Harry Campbell
The Volcker Rule, and its limitations on bank trading, may have the unintended effect of dividing the world back into investment banks and commercial banks. The unusual twist here is that Goldman Sachs and Morgan Stanley may end up stuck on the wrong side of the fence, treated under the law as commercial banks instead of the investment banks they once were.
The backdrop to this issue is that it is increasingly clear that banks are simply unable to make as much money from proprietary and other trading businesses as they did before the financial crisis. Take Goldman Sachs. In 2007, Goldman had revenue of $7.6 billion from traditional investment banking, but $31.2 billion in revenue from trading-related operations. Last year, Goldman had just $17.3 billion in revenue related to trading operations.
This is a trend likely to accelerate. Under the Dodd-Frank regulatory overhaul, derivatives are to be traded on central clearing agencies rather than between investment banks as before the financial crisis. Heightened bank capital requirements prevent warehousing large amounts of securities and increase the cost of financing. Then there is the Volcker Rule, which is likely to substantially reduce much of the banks’ profits from their trading businesses.
Last week, Moody’s Investors Service put Goldman, Morgan Stanley and 15 other global banks on a ratings watch, saying that “the combination of changed operating conditions and increased regulatory requirements and restrictions has diminished these firms’ longer-term profitability and growth prospects.”
The Volcker Rule, to be sure, also has benefits for the large banks. The more complicated the Volcker Rule, the less regulators will be able to understand it, leaving the banks with more loopholes. In addition, the rule may pose a barrier to entry to some commercial banks that can’t afford the sophisticated regulatory apparatus to comply with the rule.
But given the sums involved, the question is whether we have reached a breaking point. How will Goldman, Morgan and the other banks that depend on trading revenue try to reclaim their profits?
One possibility would be for the banks to stop being bank holding companies, a regulatory status they chose in order to survive the financial crisis.
Before the Gramm-Leach-Bliley Act overturned the depression-era Glass-Steagall Act in 1999, the American financial system was divided between investment banks and commercial banks. The commercial banks were insured by the Federal Deposit Insurance Corporation and subject to heightened regulation to ensure the safety of their deposits.
In contrast, the five large investment banks — Goldman, Morgan Stanley, Merrill Lynch, Bear Stearns and Lehman Brothers — were not regulated as banks. In exchange for lighter regulation, the five investment banks financed themselves through the private markets and could not rely on the Federal Reserve for financing of their operations.
After Gramm-Leach-Bliley, the investment banks largely stayed unregulated while the commercial banks like Citigroup and Bank of America behaved more like investment banks, increasing their trading operations.
During the financial crisis, the old-style investment banking model fell apart. Lehman Brothers collapsed and Bear Stearns nearly so. Merrill Lynch was acquired by Bank of America.
Morgan Stanley, meanwhile, took a life-saving investment from Mitsubishi UFJ Financial Group, while Goldman took capital from Warren E. Buffett’s Berkshire Hathaway. Morgan and Goldman also elected to become bank holding companies and regulated as banks.
By the time the dust settled, all of the nation’s banks now looked like commercial ones and the investment banking model was dead. Goldman and Morgan were now subject to stricter regulation and oversight. As the Volcker Rule looms, becoming a bank holding company has proved to be a Faustian bargain.
Still, the Volcker Rule is not all gloom and doom for everyone on Wall Street. It is actually a real-life experiment in market efficiency. If the Volcker Rule truly makes the cost of markets higher, then it will reduce the profits of the big banks.
But the Volcker Rule does not apply to private equity funds, hedge funds and smaller investment banks that do not themselves own banks.
So if the Volcker Rule is really a drag on the economy, hedge funds and smaller investment banks that are not subject to it may try to interject themselves and bridge the gap that the investment banks can no longer fill.
The latter-day MF Globals of the worlds — nonbank financial firms — will have an incentive to become the next Goldman or Morgan, though it is hoped with better luck than Jon S. Corzine’s actual MF Global. These newcomers will not be burdened by the full application of the Dodd-Frank Act and can sidestep the Volcker Rule.
The possibility of a new firm emerging overnight to challenge the big banks is low, but markets move quickly and there are some big players who are capable of emerging in the coming years. The Blackstone Group, Kohlberg Kravis Roberts & Company and Apollo Global Management, for example, are turning themselves from private equity firms into general service investment managers and engaging in investment banking businesses. Whether it is private equity firms, smaller investment banks or a new operation, given the profits to be made, it is likely Wall Street will find a way to close this gap.
The Volcker Rule may thus in the long term create a divided world where the old investment banks are challenged by new upstarts who are not limited by this rule. If these new competitors arise, it may even be that Goldman and Morgan reach the breaking point and give up their bank holding company status, removing the Volcker Rule straitjacket. This would allow all of them to return to their old trading practices.
Technically, this is legally possible. Each of these banks would have to elect not to be treated as a commercial bank and dispose of any banking operations. Each would still be subject to regulation, but would rid itself of the Volcker Rule’s restrictions on trading. But while this is technically possible, given the public mood right now, neither is likely to want to risk the public censure it would bring.
While the idea of Goldman, Morgan or even Merrill Lynch ridding itself of its bank holding company status seems far-fetched today, the idea of new investment banks emerging is not.
The Volcker Rule, for all its good intentions, may perhaps unleash a burst of rapid financial innovation to do something it never intended: recreating the prefinancial crisis division between investment banks and commercial banks.