Garrottes and sticks

The first of four articles on the implications of the Volcker rule examines reactions on Wall Street Jan 28th 2010 NEW YORK From The Economist print edition Illustration by S. KambayashiA RECENT episode of “Mad Money” on CNBC, a financial-news network, featured the “Lloyd Blankfein piñata”. Hung from the studio ceiling to symbolise the beating that bankers—not least Goldman Sachs’s boss—have been taking lately at the hands of politicians, the effigy rained down fake gold coins when split apart. Wall Street’s predicament is the inverse of the one it faced in late 2008, says Frederick Cannon of Keefe, Bruyette & Woods, a broking firm. Then, officials wheeled out weekly plans to save banks. Now they are rushing out measure after measure to punish the survivors, accompanied by increasingly fiery rhetoric. Barack Obama kept up the assault in his State of the Union address this week. Admitting that the bank bail-out was “as popular as a root canal”, he vowed to take on lobbyists who were “already trying to kill” financial reform. The bombardment began on January 14th, with a new ten-year tax on big banks’ liabilities. But it intensified greatly on January 21st with a plan to cap their size, ban their “proprietary” trading (bets made for their own account) and limit their involvement in hedge funds and private equity. Mr Obama wants these measures to be wrapped into a broader set of reforms that is grinding its way through Congress. A bill passed by the House of Representatives, but not yet taken up by the Senate, already allows regulators to limit the scope and scale of firms that pose a threat to financial stability. The new proposals require them to do so. Though widely characterised as a return to the Glass-Steagall act, the plan falls far short of the Depression-era law that separated commercial banking and investment banking (and was repealed in 1999). Banks can continue to offer investment-banking services to clients, such as underwriting securities and making markets. The plan’s aim, say officials, is narrow: to stop Wall Street from gambling in capital markets with subsidised deposits. The timing of the proposal—two days after Mr Obama’s party suffered a thumping Senate-election loss in Massachusetts—looks nakedly political. But it was not dreamed up overnight. Last year the president’s economic lieutenants had seemed content to shackle the banks with tougher regulation and higher capital ratios, rather than limiting their activities. In recent months, though, they warmed to the ideas of Paul Volcker, a former chairman of the Federal Reserve, who was advocating more drastic action—and after whom the new rule is named (see article). Banks have been scrambling to estimate the potential damage. Despite the lack of detail, for most the impact looks manageable. Officials admit that new limits on non-deposit funding are designed to prevent further growth rather than to force firms to shrink. Banks were already scaling back their proprietary-trading activity sharply as a result of the crisis: some say its contribution to revenue has fallen by more than half in the past three years. Prop trading now typically accounts for a mere percentage point or two of firms’ revenues (see table)—if it is defined narrowly to exclude risk-taking related to client business. Drawing a line between the two will be horribly difficult, but that will be the regulators’ problem. Moreover, banks will be allowed to keep hedge funds that hold clients’ money. JPMorgan Chase will not have to offload its prized Highbridge subsidiary, for instance. American banks have only $10 billion of their own capital invested in hedge funds, according to Preqin, a research firm. Private equity is more problematic. Several firms have large dollops of their own capital in buy-out funds, which also generate fees for their advisory and lending arms. Even if the Volcker rule’s financial impact is modest, banks could face “a thousand cuts” to profits when the full range of regulatory initiatives is totted up, says Richard Ramsden of Goldman Sachs. The latest proposals, on top of recent credit-card and overdraft restrictions, could together cost JPMorgan Chase $4.5 billion in after-tax profit, he says. Meredith Whitney, an independent analyst, sees banks losing “several points” of return on equity. Much attention is focused on the new rule’s impact on Mr Ramsden’s own firm. Goldman says that 10% of its revenues come from proprietary trading, well above rivals’ shares. Some analysts put the figure much higher. With its blend of advisory work, trading and co-investing with clients, the firm’s “entire culture is, in a sense, proprietary,” says Ms Whitney. Fortunately for Goldman, it has an escape hatch. If it gives up its small deposit-taking arm, it can go back to being a broker-cum-hedge fund, free to trade as it likes. Officials defend this get-out, saying Goldman would have no access to central-bank funding and would still be subject to enhanced capital requirements and supervision. But it would continue to enjoy implicit state support, unless markets can be convinced that it would be allowed to fail if it got into trouble. That seems unlikely. Congressional leaders may balk at giving what could be portrayed as a free pass to such an unpopular firm. The Volcker rule could easily get mangled in the legislative process. Republicans loathe such government heavy-handedness, even if they are wary of being seen to support bankers. Some senior Democrats, such as Chris Dodd, head of the Senate banking committee, have given the plan a lukewarm reaction. Mr Dodd already faced a struggle to craft a financial-reform bill that would win some Republican support. If the White House’s new initiative makes his task harder, it could prove to be a spectacular own goal. Nor has the plan won overwhelming support across the Atlantic. Britain’s opposition Conservatives, who are likely to reassume power this year, reacted positively, as did Jean-Claude Trichet, head of the European Central Bank. The Financial Stability Board, a Basel-based body which is marshalling the international reform drive, gave a qualified thumbs-up, stressing that a broader mix of approaches was needed to tame financial monsters. France and Germany were less enthusiastic. Both are wary of following an initiative that could be stillborn. “A lot of people here are saying that we shouldn’t fool ourselves into doing something that America will not do because of lobbying by American banks,” says Nicolas Véron of Brueghel, a Brussels think-tank. Many in Europe favour higher capital charges for all trading activity, arguing that risky bets are the real enemy, whether they are placed for clients or made on banks’ own accounts. If Europe fails to follow America’s lead, it would be a blow for efforts to create a joined-up approach to global regulation. With the American plan coming on the heels of Britain’s tax on bonuses, there are fears of growing unilateralism. One danger is that this fragmentation results in what Sir Howard Davies, a former head of Britain’s Financial Services Authority, has called “reckless prudence”: a cumbersome patchwork of inconsistent, overlapping rules. That would create a second risk, regulatory arbitrage. If American banks were at a real disadvantage to foreign rivals, they would try to game the rules. For America’s big banks a more immediate worry is that Mr Obama, stung by accusations that he has been too soft on bankers, unveils more punitive measures in the run-up to mid-term elections in November. The back-in-vogue Mr Volcker, it should be noted, supports inflicting bank-like regulation on money-market funds, many of which sit within Wall Street firms. The Securities and Exchange Commission voted on January 27th to impose new disclosure and liquidity rules on these funds. The administration is “trying to legislate by shouting,” Steve Bartlett of the Financial Services Roundtable, an industry group, told NPR radio, pointing out that when Mr Obama unveiled the Volcker rule he devoted more words to trashing banks than to outlining the plan. But bashing banks is good politics: a majority of Americans say Wall Street should not have been bailed out. Moves to assuage the outrage over bonuses, such as Goldman’s capping of London partners’ total pay at £1m ($1.6m), are doomed to disappoint. If public anger grows, a reintroduction of Glass-Steagall may just start to look possible. The uncertainty bred by this regulatory risk has a financial impact. Bankers are growing worried that institutional shareholders, spooked by regulatory unpredictability, will start to lose faith. It could also raise the cost of issuing debt. Moneymen fret about possible unintended consequences, too (see Buttonwood). Trading limits and caps on bank liabilities could make the huge, low-margin business of repurchase (“repo”) lending much less economical, reducing liquidity in mortgage-backed securities and Treasuries, which are used as collateral in such loans. This is no time for bankers to carp publicly. Dick Bove, a veteran bank analyst with Rochdale Securities, may overdo it in describing Mr Obama’s assault on the banks as “Venezuelan-style democracy”, but open dissent is unwise. An investment banker likens the atmosphere to the aftermath of the September 11th attacks, when no one dared call for restraint in torturing suspected terrorists. That choice of analogy may reveal as much about the depth of Wall Street’s persecution complex, and its inability to face up to its role in the crisis, as it does about those beating it with sticks.