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U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises,
Joint with the
Subcommittee on Financial Institutions and Consumer Credit,
Committee on Financial Services,
Washington, DC.

    The subcommittees met, pursuant to call, at 10:04 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises], presiding.

    Present for the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises: Chairman Baker; Representatives Bachus, Biggert, Ose, Toomey, Ferguson, Ryun, Bentsen, J. Maloney of Connecticut, Mascara, Inslee, Ford, Hinojosa, Lucas, Shows and Ross.

    Present for the Subcommittee on Financial Institutions and Consumer Credit: Representatives Bachus, Roukema, Baker, Kelly, Ryun, Biggert, Toomey, Grucci, Ferguson, Tiberi, Waters, C. Maloney of New York, Bentsen, Mascara, Moore, Kanjorski, J. Maloney of Connecticut, Ford, Hinojosa, Lucas, and Shows.

    Also Present: Representatives LaFalce and Oxley.
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    Chairman BAKER. Good morning. I would like to call this joint hearing of the House Subcommittee on Capital Markets and the House Subcommittee on Financial Institutions of the House Financial Services Committee to order.

    This morning Chairman Bachus and myself have joined together for the purpose of again reviewing the rules proposed pursuant to the enactment of Gramm-Leach-Bliley with regard to merchants' banking activities. Chairman Bachus and I both, along with Ranking Member Kanjorski, realize the significance of these proposals and do appreciate the modifications made from the earlier proposals submitted last summer to the status of the proposals currently. Certainly all Members perceive Gramm-Leach-Bliley to be a significant step toward unleashing the power of markets to facilitate economic development, utilize new technologies and create market opportunity heretofore not possible.

    It would appear to me and I am perhaps aware that others still have remaining concerns with regard to certain aspects of the implementation of the proposed regulations. Certainly we should not preclude activities which are currently authorized by law under the name of modernization and make managerial and cross-marketing decisions more difficult which are customarily utilized in the marketplace today.

    In the course of the hearing today we will hear not only from regulators, but from market participants, and I am advised that there are a series of competitive meetings ongoing so our membership here today, gentlemen, will be continually changing I am told. But it does not in any way lessen the committee's interest in this matter, nor our attention to your testimony here today.
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    At this time, I would like to recognize Ranking Member Kanjorski, then come back for opening statements.

    Mr. KANJORSKI. Thank you, Mr. Chairman, for the opportunity to speak before we begin today's hearing on the promotion of capital availability to American business.

    As the Ranking Democratic Member on the Capital Markets Subcommittee, I want to maintain the competitiveness of our Nation's capital markets. These resources help American businesses compete in the international marketplace. They also strengthen our domestic economy by helping our Nation to remain productive, providing better jobs at higher wages for American workers, and improving the quality of life for American families.

    It is therefore appropriate and constructive for us to hold hearings at this time on the revised merchant banking rules issued by our Nation's financial regulators earlier this year. These proceedings will help us determine whether these regulations run counter to the purposes of the Gramm-Leach-Bliley Act or whether they capture the essence of the law's intent.

    During the debate over the modernization law, one of the most highly contentious issues debated was the extent to which we should break down the legal barriers separating banking and commerce. In Japan, the intermingling of these sectors via cozy kieretsu combinations probably contributed to the great inefficiencies that first produced the economic disorder in their banking system in the 1990's and which continues today. Ultimately, Congress learned from these concerns and we enacted a law maintaining a firewall between banking and commerce.
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    A closely related issue examined in the overhaul of the financial services industry concerned merchant banking. This term refers to equity investments by commercial banks in non-financial firms. In our deliberations, we recognized the importance of merchant banking in providing equity capital to the private sector, but decided that for at least 5 years only units of financial holding companies could engage in such activities. Consequently, the law permits these units to acquire equity investments in non-financial companies and to sponsor equity funds, providing that they limit their ownership positions and do not retain day-to-day management control of these investments.

    In March of 2000, the Federal Reserve and the Treasury Department issued interim and proposed regulations to implement the merchant banking provisions of the modernization act. These proposals generated considerable debate among affected parties and in the press. Of particular concern to me, along with many of my Democratic colleagues, was their effect on small business investment companies, which bring important capital resources to small businesses in the communities in which they operate.

    Because commercial banks represent the largest source of the SBIC program's private funding, concerns arose that provisions contained in the merchant banking rulemaking, such as the proposed 50 percent capital charge on all equity investments, would have constricted the availability of financial resources for small businesses. During our subcommittee's prior hearing on the interim rules, I expressed concerns about the effect of the proposal on SBICs, and urged the regulators to create a limited carve-out under their merchant banking rules for such investments. To their credit, the regulators responded to many of my concerns when issuing their revised capital proposal for non-financial equity investments in January, 2001.
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    As I noted earlier, in passing the Gramm-Leach-Bliley Act, we maintained the firewalls preventing the indiscriminate mixing of banking and commerce. From my perspective, it remains very important that our Federal financial regulators strike an appropriate balance between allowing financial holding companies to engage in merchant banking activities and insulating commercial banks, which carry Federal deposit insurance, from the associated risks.

    In closing, Mr. Chairman, my colleague in the other body, Senator Paul Sarbanes of Maryland, perhaps said it best when he noted that the financial modernization law gave the Federal Reserve and the Treasury the ability to jointly develop implementing regulations on merchant banking activities ''to define relevant terms and impose such limitations as they deem appropriate to ensure the new authority does not foster conflicts of interest or undermine the safety and soundness of depository institutions or the act's general prohibitions on the mixing of banking and commerce.'' Although I generally agree with his assessments, I believe it equally important to learn more about the views of the parties testifying before us today and, if necessary, to further refine and improve merchant banking regulations in the future.

    Thank you Mr. Chairman.

    Chairman BAKER. Thank you.

    Chairman Bachus.

    Mr. BACHUS. Thank you, Chairman Baker, for your leadership on this issue and for convening this joint hearing.
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    One of the committee's chief central responsibilities in this Congress will be overseeing the implementation of the historic Gramm-Leach-Bliley financial modernization legislation. Among the issues that need to be addressed are the far-reaching financial privacy regulations scheduled to go into effect July 1 and a more recent regulatory proposal that would permit banks, through financial holding companies and financial subsidiaries, to engage in real estate brokerage and management activities.

    Though the privacy and the real estate rules are of greater interest to individual American consumers, the merchant banking rules first proposed in March of last year have enormous consequences for the financial services industry and for capital formation processes that help fuel our economy. Private equity placements and venture capital investments provide critical seed money for American entrepreneurs whose creativity and energy have helped make the U.S. economy the envy of the world.

    I was one of the Members that felt that, as originally proposed by the regulators last March, the merchant banking rules were deficient in important respects. Particularly troublesome was the requirement that financial holding companies hold 50 cents in capital for every dollar of equity investment in non-financial companies. By setting the capital threshold so high, the original capital rule served as a huge disincentive for any investment banking firm thinking of partnering with a depository institution under the financial holding structure established by Gramm-Leach-Bliley.

    To their credit, the regulators took the criticism of the original proposal to heart and have come back this year with rules that clearly move in the right direction. Most importantly, the revised proposal replaces the rigid 50 percent capital requirement with a more flexible sliding scale, an approach that increases or decreases the capital charge imposed on merchant banking investments in direct proportion to the concentration of such investment in an institution's portfolio.
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    But acknowledging that a bad proposal has been made better is not the same thing as concluding that the proposal was a good idea in the first place. In my mind the Federal Reserve and the Treasury have simply not met their burden of proof in demonstrating that additional requirements are needed in the merchant banking arena. Banking organizations have been making private equity investments pursuant to other statutory authorities since well before Gramm-Leach-Bliley was enacted, and have done so profitably and seemingly without loss to individual institutions, depositors or the system as a whole. This track record strongly suggests that bank regulators already have the legal tools needed to effectively supervise merchant banking activities of financial holding companies and bank holding companies without these new rules.

    With the welcome improvements made by the regulators, the revised merchant banking rules still place financial holding companies at a decided competitive disadvantage in relation to firms that choose to operate outside of that structure. Such a result cannot be squared with the congressional intent evidenced by Gramm-Leach-Bliley, which was to encourage, not actively impede, affiliations between securities firms and banks. This regulatory initiative before us greatly concerns me.

    I yield back the balance of my time.

    Chairman BAKER. Thank you Mr. Bachus.

    Ms. Waters, do you have a statement?

    Ms. WATERS. Yes, I do, thank you. Thank you very much.
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    Good morning, Mr. Chairman. I am pleased to have the opportunity to speak about the promotion of capital availability to American businesses.

    As the Ranking Member of the Financial Institutions Subcommittee, I believe we have a duty to oversee the regulations implementing the merchant banking provisions of the financial modernization legislation that became law last Congress. I also believe that it is important for us to monitor the expansion of merchant banking activities themselves, to ensure that the regulations are important, to carry out the intent of the Gramm-Leach-Bliley Act.

    I understand that the final revised rules address a number of industry concerns that were voiced about their original interim rules. I am pleased that the provisions governing the small business investment companies will ensure the continued ability of banks to invest in SBICs, benefiting small business as well as the communities they serve.

    Regarding the larger issue of merchant banking in general, there must be sufficient oversight of these activities. We have a responsibility to limit the risk inherent in merchant banking and not sacrifice safety and soundness in the haste to expand these activities too rapidly. This intent is crystal clear in the statutory language of the Gramm-Leach-Bliley Act.

    The legislation did permit financial holding companies to engage in merchant banking activities. Moreover, the bill imposed a series of prudential restrictions on the conduct of the merchant banking activity. It required that the merchant banking activity be conducted in an affiliate of the depository institution rather than in the depositary institution itself or a subsidiary of a depository institution.
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    It also required that merchant banking investments be held only for a period of time long enough to enable the sale or deposition of each investment on a reasonable basis. Furthermore, the legislation restricts the ability of financial holding companies to routinely manage or operate companies held under the merchant banking authority.

    Finally, the legislation specifically granted the Federal Reserve and the Treasury Board authority to issue joint regulations implementing the merchant banking activities. Merchant banking was singled out, appears the only one of nine activities listed in the legislation as financial in nature to receive an explicit grant of authority to the regulators to issue regulations. Moreover, the Federal Reserve retains this authority under the Bank Holding Company Act to set capital standards for bank holding companies which include financial holding companies.

    The legislation also explicitly prohibited cross marketing between the depository institution and merchant banking portfolio companies acquired under the new authority. I understand that there are some members of the industry that would want this provision changed, but the law is clear on this point and should not be undermined through additional changes in the regulations.

    While I understand that the industry is concerned about the ability of American banks to compete in the global marketplace, we certainly do not want to model our banking policy after the Japanese system, which serves an example to all of what can happen when the separation between banking and commerce is breached.

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    I believe these regulations will not prove to be unreasonably burdensome and will fullfil the congressional intent to ensure adequate oversight of merchant banking activities.

    During the consideration of the financial modernization legislation, Federal Reserve Board Chairman Alan Greenspan testified that, of the nine banking activities permitted in various versions of H.R. 10, merchant banking should be viewed as the most risky of those activities. With that in mind, I look forward to hearing the views of the witnesses and thank you in advance for your testimony.

    Chairman BAKER. Thank you, Ms. Waters.

    Are there additional opening statements?

    Mrs. Kelly.

    Mrs. KELLY. Thank you, Mr. Chairman. I want to thank both you and Mr. Bachus for agreeing to hold the hearing on the promotion of capital availability to American businesses.

    The issue revolves around a large source of capital to many businesses; and, as we know, capital is the lifeblood of industry. As the Chairman of the Oversight and Investigations Subcommittee, the issue is very high on my list of priorities; and I am very pleased that we all share this interest.

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    As we are aware, in March of 2000 the Federal Reserve and Treasury issued two rules for financial holding companies which contain provisions that run contrary to the language Congress agreed to as part of the Gramm-Leach-Bliley law. In particular, I was concerned about the 50 percent capital charge on all merchant banking activities and I believe that the cross marketing restrictions were too severe. I feared that the capital charge would force divestment from some banks of sound investments which could, in turn, have negative effects on the economy.

    I was pleased to see that the final rule issued in January of 2001 eliminated the hard dollar cap, removed some of the automatic penalty associated with holding investments over the time limits set by the rules and relieved some of the cross-marketing restrictions. While it was a good step in the right direction, I believe the Federal Reserve should go farther.

    The rule seems to neglect to take into account the sophisticated internal risk modeling mechanisms banks employ to accept the risks inherent in merchant banking activities and the new and existing powers for bank examiners analyzing merchant banking activities. While I strongly believe we must ensure safety and soundness, we must also ensure the law as we wrote it in Gramm-Leach-Bliley is implemented as we intended.

    I want to thank the witnesses for joining us here today to share their considerable knowledge on these issues, and I look forward to the testimony and discussing the issues with them.

    I thank you again for holding this hearing, and I yield back the balance of my time.
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    Chairman BAKER. Thank you, Mrs. Kelly.

    Does any Member wish to give an opening statement?

    If not, I would suggest that we are just under 8 minutes or so on the matter pending on the floor, that we would recess momentarily, come immediately back, keep you about 10 minutes, and we will reconvene our hearing at that time.


    Chairman BAKER. I would like to reconvene the hearing.

    Members are on their way, returning from the vote. I am told we will have about an hour before we are interrupted again, so at this time I would like to proceed with recognition of our first panel of witnesses.

    The Honorable Laurence Meyer, Governor, Board of Governors of the Federal Reserve, we welcome you here and look forward to your testimony. Your comments will be made part of record, as well as that of Mr. Hawke. Please proceed.


    Mr. MEYER. Thank you, Chairman Baker, Chairman Bachus and subcommittee Members.
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    When I last appeared here to address the topic of merchant banking, the Board and the Department of the Treasury were considering comments on rules we had proposed only recently before the testimony. As I indicated at that time, our experience has been that public comments generally provide us with valuable insights and information.

    That is, in fact, what happened in this case. The Board and the Treasury received a significant amount of useful information that led us to revise our rules that implement the merchant banking powers in the Gramm-Leach-Bliley Act. We have also consulted with our fellow banking agencies regarding the appropriate capital treatment for equity banking activities. As a result, we have significantly revised and again sought public comment on a proposed capital approach.

    Let me provide some background that I hope will put both what we did and what we have proposed in context.

    The Bank Holding Company Act reflects a long-held concern of Congress that mixing banking and commerce could result in an adverse effect that may reduce the availability of credit to unaffiliated companies and create a greater risk to deposit insurance funds and, ultimately, the taxpayer.

    As part of the consideration of the GLB Act, Congress considered and rejected the idea of allowing banking organizations to affiliate broadly with commercial firms. At the same time, Congress recognized that merchant banking represents a form of ownership of commercial firms by banking organizations that is functionally equivalent of financing for small businesses.
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    To distinguish merchant banking from the more general mixing of banking and commerce, the GLB Act requires that merchant banking investments be held only for a period of time to enable the resale of the investment and prohibits the investing financial holding company from routinely managing or operating a commercial firm except as necessary or required to obtain a reasonable return on resale of the investment.

    The final rule adopted in late January of this year focuses on defining these important restrictions. Generally, the rule permits a 10-year holding period for direct investments and a 15-year holding period for investments in private equity funds. Many commenters acknowledged that merchant banking investments are rarely held beyond these periods.

    The final rule also contains several safe harbors and examples of routine management. For example, the final rule allows representatives of a financial holding company to serve on the board of directors of a portfolio company. In addition, a financial holding company may enter into agreements that restrict extraordinary actions of the portfolio company. On the other hand, a financial holding company would be considered to be routinely managing a company if an officer or employee of the financial holding company is also an executive officer of the portfolio company or if the financial holding company restricts decisions made in the ordinary course of business of the portfolio company.

    In response to commenters, the final rule provides a mechanism for allowing specific employee and junior officer interlock in the limited situation where the interlock does not rise to the level of routine management of the portfolio company.

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    The GLB Act allows an investing financial holding company to routinely manage a portfolio company in special circumstances. The final rule adopts statutory language in this area.

    The final rule also contains several provisions that are designed to encourage the safe and sound conduct of merchant banking activities. The Board recently issued supervisory guidance that outlines some of the best practices employed by merchant bankers for managing the risks of equity investment activities. That guidance has been well received by the industry as useful and flexible.

    In addition, the interim rule contained two thresholds that triggered agency review of the financial holding companies that devote significant amounts of capital to merchant banking activities. The final rule eliminates the absolute dollar threshold and contains a sunset provision that automatically eliminates the entire threshold review process once the banking agencies have implemented final banking rules governing merchant banking activities.

    I should note that the thresholds may be exceeded with Board approval, and one experienced investment firm has already received Board approval to exceed the thresholds.

    The GLB Act contains provisions that prohibits cross-marketing activities and restricts credit and other funding transactions between a depository institution and a portfolio company controlled by the same financial holding condition. Both are contained in the GLB Act to reinforce the separation between banking and commerce and are mirrored in the final rule.

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    An integral part of our original merchant banking proposal involved the regulatory capital that would be required to support merchant banking activities. This proposal attracted quite a bit of comment, and it is an example of an area where we learned from the public comments.

    Together with the other agencies we have developed a new, revised capital proposal. In developing this new capital proposal, the banking agencies were guided by several principles. First, equity investment activities in non-financial companies generally involve greater risks than traditional bank and financial activities. I have explained in much greater detail our analysis of the risk associated with equity investment activities in my testimony last June. If anything, the activity in equity markets since last June has confirmed this analysis; and few of the commenters on that original capital proposal disagreed with the substance of that analysis or our conclusion.

    A second and related principle is that financial risks to an organization engaged in equity investment activities increase as the level of investment accounts for a larger portion of the organization's capital, earnings and activities. The grant by the GLB Act of merchant banking authority to financial holding companies with its promise of increased equity investment activities was an appropriate time to reevaluate whether existing capital charges were adequate to account for this risk.

    A third principle guiding the agencies' efforts is that the risk of loss associated with a particular equity investment is likely to be the same regardless of the legal authority used to make the investment or whether the investment is held in the bank holding company or in the bank. In fact, the agencies' supervisory experience is that banking organizations are increasingly making investment decisions and managing investment risks as a single business line across legal entities.
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    In light of these principles, the Board and the other agencies issued a revised proposal that would apply symmetrically to equity investment activities of bank holding companies and banks.

    The revised proposal would apply a series of marginal capital charges that begin with an 8 percent capital charge and increase to a 25 percent charge as the level of the banking organization's overall exposure to equity investment activities increases relative to the institution's Tier 1 capital. These charges are regulatory minima, and financial holding companies are expected to hold capital based on their assessment of the nature and risk of their investment activities.

    Commenters, including a number of Members of the subcommittee, strongly urged the agencies not to impose a higher capital charge on investments made through a small business investment company. These commenters argued that SBICs serve the important public purpose of encouraging investment in small businesses, are already subject to investment limitations imposed by the Congress and the Small Business Administration, and have generally been profitable to date.

    Commenters made similar arguments in support of an exception for investments made by State banks under the special grandfathering authority preserved by Section 24 of the Federal Deposit Insurance Act. These investments also have been reviewed and limited by Congress and are subject to further review and limitation by the FDIC.

    The agencies recognized substantial merit in these arguments. Accordingly, we revised the capital proposal so that it does not generally impose a higher capital charge on investments made through SBICs.
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    The proposal also includes an exception for investments held by State banks under the special grandfather rights in Section 24 of the FDI act.

    One of the comments made most often in response to our original proposal was that internal risk-based models for assessing capital adequacy better reflect the individual risk profile of individual organizations than the more general formulas that currently underlie the agencies' regulatory capital requirements. We have been working with the Basel Capital Committee on a proposal, recently published for public comment, that would focus regulatory capital requirements at least at large banking organizations on internal risk models developed by the organization and verified by the regulatory agencies.

    But neither the banking agencies nor most banking organizations are at the stage where we can rely on these models as a replacement for regulatory minimum capital requirements. We view our revised capital proposal for equity investment activities as a bridge to a robust internal model approach.

    The invitation for public comments on the revised capital proposal will remain open until April 16. We will carefully review all of the comments that we receive so that we may develop a final rule that will be workable and, importantly, will enhance safety and soundness.

    Chairman BAKER. I thank you, Governor Meyer.

    Our next witness is the Honorable John Hawke—no stranger to the committee as well—Comptroller of the Currency. Welcome, sir.
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    Mr. HAWKE. Thank you, Mr. Chairman.

    Chairman Baker, Chairman Bachus, Chairman Oxley and Members of the subcommittees, thank you for inviting the Office of the Comptroller of the Currency to participate in this hearing on the new and proposed rules relating to the merchant banking investment activities of banking organizations.

    Our written testimony focuses principally on the performance of national bank equity investments made through small business investment corporations—SBICs—and the OCC's involvement in the February 2001, capital proposal, which addresses the regulatory capital requirements for those investments. Because the OCC was not a party to the final rule adopted jointly by the Federal Reserve Board and the Treasury Department specifying the conditions under which the newly authorized merchant banking activities can be conducted, we do not address issues relating to that regulation.

    Merchant banking is a term with no fixed definition that is generally used to describe a range of financial activities, many of which have long been permissible for national banks. For example, national banks for many years have engaged in the business of buying and selling securities for the accounts of customers, they have advised customers on mergers and acquisitions, and they have represented customers in connection with the private placement of securities—all of which might be considered part of traditional ''merchant banking'' activities. The Gramm-Leach-Bliley Act—GLBA—did not affect the ability of national banks to engage in any of those activities.
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    The rules we are discussing today address only one aspect of the business referred to as merchant banking, namely, the making of private equity investments in non-financial firms, in particular, equity investments having a venture capital character. In this regard, as well, it is important to recognize that banks and bank holding companies have long had the authority to make such investments through SBICs and through explicit permission granted under the Bank Holding Company Act.

    Prior to the enactment of GLBA, no significant public policy or safety and soundness concerns were raised by bank regulators concerning the ability of either bank holding companies or banks to make private equity investments under existing investment authorities. In fact, the clear intent of Congress in that far-reaching new law was to expand the ability of banking organizations to make such investments in excess of the limits contained in prior law, even where such investments might constitute control of the company in which they were made.

    As part of a compromise negotiated in the final stages of the GLBA legislative process, this new merchant banking authority was limited to bank holding companies for a period of 5 years. Given the experience of banks in a broad range of merchant banking activities and the safety and soundness protections included in GLBA for financial subsidiaries of banks, we did not believe it was necessary to so limit the new authority. Prudent bank supervision has been emphasizing the need to diversify the revenue streams of banks so as to reduce the dependence of banks on net interest margins. Non-interest income has become an increasingly important component of bank earnings, and permitting banks to provide expanded venture capital financing to customers, within prudent limits, would serve to lessen the concentration of bank earnings in traditional loan income. The OCC believes that the elimination of the disparate treatment for banks and bank holding companies in this area is appropriate certainly no later than the end of the GLBA-imposed moratorium.
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    The OCC's primary objective in the development of regulatory capital rules for merchant banking activities was to protect the existing capital and regulatory infrastructure surrounding SBICs, which reflects the long-standing congressional preference for these entities. Many commenters did not believe that the original Federal Reserve Board capital proposal was consistent with that objective. That proposal would have assessed, at the holding company level, a 50 percent Tier 1 capital charge on the carrying value of private equity investments in non-financial companies held directly or indirectly by a holding company, and would have applied this capital charge to a variety of existing investment authorities for banks and bank holding companies beyond the new GLBA banking merchant authority.

    One of the OCC's principal concerns about the proposal was that any consolidated holding company capital requirement that would apply a charge to assets held by or under a bank that was more stringent than the charge that was fixed by the primary regulator of the bank would undermine the congressional mandate that bank capital requirements be set by the primary Federal bank regulator. Since the primary purpose of holding company capital is to protect the subsidiary bank, the OCC saw no basis for the judgments of the primary bank regulator to be supplanted through the establishment of more strict consolidated holding company capital requirements.

    I am pleased to say that the revised capital proposal is a significant improvement over the original proposal in several respects. First, the scope of the proposal is much narrower than the earlier version. It limits the scope of the regulation to specified equity investment activities of a character similar to those that might be engaged in by financial holding companies under Gramm-Leach-Bliley.
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    Second, the new capital proposal is more consistent with the experience that national banks have had with regard to SBIC investment activities for over 40 years, during which there have been no safety and soundness concerns. In view of this record of performance, the safeguards placed on these activities, and the important public purpose of encouraging the development and funding of small businesses, the recent proposal accords SBIC investments preferential treatment.

    The banking agencies have recognized, however, in light of the substantial growth in SBIC investments in recent years, that significant concentrations of private equity investments could potentially result in safety and soundness concerns, just as with any heavy concentration of assets. The OCC favors the approach adopted in the recent proposal, that is, requiring stepped-up capital charges when aggregate equity investment levels exceed specified concentration thresholds. Thus, we believe that the revised capital proposal promotes the continued conduct of private equity investments, while maintaining safety and soundness principles and preserving the intent of Congress to promote bank investments in small businesses through SBICs.

    I would be pleased to respond to any questions.

    Chairman BAKER. Thank you very much, Mr. Hawke.

    I would like to start our questions with you, Governor Meyer.

    Oh, excuse me, I would be reminded Chairman Oxley has joined our committee, and I would like to at this time recognize the Chairman for any opening statement he may wish to make.
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    Mr. OXLEY. Thank you, Mr. Chairman; and I will submit my formal statement for the record.

    Let me just welcome our witnesses, Mr. Meyer from the Fed and Mr. Hawke from the Comptroller's Office. We have had a number of opportunities to work together over the years, particularly on the Gramm-Leach-Bliley bill.

    I would say to both you, Chairman Baker, and to Chairman Bachus I thank you for having this hearing. I think we need to explore some of these merchant banking issues, particularly in light of the recent changes that were made in the regs; and I guess the old admonition about doing no harm from the Hippocratic oath probably has some reference here as well.

    We look for a modern financial marketplace based on the tenets of the Gramm-Leach-Bliley Act, and to a large extent all of us are working our way through this major change that was made in the statute from almost 70 years ago. It is important to have this kind of hearings so that the members can get our arms around these kinds of issues that in many cases were just simply not issues before the passage of Gramm-Leach-Bliley. The merchant banking issue is clearly one of them, and how the regulators and how the Congress deals with this will have a great deal to do with how successful we are in moving toward that modern financial services marketplace. So, again, Mr. Chairman, thank you for these instructive hearings. I yield back, and I ask unanimous consent that my statement be made part of the record.

    Chairman BAKER. Certainly, without objection. Thank you, Mr. Chairman, for your interest and your participation here this morning.
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    Chairman BAKER. Governor Meyer, under current law, the Credit Suisse First Boston now manages, on behalf of Louisiana State Teachers Pension Fund, approximately a half a billion dollars at the Teachers Pension Fund direction and from time to time will make minority investments in firms and as a condition of that investment establish a restrictive covenant which would allow Credit Suisse First Boston, for example, but not exclusively, to make managerial changes they deem in the best interest and in accordance with their fiduciary area responsibility to the pension plan.

    As I am understanding the rule as now promulgated, they would no longer have the unconditioned right to do—they could do it, but it would come only in consultation with the Fed's approval. Is that correct?

    Mr. MEYER. No, I don't think that is correct. The final rule makes clear that the financial holding companies can engage in what would be considered routine management in exceptional circumstances, and you gave one example. When it comes to changing senior management, for example, because of a change in the strategic direction of the firm or performance of the firm, the final rule recognizes that explicitly as one of the situations in which it would be appropriate to have that involvement.

    Chairman BAKER. Let's explore further what constitutes exceptional circumstances. That is the trigger then that would allow the third party to make strategic changes. Is there a blueprint that you can go down and say here's what we can do under certain circumstances?

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    Mr. MEYER. We have tried to provide a list of examples, although we do not claim it is exhaustive, because you can't in advance think of all the situations that would be relevant, but to reduce uncertainties and give guidance. So we have talked about situations where there was a change in management, where there was a sale of some business line or where there was a significant acquisition, where there were significant losses that had to be remedied. It was a long list, but I think it is a very good list of the circumstances in which it is important to give the financial holding company the opportunity to intervene to protect its investment.

    Chairman BAKER. Well, my point is that this appears, at least from an outside reading of the regulation, to restrict conduct which prior to the January promulgation may have been in the course of ordinary business an acceptable practice which now, at the very least, may be subject to a second look before you proceed to determine if the Fed's approval may be necessary. Is there anything in market practice from your view that warrants this divisional level of concern?

    My view is that the modernization proposal was to enable more relationships with less regulatory oversight to occur to facilitate economic growth. It would appear that this, at the very least, if I agree with your view that there is a list of things that you are allowed to do as illustrative but not exclusive, that there may be things that you can't do now that you could do previously without Fed's approval, is that a correct summation?

    Mr. MEYER. Let me try to work on that.

    First of all, the examples that we gave in the modifications we made in the revised rule reflected careful discussions with commenters; and we put into the final rule examples that they gave us that reflected what is considered to be best practice in the industry.
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    Before we even wrote our interim rules we sat down and we interviewed large security firms and large banks that were heavily involved in merchant banking to get an idea of what industry practice was, and we thought of ourselves as codifying best practice in these areas. Where we found we had overstepped and hadn't gotten it right, we tried to do a better job in the final rule.

    Now, let's see, I have lost——

    Chairman BAKER. Principal point was, are there things which historically you could engage in which pursuant to the promulgation you may not?

    Mr. MEYER. I think the other point that you were making is a very, very important one. It goes to the tension between Gramm-Leach-Bliley, making a determination that shouldn't be a broader mixing of banking and commerce and then on the other hand providing authority for merchant banking activities. And the key point in the legislation, mirrored in the regulation, is that there are certain restrictions on merchant banking so that it is not the same as the broad mixing of banking and commercial.

    We did not put into the legislation such things as holding periods and prohibitions on routine management. You have put them in there. But I presume the Majority put them in there because they wanted to assure that this won't become a broader mixing of banking and commerce. So we are simply mirroring what you did.

    Chairman BAKER. Let me, before I recognize Mr. Bentsen, make one declarative statement. I wouldn't have done it, but some Members did it on the direction of expert financial advice from somewhere.
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    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman.

    I apologize for having to step out during both of your testimonies. And, Mr. Hawke, I don't want you to think I missed your testimony altogether, that that is any indication of where I think you might be or not be.

    Chairman BAKER. Mr. Bentsen, can you pull your mike up, please?

    Mr. BENTSEN. Looking at the proposed capital requirements, which I guess was the most controversial aspect of the proposed rule, how did the Board and the Treasury come up with this new sort of sliding scale? Is that modeled after anything or was that just something you all came up with internally?

    Mr. MEYER. Well, after the comments came in, we thought that they justified a total reassessment of our approach to the capital rule. We began with the proposition that equity investments are riskier than traditional banking activities and required some additional capital treatment.

    As we worked further on that, we determined that the risk to the banking institution from the equity investments depended very critically on how large those equity investments were relative to the total organization. So, for example, if you have an SBIC that is 5 percent of the Tier 1 capital, that doesn't impose much risk on the banking organization because it is so small relative to the total. So we decided that what that would justify would be a sliding scale, where the capital charge would be quite low for low concentrations of merchant banking activity but get progressively larger as the concentrations rose. This came out of very careful analytical thinking.
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    The staff member who led the effort is sitting behind me, and we think it was a major contribution to an improved capital rule.

    Mr. BENTSEN. I don't know if you want to comment on that or not.

    Mr. HAWKE. Just briefly, Congressman Bentsen. During the discussions that we had with the Federal Reserve, we made our position very strongly known that we wanted a preference for SBICs, and that was our overwhelming concern about the capital reg. The Fed staff expressed the view that they were concerned about concentrations, and we recognized that at some point concentrations could become important. But the stair-step formulation that appears in the final regulation protects SBIC investments up to a level that matched the outermost limits of the experience that we had had with our banks in terms of SBIC investments. A bank can only invest up to 5 percent of its capital in an SBIC, so anything over 5 percent of total capital has to come from appreciation in the investments.

    Mr. BENTSEN. Let me ask you also, because my time is running out. The way I read this, on top of the scale the Board and the Comptroller have the authority to subsequently go back in and look at financial holding companies' equity investment in their merchant banking operation and apply other criteria. Am I reading that correct? Is that only after you exceed a certain threshold or is that in any case?

    Mr. MEYER. Well, in general, the capital rule is about a regulatory minimum. Banks are expected to hold economic capital in excess of that regulatory minimum. So in general you would be expecting to see banks hold more than that amount of capital, and we would be assessing their economic capital allocation through the supervisory process.
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    Second, once their concentration got up to a level of 50 percent of Tier 1 capital, then we have indicated that their merchant banking activities would come under more intensified scrutiny. Since we are already up to the highest marginal capital charge of 25 percent, when they get up to 25 percent of Tier 1 capital, when it gets up to 50, we would intensify our supervisory review; and depending upon the risk management and the nature of the equity investments, we could ask for additional capital.

    Mr. BENTSEN. You state in your testimony with respect to internal risk models that you all are reviewing that, but at this point in time—if I understand that, that means whether or not the internal risk models of the institution itself, not the Fed or the Comptroller, but at this time you all intend to still rely on your own risk molding, risk assessment.

    Mr. MEYER. We intend to rely on this capital charge for the purpose now. But, as we have indicated, we do think it is a bridge ultimately to the use of internal risk models by banking organizations overseen by their regulators.

    Mr. BENTSEN. With the Chairman's indulgence, you referenced the Basel reviews are ongoing discussions about this. With respect to internal risk models, would the idea be that there would be some standard, some international standard that regulators would use for what is a qualified risk model versus what anybody comes up with?

    Mr. MEYER. Yes. What the Basel approach is now working with in the new proposed rule is an approach whereby the banks could use their internal systems for their banking books, for example, to determine the appropriate capital charge in relationship to risk. But that would be overseen and validated by their supervisors.
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    I should note that banks are much more advanced in their measurement and management of risk in the banking book than they are in their equity investments in their merchant banking portfolios. Very frankly, I don't know of a single bank at this point that has a model sophisticated enough to put it before us and have any hope that it would be appropriate for determining their capital charges.

    Chairman BAKER. Mr. Bentsen, your time is expired.

    Mr. Bachus.

    Mr. BACHUS. Thank you.

    First of all, the committee has prepared about 15 questions, some of which may not be covered today in oral questions. We would like to submit those to you, those that are not answered today.

    My first question is about process; and, Governor Meyer, I am going to direct this to you. You had an interim rule in March, and then 9 days before the change in Administration you issued a final rule. Didn't that preclude the new Administration from weighing in on these rules?

    Mr. MEYER. When the law was passed, first of all, we needed to move quickly to reduce uncertainty in the industry. So within a day or two after the powers became effective we put out an interim rule. We certainly wouldn't have wanted to wait longer to reduce that uncertainty. There were a lot of comments about that rule and we wanted to move as quickly as we could to make revisions in that rule, again to reduce uncertainty and to improve it.
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    Now, you will undoubtedly recall that one of the reasons that this law was passed was because the Federal Reserve and the Treasury had worked together to bridge their differences and to reach agreements to allow it to go through, and we were partners in that process. It seemed only natural that these partners worked together to do the regulations, which we did.

    Now if we had waited, for example, for the new Administration, we would not have yet had our first meeting. The Under Secretary for Domestic Finance has not been officially nominated, to my understanding; and we would still be waiting for our first meeting with the new Administration on this topic. I don't think that would have been a prudent thing to do.

    Having said that, I expect to have as exceptional a relationship with the new Treasury as we did with the previous Treasury; and I look forward to sitting down with the Under Secretary for Domestic Finance at the earliest convenience and reviewing all of the implementation we have done with Gramm-Leach-Bliley and getting feedback on that.

    Mr. BACHUS. Thank you. I hope that you will do that.

    I have several concerns, and I noted this is what you said in response to Congressman Bentsen: Equity investments are more risky than traditional activities. Now a lot of what you have done here is premised on that fact. But, in fact, is that true? I mean, a lot of your merchant banking activities historically have been high profit, maybe some would argue not as risky as commercial lending. So did you all make a determination that this premise was, in fact, correct?
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    Mr. MEYER. We have indeed studied it very carefully. And, frankly, when we had meetings with trade associations, and so forth, to give us feedback on the original capital proposal, oftentimes the very first thing they would say is, these are no riskier than traditional banking assets. But when I confronted them and we had a full discussion on it, few held on to that position very long. Very frankly, few of the commenters made that point. Most agreed that equity investments are riskier.

    Mr. BACHUS. We are talking about a percentage. Say they invest five times and two of them go flat but three of them are highly profitable. What I am talking about is an average here.

    Mr. MEYER. Absolutely. There is an iron law of economics that when a particular activity or instrument has very high risk, it has to offer higher expected returns to get people to hold it. It is very fundamental.

    Merchant banking activity is a very good example of an activity that has a very high expected rate of return, and it must be high because of the risk that it holds. We did a study of 25 years of experience with venture capital firms, and we found that, for example, one-third to one-quarter of individual investments suffered losses and that 20 percent of these firms went out of business.

    Mr. BACHUS. Are these bank holding companies and financial holding companies?

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    Mr. MEYER. No, these are firms that had 100 percent capital backing them, no leverage. Why no leverage? Because these activities were viewed as so risky to begin with that they backed them 100 percent with capital. Leverage is a way to increase your expected return by taking on more risk. But these investments were already very risky to begin with. So I really do not think that this is a reasonable concern or an issue.

    Let me say one more thing. If you have a list of banking organizations that have told you that they can't tell the difference between the riskiness of their merchant banking investments and their loan portfolio I would like their names.

    Mr. BACHUS. One more thing. You have put—the merchant banks often have minority investments in their portfolio companies and then they require restrictive covenants to make those investments safer, but in fact, if a final rule prohibits or restricts their ability to make these restrictive covenants, doesn't it, in fact, have the perverse effect of making that investment more risky? And what do you say to the critics who say that the final rule restricts their ability to manage and protect their minority rights in the companies they invest in?

    Mr. MEYER. Well, as I indicated earlier, in the final rule we have made revisions and clarified the terms under which financial holding companies can engage in routine management in those exceptional circumstances. I think what we have done has mirrored what is industry practice.

    One has to make a distinction between routine management on a day-to-day basis and interventions in those special circumstances when the threat to the investment is there, such things as losses being taken by the firm, when there has to be a change in management, when there is an important sale of another company or when you might be selling off a line of business. So these are precisely those critical junctures when intervention and routine management is allowed, and I think we have clarified that we have done something which is consistent with the best practice in the industry.
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    Mr. BACHUS. Let me simply close by saying I would think that any restrictions that you allow the merchant banking company to have would be a good thing as far as protecting their own interest and the more management they do would be the best. So I would hope these rules do not limit them in any way.

    Mr. MEYER. I appreciate that point. I think what we are trying to do is that delicate balancing act, making those distinctions between merchant banking and the broader mixing of banking and commerce; and, quite frankly, we are hearing from some Members of this committee that they would prefer that there was a broader mixing of banking and commerce. We are restricted by what you did in the bill.

    Mr. BACHUS. Remember, as a regulator, your duty is to protect the bank, not to protect the company that is being invested in.

    Mr. MEYER. We certainly understand that. But also understand that when you put something into the legislation, expect it to show up in the regulation. Don't expect a regulation to undo what the Majority did in their legislation.

    Mr. BACHUS. If you could identify those areas, it would be helpful.

    Chairman BAKER. Thank you, Mr. Bachus.

    Mr. Hinojosa.
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    Mr. HINOJOSA. Thank you, Mr. Chairman. I am going to pass and come back with some questions.

    Chairman BAKER. Certainly.

    Mr. Lucas.

    Mr. LUCAS. Pass.

    Chairman BAKER. Mr. Ford.

    Mr. FORD. Since I just walked in, I am definitely going to pass.

    Chairman BAKER. That is OK.

    Mrs. Roukema.

    Mrs. ROUKEMA. Mr. Chairman, I didn't think I had a question, but I do want to make a statement, and then I guess I will ask a question.

    I am one of those that was very concerned in Gramm-Leach-Bliley regarding the safety and soundness and the mixing of banking and commerce. And I believe we did the right thing. I have no regrets about that. And I am deeply concerned as to whether or not you are following through consistent with the law.
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    But you have both made the case that what you are doing is enforcing the law. Now, your statement—I am going to go over them—but it sounds to me you have hit the proper balance here consistent with Gramm-Leach-Bliley.

    But I do want to ask a question, and maybe it is obvious, but it may be a good example of how you are translating through regulation the meaning of Gramm-Leach-Bliley. And I am not sure but why you have indicated that the FHCs have to wait, as I understand it, ''for an extraordinary corporate event prior to being permitted to intercede in the management of the portfolio company.''

    Now this is evidently a good example of how you have to translate the legislation into your regulation. I don't quite understand it. How do you do that? Wouldn't it be better to serve the interests of safety and soundness if there were action before the fact rather than after the fact? And I am not quite sure how you would address it after the fact, after there is significant evidence. Could you use that as an example of how you translate the legislation and your regulations into practical action?

    Mr. MEYER. Well, I think you made the point very well. The issue here is balance, and it is a difficult balance to strike. I think I would agree with that.

    The question here is, how do you carry out the statute's prohibition on routine management? And simply by saying that you can intervene any time you want with no restrictions would seem to go against the spirit of the prohibition of routine management. So we had to find a way to balance that, and so what we did was to say that, no, in the ordinary course of business you can't have covenants which restrict the ordinary course of business, day-to-day routine management, but you could in these critical cases. And we laid out a series of examples, as I noted before.
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    We don't mean that that list is exhaustive, and we will gain more experience with this regulation over time. But I think that is the only way we could do it that on the one hand would be consistent with the prohibition on routine management and on the other hand would allow opportunities for intervention at critical junctures when it is necessary to protect the investment.

    Mrs. ROUKEMA. What is an example, however, of the extraordinary corporate events?

    Mr. MEYER. Change in senior management, a significant loss that the firm was incurring, a purchase of a new business, sale of an existing business line. There are many, many other examples.

    Mrs. ROUKEMA. You would automatically take that under review.

    Mr. MEYER. We have given guidance so there would be no uncertainty. If a financial holding company found a portfolio company in one of those circumstances, it doesn't have to come back to us and ask permission. They have the authority to intervene. Now it has to be temporary.

    Mrs. ROUKEMA. I am sorry?

    Mr. MEYER. They can't do it forever.

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    Mrs. ROUKEMA. Temporary?

    Mr. MEYER. Temporary.

    Mrs. ROUKEMA. All right. Well, I hope this is working well.

    Mr. MEYER. Well, we will find out.

    Mrs. ROUKEMA. Thank you.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mrs. Roukema.

    Mrs. Maloney.

    Mrs. MALONEY. I would like to, first of all, welcome you. Good to see you. Thank you for having this hearing.

    First of all, I would like to ask the Honorable John Hawke and Governor Meyer, how does the proposed merchant banking capital rule compare with the new proposed Basel capital standards? How do they compare?

    Mr. HAWKE. Mrs. Maloney, the Basel proposal is very much a work in progress right now and——
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    Mrs. MALONEY. They came out with preliminary guidelines, did they not?

    Mr. HAWKE. The Basel proposal is out for comment—similar to a proposed rule.

    To try to simplify a very complicated process, the Basel proposal is divided into two parts. One is the standardized approach, which is very simple. The other is a complicated approach.

    In the simple standardized approach, the current proposal is that equity investments of this sort would have 150 percent risk weighting, which I think works out to be something not terribly different from what the Federal Reserve proposal is. As far as the more complicated proposal, that is still up in the air. There hasn't been a specific proposal yet for the treatment of equity in the more complicated part of the proposal.

    Mrs. MALONEY. But if the committee completes its work and the United States signs on for uniform global capital standards, wouldn't any additional merchant banking capital charges and changes be repealed? I mean, would the Basel Committee, if we sign on, would that then become the capital standard that we are going to use in this country and in foreign countries?

    Mr. HAWKE. I think that is a very good, very pertinent question; and it applies to a number of aspects of the Basel proposal. I would certainly hope that when the dust all settles our domestic capital requirement would be consistent with what Basel comes out with. But we are still quite a ways from the end of the line on that.
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    Mrs. MALONEY. When do you expect them to complete their work?

    Mr. HAWKE. The Basel Committee is hoping to have a final proposal out by the end of the year, and it would not essentially take effect until 2004.

    Mrs. MALONEY. Now, are the capital standards basically the same for domestic operations as for foreign loans? Is there any difference now?

    Mr. HAWKE. In the Basel proposal?

    Mrs. MALONEY. Not in the Basel. I am just talking about now in the United States.

    Mr. HAWKE. At present, the existing Basel Accord applies to internationally active banks, but the existing accord is much simpler in its contours than the proposed accord will be. So, essentially, it has been applied up and down the line domestically.

    Mrs. MALONEY. But are the capital standards higher for loans domestically or for foreign or are they the same?

    Mr. HAWKE. For individual loans, they are the same.

    Mrs. MALONEY. The Fed is, as I understand, heading the Basel Committee. Do you have any comments on it?
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    Mr. MEYER. The Federal Reserve does not head the Basel Committee. The president of the Federal Reserve Bank of New York is chairman of the Basel Committee. But the Federal Reserve participates, as the OCC does, as a member of the Basel Committee.

    Mrs. MALONEY. So do you have any further comment on it? Do you see it, likewise, that what they are proposing is basically what you are proposing? Is it basically the same, and once it becomes complete then that will be the standard? Is that how you see it, too?

    Mr. MEYER. I see it working the following way: First of all, right now the treatment of equity is really one of gaps that hasn't been completely worked through at Basel. We are in discussions about what that will be, particularly for the more advanced approaches; and we are hopeful that the final Basel rule will be flexible enough that it will be consistent with our rule. We will be trying to move it in that direction, but we can't guarantee that.

    Whatever happens at Basel will require us then to review our capital proposals in light of the Basel treatment. It should be understood, however, that national authorities always have the opportunity and the authority to impose higher, more conservative capital requirements than Basel. They just can't be more liberal than what Basel comes out with. So we will have to look over the Basel rule, we will have to look over the nature of the equity investments that are typical in merchant banking investments in the U.S. compared with equity investments that are undertaken abroad and reach a final determination at that time.
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    Mrs. MALONEY. So, in other words, you see a higher capital standard for our domestic——

    Mr. MEYER. Not necessarily.

    Mrs. MALONEY. I find it interesting there is more default on our foreign loans than on our domestic loans, and I read a report on that from some of our private banks. Why do you believe that is?

    Mr. MEYER. Well, I would presume that if one took a poll and one asks about the default rate as the loans were given further and further away from where that banking organization was located that the default rates would go up. That is fairly typical. It reflects the greater knowledge that banks have with respect to domestic conditions and laws, and so forth, then what is going on in other countries. So I don't find that particularly surprising.

    Mrs. MALONEY. But then, because of the outcome, should we have higher standards for foreign loans or capital requirements possibly so that we would not have such a great default?

    Mr. MEYER. Under the new Basel approach the capital requirements against individual loans would depend upon the risk assessment by the bank. That couldn't take into account all of these kinds of considerations, so I think it is perfectly consistent.

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    Chairman BAKER. Mrs. Maloney, your time is expired.

    Mrs. Kelly.

    Mrs. KELLY. Thank you, Mr. Chairman.

    Gramm-Leach-Bliley prohibits the depository institution controlled by a financial holding company from cross-marketing any product or services with or through any company in which the financial holding company or a bank holding company hold an equity interest through the merchant banking authority. However, a depository institution generally may cross-market the product or services of non-financial companies held by insurance affiliates of the financial holding companies through statement stuffers, internet sites, portals, things like that. Would the Fed support an amendment to Gramm-Leach-Bliley that would correct that kind of inequity and allow the same kind of cross-marketing abilities to be extended to products or services of portfolio companies that are held under the merchant banking authority?

    Mr. MEYER. The Board hasn't taken a position on this.

    As you well know, this asymmetry in Gramm-Leach-Bliley is probably not one of its greatest virtues, and we would agree with that. However, in correcting it, one has to make a decision as one makes it more symmetrical whether one wants to have the same restrictions on cross-marketing everyplace or reduce those restrictions everyplace.

    Again, clearly the restrictions on cross-marketing were one of the vehicles that the Congress used to make the distinction between merchant banking activities and the broader mixing of banking and commerce. That is an issue you may want to reconsider, but we haven't taken a position on it.
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    Mrs. KELLY. I want to jump to the committee statement that talks about the fact that depository institutions should be able to compete on an equal basis with Section VI(C)(3)(h) of the Gramm-Leach-Bliley Act. Do you think that the joint rules, even in their current form, given their numerous restrictions, satisfy the congressional intent which talks about the fact—and I can read it for you. It says, ''the Board shall take into account that investment banking firms affiliated with depository institutions should be able to compete on an equal basis for principal investments with firms unaffiliated with any depository institutions so the effectiveness of these organizations and their investment banking activities is not compromised.''

    Do you believe that the joint rules, even in their current form, satisfy the Congressional intent?

    Mr. MEYER. We do believe so. Remember that what we did, as I indicated earlier, is that we sat down with large securities firms and large banks to try to determine how they conduct their merchant banking activities and to put in our regulations what constituted best practice. In that way we thought we would ensure that the two-way street which is so important in the Gramm-Leach-Bliley Act remained open.

    If you take a look, for example, at capital treatment, we did find out that the large securities firms tend to hold more capital relative to their merchant banking investments than banking organizations did. So we don't really think that the capital rules are going to provide an obstacle for securities firms to affiliate with banks.

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    I will also note that a very large number of the major securities firms are already affiliated with banks, and we have had two others that have become affiliated with banks, with foreign banking organizations, and another sizable securities firm with merchant banking activities has recently elected to become a financial holding company. So I don't see this as an obstacle, and we tried very hard in our rules to keep that two-way street open.

    Mrs. KELLY. Mr. Chairman, I am going to run out of time here, but I would like to ask one more question. What is the statutory authorization for the aggregate cap on merchant banking investments?

    Mr. MEYER. For the caps?

    Mrs. KELLY. Yes.

    Mr. MEYER. I think the authority that we would use would be the authority for overall safety and soundness that comes from the Bank Holding Company Act for bank holding companies. After all, what it is is not a strict cap, but it is a threshold that requires us to do a careful review of the safety and soundness and risk management of those financial holding companies that have devoted a very high amount of their capital to these activities.

    Mrs. KELLY. So there is no statutory authorization as far as you know.

    Mr. MEYER. No. Just as we are given the authority for capital in general, in order to protect safety and soundness, it is that authority that we are using in this case.
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    Mrs. KELLY. Thank you. Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mrs. Kelly.

    Mr. Grucci.

    Mr. GRUCCI. Thank you, Mr. Chairman. I have no questions at this time and yield back my time.

    Chairman BAKER. Mrs. Biggert.

    Ms. BIGGERT. Thank you, Mr. Chairman. I have no questions either.

    Chairman BAKER. Mr. Hinojosa, if you do not have a question at this time, we will start the second round at this point.

    Mr. HINOJOSA. Go ahead.

    Chairman BAKER. Governor Meyer, I want to return to the presumption on which much of this has been constructed, something subsequent to the line Mrs. Kelly was pursuing. The explanation for many of the determinations is based on the predicate that Congress acted; therefore, the regulator implemented. But the law did not require a 50 percent capital offset, nor did it require a 20 percent offset, nor did it require a sliding scale. Those were all determinations made under the broad directive, as I understood your answer to Mrs. Kelly, that you have the responsibility to provide for capital adequacy, that is correct.
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    Second, with regard to the modifications made since the earlier addition, we now have the—and this is a summary. I don't believe this to be the rule. I didn't get that clarified.

    With regard to managerial relationships, the final rule was modified to clarify that the holding company may be considered routinely managing if they provide investment advisory services and management consulting services to the portfolio company so long as the holding company does not exercise managerial discretion of decisionmaking authority. To me, that reads, I can sit in a room and say we think you might ought to look at this, but I cannot say I recommend that you do this. What is the distinction? I see a differing view behind you there.

    Mr. MEYER. The final rule does indicate that you can provide consulting services and give advice, and that does mean giving recommendations.

    Chairman BAKER. How does that—is distinguished from making a managerial——

    Mr. MEYER. It is not a decision. It is advice. There is a difference between advice and a dictate that says, this is what you are going to do in the ordinary course of business. Do it because we are the financial holding company and we own a share of this firm. You can't do that.

    Chairman BAKER. But clearly the law didn't make a provision as to doing either A or B. That is a recommendation of the regulation.
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    Mr. MEYER. We are trying to strike the balance.

    Chairman BAKER. I understand.

    Mr. MEYER. There is no precise way of doing it. So these questions are all reasonable ones, but we had to try to strike a balance between the Majority in Congress' view that we should do something to prohibit routine management. That was a difficult task. We have done our best to try to draw that balance.

    Chairman BAKER. I am not questioning the credibility of your decisionmaking acumen. I am merely pointing out that much of the earlier explanations to questions was that Congress dictated certain courses of action to which you responded, and in my view there was a broad discretionary grant of authority given in which the Fed found it appropriate to act.

    My view is that I have some philosophic disagreements with the exercise of the discretion as provided by the final rule. But if wasn't clearly marked, it wasn't I-66 that you are on—this is more David Copperfield—first you see it, then you don't—and somebody has got to make a decision about what the final illusion looks like. Were it to be our judgment, and I am speaking a little in advance with final agreement with Mr. Bachus, and I may wish to speak to this later, to provide more clarification in the formulation of these rules by way of further congressional deliberations.

    I noted in your comment that Gramm-Leach-Bliley was not symmetrical in its market consequence. To the extent you could help us provide for symmetry I would very much appreciate your direction in order to better understand where those inequities exist. The underlying philosophy that I think many members of this committee have adopted is whatever A can do in the marketplace to B, B ought to be able to do in the marketplace to A. And from what I am getting from much of the presentation this morning and the questions, that does not appear to be the current circumstance. Do you agree with that observation?
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    Mr. MEYER. Mr. Chairman, I was responding to the asymmetry that was introduced at the last minute into Gramm-Leach-Bliley with the special preference for insurance affiliates with respect to cross-marketing activities. So that was a very good example of a place in which the law became asymmetrical at the last minute, and I could understand why there might be some questions about that. But, again, the rule mirrored that. As I say, we have not taken a position on that, on how that should be corrected.

    Chairman BAKER. That is my point. If there are identifiable areas of market distortion, we very much are interested in not wanting to provide arbitrage or preference or anything else. One might choose to try it, but I want to make sure if we provide in that manner we are correcting it and not making it worse.

    Mr. MEYER. We would look forward to working with you in those areas.

    Chairman BAKER. Thank you very much.

    Mr. Bentsen, you would be recognized for a second round, if you would like.

    Mr. BENTSEN. Thank you, Mr. Chairman. I keep trying to read the rule. Every time, you are interrupting me. But I do have a question.

    Chairman BAKER. At least I am not waking you up.
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    Mr. BENTSEN. No, no, it is really fascinating. But I do have a couple of questions.

    Mr. Hawke, and this may be more of an agency or political question, but in reading this, as I now recall some of the details of Gramm-Leach-Bliley that I have forgotten, national bank subsidiaries are precluded for 5 years from engaging in merchant banking above the current 5 percent rule or the civic rule, is that right.

    Mr. HAWKE. As I said in my direct testimony, merchant banking is a very broad term. What banks were not given was authority parallel to what holding companies got to make private equity investments beyond what they can already do, say, with respect to SBICs.

    Mr. BENTSEN. Until?

    Mr. HAWKE. Until 5 years.

    Mr. BENTSEN. Four years or five years, I guess.

    Would it be the position of the Comptroller's office that what is being proposed right now—the capital standards that are being proposed right now—would apply to national bank subsidiaries as it does to holding companies? And I would ask the same question of the Fed as well, or is that too prospective in nature?

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    Mr. HAWKE. You mean, would it apply 5 years out?

    Mr. BENTSEN. Right.

    Mr. HAWKE. We would hope that if 5 years out the Fed and the Treasury see fit to extend the new merchant banking authority to financial subsidiaries of banking organizations, we would have an opportunity to examine then what the appropriate capital requirements were under those circumstances. There is certainly going to be some momentum behind the existing rule that the Treasury and the Fed adopted in this area. I would think that it would likely become a standard for what banks might be able to do 5 years out.

    Mr. BENTSEN. Governor Meyer, would that—I mean, again, obviously, this is some ways down the road and you would have to take into consideration civic investments and other issues, but would it be fair to assume that if these standards go through and the Fed find them to be workable and prudent, that if and when a petition is made to open up merchant banking activity for national banks, which I would bet would probably be made, that the Fed would view these rules as being commensurate for a national bank subsidiary.

    Mr. MEYER. Congressman, I would not like to see you lose money, so I would just say this. There is no presumption one way or another. That is a decision that would be made within the 5-year time. There is no presumption one way or another which way it will go at this point as to whether or not this will be extended.

    Second, I think the important principle in the capital rule which I hope would be preserved would be one of symmetry. That is, the capital treatment of merchant banking investments should be independent of whether they are held in the bank holding company or in the bank; and I hope that principle would be one which would continue if the new merchant banking authority were then extended to banks.
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    Mr. HAWKE. We would certainly support the symmetrical extension of new authority to national banks.

    Mr. BENTSEN. I appreciate that.

    If I could ask one or one more question on symmetry. If I read this correctly, Mr. Hawke, in your testimony, the ongoing Basel proposal would apply a risk weight standard of 150 percent for venture and equity, and I think you all are looking at it using a factor of 100 percent. But you perceive there is symmetry because, I think, of what Governor Meyer said. You are trying to establish minimums, and you have regulatory discretion which would allow you to go higher. Is that a correct interpretation?

    Mr. HAWKE. The Basel proposal is awfully complicated, but under the simplified Basel approach there would be a 150 percent risk weighting that could be applied at the regulator's discretion to equity investments. They did not particularly characterize the type of equity investment, whether it is speculative or venture capital, but equity investment generally.

    I should say that is a very controversial issue within the Basel Committee, because there are banks in the home countries of many members of the committee that have long had the ability to be invested in equity.

    Mr. BENTSEN. Thank you.

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    Chairman BAKER. Mr. Bachus.

    Mr. BACHUS. Thank you.

    Governor Meyer, why should a financial holding company have to wait for what we have called extraordinary corporate events prior to being permitted to intervene or intercede in the management of one of their portfolio companies?

    Mr. MEYER. I would answer as I have before. Because you have, the Congress, put into the bill a prohibition.

    Mr. BACHUS. Under risk management.

    Mr. MEYER. That is the higher reason.

    Mr. BACHUS. So if we amended that——

    Mr. MEYER. Absolutely. If you eliminated the restrictions on the mixing of banking and commerce, of course, a lot of other things would be possible, too.

    Mr. BACHUS. We are talking about the risk management provision.

    Mr. MEYER. OK.

    Mr. BACHUS. As the routine management——
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    Mr. MEYER. If you eliminated the routine management, that is one of the protections that make merchant banking different from the mixing of banking and commerce, but obviously you could change that.

    Mr. BACHUS. Don't you agree that we would all be better served if these companies that have expertise were allowed to intercede before, say, their investment got in trouble.

    Mr. MEYER. You are perhaps not talking to a sympathetic party here, because I do support the provisions and the spirit of Gramm-Leach-Bliley that at this point we shouldn't move ahead to a broader mixing of banking and commerce, and I appreciate the restrictions that were put into the law to make that effective.

    Mr. BACHUS. But to me, anytime you allow one to assist in the management of something they have invested in, it would obviously improve the safety and soundness of their investment.

    Mr. MEYER. I appreciate that point, and it is a valid one. But you understand as well the balance that we are trying to strike here.

    Mr. BACHUS. I think our main concern is safety and soundness of the investment. And if these companies have expertise and management I would think we would want to encourage——

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    Mr. MEYER. In terms of risk management, that is always something that a financial holding company can intervene in, in terms of the process of risk management but not the day-to-day activity. Risk management is a process, and that process definitely comes under the review and intervention of the financial holding company. It has to be satisfied with the risk management.

    Mr. BACHUS. I am thinking about Warren Buffett, for example, going down and firing the CEO, which he does and is very successful.

    Mr. HAWKE. Mr. Bachus, if I could add a note to that. It is very traditional for banks that have extended loans to a company to exercise some involvement in the affairs of the company when the loan gets into trouble. I would hope that the rule that the Fed and the Treasury have adopted would not interfere in any way with the ability of a bank, whether it is in a holding company that made a merchant banking investment or not, to exercise the normal rights and authorities of a bank to take remedial steps with respect to a company it has made a loan to.

    Mr. BACHUS. Otherwise, if they do it in a commercial loan then they will start——

    Mr. MEYER. But it is perfectly appropriate to do that, and I think there is considerable effort to do just that, prepare for a financial holding company to intervene to protect its investment.

    Mr. BACHUS. I would just say I think they ought to be free to assist management any way they see proper.
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    But let me ask you another question. Why is a carrying value of merchant banking investment used to determine the aggregate merchant banking investments instead of the actual cost of the investment? The reason I ask that, it seems the more successful the investment the more they are penalized.

    Mr. MEYER. As the carrying value goes up, the capital to the firm goes up. As the carrying value goes down, the capital of the firm goes down. So that is the real exposure to the firm from that merchant banking investment. When the firm reports its balance sheet and its financial statements, its merchant banking activities, it is going to report its carrying value.

    Mr. BACHUS. Because of that, the more successful a financial holding company's investments are, the less ability they have to make other investments.

    Mr. MEYER. Not at all. The more successful they are, the more they can make investments. But they have to hold capital against their carrying value, because that carrying value reflect the exposure of that organization to the risks.

    OK, if you have a 10 percent or a 20 percent or a 50 percent decline in the value of the firm, the risk depends upon the current carrying value.

    Mr. BACHUS. Mr. Hawke.

    Mr. HAWKE. Mr. Bachus, I think a great many investments, particularly made by SBICs, are carried at historical cost, and they are not written up. This is particularly true of investments in privately held venture capital—in companies that don't have a public trading market. Any assets held in the available-for-sale account of an institution will be carried at what may be a higher value, but the unrealized appreciation will not count toward Tier 1 capital. So the big difference is whether the increase in value that is unrealized can be counted toward Tier 1 capital.
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    Mr. BACHUS. All right. I have got 47 seconds, right.

    Chairman BAKER. No, you are 47 seconds over, but I am not counting.

    Mr. BACHUS. I will ask a real short one.

    Chairman BAKER. Good.

    Mr. BACHUS. Has the Fed considered excluding investments from the rules once a portfolio company has gone public?

    Mr. MEYER. No. Once a portfolio company goes public those now publicly traded equities are held under the merchant banking authorities and are subject to the same rules. We have made no distinction between the private equity investments and the publicly traded ones. That is something that, over time—for example, if banks develop internal risk models that are more sophisticated and can make that distinction—we would certainly be willing to consider.

    Mr. BACHUS. Thank you.

    And I just want to make a comment. Oftentimes—you talked about market volatility and what the market has done since you came out with these rules. But I think you might agree that since you have shown the merchant banking investments are more stable than some of your publicly traded equity which have really gone down in value.
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    Mr. MEYER. Well, the difference between publicly traded equity and private equity investments is that the latter are not regularly marked to market, so you wouldn't know right now to what degree losses are incurred. If the market stays as it is right now, then we will find out over time.

    Chairman BAKER. Thank you, Mr. Bachus.

    I just want to make a quick observation. It has always been a matter of mystery to me—Mr. Bachus and I used to know the citations when we were in the depths of the Gramm-Leach-Bliley debate—why a holding company can have up to a 24.9 percent interest equity in a domestic corporation non-voting but you can have up to a 40 percent position in a foreign corporation. And I never have ever had a successful explanation as to why that appears to be a less risky position than a 24.9 percent in the domestic corporation. So there are a lot of apparent inconsistencies, to me at least, in providing opportunity as it relates to risk in the markets.

    I think this committee has a lot of work to do, and I look forward to working with Mr. Bachus and Mrs. Maloney and others on this matter.

    I am informed that we have a series of votes. Do we know how many? I am told two, two votes; and I make this announcement for the benefit of our next panel. We would conclude this panel of witnesses, express our appreciation for your courtesy and long participation this morning. It is an important matter to the committee. We do look forward to having further informational exchanges and follow-up with our written questions and look forward to working with the gentlemen.
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    Mr. BACHUS. Could I?

    Chairman BAKER. Sure.

    Mr. BACHUS. One thing that we would like you to do, we have identified the routine management provision within the Act that is problematic. Would you work with us to identify other areas in which you might inadvertently work against us?

    Mr. MEYER. I think perhaps we would like to communicate with you a little further to clarify the routine management aspects.

    Mr. BACHUS. Not only that, if there are other provisions that you are mandating, some of these regulations, we would like to sort of identify it. Because it is sort of my understanding that it did not mandate any of these regulations.

    Mr. MEYER. We are looking forward to working with you.

    Chairman BAKER. We have a follow-up question.

    Mrs. MALONEY. The Chairman raised an important point, and I would like to hear from both of you. What is the explanation that you can have 40 percent in a foreign company but only 24 percent here? What is the explanation?

    Mr. HAWKE. We pointed out that anomaly a number of times during the Gramm-Leach-Bliley.
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    Chairman BAKER. I think you and I have been doing this for a decade.

    Mrs. MALONEY. I would like to hear why.

    Mr. HAWKE. I would rather not try to justify that.

    Mrs. MALONEY. Can you, Mr. Meyer, justify it?

    Mr. MEYER. The only thing I can say is today you can have a 100 percent ownership in a U.S. firm under the new merchant banking authority, but I really can't comment on the previous rules. I don't know why they exist as they do.

    Chairman BAKER. It is an area where we really do need to do some work. We tried unsuccessfully in Gramm-Leach-Bliley to address that concern. You can only have up to a 5 percent voting interest with a 24.9 percent equity position. To me, it seems, along the lines of Mr. Bachus' questioning, if you have your financial resources at risk or worse, where you have a fiduciary responsibility to the Louisiana Teachers Fund and you see something going on, you ought to be able to exercise your discretion to improve the operation, safety and soundness of that enterprise for the benefit of teachers, much less the shareholders of the underlying management.

    Mr. MEYER. Mr. Chairman, if you see something going on that is a threat to your investment, you can. It doesn't mean you can manage the firm on a day-to-day basis.
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    Chairman BAKER. I understand that. If you can smell the smoke and see the fire, you can grab a fire extinguisher. But if you see a guy piling rubbish in the corner with matches in his pocket, you can't say a word. I think that is the distinction that troubles me.

    With that explanation, I would conclude this panel. We will reconvene as quickly as possible. Hopefully, no more than 20 minutes.


    Mr. BACHUS. [Presiding.] At this time, we will reconvene our hearing with our second panel. They are: Mr. Robert J. Kabel, Counsel for the Bank Private Equity Coalition, representing Manatt, Phelps and Phillips; Mr. John P. Whaley, Partner, Norwest Equity Partners and Norwest Venture Partners, on behalf of American Bankers Association Securities Association; and Mr. Peter D. Grauer, Managing Director, Leveraged Corporate Private Equity Group, representing Credit Suisse First Boston Equity, on behalf of the Securities Industry Association and the Financial Services Roundtable.

    We welcome you gentlemen to the hearing. Did you all have an opportunity to hear the first panel? All right. All of you did.

    At this time we will start, and we will go from my left to right with opening statements.

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    Mr. KABEL. Thank you, Chairmen Baker and Bachus, Members of the subcommittee.

    I am Robert Kabel and, just to correct the record, I am a partner at the law firm at Manatt, Phelps and Phillips, but I have been outside counsel to the Bank Private Equity Coalition for some years.

    On behalf of BPEC, I want to thank you for your continuing interest in the regulatory implementation of the merchant banking authority enacted as part of the Gramm-Leach-Bliley Act. BPEC appreciates your convening of this important hearing and the opportunity to present our views on the implementation of the merchant banking provisions of GLBA.

    BPEC was formed in early 1995 by the direct investment subsidiaries of several large commercial bank holding companies to address various statutory and regulatory issues that prevented them from competing effectively with non-bank direct investment firms.

    Prior to the enactment of GLBA, BPEC members had been involved for many years in direct investment activities. These direct investment subsidiaries have many years of direct investment experience and excellent earning track records.

    BPEC worked in the 104th Congress with then House Banking Committee Chairman Jim Leach on the merchant banking language included in the first financial modernization bill he introduced early in 1995. Identical merchant banking language was included in every subsequent version of financial modernization legislation, including the legislation that was signed into law in November of 1999. The purpose of the merchant banking provision was to expand the existing direct investment authority of commercial bank holding company subsidiaries so they could compete more effectively with securities firms and insurance companies who were not subject to Glass-Steagall and Bank Holding Company Act restrictions.
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    Prior to the enactment of GLBA, the SBA regulated SBICs, and the Federal Reserve regulated all other direct investments made through bank holding companies. The regulation of merchant banking activities was burdensome and often unpredictable. The Federal Reserve examinations varied widely in regard to several critical issues. Therefore, BPEC and others in the industry advocated the enactment of the merchant banking provisions in GLBA as a means by which to streamline the regulation of merchant baking activities as well as provide for greater competitive equality.

    Since enactment of GLBA, BPEC has worked with the Federal financial regulators on implementation issues through a series of meetings and comment letters.

    Chairman Baker, we appreciate the attention you and the Capital Markets Subcommittee have given to this important issue since enactment and look forward to working with both subcommittees in the future. BPEC strongly believes that the appropriate regulatory implementation of the GLBA merchant banking provisions in accordance with congressional intent will determine whether with this new statute leads to the modernization of our financial industry as Congress had intended. Nothing less than that is at stake here. If GLBA is not properly implemented, the two-way street concept that Congress worked toward for so many years will fail to be achieved.

    In view of the intense scrutiny given merchant banking issues during the development of GLBA, BPEC was surprised and disappointed when the Federal Reserve Board and Treasury issued their interim merchant banking regulations on March 17 of last year and the Board issued its proposed capital rules.
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    The interim rule established an extensive set of complex rules for merchant banking which BPEC members, and many other members of the financial community, thought to be exceedingly restrictive. We are pleased the regulators took into account many of the extensive comments submitted regarding the interim rule and modified several of its provisions so that the final rule provides some greater flexibility and certainty of its provisions.

    We remain concerned, however, that the final rule imposes a series of restrictions on the financial holding company merchant banking operations that our non-FHC merchant banking competitors are not required to follow. In particular, BPEC remains troubled by the cross-marketing restrictions included in the final rule. The GLBA explicitly provides insurance companies involved in merchant banking with authority to cross-market products and services. This apparent disparity is unfair and unwarranted and should be changed. If regulatory relief is not forthcoming, BPEC recommends amending GLBA to permit financial institutions to cross-market products and services.

    BPEC, like almost everyone in the financial services industry, also was disappointed by the Federal Reserve's original proposed capital rule for merchant banking activities. During the several year debate which led to the enactment of GLBA, none of the regulators ever publicly suggested that there should be the prospect of special capital rules for merchant banking activities. Congress rightly did not impose an excessive capital requirement because it recognized that existing merchant banking firms had a long history of making prudent investments and therefore did not require a separate capital rule.

    BPEC is pleased that the Federal Reserve carefully reviewed the substantial industry comments submitted in regards to the proposed capital rule and made significant changes in the revised proposal now out for comment. Comments made by this committee and others in Congress were very constructive, and we appreciate the committee's leadership on this issue.
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    While BPEC appreciates the fact that the Federal Reserve carefully reviewed and responded to many of the comments submitted on the original proposed rule, we continue to object to singling out any individual class for discriminatory treatment. BPEC believes that the Federal Reserve should utilize the internal capital allocation models of those financial holding companies with merchant banking operations. The Federal Reserve should review those models during the normal examination process and impose specific capital requirements only if the internal models are deemed inadequate to protect against the inherent risk in the institution's merchant banking portfolio.

    Again, I want to thank you for this opportunity to present the views of the Bank Private Equity Coalition on the final merchant banking regulations and the revised proposed merchant banking capital rule; and I would be happy to answer any questions.

    Mr. BACHUS. Thank you.

    Mr. Kabel, before you stop, we are going to correct the record to show that you are actually testifying—you are a partner in Manatt, Phelps, but you are testifying on behalf of the Bank Private Equity Coalition.

    Mr. KABEL. That is correct, Mr. Chairman.

    Mr. BACHUS. Also, Mr. Grauer.

    Mr. GRAUER. Yes, sir.
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    Mr. BACHUS. You are also testifying on behalf of Financial Services Roundtable as well as the Securities Industry Association.

    Mr. GRAUER. Correct.

    Mr. BACHUS. Thank you.


    Mr. WHALEY. Messrs. Chairmen, my name is John Whaley. I am a partner of Norwest Equity Partners and Norwest Venture Partners.

    I am here today on behalf of the ABA Securities Association, or ABASA, and the American Bankers Association. Many of ABASA's members regard the merchant banking authority as the most important feature of the Gramm-Leach-Bliley Act. We want to ensure that we may exercise that authority to the fullest extent allowed under the law.

    ABASA strongly opposed the original capital proposal as well as the interim rule. Subsequently, both of these were revised, and we are pleased that the regulators chose to address many of our concerns.

    Today, I will highlight three issues: the proposed special capital charge on equity investments, the rules on private equity funds and legislative relief from certain cross-marketing limits.
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    Regarding capital charges, bank regulators have proposed a three-tier system for assessing capital against equity investments made by financial and bank holding companies. Specifically, the proposed rule would assess an 8, 12 or 25 percent capital charge deduction on an organization's Tier 1 capital as the level of equity investments increase. This graduated capital charge is a significant improvement over the one-size-fits-all 50 percent capital charge originally proposed.

    We remain concerned, however, that any special capital charge will exacerbate the inequity between financial holding companies, or FHCs, and non-FHCs engaged in merchant banking activities, thereby undermining congressional intent that all investment banking firms engaged in these activities operate on a level playing field.

    The special capital charge, even as reduced under the new proposal, would preclude FHCs from engaging in merchant banking activities on the same terms and conditions as their non-bank-affiliated competitors. It also might discourage the securities and insurance firms from becoming FHCs because the price may be too steep.

    For these reasons, we earlier advocated and continue to maintain that a supervisory approach would be the optimum way to address this issue. Further, the capital charge would apply not only to newly authorized merchant banking equity investments but also to the four pre-Gramm-Leach-Bliley types of investments which are listed in my written statement.

    Of these four types of investments, only SBICs are given special treatment under the proposal. No special capital charge is applied to any SBIC investment unless the total amount of such investments exceeds 15 percent, and then only the excess amount above 15 percent is subject to the capital charge.
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    ABASA opposes any special capital charge on equity investments authorized prior to Gramm-Leach-Bliley. The banking industry has a long history of engaging in such activities, and there is simply no evidence that additional capital is warranted. At the very least, all investments through SBICs should be excluded from the special capital charge.

    If the regulators do not exclude all pre-Gramm-Leach-Bliley authorities or at least SBICs from the special capital charge, at the very least all equity investment made prior to March 13 of 2000 should be grandfathered. Without such grandfathering, many investments made before March 13 will become uneconomic, not because of any change in inherent worth but solely because of a change of regulatory treatment.

    With respect to private equity funds, merchant banking equity investments may be made through pooled funds or directly in portfolio companies. The interim rule properly recognized that investments made through a private equity fund in which an FHC, by definition, may only be a minority investor should have fewer restrictions than investments made directly in portfolio companies. Nevertheless, the interim rule needlessly imposed many of the same restrictions on portfolio investments made through private equity funds that it imposed on direct portfolio investments. That is, the rule's restrictions applied to the FHC's investment in the private equity fund itself and then looked through the equity fund and applied it to the portfolio investment made by the fund as well.

    ABASA strongly objected to these look-through provisions. The restrictions deterred FHCs from investing private equity funds and created a significant disincentive to include FHC investors in many private equity funds. We are pleased that the final rules on private equity funds have been simplified and clarified to address many of ABASAs concerns.
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    Regarding the need for relief from cross-marketing limits, under the cross-marketing limitation a bank cannot market any product or service of a portfolio company in which its FHC has made a merchant banking investment; and the portfolio company in which the FHC has invested may not market the banks products and services. A limited exception is provided, however, for banks that are affiliated with insurance companies. That kind of bank can market its product through internet websites and statement stuffers to a portfolio company in which the insurance company has made a merchant banking investment. Products and services offered by the portfolio company in which the insurance company has invested also may be marketed through internet websites and statement stuffers via the insurance company's affiliated bank.

    Nearly all of ABASAs members are FHCs that may make merchant banking investments because of their affiliation with securities firms. Very few own insurance companies. As a result, our FHC members cannot take advantage of the website statement stuffer exception. There is simply no rationale or public policy reason for this competitive inequity.

    The ability to cross-market through internet websites and statement stuffers is an important tool. As Representative Kelly stated and Governor Meyer confirmed and was mentioned by Chairman Baker, there is not a great deal of symmetry in how Gramm-Leach-Bliley is applied. Therefore, we urge the subcommittees to fix this inequity by expanding the website statement stuffer exception to all FHCs engaged in merchant banking activities.

    Thank you, and I will be happy to respond to any questions you have.

    Mr. BACHUS. Mr. Grauer.
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    Mr. GRAUER. Thank you, sir.

    I am Peter Grauer, Managing Director and Senior Partner of Credit Suisse First Boston's private equity business, which is the largest manager of private equity assets in the world. Credit Suisse First Boston as a financial holding company commends the Federal Reserve and Treasury for the significant improvements that the joint rules reflect from the original interim rules put out in March of 2000. We appreciate the Federal Reserve and Treasury's willingness to be open-minded and work with the industry to improve these rules. In the same spirit, we look forward to further refining the rules as the agencies gain greater expertise in private equity activities.

    While we recognize how far the agencies have come, we still believe that the joint rules present an unnecessarily burdensome array of restrictions that are neither mandated by safety and soundness concerns, nor in keeping with the language or spirit of Gramm-Leach-Bliley. In fact, the changes in our view do not correlate with the way successfully run merchant banking business have conducted their activities over the last 15 years. Indeed, we believe that more than any factor the merchant banking restrictions have impeded non-bank financial firms from becoming financial holding companies.

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    In our view, the unwillingness of these firms to elect financial holding company status serves to underscore both the continuing difficulties that the joint rules raise and that financial holding companies are operating at a significant disadvantage in the marketplace.

    It is important to start from this premise, entirely borne out of our experience in the business, that active merchant banking, properly managed, poses no greater risk to financial holding companies than any other activities that regulated financial institutions are permitted to engage in without restrictions.

    Today I would like to highlight three specific problem areas under the rule. The first I will address are the restrictions on routine management or operation of a portfolio company for minority investors. Second, I would like to underscore what my colleagues have stated with regard to the aggregate limit on merchant banking investments causes operational difficulties. And, thirdly, restrictions on a maximum holding period for merchant banking investments are not customary in the private equity market and will increase the risk of those investments without any countervailing benefit.

    In my view, these restrictions significantly diminish an important business opportunity for financial holding companies and undercut the intent of Congress under Gramm-Leach-Bliley without adding in any material way to the regulatory goals referred to in the joint rules.

    First, in general, the joint rules' restrictions on routine management or operation of a portfolio company appear to presume that an investment can be protected from bad or improper management through control of a portfolio company's board of directors. However, where an investor is a minority investor and therefore does not have the ability to control the portfolio company's board, the need for additional contractual and operational protections become significantly greater than in the majority-investment context.
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    The joint rules' prohibition on the use of many traditional covenants that dictate prudent business practices or controls increase the risk associated with a minority investment and cause minority investors to lose an important tool to protect value.

    Based on our experience at Credit Suisse First Boston Private Equity, I would strongly recommend that the Federal Reserve and Treasury revise the joint rules to permit financial holding companies making minority investments to retain the right to use a wide range of restrictive covenants. These covenants are intended to ensure prudent management and operating practices.

    While we recognize that the joint rules do provide limited examples of covenants that, if granted to a financial holding company, would not be considered to be routine management or operation, the regulatory list is limited and incomplete.

    I believe that the current restrictions on routine management or operation of a portfolio company are unnecessary and could result in a significant handicap to our business. Accordingly, I believe that a far broader range of events and business developments should expressly be subject to a private equity investor's approval without such approval being deemed improper participation in routine management or operations.

    Examples should expressly include: all matters affecting the financing of a portfolio company; matters affecting the regulatory tax or liability status of a portfolio company; approval of capital expenditures and major expense items; policies regarding the hiring, firing, or setting or changing the compensation of non-executive employees; any transactions with affiliates or related persons; negative covenants relating to any material operations; and the creation of any subsidiary, partnership or joint venture to conduct any part of a portfolio company's business.
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    These rights are typical of those that private equity funds routinely seek in connection with a minority equity investment in a portfolio company. Indeed, most of them are little different from a covenant that a lender would require. While the joint rules have left the door open that these items may be acceptable on some type of case-by-case basis, the facts are that market circumstances will not wait for regulators to make these determinations; and if we are unable to negotiate for these types of controls on behalf of our managed funds this will undercut our ability to participate most effectively in private equity market.

    Another aspect of the way in which the joint rules address routine operations or management that we find particularly troubling is the prohibition on any officer or employee interlock between a financial holding company and a portfolio company at the executive officer level. From time to time, it has been important for us to provide our direct expertise to a portfolio company in a variety of different contexts. Certain situations can require full-time senior assistance in building or restructuring a management team. Investors count on our ability to provide this assistance when choosing to invest in our funds. There is no reason in my judgment why flexibility should not be brought to bear in respect to appropriate senior officer interlocks, and such flexibility would be entirely consistent with the way in which non-financial holding company merchant banking and private equity operations are currently conducted.

    The second area I would like mention briefly is the aggregate percent of capital-based investments and related capital charges imposed on merchant banking investments. In light of the fact that my colleagues next to me have addressed this item in substantially more detail than I did, I would like to join in their remarks on these important issues.

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    My third point, holding periods for private equity investments should be eliminated. The recent amendments to the joint rules should reduce, but will not eliminate, the fire-sale mentality by creating these limits. A simple look at the market circumstances over the past several weeks demonstrates why forced sales and formally limited holding periods could be problematic from an investment as well as a safety and soundness viewpoint.

    Private equity is the ultimate buy-and-hold experience, and the profitability of merchant banking activities come from the ability to develop companies over a substantial time period, waiting for the appropriate market windows for exit and liquidity purposes. It seems particularly inappropriate to require prior Federal Reserve staff review of every proposed merchant banking investment holding which exceeds the regulatory maximum and to impose a capital charge for longer term investments. Requiring such a process will only provide an unfair degree of leverage to portfolio companies in dealing with their merchant banking investors if such companies know that an investor could be forced to dispose of its interest or suffer adverse regulatory consequences.

    It also dramatically changes the negotiating between the financial holding company seller and the potential buyer who would be smart enough to know the consequences to the seller if it fails to compete the sale. We submit that any abuses associated with holding investments beyond some regulatory benchmark be addressed through the normal supervisory and examination process.

    In closing, I very much appreciate the opportunity to raise these points with you. As a senior officer of an entity that until recently functioned outside the Gramm-Leach-Bliley framework, I can appreciate perhaps more than most the significant and potentially harmful impact of the imposition of rules and limitations which, for all of their good and well-appreciated intention, simply do not translate well to the actual operations of the merchant banking bills.
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    While we greatly appreciate the efforts of the Federal Reserve and Treasury staff to improve the joint rules, we still believe that, even in their current form, they give significant advantages to other non-financial holding company competitors. We do not believe that this was your intention, and we look forward to further dialogue to remedy this situation.

    Mr. Chairman, thank you.

    Mr. BACHUS. I thank the panel.

    Mr. Kabel, one problem on the cross-marketing we have is the Gramm-Leach-Bliley Act does prohibit some of the cross-marketing, but in that I think we have created an inequity, and I think Mr. Baker and I plan to offer an amendment or some legislative proposal to amend Gramm-Leach-Bliley to allow the same cross-marketing abilities to be extended to products or services of portfolio companies held under merchant banking authorities. We are going to address that.

    Mr. KABEL. Well, thank you, Mr. Chairman. We certainly support that and would like to work with you on that and promoting it.

    Mr. BACHUS. Thank you. We are not sure whether that will fix the problem, but it should, and they say it is a prohibition in the bill. Also, you heard what Mrs. Kelly, you noted that she had questioned Governor Meyer about that.

    Mr. KABEL. Actually, the Bank Private Equity Coalition would actually encourage a look again at the statute. I know that it has been stated rather explicitly that there is no discretion, but frankly it would be better if the regulators would look at it again and perhaps review that, and we would ask—we are going to encourage them to do that.
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    Amending a statute is difficult, and I think people certainly on the panel understand that better than anyone else, but we would hope they would do that. And it has created some difficulty. I think these gentlemen could address that better, but there are certain relationships that they would like to have with online companies and so forth which they can only have if they are an investor, and the cross-marketing restrictions has prevented them from having those relationships.

    Mr. BACHUS. Thank you. I think these are the usual kinks that you have with a new act, so I think we will hopefully work through that.

    Mr. Grauer, I understand your analysis insofar as it applies to large merchant banking operations such as CS First Boston, but should—or maybe I will ask it, shouldn't we be concerned that loosening up the joint rules in the manner you suggest would be inappropriate for comparatively small financial holding companies of which, by my count, there are more than 400, including 12 in Alabama?

    Mr. GRAUER. To the contrary, Mr. Chairman. I think that our suggestions are even more relevant as it relates to the smaller financial holding company operations in their merchant banking operations, that they should be given the same latitude as the larger funds have to be able to conduct their activities regardless of whether they are operating out of a major money center or anywhere else in the country. We think that is both sound investment judgment and also basically good for the economy.

    Mr. BACHUS. In fact, the view that I posed is sort of prejudicial toward your smaller companies. Many of them do have that expertise. I do agree with your answer.
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    I guess the last thing I will say, I have got a minute, Mr. Whaley, one of the things that we have asked the Fed and Treasury to respond to is why aren't all merchant banking investments grandfathered so that financial holding companies and bank holding companies do not have to reconfigure their internal capital allocations for existing activities. We think that is appropriate, so we are responding to that.

    Mr. WHALEY. Well, I appreciate that that would be very beneficial to everyone. I mean, it is kind of an issue of fairness in equity, but to have a capital charge after the fact is like a retroactive tax increase, and so I think that it would just be a fairer way to implement the regulation to grandfather existing investments.

    Mr. BACHUS. And it could cause profitable investments to become unprofitable. So I would agree with you. I would be interested in their response to that request.

    At this time, I would recognize the gentlelady from New York.

    Mrs. MALONEY. Thank you, Mr. Chairman.

    I understand you were not pleased with the original rules that came out as they affected SBICs in the revised standard. What are your comments on it? Are there any remaining concerns affecting SBIC merchant banking investments of which Congress should be aware, and your comments on their current rules on SBICs.

    Mr. WHALEY. The new rules do go a long way with respect to SBICs. They still assess a capital charge to the extent there is more than 15 percent of capital base. In a SBIC, there isn't an incremental charge, and SBICs are also counted in the aggregate total as to whether—as to which level of capital charge is appropriate. So they have improved it quite a bit, but there still is some implicit additional capital charge with larger SBICs.
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    Mrs. MALONEY. I asked the first group this question, but I would like to hear from the industry what you think about the proposed merchant banking capital rule and how it compares with the new proposed Basel capital standards. Do you have any comment on that?

    Mr. KABEL. Mrs. Maloney, if I could comment by way of background, I think all of our institutions have taken the position that we don't feel there is a need for special capital rules period for merchant banking, that existing capital rules standards for the bank holding companies were sufficient to take into consideration the risk. Because we simply do not agree with the proposition that merchant banking investments are riskier. We just simply do not agree with that.

    Frankly, I am not an expert of capital of any kind, much less the new Basel, but our position has been, BPEC's position, and it will be again in our comment letter to the Federal Reserve Board on the revised proposed rules, that they should simply utilize internal capital models to the maximum extent possible, which I think most people would agree are very well done. The purpose of these capital models is to reflect the actual risk inherent within the merchant banking portfolio. And then if through the examination process those models are viewed to be inadequate then impose specific capital with the inherent regulatory authority.

    Mrs. MALONEY. OK. Thank you very much.

    Mr. WHALEY. We would share that view, by the way.

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    Mrs. MALONEY. Thank you.

    Mr. BACHUS. Mr. Baker.

    Chairman BAKER. Thank you, Chairman Bachus.

    I would like to suggest, Mr. Chairman, that we consider on the principal elements that have been mentioned here today that perhaps you and I and other interested Members, perhaps Mrs. Maloney, consider, although the final rule has been promulgated, a letter of comment concerning some of the obvious deficiencies in the current reg, which would include the routine management definitions, comment on the aggregate limits, certainly including the holding period.

    I have before me what the Gramm-Leach-Bliley provisions are with regard to holding period. It is, quote, to enable the deposition thereof on a reasonable basis consistent with financial viability. Now to take that and to translate it into a specific term, as we were repeatedly told earlier that the Congress legislated with regard to these matters, seems to be a bit at contravention with what the language says.

    There are a couple of other additional elements I would like to throw on the pile, one of which, with regard to a holding company forming a private equity fund, and you start out with the plan to have only a 20 percent stake and, because of the way the fund is structured, the holding company winds up with a 25 percent stake, that fund then no longer qualifies as a private equity fund. Then you have got to go back to your investors and tell them they are no longer part of a qualifying fund, and you are now subject to these restrictions.

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    It is just sort of common-sense business formation issues that have no consequence with regard to safety and soundness or risk to the markets.

    Second, the area where I have the most difficulty on all of this is things that were previously permissible which now appear to be in contravention of the new rule, under Section 4(c)(6) of the Bank Holding Company Act, bank affiliated firms have made investments under that provision without any risk to safety and soundness historically, that now the agencies have determined or the Fed has determined to apply the new capital charge to those investments which previously had no capital charge against them.

    So we have—in my view of the world, we have gone backward, Mr. Chairman, instead of forward in promulgating rules which enable cooperative ventures to benefit the economy and investors. We are now taking a business practice previously authorized that has not presented market risk to my knowledge and saying you will now be subject to the new capital charge which did not previously exist.

    I would suggest, Mr. Chairman, that certainly all other matters which you deem appropriate to include in such a letter, that we will try to get Members of both subcommittees to join together in this, I think there are bipartisan concerns that the consequences of this action will deter what this Congress tried to do over longer than a decade to modernize our financial regulatory system.

    Mr. Grauer, particularly with regard to your firm's responsibility with the Louisiana State Teachers Pension Fund—you caught my attention when the word Louisiana got thrown in—where you have historically managed minority interest investments for the benefit of that fund, am I understanding that the total assets available to your organization is equal to or exceeds $5 million?
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    Historically, you have been able to enter into restrictive covenants that had certain restrictions which would enable you to take appropriate actions—''appropriate'' being defined as whatever you think it is in order to protect the interest of the individual investing teacher. Am I understanding the rule modification properly, that you would either have that ability now significantly limited or eliminated in making such covenants or agreement with minority investments of the sort you have engaged in?

    Mr. GRAUER. We believe the rules have been significantly limited.

    Chairman BAKER. Would there be cause of concern for the Teachers Fund to rethink their investment strategy, or what is the outcome of this?

    Mr. GRAUER. Each investor, and particularly the Teachers Fund, goes through an extensive due diligence process before they ever commit equity to any capital funds. One of the aspects of that due diligence is to go through and evaluate our track record, both with successful investments and less successful investments; and I think they have satisfied themselves that, as is a professional manager such as ourselves and others, we are not alone in this world by having the ability to move quickly and exercise discretion over these investments. It has gone a long way not only to protecting their investments but maximizing their returns.

    I think in the absence of that flexibility we would be looked upon by them much less favorably than perhaps someone who is not subjected to the financial holding company limitation under Gramm-Leach-Bliley.
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    Chairman BAKER. So you probably feel some obligation henceforward to advise your customer—your client that we have had these changes in law which do not enable us to take certain actions. Consequently, we want you to be aware of this. As a result of our due diligence process that here—now are the rules under which we operate, and it could potentially steer the teachers investment guidance in a different direction.

    And, for the record, I am not promoting anyone's private profitability at the expense of the teachers. What I am concerned about is getting the best return for the teachers with the best possible return available.

    I don't know if you'll say it, but my summation is the rule unintentionally precludes them from getting the best professional management advice for the return for the teachers.

    Mr. GRAUER. We would agree with that.

    Chairman BAKER. Thank you. Thank you very much.

    Mr. Chairman, I yield back my time.

    Mr. BACHUS. Thank you.

    Chairman BAKER. I had one other question. There was testimony provided by the SIA which I don't think has been made part of record, Mr. Chairman. It is here. I would like to ask that be made part of the record.
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    Mr. BACHUS. Without objection, that testimony or letter will be included in the record.

    Chairman BAKER. Thank you, Mr. Chairman.

    Mr. BACHUS. Mr. Grauer, the holding period also concerns Chairman Baker and me. You mentioned the necessity of a forced sale or having to unload the investment when equity markets are depressed. I would ask the other two gentlemen, can you see any justification for having a holding period, other than just the broad language of the Act which basically says as long as it is justified?

    Mr. WHALEY. I cannot see a reason for having an absolute time limit to hold an investment. It is true that most investments are made and then liquidated within a 10-year period, but there are many circumstances where it makes sense to continue to hold them. Sometimes it is market circumstances that require you to hold them, and sometimes it is in the very best interest of the company that we have invested in for us—it is very disruptive if we go to the company and say, you know what, we have all got to sell our positions because of this regulation. And it is a problem.

    Mr. BACHUS. I can see where Uncle Sam would want it so, particularly if it has been successful and it would generate tax revenues. Other than that, I can't imagine.

    Mr. KABEL. Mr. Chairman, I think that is an excellent example of using this issue of time period. It is really an issue that should be dealt with through the examination process, as opposed to providing regulatory time periods, whereby, if you bump up against the 10-year period, then you are required to divest. Why not have the regulators look at these investments and ask why an institution is holding an investment for a certain period of time.
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    There are some investments where there is no market for them. I am not sure what we should do with these investments when the subsidiary bumps up against the 10-year period. There may be absolutely no market for these investments. Often, they have already been written down to zero, and that is part of the process. The advantage of portfolio investing is that the institution invest in a lot of companies and a lot of different industries, and that is why the direct investment subsidiaries, on balance, have been extremely successful.

    You can say on an individual basis that an individual investment may be risky, but it is important to remember that these are banks who are doing the investing. These subsidiaries have to report to the bank holding companies, and they are prudently managed. I am not suggesting that the direct investment folks outside of banks are not prudently managed, because they are. It is a very successful business. These are people who really understand what they are investing in, and they understand how to add value to the companies in which they are investing.

    Chairman BAKER. Mr. Chairman, can I jump in on that point?

    Mr. BACHUS. Yes.

    Chairman BAKER. I just want to make sure I understand the operative conditions under which the 10-year disposition rule works.

    Let's assume you have a holding you have had for 9 years and 4 months. You know the rule requires to dispose. So you go into the market. The other guy figures this out. Maybe he is not quite so anxious to close. Maybe the terms change. Something happens. It is not to your best financial interest.
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    You then procedurally could go to the Fed and apply for an extension, but even if the extension were granted you would then have to have a 25 percent capital charge against the holding until you disposed of the asset. So that then drives down your margin or you have got to increase your price in order to dispose of the asset on the terms in which you originally contemplated. Are those facts close?

    Mr. KABEL. It is my understanding that is correct.

    Mr. WHALEY. That is correct.

    Mr. KABEL. That is exactly what happens.

    Chairman BAKER. So at the end of the day you have an arbitrary window. If it is a profitable center, you probably do not want to get rid of it. But yet if you are going to the market any time near the duration is coming to an end—if I was on the other side I would certainly like to have you in that position, knowing that if you didn't take my deal on the terms I suggested you will take the capital hit and then we will talk then. I love that.

    Mr. GRAUER. Mr. Chairman, just as a point of clarification I think that capital charge could be as high as 100 percent.

    Chairman BAKER. I am told it was at 100, but it was reduced in the modification. It could go down to as low as 25. Apparently, this is another one of those David Copperfield things. We don't know where it is.
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    Mr. BACHUS. Thank you.

    I will ask a general question of the panel, and it may give you an opportunity to expound on some of the comments of the first panel, too.

    I think underlying all this is the continuing debate on how safe are your activities and do they threaten the safety and soundness of your institution. Given the current economic conditions, how do you respond to the regulators' concern that merchant banking activities, if not subjected to close regulatory scrutiny and stringent capital requirements, could jeopardize the safety and soundness of those institutions that conduct such operations? How have merchant banking investments generally fared in comparison with other types of banking activities during tough economic times?

    We will just go from right to left.

    Mr. GRAUER. I will make a stab, and my colleagues will elbow me if I am talking too long or perhaps getting off the point.

    One of the things that we do, and I think all of us in the private equity business do, is when we—prior to making an investment we do an extensive amount of research on how we think the portfolio company will behave in different economic environments. And as we see those environments develop, either we are in them or we expect that they will occur, we try to capitalize our companies so they can weather the storm that occurs as a result of their business suffering through an economic downturn.
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    So invariably there are some companies in all of our portfolios that don't do as well as others, but, by and large, most of them have been capitalized, particularly if those are businesses that are subject to economic cycles such that they will be able to come through those cycles with solid cash flow, the ability to service their debt, meet their payroll and fulfill all the various obligations to their constituents.

    So, number one, we try to plan for that ahead of time as we do the evaluation for each new investment that we look at. Number two, we also, once we are in an investment, try and take considerable care as we go through each annual operating plan cycle to look at the more macro-economic events that are in front of us and again try to batten down the hatches to the extent we need to by downsizing the expense base to the extent we have to, shutting down our capital expenditure programs to preserve cash and do various other things to ensure that we can get through the economic cycle.

    So those of us who have been in the business for a long time, such as firms as my own, we have been doing this for over 16 years, we have been through a number of economic cycles, and I think we have prepared our portfolio to go through those economic cycles successfully. I think that is one of the factors that is not brought to bear in the kind of broader analysis that occurs in preparing legislation like Gramm-Leach-Bliley where perhaps the level of professional investment expertise that each one of the major merchant banking firms have exercised and developed over the years is not necessarily taken into account. It is a business that clearly has risks associated with it, but certainly as professional managers we do our darnedest to be able to take those risk out of the equation day-in and day-out.

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    Mr. BACHUS. Thank you. I would note for the record that we have your resume, and it firmly establishes that you have been very successful in making these investments and that you certainly have the background to testify and to be an expert witness.

    Mr. GRAUER. Thank you, Mr. Chairman.

    Mr. WHALEY. That was very well said, Peter.

    I would just add to that the fact that, at Norwest, we have been in the private equity investment business for close to 40 years now, which includes a number of upcycles and downcycles, and you learn to manage through those cycles really doing the kind of things that Peter alluded to. How that performs relative to other banking assets, I can't really respond succinctly to that, other than to say that there was a lot of discussion earlier today about risk and how you manage that risk. And it isn't the riskiest class of assets that banks have. I think risk is only half the equation.

    You have to look at the risk return situation, and I think we would be much more interested in managing a portfolio of 25 equity investments, as opposed to 25 senior loans that are fully collateralized. Because you have less risk in the loan that is fully collateralized. You don't make a lot of money on a loan. You make a net interest margin, whereas in the private equity business you have the opportunity to make a number of times on your investment; and, on balance, I think that it affords the opportunity to make more money and make a more meaningful revenue stream for the bank holding company.

    Mr. KABEL. Mr. Chairman, I don't have much to add. These gentlemen have been in the business for many years.
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    But each member of the Bank Private Equity Coalition is similarly situated in that they have all been in the business for many, many years. They have well-diversified portfolios, and they do understand how to manage risk. That is why they have been so successful.

    The regulators often during the course of the lengthy process—during the process leading up to Gramm-Leach-Bliley and certainly subsequently would say to my members, we are really not concerned about you. We are concerned about people entering the business.

    I can appreciate that. But, again, I fall back—the Federal Reserve examiners are excellent regulators. They understand how to look at portfolios. They understand how to talk to the executives of the organizations about what they see.

    So, again, I think we fall back on the fact that there was a system in place that was working. We promoted the specific merchant banking language in the Gramm-Leach-Bliley Act because we wanted in the statute a section that talked about classic portfolio investing that is exactly what the Gramm-Leach-Bliley provisions provide. That is why when we get into the definitional issues is where we are clearly running into problems. But we wanted that statutory provision because of some of the problems we have seen through the examination process over a period of years where examiners had different views as issues.

    The classic example that was often brought up was, depending on where you were situated in the country, you either could or could not have a member of a board of directors if you were an investor. I think anyone who looks at that objectively for safety and soundness would say, of course you want to have a member of the board of directors. The board of directors members are the ones who learn of the information first to know whether there is a problem.
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    So that has been taken care of. Clearly, that is one of the advantages of having this provision enacted as part of Gramm-Leach-Bliley. And I think just over a period of time hopefully we will be able to work our way through a lot of other issues hopefully in dealing with the Congress and hopefully in dealing with the regulators.

    Mr. GRAUER. Mr. Chairman, if I could add one other thing. That is, particularly as it relates to some of the restrictions that I talked about under the new legislation on our ability to act in both majority and minority investments, in addition to the analytical framework that I described that we applied both before and as we look at investments, we monitor our portfolio companies literally on a monthly basis and in some instances on a weekly basis, depending on what they are doing, what kind of capital they are spending and what we think the cash flow implications of that are.

    We oftentimes will make changes. We will move in very quickly to do things. That is largely because we have consummated over the last 16 years over $50 billion worth of acquisitions. We have put to work over $5 billion worth of equity capital, over $7 billion of equity and no capital. We have dealt with some 160 investment opportunities over that period of time where we have had a portfolio shareholder interest.

    As a consequence, the same way you and your colleagues structure the legislation and other things that you do day-in and day-out both for your constituents and for our country, we do the same thing with our portfolio companies. And having either one hand or two hands tied behind our back and limiting our ability to do that we are not serving our constituents, people like the Louisiana teachers and the retirees that exist in that system, properly.
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    I want to say one other point before we give up our time. We in your number of the 29 States that are represented on your two subcommittees, we manage a retirement system capital for 10 of those States. We manage today—of the $22 billion of assets that we have under management—roughly 50 percent of that capital comes from the public pension fund retirement system, either public employees in the case of Utah—excuse me, in the case of Louisiana, it is the teacher system. In the case of Utah, who we manage over $800 million for, it is the public employee retirement system.

    We do the same thing for the States of Arkansas, Connecticut, California, Illinois, Massachusetts, Michigan, North Carolina, Pennsylvania, just so mention some of the representatives who are in your committees.

    We have to have the ability to make decisions and make those decisions on an unfettered basis not only to protect your constituents but also to generate the kind of rates of return that we expect our investors have put their monies with us as a fiduciary to accomplish.

    Mr. BACHUS. Thank you.

    Chairman Baker.

    Chairman BAKER. Mr. Chairman, I have no further comments. Thank you for your courtesy.

    Mr. BACHUS. Ranking Member Waters had indicated she had no questions.
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    Ms. WATERS. No, I have no questions. I thank you. I did not have an opportunity to thank you for making sure that your subcommittee joined in to have this combined hearing, and we got a lot of information from it. Thank you.

    Mr. BACHUS. Thank you.

    Finally I will just conclude, Mr. Kabel, we appreciate your comment about whether or not Gramm-Leach-Bliley does, in fact, prohibit cross-marketing that we have talked about. I know Mrs. Kelly's question presupposed that it did. We will go back and take a look at that. She had suggested that a regulation could possibly take care of that interpretation, that concern.

    So, with that, if any of you gentlemen want to make a final comment, we would invite it. But I think we have a wonderful record. I think we will close at this time.

    Mr. KABEL. Thank you very much.

    Mr. WHALEY. We appreciate your leadership on this whole process. It has been very helpful from our end.

    Mr. BACHUS. Chairman Baker particularly has expressed his concerns for over a year, which you all have concerns, and has alerted me to these concerns. So this won't be the end of the story. Thank you.

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    Mr. WHALEY. Thank you.

    Mr. BACHUS. The hearing is adjourned.

    [Whereupon, at 1:20 p.m., the hearing was adjourned.]