WASHINGTON - The Federal Reserve Board issued guidelines Thursday to help banks comply with new rules on merchant banking, but industry officials remain anxious about unresolved capital requirements.
The guidelines were provided in a 16-page letter to examiners and the nearly 7,000 financial holding companies and state member banks regulated by the Fed.
They emphasize active involvement by senior managers, improvements in public disclosures, and careful scrutiny of overlapping financial relationships with investment partners.
The expanded powers to invest in nonfinancial companies are among the most celebrated plums of the Gramm-Leach-Bliley Act of 1999, but they have sparked intense controversy. The Fed and Treasury Department issued an interim implementing rule in March that imposes time and dollar restrictions on investments, while the Fed issued a separate proposal that would impose a 50% capital charge on these activities.
Though bankers have charged regulators with undercutting the law's intent to let them diversify and develop new sources of revenue, the new Fed guidelines reiterated the caution flag embodied by its capital proposal.
"While equity investments in nonfinancial companies can contribute substantially to earnings, such investments, like other rapidly growing and highly profitable business lines, can entail significant market, liquidity, and other risks," according to the guidelines. "Such activities can also give rise to increased volatility of earnings and capital."
Fed officials, however, said the guidelines are meant to be as flexible as possible and to stress to examiners that standards must be adjusted to fit the size and riskiness of a financial institution's investment holdings.
"We have tried to put in writing sound practices based on reviews in the past and on discussions with banking organizations," said Richard Spillenkothen, the Fed's supervision director. "We were trying to take a risk-focused approach. We are not taking a one-size-fits-all approach."
Experts who read the document said they found no surprises, nor did they uncover any hints whether the Fed plans to revise its capital plan.
"This is a prudent move by the Fed" and raises no new issues of regulatory burden, said Richard M. Whiting, executive director of the Financial Services Roundtable. "It does highlight the Fed's belief that this is a potentially more risky activity than others."
The Fed said it expects directors to be heavily involved in all aspects of merchant banking. Board members should approve investment policies and objectives, establish specific limits on aggregate investments and geographic concentrations, and "actively monitor" the performance and risk profile of their holdings.
Stressing the importance of market discipline, the Fed said banks should improve their public disclosures. "It is in the interest of the institution itself, as well as its creditors and shareholders, to disclose publicly available information about earnings and risk profiles," the guidelines said. Among other things, companies are expected to report the size of their portfolios, the mix of public and private holdings and other specific characteristics of overall investments. The companies should disclose details on the purchase price, book value, and market value of investments, as well as gains and losses.
The guidelines warn that companies will have to pay special attention to avoid conflicts of interest and ensure that any loans to, or other relationships with affiliated companies, are conducted at arm's length.
That includes a host of transactions including, for example, loans to private equity-financed companies in which the banking organization has no ownership stake but where borrowing companies are owned by partners in its other investments.