WASHINGTON - The Federal Reserve Board's plan to impose a 50% capital charge on merchant banking activities usurps the will of Congress by preventing financial services firms from taking full advantage of the financial reforms enacted last year, critics say.

"The industry was stunned by the scope" of the Fed's Feb. 17 proposal, said Robert J. Kabel, legislative counsel for the Bank Private Equity Coalition.

"It really goes to the heart of whether or not the Gramm-Leach-Bliley Act is going to work the way it was intended to work - which was to encourage institutions to do merchant banking. If they can succeed in imposing these kinds of rules, it may not."

The Fed's proposal requires a financial holding company to deduct 50 cents from the Tier 1 capital of its consolidated holdings for every $1 invested in merchant banking activities.

The proposal, if adopted, would put a retroactive price tag on some lucrative investments.

"Some bank holding companies have used that power to make considerable profits in the venture capital business. Now, they get the bill," said Karen Shaw Petrou, president of the bank consulting firm ISD/Shaw.

Hiking regulatory capital requirements "radically revises" the profitability of banks' investments, Ms. Petrou said. "Lines of businesses that banks have been in are instantly less profitable by a significant margin."

Mr. Kabel added, "Clearly this will have an impact on how much capital the parent holding company wants to invest in future merchant banking activities."

Comments are not due on the plan until May 22, but already financial services trade groups are squawking. The extra charge would make merchant banking less profitable, which would lead to fewer institutions engaging in it, they claim.

"This really has the opportunity to undo the two-way street that the financial modernization act envisioned," said Edward J. Hill, director of regulatory affairs for the Financial Services Roundtable. "Congress did not require the Fed to set additional guidelines for merchant banking activities."

The Fed said it selected the 50% level because it mirrors the internal capital charge many banks impose on these investments. But industry sources noted that an offset: internal systems also set capital needs below regulatory requirements for other assets.

But the central bank described the steep capital charge as "necessary to prevent the buildup within banking organizations of excessive risk from merchant banking and other investment activities."

The Fed stressed that applying the 50% standard to existing investments would cause few if any financial institutions to fall below the well-capitalized level, and would leave many with room to make further investments.

But observers say that because banks would want to maintain their current cushion above the well-capitalized mark, they would be forced to post more capital. (Currently, holding companies must hold capital equal to 8% of their consolidated risk-weighted assets in order to be considered adequately capitalized by regulators. At 10% they are considered well-capitalized. The industry average is roughly 13.5%.)

Investments covered by the proposal include any equity holdings in nonfinancial companies and any debt holdings that are convertible into equity. It also applies to credit extended to companies in which the financial holding company owns 15% or more of total equity.

The proposal makes exceptions for short-term secured loans for purposes of working capital, for debt that is at least 50% syndicated to other institutions, for government-guaranteed debt, and for credit collateralized under the Federal Reserve Act's Section 23A.

The 50% capital charge applies not just to newly authorized merchant banking activities, which became legal for financial holding companies under the Gramm-Leach-Bliley Act, but to activities banks already engage in. For instance, the Fed's Regulation K and Section 24 of the Federal Deposit Insurance Act allow bank holding company affiliates to make limited investments in nonfinancial companies.

The Fed proposal would subject all such investments to the 50% capital charge. Up to this point, such assets have been subject to the same 8% capital charge that applied to the rest of an institution's holdings.

The capital proposal accompanied an interim rule to implement the merchant banking provisions of the financial reform law. The rule limits the amount of a holding company's merchant banking investments to the lesser of 30% of Tier 1 capital or $6 billion. Most investments must be sold within 10 years, and holding company personnel are barred from participating in the day-to-day management of companies in which it invests. These provisions are already in effect, but the Fed is taking comments on them until May 22.

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