there; and each bank ought to come up with their own internal capital allocation mechanism across all of its 150 businesses to appropriately manage itself. I don't think that the Fed understands our businesses and the 150 other businesses well enough to tell us how to allocate capital, because we are not sure that we do, either.
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    Mr. KANJORSKI. Then nobody should tell you. Are you arguing for an unregulated system?

    Mr. WALKER. No, I think they should regulate us as a bank and as an overall holding company and not micromanage our business.

    Mr. KANJORSKI. What is your solution to their proposal?

    Mr. WALKER. I think they ought to eliminate a capital test for a specific business, and I would argue not just for our business, but any business within the institution; and I think they should not have a cap on how much we should be able to put in that business. I think they should watch the safety and soundness of the overall institution.

    Chairman BAKER. After there is a failure, then they should come in?

    Mr. WALKER. No. Every day they should come in and evaluate how good our management systems are, how good our controls are, what kinds of loss rates we have had.

    Mr. KANJORSKI. Would your bank or any of your companies invest in Long-Term Capital Management?

    Mr. LACKRITZ. We were.

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    Mr. KANJORSKI. Nobody there had a billion dollar exposure?

    Mr. LACKRITZ. A number of our firms were invested.

    Mr. WALKER. But none of your firms, Mr. Walker?

    Mr. WALKER. I am not sure. We may have had a loan outstanding to them, but it is not my area, so I don't know.

    Mr. KANJORSKI. There was a terribly sophisticated group of guys and tremendous models. It seemed almost like there was no possibility of failure, and yet a series of circumstances happened at a precise moment in time to produce a collapse without some form of rescue going in.

    Isn't your testimony reasoning that if they do not pay attention and they do it prospectively, if your management team dissipates, or if something happens then they will come in and allocate some safety and soundness standard? Is your testimony opposed to presuming that if they are too conservative—I listened to all of the testimony today, and let me exclude some—you probably were not in the room. I have a particular interest in the public policy of SBICs, and I think they are no risk to the system for safety and soundness. To exempt them is not a problem.

    On the other hand, I do not believe that everybody is the same. I would like to develop a system where there is a weighted value depending on performance. That however, is something that has to happen prospectively. They now have to start a standard. The testimony was that they are grandfathering existing transactions. So they are not going to get into that. It is the future transactions that are going to be under the regulation. We can check that if that is not the case.
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    Mr. WHALEY. That is not my understanding of the law.

    Mr. KANJORSKI. I think that is what the Governor testified to.

    Mr. WHALEY. The capital requirements are going to apply to all of the old existing transactions.

    Mr. KANJORSKI. That is a good point. Let us examine it. But the testimony that I heard from several of you, particularly in the financial investment field, is almost the hue and cry I would have expected to hear from the brokers and speculators in 1930 and 1931 when the securities were going to implement limitations on margin lending. ''Now you are going to restrict our market. Now we will not be able to buy.''

    Certainly the brokers would have been screaming, and in reality it seems to me that we have tried to open up the competitive field with full knowledge that there may be some risk to safety and soundness if not properly regulated. I concede that none of us have the expertise to provide that management or regulation now. It does fall to the Federal Reserve and Treasury, and they are struggling with how to do it.

    I would hope that more of your comments could be directed to what you suggest they can do, defending that proposition, as opposed to attacking what they have done and leaving it at that. Ultimately, we must have a regulation. Maybe you can help, and I am sure that you have put in your comments and suggestions to accomplish that objective.

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    I have the impression from your testimony that you thought we passed the Act, and all prior conditions were going to exist. I would say that would be a bonanza for some people and a catastrophe for others, and I think that is where the Federal Reserve and Treasury have a problem. They have to balance out these equities, and I think balance is the intent of Congress, but let us do it intelligently and smartly.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    Mrs. Maloney.

    Mrs. MALONEY. Thank you, Mr. Chairman.

    I did hear Mr. Walker mention several companies in New York which have been high-growth, important companies in the district that I represent. I join my colleague, Mr. Kanjorski, in viewing oversight of the safety and soundness of the banking system as my primary responsibility as a Member of this subcommittee, but it seems that some of the rules, as drafted, appear to really overstep the authority granted by the regulators in the financial modernization legislation.

    In reading the regulators' testimony, they contend that their 50 percent capital charge for merchant banking activities is reflective of current industry practices, and I would like to ask is that true? Is that the current industry standard?

    Mr. LACKRITZ. It is not. I mean, it is reflective of the survey that they may have done in terms of averaging, doing an arithmetic average of what people's internal capital charges were; but it is distortive, because they are proposing a single capital standard of 50 percent across the board, and second, they have taken out one part of an internal risk management model, one asset that is part of an internal risk management model, and pulled out that element without taking into account lower capital charges on other assets in that model and without putting all of the other characteristics of the model in.
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    So instead of using a fairly sophisticated and risk-sensitive model, they have adopted an across-the-board 50 percent number, which is arbitrary, and it doesn't reflect the industry best practices at all.

    Mrs. MALONEY. Anyone else?

    Mr. WHALEY. Wells Fargo has been in the venture capital merchant banking business for forty years, and our capital assessment, if you will, is really 6 percent. It is what it is across the board in all Wells Fargo businesses, and we are no different. And so we are operating with a 6 percent capital.

    Mr. WALKER. It is a variety, up and down. The key is, now they are going to talk about loans, and is it 3 or 4 percent or 20 percent; and then we have to go to credit cards, and what are they. You can't look at each business on a stand-alone basis and allocate capital. You have to put it together in a portfolio.

    Mrs. MALONEY. What will be the impact of this requirement on the investment in SBICs?

    Mr. MERCER. I am Lee Mercer, appearing for the National Association of SBICs.

    Logically, you would expect it to have a negative impact. To the extent that you increase the capital charge for any activity, you either have to pull back from the activity or increase your capital. So, logically, you expect for those institutions that can't increase their capital, they are going to have to pull back.
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    Also, as I indicated, I think the potential is there for it to negatively impact SBICs, because what you will have is a capital charge equal to that for Gramm-Leach-Bliley activities, which are going to be less regulated, if you will, or appear to be less regulated, than the SBIC program.

    So if I were in charge of a bank and I were allocating my capital, I would allocate it to the activity that had the greater potential for gain and the least amount of regulation and restrictions associated with it. And that would be a Gramm-Leach-Bliley activity rather than an SBIC activity.

    Mrs. MALONEY. Yes, sir.

    Mr. ALFORD. That certainly would decrease the amount of capital access or opportunity amongst urban communities. There is a saying that minority businesses have and that is, ''Every time I learn how to play this game, they change the rules.'' That is applying here.

    Mrs. MALONEY. I do note that the SBA management contends they are not aware of any failures of bank-owned SBICs in the last ten years.

    I would also like to ask, following up on Mr. Mercer's comments, could this encourage FHCs to actually invest in riskier enterprises in order to make a return, because of the high capital requirement? Would it have that effect, do you think?

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    Mr. MERCER. I would probably defer to the folks from the banks, Mr. Whaley or Mr. Walker.

    Mrs. MALONEY. OK.

    Mr. MERCER. I would certainly agree with the logic.

    Mrs. MALONEY. Could it possibly result——

    Mr. WALKER. It is unlikely to motivate a higher risk orientation. It will have the corporate capital allocation reduced for the entire private equity business. We evaluate our investments and will still make good investments.

    Mrs. MALONEY. But would be there be an incentive to invest in riskier businesses?

    Mr. WALKER. No, we would have less capital allocated to us by the bank, by the institution.

    Mrs. MALONEY. One of the areas that concerns me tremendously is the whole new technology in e-commerce. I am just coming from a Joint Economic Committee where that was the focus of the hearing, and I also represent an area called ''Silicon Alley,'' and I note that Mr. Walker mentioned in his statement earlier that he had invested in this area. It has been the highest job growth area in recent history in New York City. The City attributes over 200 thousand jobs to this area; it is just unbelievably large.
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    What concerns do you have about this particular merchant bank proposal on these high tech and e-commerce ventures?

    I might note that the Banking Committee and Congress have encouraged the Federal Reserve and other banking regulatory agencies to take steps to assure that financial institutions are authorized to engage in a wide range of high tech and e-commerce activities that are just really changing dramatically, probably as we speak during this hearing, they are changing so quickly. So I do have concerns about what impact this proposal would have on these high tech and e-commerce ventures, and I would invite anyone to comment.

    Mr. WHALEY. Well, it is hard to know what the impact would be, but Norwest Venture Partners is headquartered in Palo Alto and is involved in financing the new economy.

    Will dollars be apportioned elsewhere and not to Norwest Venture Partners? It is hard to know. When we go back to Wells Fargo and tell them that they have to charge eight times the amount of capital to fund our activities, they will scratch their heads and say ''Maybe your funding should be less robust than it is.'' That could be an outcome.

    Would we decide to get out of the business entirely because of this? I don't think that would be the case, because it clearly—there is nothing here that encourages us to do more.

    We thought that this legislation was going to open the gates and let us compete without one arm tied behind our backs, and it has done the opposite. We are now deciding how much should be cut back, how much can we afford, whether we have to make riskier investments. It has had a completely unintended result.
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    Mr. WALKER. We started up a company five years ago called Flatiron Partners, and it does internet investing in Silicon Alley, and it created Silicon Alley and StarMedia and Kosmo and Geocities and a whole variety of others; and we moved businesses into New York, and we set up Urban Box Office, which is an internet site, one of our largest employers in Harlem. It is bringing jobs back to New York City, and it has made New York alive again.

    You can do that time and time again. What this will do is take away commitment to assets in all categories that we have been investing in across the board.

    Mrs. MALONEY. Finally, I would like to question an area that is tremendously important in New York City, and that is minority lending. It was touched on earlier, but would anyone like to elaborate on what this capital requirement would have on minority lending, if it would have any?

    Mr. ALFORD. I think it would be devastating, ma'am.

    SBICs probably have been the sole source of any successful black-owned business, the most being Beatrice International. That was an SBIC loan, as well as Microsoft and FedEx.

    But I see where the withdrawal of the activities occurs, African-American businesses only do 1 percent of the sales of this country today. Hispanic maybe 2.5 percent. Those numbers are not going to increase because of this, certainly; we may be obliterated. I really have a fear, and I don't think I am being hysterical about it at all.
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    Mrs. MALONEY. Earlier, in response to my question, you said this was not the practice that is out there now, and one of the goals of banking modernization was to level the playing field.

    And what is the impact on that aspect, if any?

    Mr. ALFORD. It doesn't level it at all. I see the APEX as being an answer to upstart businesses, small businesses. These SBICs will take the successful business owner, the one who may be doing $5 million a year in sales, could take him to the realm of $20-$25 million a year in sales, but I see this limiting at that $5 million level and making that company vulnerable to larger companies who may compete with larger businesses.

    Mr. WHALEY. The bill, I think, does level the playing field. It is a huge step forward. It is something that we have worked for for sixteen years. Unfortunately, these proposed regulations completely neutered the bill.

    Chairman BAKER. Thank you, Mrs. Maloney.

    To the panelists, I appreciate your participation here today. As you may have noted when the regulator panel concluded, I requested another opportunity for the subcommittee to interact with the regulators before the final rule is promulgated. In that regard, I would ask each of you and any interested party who has specific recommendations that they would like for us to consider to submit them, perhaps by way of letter to the regulator or other means. I would certainly welcome them, as I am sure other Members of the subcommittee would welcome them.
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    Clearly, there is universal agreement as to the adverse consequences on SBIC lending and to other, shall I call it ''social centers of interest'' by the subcommittee. I think there is significant interest among most Members that the effect of Gramm-Leach-Bliley not be stopped or, worse, reversed. And to the extent that I can get Member participation to communicate those views, I certainly would make the effort to do so.

    I think the hearing has been most informative and helpful, and I do believe the regulators are having a work-in-progress; I don't believe that they have concluded and reached any final decisions, and so the window of opportunity that we have available to us is very critical if we are going to gain the benefits that all of us hoped that we gained with the passage of this important act.

    I thank you for your participation and our hearing is adjourned.

    [Whereupon, at 12:45 p.m., the hearing was adjourned.]