Goldman Sachs and Morgan Stanley are facing headwinds like never before. The two financial firms are widely expected to post weak third quarter earnings in the coming days thanks to the spooked capital markets and sour trading environment. Analysts at Citigroup now predict Goldman will report a loss for the quarter -- it would be only its second quarter in the red since becoming a public company.
But the third quarter should be the least of their worries. New regulations are set to roll out in the coming months that threaten to kill off a large chunk of their profits -- most notably, the controversial Volcker Rule. While the specifics of the Volcker Rule are still being debated, the long-term impact on the firms' bottom line could be quite damaging. If the banks fail to engineer satisfactory loopholes to protect their profitable broker-dealer operations, they will then face a daunting choice – to be or not to be a bank holding company.
The first draft of the proposed Volcker Rule was released to the public on Tuesday. At 298 pages, the draft rule is full of questions and comments regarding one of the most esoteric corners of Wall Street.
The Volcker Rule was proposed by President Obama in 2009 as a way of mitigating risk in the financial system. The rule, which was folded into the Dodd-Frank financial regulatory bill, would limit a bank's ability to trade and invest its own capital in an effort to shield their depositors from potentially large trading losses. Banks would be barred from owning and investing in private equity and hedge funds and would be forced to curtail many of their broker-dealer operations.
The implications are significant for the large banks. The rule forces them to shut down a variety of high margin profit centers and focus on safer, lower margin businesses. It would also bar them from engaging in trading schemes that would be considered to be a "material conflict of interest," between the bank and its customers, effectively ending the banks' ability to front run or bet against their client's orders. While core investment banking operations, like deal-making and taking companies public, would be spared, anything in the trading realm could be up for elimination.
The original rule made exceptions that allowed banks to keep their market-making activities in order to help their clients hedge their positions and maintain liquidity in the markets. But to engage in market-making, a bank must take on a certain amount of risk by buying up and selling securities. Many fear that the banks will just lump all their proprietary trading activities under the market-making exception to allow business to go on as normal.
But the government is well aware of that risk and appears to be taking it very seriously. In fact, the majority of the draft is spent on this very topic. One proposed rule would force the banks to report any trading plan used for market making activities. It would require the banks to prove that they were not engaging in a short-term resale of a security and also prove that they were not benefitting from any actual or short-term price movements through trading arbitrage or hedging.
It would then all come down to enforcement. The regulators don't have to catch every prop trade disguised as a market-making trade. Hefty fines for just a few violations will eventually squeeze the profit margin of the business, forcing the firms to eventually comply with the spirit of the law.
Discussion of the Volcker Rule couldn't have come at a worse time for the banks. High margin capital markets activity at the big U.S. banks has hit a snag amid uncertainty in the world economy. The amount of money raised in IPOs in the third quarter globally was down 49% from the same time last year, while the number of mergers and acquisitions announced globally were down 19%. Global investment banking revenue is expected to fall 37% in the third quarter compared with the previous quarter, according to Dealogic.
