By Michael J. Moore & Dakin Campbell – Dec 4, 2013 6:24 AM PT
With U.S. regulators scheduled to vote Dec. 10, the largest firms are getting little detail about the final terms of the Volcker rule’s ban on proprietary trades, and still have basic questions about what kind of market-making will be allowed, said three senior U.S. bankers. They’re also wondering whether they’ll have to change practices or curtail business in some less-liquid markets, the bankers said.
The answers could threaten their revenue and affect transaction costs for clients of firms such as JPMorgan Chase & Co., Bank of America Corp. and Goldman Sachs Group Inc.The Volcker rule is close to being adopted more than three years after it became a centerpiece of the 2010 Dodd-Frank Act, designed to prevent a repeat of the global credit crisis.
“Everything in the Volcker rule that defines what is permitted market-making, and what is not, is by far the most important part of the rule,” said David Hilder, an analyst at Drexel Hamilton LLC in New York. Regulators probably have been silent on the specifics to preserve agreements they’ve made, he said. “Outside input in the late stages of a negotiation tends to blow apart consensus.”
Market-making, or principal trading, is the business of using a firm’s capital to buy and sell securities with customers, while profiting on the spread and movement in prices. Proprietary trading involves banks placing speculative bets with their own capital. The Volcker rule, named for former Federal Reserve Chairman Paul Volcker, seeks to stop banks with federally insured deposits from making such trades that could threaten their stability.
Regulators including the Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp. and Commodity Futures Trading Commission are scheduled to meet next week on the rule’s final version. The Securities and Exchange Commission probably will act at about the same time.
The $44 billion at stake represents principal trading revenue at the five largest Wall Street firms in the 12 months ended Sept. 30, led by New York-based JPMorgan, the biggest U.S. lender, with $11.4 billion. An additional $14 billion of the banks’ investment revenue could be reduced by the rule’s limits on stakes in hedge funds and private-equity deals. Collectively, the sum represents 18 percent of the companies’ revenue.
Goldman Sachs and Morgan Stanley may be the most affected by any additional restrictions since they generate about 30 percent of their revenue from principal trading. JPMorgan generated about 12 percent of its total revenue from principal transactions in the 12 months ended Sept. 30. The figure was less than 10 percent for Bank of America, based in Charlotte, North Carolina, and New York-based Citigroup Inc.
The executives at three banks, who asked not to be identified because the talks are private, characterized the lack of communication from regulators so close to the end of the rulemaking process as unusual. The U.S. Chamber of Commerce’s capital markets unit asked regulators last month to re-propose the rule to allow more comments and discussion.
Treasury Secretary Jacob J. Lew warned chief executive officers of top U.S. banks in a private meeting in October that the final Volcker rule would be tougher than Wall Street expects. Lew, who’s coordinating efforts of the five regulators, told the bank group that to get the rule right, he prefers to err on the side of making it tougher, said one of the people familiar with the discussion.
The Obama administration has self-imposed a deadline to complete the rule by the end of the year. Banks have until July 21 to implement it, even though regulators are behind the schedule outlined by Dodd-Frank. Regulators have assured industry representatives that that deadline probably will be extended, according to three people involved in the talks.
Volcker said in a Senate hearing last year that the rule that bears his name should prevent risky trades that could cripple a bank, and that it should change the culture of large firms that accepted conflicts of interest and rewarded “unnecessarily dangerous behavior.”
“This is speculative trading, but its influence goes far beyond the particular risks involved and particular transactions,” he said. “It’s a cultural issue.”
Banks already have shut or broken off stand-alone groups that traded separately from units that serve clients. New York-based Morgan Stanley spun out Process Driven Trading, a quantitative equity-trading unit run by Peter Muller, into a hedge fund. JPMorgan shuttered its commodity proprietary-trading group, while Goldman Sachs shut at least two such units across equity and fixed income.
Those stand-alone proprietary-trading desks produced about $5 billion in revenue for the six largest U.S. banks in 2009, after losses in 2007 and 2008, according to a 2011 report from the Government Accountability Office. Goldman Sachs said such groups generated about 10 percent of its revenue, meaning the figure could have reached $4.5 billion in some years.
Bankers are concerned that the final version of the rule will go beyond those standalone units and affect customer trading, the executives said. The rule could set limits on how long or how much inventory can be held to head off proprietary trading. A span that’s too short would hurt their ability to make markets where trades are infrequent, they said.
Spokesmen for the banks declined to comment for this article.
While banks may face a revenue squeeze if regulators seek to add restrictions to the rule, authorities led by the Fed probably will agree on wording that’s “reasonable” and doesn’t interfere with market-making, said Chris Kotowski, an Oppenheimer & Co. analyst.
“Imagine writing a rule telling used-car dealers that they’re supposed to trade in used cars, but they’re not allowed to speculate on the value of used cars,” Kotowski said. “Ultimately, they’re going to try to avoid doing something that’s disruptive to the economy and markets.”
The wide range of potential outcomes has made it difficult for outside analysts to predict what the rule could mean for banks’ results. Standard & Poor’s estimated that the change could sap combined pretax profits at the eight largest U.S. banks by $2 billion to $10 billion a year.
Brad Hintz, an analyst at Sanford C. Bernstein & Co., said after the initial proposal was released in 2011 that banks’ fixed-income desks could see revenue fall as much as 25 percent, or about $14 billion based on last year’s revenue at the five firms.
Banks have said that trading customers will suffer from wider spreads and lower liquidity if the rule is too harsh. That raises the possibility that revenue may not fall as lower activity is offset by better margins, said one of the three executives.
“The rule will be constructed in a way that will allow us to conduct the important functions that our clients need us to perform,” Goldman Sachs CEO Lloyd C. Blankfein, 59, said at an investor conference last month. If not, he said, “there would be such a clamor from the user base that it would be modified and the pendulum would swing.”
The wait for Volcker hasn’t scared investors away from Wall Street banks. All five firms have beaten this year’s 26 percent gain for the Standard & Poor’s 500 Index through yesterday, and Morgan Stanley more than doubled the benchmark with a 62 percent advance.
The final version isn’t likely to “materially impact” the earnings power of the largest banks because they’ve already exited businesses most affected by the Volcker rule, said Shannon Stemm, a bank analyst at Edward Jones & Co. in St. Louis. Still, the potential for a harsher-than-expected rule led analysts at Stifel Financial Corp.’s KBW unit to recommend investing in European lenders over their U.S. peers.
“The real issue is if activities that the largest banks are engaged in go elsewhere,” saidFrederick Cannon, director of research at KBW. “We’re in a capitalist economy. If there’s money to be made, someone outside of the largest banks will step in. That’s probably fine with the Fed. They like a lot of these activities to be done by entities that aren’t too big to fail.”
U.S. firms also have begun cutting their stakes in private-equity and hedge funds. Further reductions are necessary as banks seek to meet a limit of 3 percent of their Tier 1 capital invested in the funds.
Goldman Sachs cut its stakes in such funds to $14.9 billion as of Sept. 30, down from $15.4 billion when Dodd-Frank was passed, and Blankfein said that investment appreciation has masked even greater reductions. The New York-based firm would be limited to $2.1 billion of such investments given its Tier 1 capital last quarter. Morgan Stanley has $4.8 billion of private-equity and hedge-fund stakes, above the $1.8 billion limit under Volcker.
Banks will be waiting to see what types of funds are covered under the Volcker rule’s limits. Goldman Sachs, which has the largest family of mezzanine loan funds, has pushed for funds that buy or make extensions of credit to be excluded from the limit.
The revised rule could also seek to head off proprietary trades by requiring hedges to be more closely tied to holdings. That had been a point of contention among some regulators, with CFTC Chairman Gary Gensler and Kara Stein, a Democrat on the SEC, pushing to make it more difficult for banks to classify some trades for their own accounts as legitimate hedges, three people familiar with the talks said in October.
The restrictions are a response to JPMorgan’s so-called London Whale trades, which cost the bank $6.2 billion in 2012 and were described by executives as portfolio hedging. JPMorgan’s synthetic credit portfolio produced about $2.5 billion of revenue in the five years before 2012, according to a Senate subcommittee report on the bets. The Whale nickname was derived from the size of the positions.
A limit on portfolio hedging may affect commercial banks that seek to hedge bond investments made with excess deposits or mortgage operations.
The rule threatens firms’ trading revenue as they grapple with lower revenue and leverage, and what some bankers foresee as increasingly stringent regulation. McKinsey & Co. said in a report last month that investment banks must make more sweeping changes to help improve profitability as capital rules and new regulations push returns on equity at the 13 largest investment banks from 8 percent last year to 4 percent by 2019 unless remedies are found.
Bank of America General Counsel Gary Lynch said at an industry conference last month that the current “regulatory fervor” probably will continue for a couple years. Stephen Cutler, JPMorgan’s general counsel, said at the same event he sees a period of “regulatory spiral.”
The true impact of the Volcker rule may not be known next week, as it may be written in a way that gives the five regulators some discretion in determining what is prop trading, KBW’s Cannon said.
“In some ways, areas of gray would be the most challenging for banks,” he said. “Because it would give regulators a lot of leeway to come in and say, that’s not really market-making.”