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When President Clinton signed the Gramm-Leach-Bliley Act into law in November 1999, he vowed that the measure reforming Depression-era banking laws would stimulate greater competition and dealmaking in the financial sector. More than one and a half years later, such goals have yet to be fully realized. Rather than subject themselves to greater regulation, financial firms are avoiding bank charters and finding other ways to get into the banking business. The result is a growing divide between the newly created financial services holding companies such as Bank of America Corp. and their rivals without bank charters such as Prudential Insurance Co. of America and American Express Co. Experts said the faults with the financial reform law are seen most clearly in the ongoing fights over bank acquisitions of real estate brokerages and over merchant banking rules. The real estate issue pits the banking industry against the National Association of Realtors. The banks requested that the Federal Reserve Board and the Treasury Department declare that acting as a real estate agent or property management broker is closely related to a financial activity and thus permitted under the 1999 law. ONE-STOP SHOPPING Their goal was to let banks buy real estate agencies and property management companies so a customer could get one-stop shopping for home-buying or office-leasing experience. This is similar to the type of service already offered by some of the largest real estate agencies, such as Long & Foster, Cendant Corp. and GMAC Home Services Inc. They tout in advertisements the ability to keep the transaction within a single family of companies as an advantage to the consumer. The banks argued this is a virtually risk-free business because they would be acting as an agent, not a principal. Also, they noted that they have enormous experience with real estate because of their residential and commercial mortgage businesses. But the Fed’s proposal to let banks offer this same experience by acquiring real estate agencies has set off a firestorm of protest from realtors. In letters to the Fed and to President Bush, the National Association of Realtors argued: “The proposal is illegal because the Fed may only grant new powers based on changes in the financial services marketplace or in technologies used to deliver these services. Neither has changed materially in the past two years. “ BAN ON MIXING Real estate brokerage is a commercial activity — not a financial activity. That means any financial firm affiliated with a bank may not enter real estate brokerage because Congress left intact the ban on mixing banking and commerce. Congress implicitly banned banks from real estate brokerage when it did not include it in a list of activities in the 1999 act that were deemed to be financial in nature and thus permitted for banks. Consumers would suffer because the goal of bank-owned brokerages will be to push mortgages and other products offered by their parent company rather than to find the best housing alternative for home buyers. Opening the business to banks would result in the failure of many independent realtors. The resulting concentration would limit consumer choice and cause higher prices. The banking industry refutes all these charges. It has said that Congress intended for banks to enter the business, that real estate is a financial activity because a home is the typical consumer’s largest asset and that mixing mortgage banking and real estate brokerage is already occurring with few consumer complaints. HARMFUL INTERVENTION But bank advocates argue the stakes here are far greater than just whether banks will acquire real estate agencies and property management companies. “This is the big test because it is a question of how forward-looking these regulators will be in defining what is financial in nature,” said Bert Ely, president of industry consulting firm Ely & Co. “If they come down on the side of the Realtors, that will effectively gut Gramm-Leach-Bliley.” In the eyes of bankers, intervention by lawmakers would be especially harmful. “There is a real concern that if the Congress moves to stop the agencies from making this determination, then the effect would be to unwind Gramm-Leach-Bliley,” said Jim McLaughlin, director of regulatory and trust affairs at the American Bankers Association. “It would indicate that there was no intent to have a level playing field for competition for financial services.” The comment period on the proposal closed May 1, and the agencies are not expected to act before the end of summer. The battle over merchant banking rules is less political, though it raises many of the same issues. The 1999 law expressly lets banks enter the merchant banking business, but it gives the Fed and Treasury the power to regulate this activity. Federal regulators fear problems at a merchant banking unit could be so great that they would drag down any affiliated banks regardless of whether the bank has separate capital reserves. To protect the federally insured bank, regulators have imposed capital requirements and other restrictions on merchant banks that are affiliated with commercial banks. Independent merchant banks are not subject to these same restrictions. This has led to howls of protest from commercial bankers and merchant bankers, who argue that it effectively creates an unfair environment based solely on whether the parent company also happens to own a federally insured bank. COMPLEX RULES The independent merchant banks — which consist of the hundreds of venture capital firms that fund start-up businesses — complain that the regulations effectively bar them from acquiring a commercial bank, with which they could provide their clients with traditional loans as well as venture capital financing. This is because these venture capital firms would have to subject themselves to rules that are extremely complex. For example, there is a five-part definition of what constitutes a private equity fund. The regulations also would impose new limits on venture capitalists, such as a 10-year cap on holding equity investments and a restriction on their ability to take over companies when management fails to make the business work. Adding further troubles for VCs who want to be affiliated with a bank are capital requirements that range between 8 percent and 25 percent of venture capital investments, with the higher reserve requirement being triggered as the percent of assets devoted to venture capital exceeds a quarter of all capital. This led the Securities Industry Association to complain to Congress in April that regulators were abusing their authority. “Congress … 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,” SIA told the House Financial Services Committee: “The current merchant banking rules do not achieve these goals.” While regulators have finalized merchant banking rules, some large banks and securities firm are pushing for lawmakers to reopen the subject by either passing legislation or pressuring lawmakers to eliminate some of the new merchant banking rules. The issue could heat up in Congress this fall. FINANCIAL RESTRUCTURING Some argue that the ability to offer nearly identical products as a bank without actually getting a bank charter has contributed to the relative paucity of bank acquisitions by insurance companies and securities firms. Instead, the vast bulk of deal activity has been banks buying into other financial industries. One way to gauge the appetite for banks is to see how many firms have undertaken the necessary restructuring to make such an acquisition possible. Though no formal list is kept of nonbanks switching to financial holding companies, Federal Reserve data shows that nearly all of the 537 conversions through the end of May involved banks becoming financial holding companies. Fewer than a dozen appeared to involve nonbanks. The only major exceptions are Charles Schwab Co. and MetLife Inc. This is significant because a financial firm may not buy a bank without first becoming a financial services holding company. Some argue that the only reason the bank charter remains popular with the large commercial banks is because they can leverage their business loans into work for their securities units. “Clearly a bank cannot go and say that in order to get a loan you have to let us be your underwriters,” one industry expert said. “That is illegal. But it can be implied.” H. Rodgin Cohen, managing partner of Sullivan & Cromwell, said the fight over real estate brokerage and merchant banking is indicative of the bigger battle over how the banking, securities and insurance industries will compete. “If you accept Gramm-Leach-Bliley on its face as saying that competition is in the public interest, then it comes down to whether we will make these decisions in the public interest or the special interest,” he said. COMPETING BUSINESS MODELS But Bill Sweet, a partner in the Washington, D.C., office of Skadden, Arps, Slate, Meagher & Flom, argues that lawmakers never intended to make the battleground completely fair because that would have been politically impossible. Instead, they retained numerous types of charters and business models that can compete against each other. “You will find that financial competitors can exist alongside banking organizations and provide similar products,” Sweet said. As long as that remains true, don’t expect banks to be gobbled up by insurers and securities firms. “People expected a consolidation amongst all the industries, which if you look back at the speeches, was not the same as what the leaders of the industry said they wanted,” Sweet said. But Peter Wallison, a fellow at the American Enterprise Institute and former Reagan administration Treasury Department official, blames the problems on Capitol Hill. “Congress retained restrictions on what a bank could be affiliated with,” he said. “They did that because they still have in mind the fundamentally silly idea that there is a reason to separate banking from other types of activities. As long as Congress thinks that makes sense, you won’t be able to have companies that own banks compete on a level playing field.” Copyright (c)2001 TDD, LLC. All rights reserved.

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