The De-Occupation of Wall Street

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

The Occupy Wall Street movement is a symptom of the popular belief these days that Wall Street is evil and banks are criminal, especially Goldman Sachs.  Unfortunately for Wall Street banks, the current US President sympathized with the Occupy movement. Aside from just publicly sympathizing with this movement, President Obama imposed massive amounts of regulation on Wall Street banks in order to prevent future financial crises. The banks who are hit hardest by the new regulation are: JPMorgan Chase (NYSE: JPM), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), Bank of America (NYSE: BAC) and Morgan Stanley (NYSE: MS). These banks are all very big; some are worldwide players (especially Citi) or have relatively large proprietary trading and investment banking activities, like MS, JPM, and GS. About the cost of regulation: Jamie Dimon, CEO of JPMorgan, stated it will cost the bank $3 billion to fully implement all the regulatory changes it has to deal with. That’s just compliance and reporting.

Currently, a former private equity guy runs for office. But what exactly does this challenger, Mitt Romney, want for Wall Street? It’s important to think about this before he voices his opinion about this clearly, or if he gets elected, implements changes. Investors acknowledge potential change in future profits when they see them, as coal companies have shown after the 10/3 debate. So let’s take a look at some of the most important regulations, their consequences, and Romney’s stand on them.

Basel III

Basel 3 intends to increase equity capital in banks and weigh assets according to riskiness perceived by the committee (which is made up of central bankers). The increased capital requirements are sensible, as it increases safety and helps preventing bail-outs, but the risk adjusting of capital creates capital allocation problems like the one which led to the sub-prime mortgage crisis. All in all, this is a tough regulation for banks, but not one that a US President realistically can or will do much about, as it’s a central banker requirement. It is interesting however, to look into how far banks have gotten with increasing their capital. The first stage of Basel 3 kicks in on Jan. 1, 2013 and is fully loaded by 2019.

Tier 1 Common ratio's (Q2 2012)

<table> <tbody> <tr> <td> </td> <td>Basel I</td> <td>Basel III</td> </tr> <tr> <td>BAC</td> <td>11.2</td> <td>8.1</td> </tr> <tr> <td>C</td> <td>12.7</td> <td>7.9</td> </tr> <tr> <td>GS</td> <td>13.1</td> <td>7.9</td> </tr> <tr> <td>JPM</td> <td>10.3</td> <td>7.9</td> </tr> <tr> <td>MS</td> <td>13.5</td> <td>8.5</td> </tr> </tbody> </table>

Note: Basel 3 ratio's are banks' own estimates.

All banks in this list seem to be fairly well prepared for the upcoming changes, although it’s striking how 3 out of 5 have estimated their B3 Tier 1 Common at 7.9% while their current Basel 1 capital ratios differ greatly. Citi claims its conservative in its estimates and JPMorgan seems to be surprisingly optimistic about the risk of its activities. The minimum Tier 1 Common capital will be 7% by 2019, plus requirements for ‘Systemically Important Financial Institutions’. JPM and Citi both assume (in their pro-forma ROE calculations) they will need a tier 1 common ratio of 9.5%.

Dodd-Frank Act

This act is pretty much the mammoth of US banking regulation. Its goal is to enhance financial stability by regulation. S&P wrote in a report that the impact of Dodd-Frank will decrease pretax earnings of the eight largest US banks by $23-34 billion annually. The Durbin amendment in Dodd-Frank, which limits (debit card) fees banks can charge merchants, is estimated to cost as much as $1.72 billion for Bank of America and $1.6 billion for JPMorgan Chase. Although they mitigated the costs by charging higher checking account fees on consumers, this isn’t the kind of regulation banks like. The most damaging part (to ROE of banks) about this legislation is the additional (not yet determined) amount of capital it requires ‘systemically important’ financial institutions to hold.

About Dodd-Frank Romney’s plan says this “As president, Mitt Romney will also seek to repeal Dodd-Frank and replace it with a streamlined regulatory framework”. It then goes on about streamlined regulation, but it is safe to guess ‘streamlined’ is code for ‘less’.
In the 10/3 debate, the Dodd-Frank Act was the first example Romney gave when he was asked about excessive regulation. This is important, as it indicates he sees the new banking regulation as the prime example of excessive regulation. He also said the bill marked some banks as too big to fail, which he thought was wrong, thereby hinting on the removal of the additional capital requirements for large systemic banks.

One investor-friendly provision of Dodd-Frank is ‘say or pay’ which lets shareholders vote on executive compensation. Citi CEO Vikram Pandit is the most notable victim of this provision with a denied pay package of $15 million.

The Volcker Rule

The Volcker rule is part of the Dodd-Frank bill that was added at a later stage and intends to separate investment banking (especially trading) from commercial banking. This obviously is bad for banks, especially Morgan Stanley and Goldman Sachs which have large trading desks that earn them a great deal of money in good years. Trading made up 60% of Goldman’s revenue in 2011, for Morgan Stanley this was 44%. On the other hand, proprietary trading (for only own account) isn’t that complementary to the business of banking and the required capital is can easily be employed elsewhere. The problem is though, that this Rule is probably going to limit more trading activities than just proprietary trading, it all depends on the interpretation of the Volcker Rule when implemented. S&P estimates its aggregate additional annual impact of a loose interpretation at $2 billion to $3 billion and the impact of a strict interpretation at $8 billion to $10 billion. On top of all these issues, Morgan Stanley is experiencing trouble with financing infrastructure funds because of the Volcker Rule. 

Mitt Romney hasn’t been very clear on this piece of legislation. We also know Wall Street and big banks especially aren’t that popular among the public these days and Romney wants people to vote for him. But we do know Republican congressmen have pointed out that all the U.S. legislation (particularly Volcker) applies to the worldwide operations of U.S. banks while foreign banks only have to comply with them for their operations in the US. This hurts the competitiveness of US based banks, while producing the bizarre side effect of driving up property prices in London. So Romney will probably at least try to level the playing field if he is elected.

The bottom line

But can't higher capital requirements and regulation contribute to the safety of banks? Sure they can. It is up to the financial institutions and their shareholders to create the best and most efficient way to build their company to last and they have come a long way since then. No one wants to see another financial crisis like the one in 2008. When current legislation gets fully implemented, Wall Street will become unoccupied, with banking activities leaving for London, if the next government changes course, Wall Street will be de-occupied from government regulation that hurts returns to stockholders. The recent trading loss of JPMorgan shows the desperation among banks (due to a combination of Basel, Dodd-Frank and Volcker), which try to pump up return on equity as much as possible by adopting risk models that primarily look at regulatory capital needs.

However nice the less regulation might seem for banks, it's not certain who will win or who will really remove some of the most restraining parts of the legislation. As for now, it's about a 50/50 chance who will win the election. For (potential) investors in US banks it is a positive sign that banks' stocks haven’t showed a clear correlation with the development of the elections yet, so do yourself a favor and front run the crowd.

Investor89 owns shares of JPMorgan Chase & Co. and Citigroup Inc. 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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