WASHINGTON - Federal regulators are poised to propose much lower capital requirements for merchant banking investments.

The proposal, which is still evolving, is expected to use a sliding scale to link a company's capital requirements to the amount of its equity investments. The more investment, the more capital regulators will require, said sources familiar with the plan who demanded anonymity.

However, the highest capital charge is expected to be significantly below - perhaps by more than half - the 50% originally proposed in March.

Officials at the Federal Reserve Board and the Office of the Comptroller of the Currency are putting the final touches on the plan, which Fed General Counsel Virgil Mattingly this week told industry officials would be issued for public comment by yearend or in the first few weeks of January. OCC staffers are less optimistic on the timing, but it is clear the revised plan will be less onerous than the version published by the Fed in March.

Watching closely what the bank regulators do is Robert J. Kabel, a partner at the Manatt, Phelps & Phillips law firm here who represents the banks most involved in merchant banking. If the agencies adopt a sliding scale, he said, they should require less capital of firms with large portfolios.

"If it's a sliding scale that goes higher as assets increase, that's a problem," Mr. Kabel said. "If it slides down, that would certainly be preferable."

The Gramm-Leach-Bliley Act of 1999 granted financial holding companies wide latitude to make equity investments. But Congress left it to the Fed and the Treasury Department to set parameters for the new powers. The two agencies jointly proposed an interim final rule in March that laid out how these investments may be made, including a $6 billion cap and deadlines on how long an investment could be held. Treasury officials said they are trying to finalize that rule by yearend.

On its own, the Fed proposed a companion plan that would have required 50 cents of capital to be held for every $1 invested. The central bank said it based its proposal on existing practices at banks and securities firms.

But industry executives objected, arguing that the Fed had confused regulatory capital requirements with internal capital allocations - two very different calculations. A bank, for example, may hold 50% or more against a merchant banking investment, but that large reserve is offset by holding less capital than regulators require against some other asset. The industry asked the Fed to let institutions use internal systems to determine how much capital to hold.

Criticism of the Fed's plan mounted all summer as a variety of lawmakers joined the chorus, suggesting the Fed was exceeding the authority granted under the financial reform law. Lawmakers even took the unusual step of asking the Fed to brief Congress on the final rule before adopting it.

Under this pressure, the Fed decided to go back to the drawing board. In late October, Fed Governor Laurence H. Meyer said the agency would revise the plan and put it out for a second round of public comment. What's more, the Fed decided to involve the other banking agencies in drafting the revised proposal.

When a final rule is eventually adopted, it will apply to banks, their holding companies, and the diversified financial holding companies allowed under Gramm-Leach-Bliley. Like the original proposal, it is expected for the first time to impose capital requirements on investments that banks and their holding companies have been able to make for years, such as stakes in Small Business Investment Companies.

In a Nov. 16 letter to a handful of lawmakers, including Rep. Richard H. Baker, who chairs the House Banking Committee's capital markets subcommittee, Mr. Meyer acknowledged that the plan would be proposed again, but subtly refused to give Congress a peek. "The Board, of course, also will brief interested members of the subcommittee as soon as possible, once the Board takes any additional action on the interim rule or capital proposal," he wrote.

Regulators consider private equity investments to be risky long-shots where the outsized success of a few stakes covers the losses generated by the bulk of the investments. The business has grown rapidly in recent years, hitting $400 billion in 1999. Of that, roughly $125 billion is venture capital or equity financing of new firms.

The banking industry has about 10% of this business and participation is concentrated in the largest firm.

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