Testimony Archives
STATEMENT OF THE SECURITIES INDUSTRY ASSOCIATION
BEFORE THE SUBCOMMITTEES ON
CAPITAL MARKETS, INSURANCE, AND GOVERNMENT-SPONSORED ENTERPRISES, AND FINANCIAL INSTITUTIONS AND CONSUMER CREDIT OF THE COMMITTEE ON FINANCIAL SERVICES UNITED STATES HOUSE OF REPRESENTATIVES
HEARING ON
THE PROMOTION OF CAPITAL AVAILABILITY TO AMERICAN BUSINESSES
APRIL 4, 2001
The Securities Industry Association ("SIA") appreciates this opportunity to present its views on the merchant banking rules issued jointly by the Board of Governors of the Federal Reserve System ("Board") and the Treasury Department ("Treasury") on January 10, 2001, and the merchant banking capital proposal issued by the Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation on January 18, 2001. SIA brings together the shared interests of more than 740 securities firms, investment banks and broker-dealers that operate throughout the United States and North America. SIA member firms are active participants in U.S. and foreign securities and capital markets and in all phases of corporate and public finance. Many of SIA's member firms are affiliated with banking organizations and, thus, affected by the merchant banking regulations.
At the outset, SIA wishes to thank Chairmen Bachus and Baker and the Subcommittees for holding this important hearing. As the Chairmen and many members of the Subcommittees know, SIA and its member firms have been deeply concerned about the capital requirements and other regulatory restrictions imposed by the Board, Treasury and other agencies on the equity investment activities of bank-affiliated securities firms and, consequently, SIA has been an active participant in the public policy debates regarding these restrictions. SIA first shared its concerns about the rules in detailed comment letters that it filed with the relevant agencies last spring and then in testimony last June before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises.
Those hearings helped to highlight and draw attention to the serious concerns that SIA and many others in the securities and banking industries had regarding the Board and Treasury's initial approach to regulating merchant banking activities. In particular, SIA voiced the view that the rules, as proposed last March by the Board and Treasury, would have had a significantly adverse effect on the ability of securities firms within financial holding companies ("FHCs") to make merchant banking and other permissible non-financial equity investments on the same scale and to the same extent as securities firms that are not part of a FHC family. For this reason, SIA worried that the rules effectively closed the "two-way street" between the securities and banking industries that is at the very core of the Gramm-Leach-Bliley Act ("GLB Act").
In response to the concerns voiced by SIA and others, and as a result of the significant and timely efforts of the members of the Subcommittees, the Treasury, the Board and the other bank regulators have made a number of positive changes to the merchant banking regulations. SIA thanks the members of the Subcommittees for their help in effecting these changes and the regulatory agencies for addressing in their final merchant banking rule and capital proposal some of the significant issues raised by SIA.
Thus, much has changed since SIA last presented its views before the Subcommittee on Capital Markets; unfortunately, not enough. As detailed further below, SIA continues to have significant concerns about the final merchant banking rule adopted by the Board and Treasury and the revised capital proposal. As a general matter, the final rule and the revised capital proposal continue to present a highly complex and overly burdensome array of restrictions and limitations on merchant banking activities that, in SIA's view, are neither mandated by legitimate safety and soundness concerns nor in keeping with the language and spirit of the GLB Act, which sought to promote venture capital activities. In addition, in a number of respects, these rules still do not reflect fully the manner in which securities firms conduct their venture capital activities.
The regulatory agencies continue to operate on a premise, which SIA submits is faulty, that merchant banking poses substantially greater risks than other permissible activities. This premise ignores the fact that securities firms, including those affiliated with banks, have a long and exemplary record of successfully making and managing merchant banking investments. Indeed, it is quite notable that even the recent large declines in the U.S. equity and venture capital markets have not led to any breakdowns or significant problems at securities firms that are actively engaged in merchant banking activities.
Moreover, the regulators ignore the fact that Congress was fully aware of the risks posed by merchant banking activities, and it adopted a full set of measures in the GLB Act to guard against these risks. As an initial matter, Congress granted merchant banking authority only to FHCs, which by definition have depository institutions that meet certain well-capitalized and well-managed standards; entities that do not meet these high capital and management standards cannot even engage in this activity. Congress also prevented merchant banking investments from being held by depository institutions; adopted special rules under sections 23A and 23B of the Federal Reserve Act to govern transactions between merchant banking portfolio companies and commonly controlled depository institutions; and imposed a moratorium that, at least for the next four years, prevents the financial subsidiaries of depository institutions from engaging in merchant banking activities. Congress nowhere indicated that these restrictions needed to be supplemented with additional restrictions, especially rules as burdensome and complex as the ones that the agencies have set forth currently.
In addition to addressing the risks associated with the activity, Congress expressly authorized securities firms affiliated with FHCs to engage fully in the business of merchant banking. Congress further emphasized that such firms should be permitted to conduct merchant banking activities in substantially the same manner as their competitors that are not affiliated with banking organizations.
The current merchant banking rules do not achieve these goals. SIA respectfully submits that the regulators' safety and soundness concerns can be addressed by a less restrictive and complicated set of rules that defer to the industry's prudent, time-tested and well-functioning internal risk management systems and capital allocation models and supplemented by appropriate levels of supervisory guidance and oversight. Such a set of rules also would accord, in a way that the current rules simply do not, with the mandate of Congress in the GLB Act.
SIA appreciates the opportunity afforded by this hearing to continue this dialogue about the merchant banking rule and capital proposal. SIA encourages the regulatory agencies to re-examine their rules, particularly as they gain further understanding of the business of merchant banking. We encourage the agencies to ultimately fashion rules that truly permit full, fair and effective competition in the capital markets by all of the participants in a unified financial services industry, in precisely the manner that Congress intended when it enacted the GLB Act.
I. The Final Merchant Banking Rule
With respect to the final merchant banking rule, SIA commends the Board and Treasury for revising several of the restrictions found in their interim rule governing FHC merchant banking investments. In particular, SIA is pleased that the agencies have removed the dollar cap on total merchant banking investments and established a "sunset" provision that will eliminate the cap that is based on Tier 1 capital once the Board issues final capital rules. These twin restrictions -- for which there was no support in the statutory language or legislative history of the GLB Act -- had been of paramount concern to SIA and its members. SIA also supports the decision by the agencies to expand the definition of "private equity fund" and to adopt safe harbors that allow FHCs to make certain merchant banking investments without being subjected to affiliate-transaction limitations.
A. General Concerns.
Although it regards these changes as moves in the right direction, SIA continues to believe that the final merchant banking rule -- particularly when its provisions are considered in their totality -- presents an unnecessarily complex and burdensome regulatory scheme. The final rule, for example, contains a variety of intricate regulatory definitions and restrictions that will make doing business under and compliance with the rule difficult, expensive and time consuming for affected firms.
An example of the complexity of the rule is its treatment of "private equity funds." The final rule -- in SIA's view, quite appropriately -- imposes fewer restrictions and limits on portfolio investments made by FHCs through private fund vehicles. The rule, however, has a five-part definition for private equity funds, and then it imposes different sets of operational, recordkeeping and reporting restrictions on funds that meet this definition and those that do not. In addition, the final rule places different sets of limits on funds -- both those that qualify for private equity fund status and those that do not -- that are "controlled" by FHCs from those funds that are not. Thus, a single FHC may face four different sets of restrictions that apply to its fund investments: one for private equity funds that are controlled by a FHC; a second for private equity funds that are not controlled by a FHC; a third for funds that do not qualify for private equity fund status and that are controlled by a FHC; and a fourth for funds that do not meet the private equity fund definition and that are not controlled by a FHC.
These complex rules, of course, create a myriad of business and compliance difficulties for FHCs. One example may be illustrative: a FHC may intend to form a private equity fund in which the FHC owns only a 20% stake and that would be a qualifying fund under the rule. But, if for some reason, the FHC ended up owning more than a 25% equity position in the fund -- in which case the fund would no longer qualify as a private equity fund -- the final rule would impose on the now non-qualifying fund additional investment and operating restrictions. Accordingly, the FHC would be obligated to go back to the fund's investors to explain that additional restrictions apply to the fund, which restrictions could affect the fund's investment strategy, flexibility and returns. Under this scenario, fund investors, quite naturally, may not wish to invest in a vehicle that is subject to these additional restrictions and could withdraw their investment positions. This is just one example of how these overly restrictive rules could lead to unintended results.
Similar complexity is found in the final rule's limits on relationships that involve FHCs having "routine management or operational control" over a portfolio company. The final rule has restrictions on the types of covenants and agreements that FHCs may use to restrict the activities of portfolio companies -- restrictions that, as pointed out in detail in the testimony of Peter A. Grauer of Credit Suisse First Boston, prevent the type of covenants that are commonly used by securities firms to protect their merchant banking investments. The final rule also contains a variety of restrictions on the types of FHC employees and officers that may be involved in the portfolio company. SIA submits that FHCs require greater flexibility than is afforded by these provisions. FHCs have no intention, interest in or expertise in running the day-to-day operations of portfolio companies in a manner that would contravene the "banking and commerce" demarcation of the GLB Act. FHCs, however, do require the ability to impose various activities restrictions on and establish certain employee relationships with portfolio companies to protect their investment positions in such portfolio companies.
SIA respectfully submits that the statutory objectives of the GLB Act and the safety and soundness concerns of the Board and Treasury can be best addressed through a combination of
(a) rules that are far less restrictive and complicated than what has been adopted, and
(b) appropriate supervisory guidance, such as the Supervisory Letter that the Board issued in June 2000. It is plain that securities firms that are not part of a FHC family do not face the types of detailed and burdensome restrictions that are set forth in the final rule. As a consequence, and because merchant banking is such an important part of the business of many securities firms, the final rule promulgated by the Board and Treasury may deter some securities firms from becoming FHCs and may limit affiliations between securities firms and banking companies.
B. Particular Issues.
Particular aspects of the final rule also trouble SIA. To cite one example, the final rule retains the interim rule's arbitrary limits on the ability of FHCs to hold investments beyond 10 years (or 15 years for private equity fund investments). These pre-set holding periods are plainly at odds with the flexible limits mandated by Congress in the GLB Act. The GLB Act permits FHCs to hold merchant banking investments for such period of time to "enable the disposition thereof on a reasonable basis consistent with the financial viability" of the investments and specifically avoids placing any pre-set time limit on how long investments may be held. The legislative history clearly supports this reading.
By imposing a rigid and artificial time frame on holding investments, the final rule not only ignores the unequivocal congressional directive but also may cause FHCs to sell certain investments prematurely, rather than when financially optimal, to avoid having to apply to the Board for an extension and to avoid the mandatory additional capital charge on investments held for longer than the prescribed time period. This outcome does not make sense from a safety and soundness perspective.
Similarly, SIA remains concerned about the yet undefined reporting requirements in the final rule. In promulgating their final rule, the Board and Treasury have reaffirmed that FHCs will be required to submit quarterly reports on their merchant banking portfolios and annual information with details on particular merchant banking investments, including anticipated exit strategies. SIA believes that detailed reporting requirements will impose needless costs on merchant banking activities, are unnecessary given the other forms of regulatory supervision to which FHCs are subject and flatly contradicts the GLB Act's dictate to the Board to reduce the regulatory burden that it inflicts on FHCs. SIA also is concerned about the requirement to disclose divestiture plans, which it believes serves no legitimate regulatory purpose and could unnecessarily limit a FHC's flexibility. For these reasons, SIA urges the Board and Treasury to streamline the number and scope of the reports that will need to be filed by FHCs.
II. The Capital Proposal
As with the final merchant banking rule, the revised capital proposal represents a measured improvement over the Board's original proposal of March 2000. The revised proposal -- by replacing the excessive 50% capital deduction with a sliding scale deduction based on the ratio of total non-financial investments to Tier 1 capital -- imposes a less onerous capital requirement on banks, bank holding companies and FHCs engaged in merchant banking and other non-financial equity investment activities than the Board's original proposal. In addition, SIA agrees with the agencies' decision not to apply the capital deduction to investments made through Small Business Investment Companies ("SBICs"). Despite these improvements, SIA believes that the instant proposal continues to unduly restrict and interfere with the merchant banking and other equity investment activities of bank-affiliated securities firms.
A. Internal Capital Models .
SIA continues to believe strongly that the Board and other bank regulatory agencies should allow firms to rely fully on internal capital allocation models to control the risks of non-financial investment activities. Each institution's internal capital model can best measure and capture the complexity of that firm's merchant banking and non-financial investment program, accounting for the risks and capital needs that are specific to the nature and level of the firm's portfolio investment activities. In addition, internal models can be fine-tuned on a continuous basis to accommodate developments and changes in economic, investment and portfolio conditions in a manner that the proposed rules simply cannot.
The regulatory agencies express concern in their rulemaking proposal about the differences in the level of sophistication of models at various organizations; SIA submits that this issue can best be addressed through supervision and examination. If a particular institution's capital allocation model, in conjunction with other aspects of its risk management program, is found to be inadequate by examiners, then that institution -- and only that institution -- should be required to hold additional capital commensurate with the level of its merchant banking investment activities and the deficiencies found in its capital model. This individualized approach has the decided advantage of ensuring that each institution develops and maintains sound internal capital and risk management systems and of targeting supervisory and examination resources to precisely those institutions that evidence material capital allocation and risk management deficiencies.
In addition, reliance on an internal model/supervisory framework serves to encourage institutions to improve continuously risk management systems and capabilities so as to produce more sophisticated, reliable and accurate capital measurements. By contrast, the approach taken by the agencies in their rulemaking -- by applying the same capital charge to all institutions that make the same level of merchant banking and non-financial equity investments as a percentage of their Tier 1 capital -- penalizes institutions regardless of how carefully they monitor and manage their portfolio investment activities.
The agencies acknowledge that reliance on internal models represents a preferable method for determining the capital adequacy of an organization and yet reject such reliance because they regard internal models to be "untested." SIA submits that, in taking this position, the agencies have ignored the fact that securities firms and banking organizations have for many years actively participated in the venture capital markets relying exclusively on internal risk management systems -- including capital allocation models, valuation policies, internal reporting and similar safeguards -- without any additional external capital requirements of the sort proposed now. The industry's current risk management and capital allocation systems have allowed securities firms to make non-financial equity investments prudently and properly for decades, through both substantial bull and bear markets, without significant problems.
B. Investments Made Pursuant to Pre-Existing Statutory Authorities .
SIA also is disappointed with the decision of the regulatory agencies to apply the proposed capital charge to investments held under statutory authorities that pre-dated the GLB Act (such as section 4(c)(6) of the Bank Holding Company Act ("BHC Act")). As SIA and others have pointed out both to Congress and the relevant regulatory agencies, bank-affiliated firms have long made investments under section 4(c)(6) of the BHC Act and other statutory authorities without any risks to safety and soundness. For this reason, investments made under section 4(c)(6) should be excluded from the capital charge in the same manner as investments made through SBICs.
In addition, SIA strongly believes that, regardless of what regulatory capital standard is ultimately adopted, the retroactive imposition of any additional capital requirements to the existing equity investments that are already on the books of securities firms that are affiliated with bank holding companies and FHCs is fundamentally unfair, unjustified and unnecessary. Imposing a capital charge on these investments, without any evidence that such investments pose a safety and soundness risk, would penalize institutions for engaging in long permissible activities.
SIA respectfully submits that imposing a capital charge retroactively is akin to altering the rules in the middle of a game, and doing so could have adverse consequences. Specifically, the capital charge would change the economics of existing equity investments, lessen the profitability of investments and may even turn some otherwise profitable investments into unprofitable ones. As a result, at the worst, changing the capital requirement for these investments could lead some institutions to sell certain perfectly safe and prudently managed investments, which sale could have an adverse impact not only on the bank, bank holding company, or FHC that holds the investment but also the portfolio company whose shares are being sold.
SIA will submit other detailed comments on the capital proposal in a comment letter that will be submitted to the agencies later this month.
III. Conclusion
SIA is pleased with a number of the changes made by the regulatory agencies to the initial merchant banking rule and capital proposal that were issued last March, but SIA strongly believes that more changes can and should be made. SIA hopes that this hearing -- like the previous hearing held by Chairman Baker and the Subcommittee on Capital Markets -- will push the Board, Treasury and the other regulatory agencies to re-examine their rules and to rely to a far greater extent on the industry's existing practices and the regulatory agencies' ample supervisory authority. SIA looks forward to continuing the dialogue with Congress and the regulatory agencies regarding these merchant banking rules and, ultimately, to crafting rules that will advance the goals of financial services reform, safeguard safety and soundness of FHCs and their affiliated depository institutions, and truly achieve the "two-way street" contemplated by Congress in the GLB Act.