WASHINGTON - Federal Reserve examiners may be broadly defining merchant banking to include high-tech joint ventures and could force banks to move these investments to holding company units.
"I was stunned," said John L. Douglas, chairman of the financial services practice at the Alston & Bird law firm in Atlanta, who is working with a bank that is under pressure from the Fed.
Mr. Douglas, a former general counsel at the Federal Deposit Insurance Corp., said bank subsidiaries are freer to deal with affiliates than are holding company units.
The Office of the Comptroller of the Currency has let national bank subsidiaries form joint ventures with data crunchers, Internet services providers, and other technology firms by defining these services as "incidental" to banking.
Typically, the ownership of these subsidiaries is divided among the bank, a high-tech company, and outside investors. Often the technology firms involved are start-ups and are using deals with banks to jumpstart their business. But experts said that the investments differ from merchant banking because they are being done to provide a service to customers and are connected with banking.
"The notion that the Fed would be involved in regulating national bank joint ventures is something that I can assure you the industry would be very concerned about," said William J. Sweet Jr., a partner at the Skadden, Arps, Slate, Meagher, & Flom law firm in Washington.
"Among the mid-size to larger banks, this kind of joint venture has been critical to their ability to form strategic partnerships with dot-com companies where an agreement to provide services or obtain services is typically associated with an investment interest in the dot-com directly or in a joint venture," Mr. Sweet said.
Deals between banks and high-tech information services companies have been multiplying in recent months.
Bank of America and Ariba Inc., a software firm based in Mountain View, Calif., announced last week that they were forming a joint venture company, Banc of America Marketplace LLC, to run a so-called "Internet marketplace" where companies can buy and sell goods. A month earlier, PNC Bank unveiled a joint venture with Perot Systems Corp. called BillingZone that would let corporations deliver and pay bills over the Internet.
Small banks are inking similar deals. City National Bank of Charleston, W.Va., bought an Internet services provider and Web site development firm in 1998 and provides online access to customers. Lamar Bank based in Purvis, Miss., teamed up last year with a computer maker and a cellular phone company to provide customers with low-cost personal computers and discounted Web access.
A Fed spokesman declined comment Monday, and bankers are reportedly trying to persuade Fed higher-ups to get examiners to back off. Some national banks are also planning to raise their concerns with the Office of the Comptroller of the Currency, where an agency spokesman declined comment.
But if the Fed persists, the move is sure to ignite another turf war with the comptroller, which regulates national banks. The two agencies battled last year when Congress was debating the Gramm-Leach-Bliley Act of 1999. The law drew a line between banking and commerce but did allow limited, nonfinancial equity investments. However, lawmakers said only holding company units may engage in merchant banking for at least five years.
One of the key advantages of using a direct subsidiary, experts noted, is that banks generally own more than 25% of these joint ventures and escape the so-called 23A and 23B limits on transactions between affiliates, which are named for the sections in the Federal Reserve Act where they are found. Chief among these limits is that loans to, or investments in, any single affiliate may not exceed amounts equal to 10% of capital. Credit extended to, or investments in, all affiliates may not exceed 20% of capital.
The Fed and Comptroller's Office sparred over the application of these limits several years ago - after Comptroller Eugene A. Ludwig began expanding bank subsidiary powers in 1996 - but never reached a solution.
The Comptroller's Office has argued that national banks are its territory and that banks' ability to process financial or economic data or to sell excess computer capacity was settled long ago. But the Fed has told at least one bank these limits apply to joint ventures.
"I would worry that a wooden application of the 23A and B rules would cut off opportunities that could be quite low risk and quite beneficial to the bank," said Mr. Ludwig, who left the comptroller's office in 1998 and is now managing partner of a start-up investment banking firm called Promontory Capital Group.
If deemed merchant banking, these activities would also be subject to tough capital rules proposed by the Fed on March 17. The plan would require a financial holding company to deduct 50 cents from the Tier 1 capital of its consolidated holdings for every $1 invested in merchant banking activities. Comments are due May 22.