WASHINGTON - Federal regulators issued a rule Friday that, effective immediately, lets financial holding companies make a wide variety of investments, including taking 100% ownership of nonfinancial companies.
However, the Federal Reserve Board and the Treasury Department imposed a $6 billion cap on merchant banking and generally limited investments to 10 years. Under a separate proposal, financial holding companies would face a stiff capital charge equal to 50% of investments.
The rule and proposal are a blow to banking industry executives who had urged regulators for weeks not to impose new capital requirements or impose time limits on investments. The expanded merchant banking powers are the most coveted benefit of the Gramm-Leach-Bliley Act of 1999, which overhauled the nation's financial laws.
The rules "take the most attractive new investment authority granted banks and put a huge set of brakes on it," said Robert J. Kabel, legislative counsel for the Bank Private Equity Coalition. "It really flies in the face of what the Congress had in mind."
William H. McDavid, general counsel at Chase Manhattan Corp., said the rules will give brokers and insurers an advantage over banks.
The new law permits banks, securities firms, and insurance companies to own each other, but requires such conglomerates to form financial holding companies regulated by the Fed. Brokers or insurers that do not want to buy a bank do not have to form financial holding companies, and face few restrictions on merchant banking.
"This is a rule that would be applicable to financial holding companies but would not be applicable to competitors," Mr. McDavid said. "It has the potential of creating an inequality inconsistent with the thrust of Gramm-Leach-Bliley and could discourage companies not subject to Fed regulation today from ever becoming financial holding companies."
Financial Services Roundtable lobbyist Lisa McGreevy called the rules "unduly harsh."
"The regulators were not required by Congress to issue any regulations in this area," she added.
But Treasury Under Secretary for Domestic Finance Gary Gensler said the rules are necessary to ensure the law's mandates are followed, particularly its provisions barring permanent mergers between banking and commercial companies. "There's an importance to keeping a separation between banking and commerce," he said Friday.
The law did not specifically require new capital rules, but the Fed and Treasury said that they are necessary to protect the financial integrity of diversified financial companies, many of which will be embarking on venture capital and other merchant banking activities for the first time.
But they insisted that capital requirements, limits on the how long an investment may be held, and other limits correspond with current industry practices and in many cases are more generous. They stressed that the rule and capital proposal should not deter companies from taking advantage of the new law.
"With virtually no exception, bank holding companies would remain well capitalized on a consolidated basis even after applying the proposed capital charge on all of the investments currently made by these companies," according to the proposal. "Nearly all of these companies would be able to increase significantly their level of investment activity and continue to be well capitalized on a consolidated basis after applying the proposed capital charge."
The new investment authority is significantly broader than in current law. Under the interim rule released jointly by the Fed and Treasury, a financial holding company may own an entire nonfinancial company. Previously, banking holding companies were restricted to 5% of voting shares and a 25% stake in the company overall.
But, at least until the capital rules are finalized, merchant banking investments could not exceed $6 billion or 30% of a financial holding company's Tier 1 capital, whichever is lower. A company may apply for Fed permission to exceed that cap.
The law required that these investments ultimately be resold. The rule lets financial holding companies keep their investments for as many as 10 years, but requires a divestiture plan after eight years. The Fed may grant extensions in "exceptional circumstances." The rule gives financial holding companies more flexibility to conduct merchant banking through private equity funds with other investors who could share risk.
The law also barred day-to-day management, but a holding company could hold every seat on the board of the company it invests in. No employees, officers, or directors, however, could work for the company. Exceptions could be granted if the company runs into trouble.
Regulators invited comments on the capital proposal until May 22. Not only would banks have to deduct 50% of the "carrying value" of investments - meaning the purchase price plus accrued value - from Tier 1 capital, but they would also have to deduct 100% of the investment from assets.
It applies to equity in a nonfinancial company, debt instruments that are convertible to equity, or debt that a holding company extends to a nonfinancial company of which it owns 15% or more.
- Joint press release (Source: Federal Reserve System and Department of Treasury)
- Joint interim rule - 55-page PDF file (Source: Federal Reserve System and Department of Treasury)
- Proposed rule on capital - 12-page PDF file (Source: Federal Reserve System and Department of Treasury)
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