LETTER TO THE FEDERAL RESERVE
RE: MERCHANT BANKING REGULATIONS

Dated: May 22, 2000

Ms. Jennifer J. Johnson
Secretary
Board of Governors
Federal Reserve System
Washington, D.C.20551

Dear Ms. Johnson:

On behalf of the American Association of Bank Directors, I wish to comment on the interim rule on merchant banking activities published at 65 Federal Register 16459 (March 28, 2000). We believe that one of the provisions of the interim rule is unduly restrictive and has the unintended effect of barring many community financial holding companies from offering merchant banking services as permitted by Section 4(k)(4)(H) of the Bank Holding Company Act, as amended ("BHC Act"), to their customers.

The American Association of Bank Directors advocates the position that boards of directors of commercial banks and savings institutions, whether serving in large or community organizations, should be permitted to be as free as possible to exercise their good faith judgment in supervising their institutions. This includes decisions on the financial activities appropriate for their institutions. We recognize that principles of safety and soundness should limit the discretionary authority of bank boards of directors. However, we are in favor of the federal banking agencies interpreting the law in a manner, consistent with safe and sound banking principles, that allows bank boards to exercise good faith judgments without unnecessary restrictions.

Section 225.170(f) of the interim rule requires that in order to utilize the merchant banking powers under Section 4(k)(4)(H) of the BHC Act, a financial holding company must have either a "securities affiliate" or an insurance affiliate with an investment adviser affiliate. Section 225.170(f)(1) of the interim rule defines "securities affiliate" as a company that is registered with the Securities and Exchange Commission ("SEC") as a broker or dealer under the Securities Exchange Act of 1934. In the prefatory material to the interim rule, the Board of Governors and the Secretary of Treasury request comment on whether this or another definition is appropriate, and whether expertise or policies developed in the course of conducting specific types of securities activities may be necessary or appropriate for making merchant banking investments in a safe and sound manner.

For most community bank organizations, the establishment and maintenance of a broker-dealer registered with the SEC would be unduly burdensome, expensive and unnecessary in order to carry out the merchant banking activities authorized by law. In addition, such a requirement is not required by law or by principles of bank safety and soundness.

The statute does not define "securities affiliate", and there is no suggestion (as far as I can determine) in the legislative history of the Gramm-Leach-Bliley Act (which added Section 4(k)(4)(H) to the Bank Holding Company Act) that "securities affiliate" means only an SEC-licensed or regulated entity. The Board of Governors has the discretion to define the term more broadly to encompass, for example, any affiliate that engages predominately in the purchase, sale, or underwriting of, or investment in securities as principal or agent.

There is also no bank supervisory reason to define "securities affiliate" to mean a broker-dealer registered with the SEC. The skills required to make merchant banking investment decisions may or may not reside in those who are employed by broker-dealers. In addition, there are many qualified individuals who are not employed by broker-dealers who have expertise in making merchant banking investments, and are either employed or may be hired by banks. Merchant banking activities are defined extremely broadly and certainly entail activities for which a broker-dealer registration is not required.

The important point is that for a financial holding company that wishes to engage in merchant banking activities, it should not matter whether or not it has an affiliate that is registered as a broker-dealer. What matters is that it employs qualified individuals to manage the particular merchant banking activity under reasonable policies, procedures and systems. These qualified individuals are either already employed by the financial holding company or are available for hire in the marketplace, whether or not the financial holding company has an affiliate registered with the SEC.

The interim rule also places substantial safety and soundness restrictions on merchant banking activities that make it unnecessary to also impose a requirement that the financial holding company control an affiliate that is registered as a broker-dealer. The interim rule requires the adoption of written policies, procedures and systems to manage the risks associated with making merchant banking investments. A system to manage such risks entails the retention of qualified management and staff. The interim rule also includes a limitation on aggregate merchant banking investments of 30% of capital; limitations on the time that the institutions may hold the investment and on the liability that an institution may assume in connection with the investment; and the requirement that the merchant banking activity be part of a bona fide underwriting or merchant or investment banking activity.

In sum, there is no good reason from a bank supervisory standpoint to adopt a requirement that a financial holding company maintain a registered broker-dealer to engage in activities that may not require such registration under current securities laws. Such a requirement is not an issue for many large financial holding companies, which already have established registered broker-dealers because they engage in securities activities that require registration. But for those financial holding companies that do not have broker-dealers because they do not engage in securities activities requiring registration, the establishment and maintenance of such broker-dealers is an unnecessary burden. For many community financial holding companies, the requirement will be an insurmountable burden and will result in them being precluded from engaging in merchant banking activities authorized by Section 4(k)(4)(H).

We request that the Board of Governors amend the interim rule to eliminate the provision requiring financial holding companies to have an affiliate registered as a broker-dealer with the SEC, and adopt a definition that broadly defines the securities affiliate in a manner that will permit both large and community based financial holding companies to establish merchant banking activities in accordance with safe and sound banking practices.

Sincerely,

David Baris
Executive Director

cc: Merchant Banking Regulation
Office of Financial Institution Policy
U.S. Department of the Treasury