WASHINGTON - Bankers are calling expanded merchant banking authority the hidden gem in the new financial reform law, but they are also raising concerns that federal regulators could dull its shine with overly restrictive regulations.

The Federal Reserve Board and the Treasury Department are crafting a rule that agency officials said will be issued before March 13, the first business day that banks, securities firms, and insurance companies may begin freely merging with each other under the Gramm-Leach-Bliley Act.

Bank holding companies have been permitted to make equity investments for years. In fact, bank affiliates have poured nearly $2.9 billion into start-up companies and other portfolio investments in the past four years, according to data compiled by Venture Economics and the National Venture Capital Association. Chase Manhattan Corp. and others are attributing strong fourth-quarter earnings in large part to such investments.

But merchant banking has been heavily restricted, and only now are experts and industry executives beginning to appreciate how much this business could expand.

"This seems to me to be the most attractive of all opportunities offered by the new legislation," Fed General Counsel J. Virgil Mattingly Jr. said this week. Previous law imposed "significant restrictions on the ability of bank holding companies and their subsidiaries to make equity investments. The new merchant banking authority in the statute is a sweeping override of this limitation."

An emerging dispute, however, concerns whether the Fed will make companies hold additional capital to cover their merchant banking operations, which regulators consider riskier than traditional banking services. Mr. Mattingly has said such a requirement is under consideration, but industry officials are urging the Fed to back off.

Jeffrey P. Neubert, president and chief executive of the New York Clearing House, wrote a letter to Mr. Mattingly last Friday arguing that special capital requirements would be unfair because foreign banks, securities firms, and insurance companies would not be subject to them.

"Gramm-Leach-Bliley was clearly intended to permit bank affiliates to engage in merchant banking activities on a meaningful and competitive basis," Mr. Neubert wrote on behalf of the clearing house's nine member banks, which include Chase, Bank of New York Co., and Citigroup Inc. "The imposition of higher capital requirements on such investments would defeat that objective."

Ernest T. Patrikis, senior vice president and general counsel of American International Group Inc., agreed. When financial services companies take an investment stake, he said, it signals their confidence in its safety "They still haven't got it," said Mr. Patrikis, a former Fed official. "It's the commercial banking that is risky, not the merchant banking."

Regulators defend their concerns, saying they want to encourage banking companies to diversify but must ensure that those without experience in merchant banking are properly cushioned against losses.

The agencies might take other precautions, too.

William J. Sweet Jr., a partner at the Skadden, Arps, Slate, Meagher & Flom law firm here, said the Fed is not expected to set an explicit cap on merchant banking activities as a percentage of revenue. However, he predicted that examiners would set limits on a case-by-case basis if they see merchant banking is becoming too big a part of a company's overall business or is being managed improperly.

"Regulators don't like to see overconcentration of risk in a particular business activity," said Mr. Sweet, who helped Citicorp and Travelers Group get Fed permission to merge in 1998. "From time to time, they may find a company has too much exposure in a business … . They would be concerned you have all your eggs in one basket."

Under the law, financial holding companies will be able to invest in debt and equity securities, partnerships, trust certificates, and other instruments involving any type of business. For the first time, banking companies will be able to take a controlling stake in unrelated companies because the law eliminates the 5% cap on ownership of voting shares and the 25% limit of a company's overall equity shares.

The law sets several conditions. Investments must be made by affiliates separate from bank or thrift units. Direct bank subsidiaries are barred from most merchant banking for at least five years. Holding companies must plan eventually to sell their investments and may not be involved in daily management of a company unless it becomes troubled.

Mr. Sweet predicted that the Fed would interpret these limits broadly. For instance, he said, holding companies could probably control the board of a company, and the definition of a troubled investment would be generous.

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