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."

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About the Author

David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.

Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.

Dave has a BA in English and Mass Communications from Loyola University Maryland.

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