he merchant banking rule adopted by federal banking regulators came under attack for violating the "two-way street" envisioned by the Gramm-Leach-Bliley Act during recent congressional hearings. Securities firms not part of a financial holding company family do not face the detailed restrictions set forth in the rule, observed the Securities Industry Association, and consequently, because merchant banking is such an important part of the business of many securities firms, the rule may deter some securities firms from becoming FHCs and limit affiliations between securities firms and banking companies.

In defending the rule before a joint House subcommittee, Federal Reserve Board Governor Laurence H. Meyer maintained that the rule adhered to the Gramm-Leach-Bliley vision of allowing merchant banking activities subject to necessary restrictions. Restrictions in the rule are firmly grounded in GLB's requirements for permissible merchant banking investments, he believes.

Merchant banking is generally the business of making private equity investments in non-financial firms, in particular equity investments having a venture capital character. Earlier this year, the merchant banking rule was jointly issued by the Federal Reserve Board and the Treasury Department.

The SIA and its member firms are deeply concerned about the restrictions imposed by bank regulators on the equity investment activities of bank-affiliated securities firms. The SIA told Congress it is worried that the rule effectively closes the "two-way street" between the securities and banking industries that is at the very core of the Gramm-Leach-Bliley Act.

Generally, the final rule presents a highly complex and overly burdensome array of restrictions on merchant banking activities that, in the SIA's view, are neither mandated by legitimate safety and soundness concerns nor in keeping with the language and spirit of the Gramm-Leach-Bliley Act, which sought to promote venture capital activities. In addition, in a number of respects, the rule does not fully reflect the manner in which securities firms conduct their venture capital activities.

The banking regulators, said the SIA, continue to operate on the faulty premise that merchant banking poses substantially greater risks than other permissible activities. This premise ignores the fact that securities firms, including those affiliated with banks, have a long and exemplary record of successfully managing merchant banking investments.

Moreover, the regulators ignore the fact that Congress was fully aware of the risks posed by merchant banking activities and adopted a full set of measures in Gramm-Leach-Bliley to guard against those risks. As an initial matter, Congress granted merchant banking authority only to financial holding companies, which by definition have depository institutions that satisfy well-capitalized and well-managed standards.

Congress also:

• prevented merchant banking investments from being held by depository institutions;
• adopted special rules under the Federal Reserve Act to govern transactions between merchant banking portfolio companies and commonly controlled depository institutions; and
• imposed a moratorium that, at least for the next four years, prevents the financial subsidiaries of depository institutions from engaging in merchant banking activities.

Congress has never indicated, emphasized the SIA, that these restrictions had to be supplemented with additional ones.

In addition to addressing the risks associated with the activity, Congress authorized securities firms affiliated with FHCs to engage fully in the business of merchant banking. Congress further emphasized that such firms should be permitted to conduct merchant banking activities in substantially the same manner as their competitors that are not affiliated with banking organizations.

In the SIA's view, the current merchant banking rule does not achieve these goals. The SIA urged the banking agencies to ultimately fashion rules that permit full and fair competition in the capital markets by all of the participants in a unified financial services industry in the manner that Gramm-Leach-Bliley envisions.