CHICAGO - Federal Reserve Chairman Alan Greenspan on Thursday defended proposed rules restricting the merchant banking activities of financial holding companies.

Mr. Greenspan argued in a speech here that the proposal, roundly criticized by the industry, actually reflects the "quite conservative" approach to equity investing banks pursued before the Gramm-Leach-Bliley Act of 1999 was signed.

That financial reform law created financial holding companies and permitted them wide latitude to invest in other, nonfinancial companies.

Regulators have proposed rules to implement the new powers, and the most controversial restriction is the capital charge.

"Current interim regulations, which propose for comment a 50% capital charge on all nontrade-account equities held by banking organizations, should not be viewed separately from the current state of the economy," Mr.Greenspan said in a speech sponsored by the Federal Reserve Bank of Chicago.

The current state of the financial markets, he suggested, encourages greater risk taking in banks' investment portfolios. In developing the rules, regulators sought to limit the risk that banks could pose to the federal deposit insurance funds.

"Most bad commercial loans are made during times of prolonged financial prosperity," Mr.Greenspan said. "I suspect that the experience of bank equity investment has been similar."

Many sources expect the Fed to relax the tough limits eventually.

Asked if bankers could expect the 50% capital charge to be reduced in the future, Mr. Greenspan replied, "I would think so. … What we as regulators are trying to do … is to create a regulatory capital scheme which replicates best practices."

Financial Services Roundtable president Steve Bartlett on Wednesday led senior level executives from 14 of the group's members to discuss their objections to the merchant banking rules with Senate Banking Committee Chairman Phil Gramm, House Banking Committee Chairman Jim Leach, and Rep. John J. LaFalce, the ranking Democrat on House Banking.

"The message was unanimous: the proposed merchant banking regulations are a disaster," Mr. Bartlett said in an interview. "The Fed and the Treasury have based their regulations on a fundamentally flawed understanding of merchant banking as an activity."

The Fed has said they based the proposed 50% capital charge on current industry practices, but Mr. Bartlett said the central bank surveyed too few institutions and confused economic capital with regulatory capital. Besides criticizing the capital charge and $6 billion cap on merchant banking activities, Mr. Bartlett said Gramm-Leach-Bliley does not call for regulations on new merchant banking powers or authorize capital requirements on previously permitted investments.

However, Rep. Leach said in an interview that he will defer to regulators on the merchant banking rules. "I don't think there is likely to be a legislative cure," the Iowa Republican said. "The legislature has given the mandate to develop rules to professionals in the Fed and the Treasury. My own sense is that these rules are likely to be preliminary rules and over time they could well be adjusted."

Rep. Leach said he has no plans to hold hearings on the subject.

Dean Anason contributed to this story from Washington.

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