It wasn't much better on the trading side of the business. While trading velocity was strong in the third quarter due to all the volatility in the markets, much of the flow seem to be coming from lower-margin electronic trading activity. The once lucrative high yield market went virtually silent as investors shied away from risky credit instruments. Activity in that market was down 75% in the third quarter compared with the previous quarter. Meanwhile, wide spreads and incongruent pricing in the rest of the credit markets led to many banks to take negative inventory marks, which will most likely outweigh broker commissions.
All this bad news is expected to weigh heavily on bank earnings. Analysts have slashed their estimates in preparation for the weak numbers, dragging down the share prices at all the major banks. But this short-term blip in profits pales in comparison to what could happen to the banks' bottom line if the Volcker Rule is fully enforced by the government. While all the major banks will be hit hard, the two investment-banks-turned-bank-holding-companies, Goldman Sachs (GS) and Morgan Stanley (MS), are expected to experience the most pain.
Goldman could see 14% of its total investment banking revenue impacted if the government focuses solely on trades that are proprietary in nature, according to an analysis by JP Morgan (JPM). But if the government clamps down hard on market making as well, that number jumps to 52%. Morgan Stanley's bottom line would also be eviscerated, with 40% of its investment banking revenue impacted by a strong Volcker Rule.
Both banks have taken steps to close business units that are clearly proprietary in nature. Goldman shuttered several of its prop desks in 2009 and 2010 and is currently winding down its once high-flying Global Alpha hedge fund. Morgan Stanley closed most of its prop trading units after experiencing heavy losses as a result of the mortgage meltdown in 2008. But neither has taken steps to seriously prepare for a strong Volcker Rule where their market-making activities could be seriously impacted. It was always assumed that the government would go easy on them in that regard.
Bank holding companies
But with the draft rule clearly focused on market-making, the banks may need to rethink their strategy. A strong Volcker Rule would clearly be unacceptable to both banks given how important the broker dealer operations are to their bottom lines. That's because they are really not traditional banks. In 2008, the two became bank holding companies so they could have access to the government's bailout programs. The money market and overnight repo funding markets dried up and they needed access to cheap government funds through the discount window in order to resolve what could have been an insolvency crisis. In return, they basically agreed to become boring commercial banks, which would open them up to more regulatory oversight.
Two years later, little has changed for the firms. Goldman and Morgan may be bank holding companies, but it's really in name only. For example, there aren't any Goldman Sachs retail bank branches or ATMs around town and there are no Morgan Stanley debit cards in sight. The firms receive just 10% of their funding needs through customer deposits. That's in contrast to the large commercial banks, like JP Morgan, Bank of America (BAC) and Citigroup (C), which derive around half of their funding needs from deposits.
The Volcker Rule is aimed at the commercial banks, not the broker dealers. Pure play broker dealers and non-bank affiliates appear to be exempt from Volcker and can trade as they like without much government interference. There would be very little switching costs for Goldman and Morgan to go back to being broker dealers. Goldman has said publicly it would not give up its bank charter, but internally there have been discussions about doing just that, according to a person familiar with the firm's thinking. The question is: what's holding them back?
It all comes down to perception. The firms may be afraid to give up cheap funding from the government at a time of severe market stress. The government lifeline allows them to borrow whatever they want, whenever they want it, and in relative secrecy. Pure-play broker dealers are dependent on the fickle money markets to fund their trading activities and don't have access to that government backstop -- a dangerous game in today's volatile markets.
Goldman and Morgan have had two years to figure out what they want to be in the post-financial crisis world. If they want to be banks, they should accept that the government will no longer be backstopping them while they gamble for their own account. If they want to make big trading profits, then they should accept all the risks that go along with that proposal and give up the government lifeline. For now, the firms are hoping to have their cake and eat it too. But a strong Volcker Rule just might take the cake away.
