U.S. financial reformers hang tough to bitter end

June 25, 2010

Even near the bitter end, big banks hoped Congress would pull its best punches. But the regulatory reform bill agreed early on Friday by U.S. House and Senate negotiators lands solid blows. Though no knockout, it looks set to constrain Wall Street banks’ risk-taking — and profit.

As the most radical reformers see things, of course, banks have just performed a successful bit of rope-a-dope. Despite the most serious financial crisis since the Great Depression, they haven’t been broken up like early 20th-century American cartels. And they will continue to be allowed to do things that go well beyond narrow lending to businesses and consumers. But it will be a far trickier task to turn that into lavish returns and bonuses.

Banks won’t be completely banned from running lucrative derivatives desks, as they once feared. But for riskier varieties of instruments, they will have to spin trading off into a separately capitalized subsidiary. Most derivatives will also have to be centrally cleared. Both changes are likely to affect banks like JPMorgan that have big derivatives businesses.

The Volcker Rule also survived the more than 20 hours of last-ditch negotiations. Banks will be largely barred from trading solely for their own accounts — a blow to Goldman Sachs and other firms that have done this very successfully over many years. The financial industry did win a concession on the private equity and hedge funds front, gaining the ability to hold small investments, relative to their capital, rather than none as originally proposed.

Large banks and hedge funds will also have to pay for the implementation of the bill with an unexpected risk-based fee. That will cost $19 billion over five years — hardly crippling, but a further burden nonetheless.

The extent to which these and other provisions will hit profits is unclear. A Citigroup analyst took a swing at it, calculating that earnings at Goldman and Morgan Stanley, for instance, could be reduced by a fifth. But such estimates should be taken with a grain of salt. It will take a while to fully digest the implications of the 2,000-page bill. And details on other key changes, like higher U.S. and global capital requirements, are still ahead.

Take the Volcker Rule. Though the fairly strict final version appears to be a defeat for the financial industry, the implementation process is complicated. Banks might have as long as seven years to come into compliance. In political terms, that means several congressional elections and myriad opportunities to weaken the limits. As it is, regulators have broad authority to permit trading that enhances a bank’s safety and soundness.

So by the time its provisions bite, lawyering and lobbying might have made the bill less painful for banks — though that didn’t happen as it made its way through Congress. For now, bankers can take comfort in still having a more or less intact business — and greater certainty about the rules that will govern it.

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