The Volcker Rule and the Dodd Frank Act have been hanging over the head of bank stocks for so long now that when the Volcker Rule was finally approved Tuesday, financial shares barely shrugged.
But make no mistake: Going forward, banks are going to be much less profitable.
That’s especially the case at bank stocks such as Goldman Sachs (GS), a firm which practically prints money with its own proprietary trading operations. Those prop trading desks are officially goners.
Not that there were many left, anyway.
Big bank stocks knew proprietary trading would be banned under the Volcker Rule years ago, so they’ve been shutting down desks and cutting traders loose for a while.
What they didn’t know was just how hard the Volcker Rule would come down on prop trading. Heck, no one did. The Dodd Frank Act — of which the Volcker Rule is a central part — has been under construction for so long that even if you asked regulators “What is Dodd Frank, exactly?” they couldn’t really answer.
But now things have become much more clear. The adoption of the Volcker Rule pretty much completes the Dodd Frank Act’s regulatory overhaul of the banking sector — an enormous enterprise meant to keep banks from blowing themselves up.
Highlights of the Volcker Rule
We’ll explore what all this means, but first, here are some key passages from the Volcker Rule:
- A banking entity may not engage in proprietary trading.
- A banking entity may not, as principal, directly or indirectly, acquire or retain any ownership interest in or sponsor a covered fund (for example, a hedge fund or private equity fund).
- Each banking entity shall develop and provide for the continued administration of a compliance program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions on proprietary trading and covered fund activities and investments.
- Each banking entity must adopt a written compliance program approved by the board of directors, an appropriate committee of the board, or equivalent governance body, and senior management.
- Based on a review by the CEO of the banking entity, the CEO of the banking entity must, annually, attest in writing that the banking entity has in place processes to establish, maintain, enforce, review, test and modify the compliance program.
Volcker Rule: Saving Banks From Themselves?
The Volcker Rule — named for former Federal Reserve Chairman Paul Volcker — will help make banking boring again. Taking in deposits and making loans is hardly a road to crazy profit and share-price growth … but it’s safe.
On the other hand, proprietary trading, owning hedge funds and private equity funds, and engaging in other kinds of high-stakes Wall Street wheeling and dealing can be amazingly profitable.
But they’re also risky enough to bring down the entire financial system if not kept in check.
Remember the financial crisis? Bear Stearns and Lehman Bros. — two of the Big Five Wall Street investment banks at the time — are gone. Heck, two of the biggest money center banks from the pre-crisis days — Washington Mutual and Wachovia — are gone too.
No, proprietary trading didn’t cause the crisis — but a total lack of risk management sure did.
The Volcker Rule helps puts the kibosh on banks playing games of Russian roulette — and well that it should. A bank that takes in your deposits — deposits which are backstopped by your tax dollars — shouldn’t be putting those funds at risk, especially if the risk is so great that it can bring down the whole bank.
True, JPMorgan Chase (JPM) was able to absorb the $6 billion “London Whale” trading loss. But plenty of banks can’t.
The Future for Bank Stocks
The Volcker Rule and Dodd Frank Act are hardly perfect, with plenty of gray areas. Banks already are — and will forever be — looking for loopholes. Interpretation and enforcement are just a couple of the unknowns as the new regulations come into effect.
What is certain is that investors in bank stocks have to recalibrate their expectations for the sector’s profit growth in the Volcker Rule era.
Proprietary trading generates a lot of money for banks — profits the Volcker Rule is going to wipe out.
Indeed, a strict interpretation of the Volcker Rule collectively costs the eight biggest banks anywhere from $8 billion to $10 billion in annual pretax profits, according to estimates by Standard & Poor’s.
And it will hurt some banks more than other.
Goldman Sachs — known for its astounding trading skills — could lose as much as 25% of its yearly revenue because of the Volcker Rule, according to research from FBR Capital Markets.
The banking business is changing, for the better if more boring. That’s a good thing.
But the Volcker Rule means investors in these stocks are going to have accept that the days of crazy-fast profit growth are over.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.