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Regulators adopted rules Wednesday restricting how financial companies may engage in merchant banking, but the limits were much less onerous than industry officials had feared. Acting jointly, the Federal Reserve Board and the U.S. Department of Treasury were implementing new powers granted to banking companies in the 1999 Gramm Leach Bliley financial reform act. The rules replace interim regulations adopted in March and apply only to merchant banks affiliated with financial services holding companies, such as Bank of America Corp. or Citigroup. Observers lauded the new rules, saying the agencies had curbed some of the most burdensome restrictions contained in the interim regulation. “They seemed pretty responsive to our concerns,” said Richard Whiting, executive director of the Financial Services Roundtable, a trade group for the largest banking, securities and insurance companies. “We are hopeful this will make business a little more efficient for our members.” Gone is a $6 billion cap on equity investments by merchant banking units. This is likely to benefit some of the largest financial services holding companies, including Citigroup and J.P. Morgan Chase & Co. Regulators retained a related requirement that equity investments not exceed 30 percent of capital but said that limit would be automatically dropped once a related capital rule is adopted late this year. Beth Climo, managing director of the ABA Securities Association, called the change “positive,” noting it would provide financial services companies with more flexibility in how they conduct merchant banking. While praising the changes, industry officials also said banking companies will not be able to fully enjoy the new powers until regulators revise the capital charges for merchant banking. The interim rule requires banking companies keep 50 cents in reserve for every $1 invested. That amount is so high that it makes merchant banking unprofitable for many institutions. The Federal Reserve considered behind closed doors an alternative plan that would permit a bank to make equity investment equivalent to 5 percent of their capital without additional reserve requirement. Once a banking company exceeded 5 percent, it would have to hold increasingly more capital until topping out at a 25 percent reserve requirement. Fed Governor Edward Kelley said he expected the capital rule will be finished within two months, though industry experts said three to four months is more realistic. It would then be released for 60 days of public comment and likely become final a month or two later. William Sweet, a partner in the Washington, D.C., office of the Skadden, Arps, Slate, Meagher & Flom law firm, said he was disappointed regulators did not approve the capital rule Wednesday. “It is a punt on the big issue which is capital, but we will get to it eventually,” Sweet said. Regulators Wednesday did retain a requirement that merchant banks only hold equity fund investments for up to 15 years and stakes in companies for up to 10 years. But it eased the restriction slightly by allowing merchant banks to ask 90 days before the time period expires for an extension. A merchant bank previously only could ask for the extension a year before the time period expired. Other changes included: Easing restrictions on having employees work for the financial services company and the firm receiving equity investments from the merchant bank. Allowing banking companies that underwrite municipal securities directly in a bank to qualify for the new powers even though they do not operate a separate securities affiliate. Establishing safe harbors from rules that limit cross-marketing by affiliated merchant and commercial banks. For instance, the restriction will not apply if the merchant bank does not control the private equity fund that it invested in. See Related Chart Copyright (c)2001 TDD, LLC. All rights reserved.

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