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Banks ‘Dodged a Bullet’ as Congress Dilutes Rules

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wall_rus   Friday, 06/25/10 12:22:02 PM
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Banks ‘Dodged a Bullet’ as Congress Dilutes Rules

June 25, 2010, 11:25 AM EDT
By Christine Harper


June 25 (Bloomberg) -- Legislation to overhaul financial regulation will help curb risk-taking and boost capital buffers. What it won’t do is fundamentally reshape Wall Street’s biggest banks or prevent another crisis, analysts said.

A deal reached by members of a House and Senate conference early this morning diluted provisions from the tougher Senate bill, limiting rather than prohibiting the ability of federally insured banks to trade derivatives and invest in hedge funds or private equity funds.

Banks “dodged a bullet,” said Raj Date, executive director for Cambridge Winter Inc.’s center for financial institutions policy and a former Deutsche Bank AG executive. “This has to be a net positive.”

Hashed out almost two years after the worst financial crisis since the Great Depression, the legislation shepherded by Senate Banking Committee Chairman Christopher Dodd and House Financial Services Chairman Barney Frank places limits on potentially risky activities such as proprietary trading or over-the-counter derivatives and gives regulators new powers to seize and wind down large, complex institutions if needed.

The overhaul, which still requires approval from the full Congress, won’t shrink banks deemed “too big to fail,” leaving largely intact a U.S. financial industry dominated by six companies with a combined $9.4 trillion of assets. The changes also do little to solve the danger posed by leveraged companies reliant on fickle markets for funding, which can evaporate in a panic like the one that spread in late 2008.

‘Fig Leaf’

The Standard & Poor’s 500 Financials Index, whose 79 companies include JPMorgan Chase & Co. and Goldman Sachs Group Inc., rose 1.1 percent at 10:50 a.m. in New York.

The legislation is “largely a fig leaf,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “Given where we were when this got started, I’d have to imagine the Wall Street firms are pretty happy.”

Banks avoided drastic curbs on their highly profitable derivatives businesses. Lenders including JPMorgan and Citigroup Inc. will be required to move less than 10 percent of the derivatives in their deposit-taking banks to a broker-dealer division during the next two years, which may require additional capital.

Goldman Sachs and Morgan Stanley, which were the two biggest U.S. securities firms before converting to banks in September 2008, won’t be as affected because they kept most of their derivatives in their broker-dealer units.

‘Pennies’ of Dilution

“There’s going to be some adaptation, but I don’t think there’s going to be any colossal impact,” said Benjamin Wallace, an analyst at Grimes & Co. in Westborough, Massachusetts, which manages $900 million and holds stakes in Bank of America Corp., JPMorgan and Wells Fargo & Co. Derivatives rules mean “there’s going to be a capital raise, but the analysis we’ve seen suggests we’re talking in the pennies in terms of dilution” of earnings per share.

Senator Blanche Lincoln, a Democrat from Arkansas, had originally advocated forbidding banks that receive federal support such as deposit insurance from trading swaps, a rule that could have required banks to spin off those businesses.

The final agreement provides a number of exemptions: Banks can continue trading derivatives used to hedge their risks and can keep trading interest-rate and foreign-exchange contracts. Banks will have up to two years to move other types of derivatives, such as credit default swaps that aren’t standard enough to be cleared through a central counterparty, into a separately capitalized subsidiary.

97% of Market

U.S. commercial banks held derivatives with a notional value of $212.8 trillion in the fourth quarter, of which 92 percent were interest-rate or foreign-exchange derivatives, according to the Office of the Comptroller of the Currency. The five U.S. banks with the biggest holdings of derivatives -- JPMorgan, Goldman Sachs, Bank of America, Citigroup and Wells Fargo -- hold $206.2 trillion, or 97 percent, of that total, the OCC said.

The rules are “nowhere as bad as what the banks might have feared as recently as a week ago,” Bill Winters, the London- based former co-chief executive officer of JPMorgan’s investment bank, told Bloomberg Television today. “Banks have pretty much factored in already the idea that most derivatives will have to be cleared through a central clearing counterparty. Not a huge surprise and probably not a huge cost either.”

Volcker Rule

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. They include credit-default swaps, which act like insurance for investors in case a debt issuer can’t repay.

Swaps sold by American International Group Inc. that later went sour helped push the insurer to the brink of bankruptcy and triggered a $182 billion federal bailout of the New York-based company during the near collapse of the financial system in 2008.

Another portion of the legislation that was amended in the final conference was the so-called Volcker rule, named after Paul Volcker, the former Federal Reserve chairman who championed it. Originally the rule would have prevented any systemically important bank holding company from engaging in proprietary trading, or bets with its own money, as well as investing its own capital in hedge funds or private-equity funds. Goldman Sachs executives have estimated that about 10 percent of the firm’s annual revenue comes from proprietary trading.

3% Rule

In the final version, the banks will be allowed to provide no more than 3 percent of a fund’s equity, and will be limited to investing up to 3 percent of the bank’s Tier 1 capital in hedge funds or private equity funds. That represents a ceiling of about $3.9 billion for JPMorgan, $3.6 billion for Citigroup and $2.1 billion for Goldman Sachs, according to the companies’ latest quarterly reports.

“I don’t think it will have any impact at all on most banks,” Winters said of the amended Volcker rule. “It’s a pragmatic solution that will result in the banks having no big issues.”

While the rule has been watered down, it still represents an important change in direction for a financial industry that had been allocating a larger and larger portion of capital over the last decade to making bets and investments with their own money, said James Ellman, president of San Francisco-based hedge fund Seacliff Capital LLC, which specializes in financial industry stocks.

‘Casino’ Must Go

“You’re going to be taking out of the banks areas of investing that every 10 years or so, at certain points in the cycle, tend to have dramatic losses,” Ellman said. “Effectively you’re telling the system: We have to take the casino out of the utility.”

While Ellman said the legislation will help to make the financial system safer, he added that “it won’t satisfy anybody who wanted really strict additional regulation of banks.”

The new version of the Volcker rule also incorporates changes proposed by Democratic Senators Jeff Merkley of Oregon and Carl Levin of Michigan that aim to curb conflicts of interest by preventing firms that underwrite an asset-backed security from placing bets against the investment. In April, Levin presided over a hearing in which Goldman Sachs executives were accused of betting against some of the same collateralized debt obligations that they underwrote; the executives responded by saying they were acting as market-makers.

Market-Based Funding

While requirements for an increase in capital will provide banks with a bigger cushion to absorb losses, the legislation does little to reduce banks’ dependence on the markets to finance their balance sheets. It was that market-based funding that made firms like Goldman Sachs and Morgan Stanley vulnerable to the panic that spread in 2008.

“Something has to be put in place to cause banks to have deposit-based liabilities and not market-based liabilities,” Grimes & Co.’s Wallace said.

The effects of the legislation won’t be seen for several years as new regulations are drafted and implemented, analysts said. New international capital requirements under consideration by the Basel Committee on Banking Supervision, which could be implemented by the end of 2011, will also be important.

Investors and analysts including Optique Capital Management’s William Fitzpatrick said bank stock prices have already factored in any likely reduction in revenue from the changes.

“Profitability is indeed going to take a hit and we’re going to see more stringent capital requirements,” said Fitzpatrick at Milwaukee-based Optique, which oversees about $800 million including stock in Bank of America, Goldman Sachs and JPMorgan. “The changes are most certainly necessary. They can certainly lead to a more stable and predictable earnings stream.”

Still, he added, “this doesn’t remove all of the elements of financial distress that could lead to some of the challenges we had in 2008.”

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