WASHINGTON - Industry representatives assert that the Federal Reserve's merchant banking proposal misjudges the riskiness of investments in small business investment companies and would choke off funding for hundreds of start-up firms.

The Fed in March proposed requiring financial holding companies to reserve 50 cents of capital against every dollar invested in merchant banking activities, including SBICs, which the Fed considers as risky as any other form of equity investing.

Floyd W. Collins, president of Independent Bankers Capital Fund, a Dallas SBIC, said that raising the capital requirement from the current 8% held by most banks to 50% would reduce banks' participation in his SBIC and the amount of money it has to invest in small businesses.

"Some of our bank investors have told us that with the higher requirement they would not have invested," said Mr. Collins. "With a higher reserve ratio they have less equity in the bank for traditional banking purposes."

The government created SBICs in 1958 to channel venture capital into small businesses. Banks may own SBICs directly or invest in independent SBICs like the one run by Mr. Collins. According to the Small Business Administration, there are 101 bank-owned SBICs in the United States, with $5.3 billion of assets, or 61% of all SBIC assets. In 1999, SBICs invested $4.2 billion in U.S. companies, most of which had been in business for fewer than three years.

In testimony before Congress last week, Lee W. Mercer, president of the National Association of Small Business Investment Companies, chastised regulators for threatening the supply of funding to small businesses and said they did not have adequate information about these ventures.

Mr. Mercer told legislators that bank-owned SBICs, far from being high-risk, have actually turned a profit in every year but one since 1978. Their average annual rate of return has been 12.9%, he said.

"To seek to impose a significant arbitrary requirement in an area so important to the national well-being without broad factual analysis carries with it at least the same - if not a greater - level of risk as that the proposed regulation seeks to address," he said.

In testimony before the House Banking Committee last week, Fed Governor Laurence H. Meyer said that the central bank did not distinguish between SBIC investments and typical merchant banking investments, in part because of their high returns. "Recall the iron law that high return means high risk," he said.

The Senate Banking Committee is slated to hear testimony today from Mr. Meyer and Gary Gensler, Treasury under secretary for domestic finance.

The Fed proposal is an adjunct to an interim final rule, issued in conjunction with the Treasury, that would put separate limits on merchant banking activities as required by the Gramm-Leach-Bliley Act.

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