Statement of Lee W. Mercer, President of NASBIC, before the U.S. House of Representatives Committee on Banking and Financial Services Subcommittee on Capital Markets, Securities & Government Sponsored Enterprises
June 7, 2000

NASBIC President Lee W. Mercer

Chairman Baker, Mr. Kanjorski, and members of the committee:

My name is Lee Mercer. I am president of the National Association of Small Business Investment Companies (NASBIC). NASBIC is the nonprofit association that has represented the SBIC industry since Congress passed the Small Business Investment Act of 1958 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 SBICs. 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 others to ensure that information published about the SBIC program is as complete and accurate as possible.

On behalf of the members of our association, I thank you for the opportunity to appear before you to present our views on the merchant banking capital requirement proposed by the Federal Reserve Board (the Board), in consultation with the Secretary of the Treasury (Treasury) in Dockets R-1065 & R-1067. We believe that the proposed capital requirement would have substantial adverse consequences for both bank-owned SBICs and those SBICs that have or are seeking banks as minority investors in their funds. We believe the Board and Treasury acted precipitously and against the weight of existing facts and congressional intent by stipulating that the proposed regulation should be applicable to bank investments in small business investment companies (SBICs). We believe that both the facts and congressional intent related to the SBIC program support the proposition that bank investments in SBICs should be exempt from the requirements of the proposed regulation.

SBICs represent a major source of critical venture capital for thousands of U.S. small businesses. In FY 1999 alone, SBICs invested $4.2 billion in U.S. small businesses. Importantly, 53% of that total was invested in companies in business for three years or less. The average number of employees in an SBIC-financed company was 158; the median number of employees was 27.

Bank-owned SBICs accounted for $2.9 billion (68%) of the $4.2 billion total invested by all SBICs in FY 1999. 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 all independently managed SBICs licensed in the past 2.5 years.

The average investment for bank-owned SBICs in FY'99 was approximately $3.6 million; the more important median was approximately $1 million. For non-bank SBICs, the FY'99 average investment was approximately $660,000; the median was approximately $400,000. In the private equity industry as a whole, the average 1999 venture capital deal-size in was about $7 million and the median approximately $4 million.

The $4.2 billion in total SBIC investments was only about 10 percent of total venture capital investments. Of great importance, however, is the Small Business Administration (SBA) estimate that the total 3,096 SBIC transactions represented approximately 50% of the number of venture capital transactions in the United States during that 12-month period. Bank-owned SBICs alone accounted for 798 (26%) of the 3,096 total investments made by SBICs in FY 1999.

These statistics prove that SBICs—for which bank capital is such an integral part—are a critical source of venture capital for U.S. small businesses whose requirements have yet to reach the level that would attract the interest of non-SBIC venture capital funds. If thought of in terms of a pyramid, the SBIC program is the wide base—in terms of a great number of smaller-sized transactions—that supports thousands of small businesses that are started each year. Without that base, the number of small businesses that would be able to grow to the extent that they would merit the support of the balance of the U.S. private equity industry would be substantially reduced. That, in turn, would likely have a substantial negative impact on the U.S. economy.

Any regulation with the potential to impart a significant 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 tables indicating the results of bank SBICs over time—during both growth and recession cycles. In fact, SBA data indicates that since 1978, bank-owned SBICs have realized positive returns on invested capital in 21 of the 22 years for which data is available. The mean return for the period is 12.9%.
   
   
3. Given the number of bank-owned SBICs, the analysis should have explored the full range of internal accounting models used by banks for their SBIC investments. Such a survey would have captured 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 a small "sampling of call reports of (large) 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.
   
   
4. 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 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 existing SBIC laws and 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.
   
   
5. 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 are questions should have been addressed by the Board and Treasury.
   
   
6. Although the Board references its obligations under the Regulatory Flexibility Act (5 U.S.C. 603(a)), it provides no analysis of the impact that the proposed regulation will have on small businesses. Such an analysis is clearly warranted given available SBIC statistics.
   
   
7. Finally, although the Board indicates that its proposed regulation was promulgated following consultation with Treasury, there is no indication that the process included consultation with agencies that are generally involved with bank capital adequacy standards. These would include the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS). These agencies and the Board have typically used the Federal Financial Institutions Examinations Council (FFIEC) to address issues such as that addressed by the proposed regulation. The proposal should have included a discussion of the normal process and an explanation of why it was not used.

In conclusion, we believe that no adequate justification has been presented which would warrant 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.