WASHINGTON - Federal Reserve Board and Treasury Department officials were warned Wednesday to clear final merchant banking rules with Congress.

"Our purpose here is to ensure that the two-way street Congress constructed is not converted into a one-way street, or worse, a parking lot," said Rep. Richard H. Baker, R-La.

The chairman of House Banking's capital markets subcommittee convened the first of two congressional hearings on how the regulators are interpreting the merchant banking powers awarded by the Gramm-Leach-Bliley Act of 1999. The Senate Banking Committee has scheduled a hearing for June 13.

Industry leaders claim the Fed and Treasury overstepped their authority on March 28 when they released the controversial interim merchant banking rule and the Fed proposed new capital requirements.

Expressing some frustration that lawmakers are forced to revisit Gramm-Leach-Bliley just seven months after its enactment, Rep. Baker said, "We don't want to be in the business of rule-writing, but we'd like to know where this is going before we read it as a final [version]."

Fed Governor Laurence H. Meyer and Gary Gensler, Treasury Under Secretary for Domestic Finance, defended the proposal and interim rule in testimony before the subcommittee. However, Mr. Meyer left the door open to some changes, saying, Critics have "raised important questions, and the Board will carefully evaluate them and modify its proposal and interim rule where necessary and in the public interest."

Steve Bartlett, president of the Financial Services Roundtable, was encouraged. "It is clear that they are beginning to hear the message: that the regulations, if enacted as proposed, will be a disaster for the economy, a disaster for Gramm-Leach-Bliley, and a disaster for the banking industry."

The Roundtable and other trade groups have charged that the rules are slapping restrictions on activities banks have been engaging in, profitably and safely, for years.

Prior to the financial modernization bill's enactment, banks were able to engage in limited merchant banking. At yearend 1999, commercial and investment banks accounted for approximately 20% of the $400 billion U.S. private equity market, Mr. Gensler said. Commercial banks held $35 billion to $40 billion, and investment banks held $40 billion.

Wednesday's hearing focused on two aspects of the planned regulations that have aroused the most controversy: a 50% capital charge for all merchant banking investments, and a cap on new merchant banking activities of $6 billion or 30% of Tier 1 capital.

The Fed-proposed capital charge would require banks to hold 50 cents for each $1 invested in merchant banking activities. The financial services industry has complained that the 50% charge is not required by law, is too high, and is too inflexible.

Mr. Meyer said the central bank extensively surveyed current industry practice and found that institutions view merchant banking activities as very risky and set aside between 25% and 100% capital against them.

Although a capital requirement is not specifically called for in Gramm-Leach-Bliley, he said, the Fed is justified in imposing it because of safety and soundness concerns.

Addressing the inflexibility of the requirement, he conceded that it would be better to have a system that allowed financial holding companies to vary capital charges with the riskiness of their investments. However, he said, companies are not yet equipped to do that.

"The underlying methodologies banks use to allocate internal capital aren't that sophisticated and don't allow banks to make those distinctions," he said.

Several lawmakers questioned the Fed's decision to apply the 50% requirement to investments made through Small Business Investment Companies, which have been highly profitable for banks and have presented no serious safety and soundness risks despite carrying only a 4% capital requirement.

Rep. Paul E. Kanjorski, D-Pa., asked the two agencies to considering creating a "carve-out" that would exempt those investments from the capital charge. Neither regulator directly responded.

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