Letter from NASBIC President Lee Mercer to the Board of Governors of the Federal Reserve System and the U.S. Department of Treasury stating NASBIC's position that bank investments in SBICs should be exempt from the proposed merchant banking capital requirements

May 22, 2000

Ms. Jennifer J. Johnson
Secretary
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, D.C. 20551

Merchant Banking Regulation
Office of Financial Institution Policy
U.S. Department of Treasury, Room SC 37
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Dear Ms. Johnson and Sir or Madam:

On behalf of the National Association of Small Business Investment Companies (NASBIC), I am writing with respect to the referenced proposed merchant banking capital requirement. For the reasons stated, we believe the bank investments in SBICs should be exempt from the requirements of the proposed regulation.

NASBIC is the nonprofit association that has represented the SBIC industry since 1958, the year Congress passed the Small Business Investment Act establishing the SBIC program. NASBIC works with Congress to provide the information it needs to draft well-conceived SBIC legislation and with the Executive Branch (primarily SBA) to help develop reasonable operating regulations for SBIC licensees. NASBIC also produces educational programs (e.g., the Venture Capital Institute) and publications designed to help SBIC managers and others in the venture capital industry gain the knowledge and skills required to invest successfully in small private businesses. Finally, NASBIC works with the news media and information providers to ensure that information published about the SBIC program is as complete and accurate as possible.

NASBIC appreciates the opportunity to comment on the referenced proposed regulation on behalf of both bank-owned SBICs and those SBICs that have or are seeking banks as minority investors in their funds. Both types of SBIC believe that the proposed regulation will have substantial adverse consequences to their current and future ability to raise funds for investment in the thousands of U.S. small businesses that rely each year on SBICs for critical venture capital in the $250,000 to $4 million range. In FY 1999 alone, SBICs invested $4.2 billion in U.S. small businesses, with bank-owned SBICs accounting for $2.9 billion (68%) of the total. Currently, 101 bank-owned SBICs hold $5.3 billion in capital assets—61% of the total $8.73 billion in private capital invested in all SBICs. Additionally, banks are increasingly important investors in independent SBICs, having provided 25% of the $1.76 billion in private capital held by independent SBICs licensed in the past 2.5 years.

The gross numbers tell only part of the story. By number of transactions, bank-owned SBICs accounted for 798 (26%) of the 3096 total investments made by SBICs in FY 1999. The average investment for bank-owned SBICs was approximately $3.6 million; the more important median was approximately $1 million. To put these numbers in perspective, in the private equity industry as a whole, the average venture capital deal-size in 1999 was approximately $7 million and the median approximately $4 million. For non-bank SBICs, the FY'99 average investment was approximately $660,000; the median approximately $400,000. These statistics indicate that bank-owned SBICs are a critical source of venture capital for U.S. small businesses whose needs have grown beyond the capacity of many non-bank SBICs but have yet to reach the level that would attract the interest of the ever-growing (in terms of capital under management) non-SBIC venture capital funds.

A regulation with the significant potential to impart a negative blow to the SBIC program as an important source of capital for U.S. business, job, and technology growth should not be imposed without a significant factual base to support it. That factual base has not been established in the proposed regulation. Specifically, we would like to draw your attention to the following points.

1. The following statement is made to justify making bank investments in SBICs subject to the capital charges of the proposed regulation: "Importantly, the risks associated with these investment activities do not vary according to the authority used to conduct the activity." What are the facts that would lead one to conclude that investing in an SBIC is such a risky endeavor that current rules relating to capital charges must be changed? None are presented. Only unsupported assumptions are advanced: (a) that all merchant banking activities are the same and carry the same substantial risk that must be addressed by an arbitrary approach that has never been imposed before; and (b) that the 50% capital allocation to merchant banking activities apparently used by some banks for internal modeling purposes is appropriate for all banks and all purposes. This is an inappropriate approach given that SBICs are subject to regular government examination. It is also an unfair assessment of all risks associated with bank SBIC investments. When banks invest as limited partners in independent SBICs, the diversification they achieve with respect to the investment substantially mitigates risk.
   
   
2. Given the substantial data on SBIC operations that is available from both banks and SBA, at a minimum the analysis should have provided: (a) tables indicating the results of bank SBICs over time—during both growth and recession cycles; (b) a listing of the entire range of internal accounting models used by banks for their SBICs; and (c) the results of surveys that would have tried to capture the likely impact of the proposed regulation on present and future bank investment in SBICs—with banks listed by size. In that latter regard, merely assuming that the proposed regulation will have no impact based on an unquantified "sampling of call reports of bank holding companies engaged currently in significant investment activities" is insufficient. 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 greater—level of risk as that the proposed regulation seeks to address.
   
   
3. In addition to an analysis of bank-owned SBIC operational data, we believe that the analysis should also include a discussion of the laws and regulations governing SBIC operations. Congress and SBA have moved aggressively since 1992 to address safety and soundness issues related to SBIC operations. In addition, banks may not invest more than five (5) percent of their capital and surplus in SBICs. There should be no finding that bank investments in SBICs pose substantial risks to banks—risks of the same level as merchant banking activities carried on under other authority—without an analysis of the current legal and regulatory requirements that have been imposed to address the same issue addressed by the proposed regulation. To do so indicates either a belief that regulations have no impact on risk or that the only way to address risk in the SBIC program is through a 50% charge to capital. Neither proposition is supportable.
   
   
4. Banks currently receive presumptive Community Reinvestment Act (CRA) credit for investments in SBICs. The proposed regulation does not address this fact and the issues that are related to it. The proposed regulation would likely make it more difficult for banks to meet their CRA investment requirements. Would that impact be felt equally among large and small banks? Does the proposed regulation take into account congressional intent with respect to CRA? If not, why not? These questions should be addressed by the Board.

In conclusion, we believe that no adequate justification has been presented which would justify application of the proposed regulation to bank investments in SBICs in accordance with authority granted under the Small Business Investment Act of 1958. Absent a complete and thorough review and discussion of historical operational results, the laws and regulations already in place to address risk, and congressional intent with respect to the SBIC program, bank investments in SBICs should be exempt from any final regulation that would change current regulations regarding capital required to support investments in SBICs. That is the essence of good government in general and of the requirements of the Regulatory Flexibility Act in particular. NASBIC and its members would be happy to assist if the Board of Governors of the Federal Reserve System and the Secretary of Treasury decide to go forward with such a review.

Sincerely yours,

Lee W. Mercer
President