Subscribe to Money Morning get daily headlines subscribe now! Money Morning Private Briefing today's private briefing Access Your Profit Alerts

Big Banks Are About to Get Blasted by the Volcker Rule

When the Volcker Rule regulations go into effect next year, its restrictions could slam the revenue of the fixed income trading operations of several major U.S. banks by as much as 25%.

The Volker Rule is one of the elements required by the Dodd-Frank financial oversight law, which was written to rein in the sort of excessive Wall Street risk-taking that led to the financial crisis of 2008.

A draft version of the rule was released this week by the U.S. Federal Reserve, which was approved by both the Federal Deposit Insurance Corporation (FDIC) on Tuesday and the Securities and Exchange Commission (SEC) yesterday (Wednesday).

The rule aims to ban proprietary trading, in which the banks traded for their own benefit rather than for the benefit of their customers, but also will address other areas such as hedge fund investing.

Since a significant chunk of the big banks' profits – especially that of Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS) – come from various forms of proprietary trading, the Volcker Rule stands to cost the industry billions in revenue.

To prevent cheating, complex compliance rules will require that banks prove that all their trading activities are for clients' benefit, and not proprietary. Compliance alone is expected to tack on another $2 billion in costs.

"[The Volcker Rule will] diminish the flexibility and profitability of banks' valuable market-making operations and place them at a competitive disadvantage to firms not constrained by the rule," noted a report by Moody's Corp. (NYSE: MCO).

The rule is named for former Fed Chairman Paul Volcker, who has made the case that such regulations are needed.

The new regulations will deal another blow to an already-struggling industry, which has watched earnings sag as a result of a falloff in equity trading volume, weak demand for loans, and costly legal headaches.

Although there's still time for the Volcker Rule to be tweaked before it takes effect on July 21, 2012, it will fundamentally change how the big banks operate.

The rule's impact on Goldman Sachs and Morgan Stanley will be particularly brutal, especially if the final version imposes broader restrictions.

Golden Days Over

According to David Trone, an analyst at JMP Securities, the Volcker Rule would have cost Goldman $700 million, or 9% of its annual earnings, had it been in effect in recent years.

JPMorgan Chase & Co. (NYSE: JPM) estimates that 14% of Goldman's investment banking revenue would be affected by the proprietary trading restrictions. But if the rules include market making – which the draft rule clearly does — 52% of Goldman's investment banking revenue and 40% of Morgan Stanley's would be affected.

Both banks have moved to wind down their proprietary trading, but have changed little in regard to their market-making operations.

Concern about the Volcker Rule's impact on revenue has forced the two firms to consider shedding their status as bank holding companies to evade the regulations. They both converted from securities firms to bank holding companies in Sept. 2008 to be eligible for the government bailout programs.

Another unsavory option would be to split off some of their investment banking operations, but that has costs as well.

"You have to ask which parts of the business are they simply not going to be able to continue to do or maintain the talented people who do it because those guys would have better options if they left the firm and went to a hedge fund," Roy Smith, a finance professor at New York University's Stern School of Business and a former Goldman Sachs partner, told Bloomberg Businessweek. "You don't want to be left with the third team running your expensive market-making trading desk."

Sending Business Overseas

The other big banks have less to fear. JPMorgan, Bank of America Corp. (NYSE: BAC), and Citigroup (NYSE: C) derive less than 10% of their revenue from such activity.

"We emphasize that the revenue won't all go away, but just that GS and MS would be more impacted by the Volcker Rule," writes Nomura Holdings (NYSE ADR: NMR) analyst Glenn Schorr. "Nevertheless, we strongly believe that an overly restrictive set of rules is bad for everyone, will hurt liquidity in the markets, and will put U.S. banks at a competitive disadvantage."

Many see the loss of business to foreign banks – which won't be subject to the regulations unless they have personnel in the United States conducting the types of trades it covers – as adding to the rule's negative impact on banks.

For the big banks, there is no silver lining to the Volcker Rule, unless you count the fact that they still have time to lobby the government for changes. But given the public animosity toward Wall Street these days, any meaningful adjustments will be hard won.

"A draconian form of the Volcker Rule will likely have unintended consequences, such as reduced liquidity, higher funding costs for U.S. companies, less credit for small businesses, higher trading costs and lower investor returns, less ability to transfer risk, and competitive disadvantages for U.S. banks relative to foreign banks," Nomura's Schorr said. "We are hopeful regulators are mindful of these risks and doing their best to write fair, yet effective, rules."

News and Related Story Links:

Join the conversation. Click here to jump to comments…

  1. Stanley C. "Jack" Johnston | October 13, 2011

    I think your information is by the far the best I haved ever had but life's problems rear there ugley head and I have had mine in Spaydes! I am a proud Marine who served in WWII and spent two years in the South and Central Pacific, I came home with many problems. I can hardly hear, I have had hearing aids for many years, I have no discs in my neck and have to have all kinds of treatment. My doctor wants to oprerate but that won't stop the pain, nor will it get rid of my vertigo, I would never be able to move my neck again. I can handle the pain, I refused the operation. I am not allowed to read anything on the computer screen, everything has to be copied. I have been having more proplems, I just returned from the doctors office, he said, "You have been on your computer too much and you may be driving too far again. I told him he was right on the computer, I have been on a great deal because of the wonderful information I am getting from Money Morning, Dr. Moors and The Permanent Wealth Ivestor. I am sorry but for the good of my health I have to terminate all of the above, I wish I could stay but I guess this is one thing that has to go. I am 87 years old, in the event I should live a long life, and get better you can be sure I will return. Please pass this information on to Dr. Moors, and all Permenent Wealth, I am doing every thing I can to releave my problem and live a good life. I left my broker and am alone, I wish you handled such things, I would move it to you. I really don't have that much but anything helps. Thanks, Stanley Jack

    • Jamie Morris | October 26, 2011

      Stanley Jack,

      You are reminding me of my father who fought as an engineer with the 2nd Marine Division in WWII and is approaching 87 years young as yourself. Hey, you guys may be dead tomorrow just like on those islands against the japs and everything else mother nature threw at ya"ll, but as then your still here alive and maybe not as well but alive and looking at the world around you thinking,"Well, it may look bad but nothing looked as hopeless as America in 1942". So sinch up those boot straps and I'll tell you like I still tell my good ole man, "Dad just make everyday a personnal chalenge to just enjoy yourself, and clean air, a bit of stretching, exercise and a good dog to talk too and you can't go wrong.
      Hang in there and maybe this old world won't go away without a fight. I plan to do the same. You can tell the doctor what he wants to hear, but a young thearapist, about fiftish can do wonders for your charm gone cold as well as your motivation to keep on truckin. Take care Marine, and remember guys like You and my Dad are this countries national treasures and don't ever forget how much we love you.

  2. Joe Ricci | October 14, 2011

    THANK YOU for you service to this country!

Leave a Reply

Your email address will not be published. Required fields are marked *

Some HTML is OK