Will Banks Fail with the Volcker Rule in Place?

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Of course the banks can't "fail." They have been labeled as "too big."  But can they fail investors?

With the Presidential election behind us, I cannot help but consider the next state of large-cap U.S. banks.  No doubt that Dodd-Frank has created a flurry of changes in the industry – with more to come. 

Here are some thoughts for U.S. community banks, and a few of the major U.S. banks, including Goldman Sachs (NYSE: GS), JPMorgan (NYSE: JPM), Citigroup (NYSE: C), Bank of America (NYSE: BAC), and Morgan Stanley (NYSE: MS).

The Ruling

In regard to small U.S. banks, Frank Keating, President and CEO of the American Bankers’ Association (ABA), wrote a letter to Treasury Secretary Timothy Geithner.  In the letter, Keating explained that he appreciates the intent of Dodd-Frank, which is to help community banks.  However, he asserts that reality is far different. 

Keating believes that the Dodd-Frank regulation is hurting small banks.  The bill also curtails the profitable operations of major Wall Street banks.

Goldman Sachs and Morgan Stanley earn a fair share of their revenues and profits from trading activities.  The Volcker Rule, a provision in Dodd-Frank, curtails these actions, a blow to these firms.  Also, the rule does not permit banks to hold more than a 3% stake in a fund, although it does give some timeframes and concessions for illiquid funds.  Also, the holding must be “immaterial.”

Goldman’s proprietary trading desk earned $1.8 billion during the third quarter.  Less trading activity would trim Goldman’s profits.  Also, it is estimated that Goldman could lose 52% of its investment banking revenues if the Volcker Rule stays in place.

Morgan Stanley is in a similar predicament.  According to one author:

Around 44% of the bank's entire revenues for the year 2011 came from proprietary trading activities. The Volcker rule is also restricting the capital Morgan Stanley can allocate to its global infrastructure fund. The bank wants to allocate 10% of capital to new private equity funds, whereas the rule allows a maximum of 3%. This will put the bank at a disadvantage with respect to other asset management companies such as Carlyle Group LP and Blackstone Group LP.

Less than 10% of JPMorgan’s revenue comes from prop trading.  However, JPMorgan has the talent and the capital to quickly enter more deeply into prop trading, if favorable regulation would allow it to.

Like JPMorgan, Citigroup and Bank of America earn less than 10% of their revenues from trading.  For these firms, the Dodd-Frank bill is a lot more about increasing regulatory and compliance costs than it is to trim stellar revenues.  However, like JPMorgan, these firms could quickly acquire high-profit “prop shops” or open hedge funds.

However, a lack of astronomical trading revenues did not stop these firms from being among the top supporters of Governor Romney’s campaign.  Affiliates of the above banks were all top supporters of Mitt Romney. (Data here.) 

Also, Goldman Sachs contributed a colossal amount to the Republican Party in 2012, a contrast to its major gifts to the Democratic Party in 2008.  It is important to note, however, that companies can often contribute to both parties.  For example, Goldman also contributed to the Democratic Party in 2012.

Conclusion

The Dodd-Frank bill and the Volcker Rule have a number of implications for the financial sector, with both small and large banks.  Hopes of the Republican Party taking office and paring down Dodd-Frank – a potential boon to the financial sector - are dashed. 

Instead, I am skeptical that the banks will be able to touch the enormous profits they enjoyed in the boom years.  I will eye Goldman Sachs and JPMorgan shares in a downturn, because banks have a propensity to get hit hard when things go bad and run fast when times are good.  But for now, I'm on the sidelines.

Dig Deeper

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ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co. Motley Fool newsletter services recommend Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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