Thursday, June 17, 2010


From trading room to trading room, from bank to bank, these must be anxious times. And not necessarily because of market volatility or aggressive algorithmic trading that can spur 1,000-point dives in the Dow. Banks await the outcome of financial reform and are especially attuned to how the expected "Volcker Rule" will roll out.

The Volcker Rule is simple. The details, the implications, and the impact on financial institutions will be substantial. Right now, there are variations of the rule--a House version and a Senate version with countless other drafts, revisions, and finetuning to follow.

The Volcker Rule--espoused by former Federal Reserve chairman Paul Volcker--intends to forbid banks from engaging in "proprietary trading" and from investing in hedge funds or private-equity activity. More explicitly, deposit-taking banks that rely on Federal guarantees of deposits or have access to Federal Reserve funding will be prohibited from participating in these activities.

What does this mean? What real impact will it have on the industry, top banks, regional banks, top bankers and traders, and for talent to come--MBA's in finance?

The rule is essentially a turnback to days toward Glass Steagall laws, which didn't allow commercial banks to be involved in equity trading, stock underwriting, brokerage, private equity, and more. During the 1990's, those laws slowly disappeared.

A liberal version of Glass Steagall, known for awhile as "Section-20," allowed commercial banks to engage in these activities, but at modest levels, with limitations, and in entities separated from the commercial-banking operation. Back then, J.P. Morgan, a commercial bank, could be a prominent, but limited participant in equities and mergers & acquisitions. Shortly afterward, Glass Steagall was repealed. Today, J.P.Morgan is JPMorgan Chase, a big commercial bank and arguably an even bigger investment bank.

Commercial banks--under the parentage of bank holding companies--are permitted to engage in these activities or buy other institutions, firms, or outfits that are involved in them. During the financial crisis and now in its aftermath, many claimed the repeal of Glass Steagall exacerbated financial turmoil and contributed to substantial losses at banks around the country.

That's arguable from both sides. The debate continues, but now we are at the point where (a) the Volcker Rule is on the table and some version of it will likely become law, (b) big banks might still be fighting it, but know they must prepare for its implementation, and (c) in some way or another, it will change the structure, the business, the profits and returns and maybe even the behavior and culture at some banks. For some banks, within whatever version is passed, they'll find a convenient (legal) way to continue doing business the old way by wearing different masks.
Goldman Sachs and Morgan Stanley, two major investment banks that became bank holding companies in the middle of the crisis if only to ensure their long-term survival, will be affected. So will JPMorgan, Citigroup, Wells Fargo, and Bank of America--historically commercial banks that evolved to become major investment banks and trading houses, as well.

The essence of the rule is basic; the details are complex, still vague, still being hashed out. How would proprietary trading be defined? Proprietary trading is normally defined as a bank trading for its own account or trading like hedge funds. Not all proprietary trading (or principal trading, as it is sometimes known) is for the firm's account. Some "prop-trading" is done as an accommodation for clients. Does the Volcker Rule (or should it) isolate this activity? If it does, how will regulators be assured that an equity trade, a block trade, a purchase of a basket of stocks, etc. was done on solely behalf of clients?

How would a brokerage operation, which is separate from prop-trading, exist without being able to sell client positions to a prop-trading desk? How would it be possible to manage an investment-banking underwriting function without a prop-trading unit to hold, manage and distribute unsold offerings? What about the blending and blurring of financial products--the corporate loan that looks like a corporate bond that is convertible into some form of equity, all of which is traded in markets?

Now all of a sudden, what sounded basic now sounds difficult and arcane, unless the rule is accompanied by voluminous detail. Would banks still be permitted to engage in profitable currency trading, fixed-income trading, and interest-rate-swap derivatives, activities that ballooned historicially within commercial-banking operations and that might not constitute prop-trading under the new rule.

Some versions of the rule suggest banks could spin off prop-trading activity. Does that mean it could be spun off into an entity that shares that same parent as the commercial bank? (If so, many banks already manage their organizations this way.) Or does it mean the activity has to reside beyond and outside the bank holding company--where profits and losses are remote and distant?

If banks will not be allowed to invest in hedge funds, will they be permitted to invest in the management companies of hedge funds--which some do today? They manage a hedge-fund business without investing directly into the fund.

Would a Goldman Sachs or Morgan Stanley be daring enough to continue as bank holding companies, but forego FDIC insurance on deposits or access to the Federal Reserve for emergency borrowings? That would make economic sense only if it values having a large deposit base as much as it values keeping all prop-trading intact. But without insurance, the deposit base could dwindle.

More likely, these two bulge-bracket firms are more likely weighing giving up their just-obtained bank licenses and return to being pure securities firms regulated by the SEC. No doubt armies of analysts within those firms are outlining options, pros and cons and doing so based on economics, reputation and a long-term view of how they see themselves.

For all big banks (and to a lesser extent, regional banks), if the rule becomes law, they will undergo a restructuring, revamping, and de-consolidating of the prohibited businesses. They will do this in a mechanical way. Anxiety, however, will prevail, as they see precious profits from these activities flee.

Overall it may mean:

1. Some banks will be more inclined to focus on the historical basics: deposit-taking, corporate lending, payments, retail banking, custody and trust, securities processing, and some corporate finance and advisory. Banks without a major trading presence won't be looking to expand as such.

2. Investors will miss the occasional spike in profits from explosive trading activity. Over time, they might be inclined to respect and value less-volatile, more predictable revenue streams.

3. Financial innovation could be stifled. It will continue to exist (new products, new services, new ways of doing old things). Narrowing the scope of what banks can do, however, could narrow the realm upon which they create new financial instruments to trade, distribute, and sell.

4. If banks are permitted to manage proprietary activity in hands-off affiliates, but still under the same parent, then the impact is less than if they must sell these activities, exhibit no control over them, or not be able to benefit from returns on investing in these activities.

5. Talent might disperse. Top banks, hedge funds, and private-equity firms compete in a scrum for top talent. The Dartmouth-Tuck MBA who once considered a cherished spot in equity derivatives at Citigroup might opt to do the same at Citadel, try her hand at Blackstone, or pursue opportunities at boutique trading houses or at growing high-frequency trading outfits. Big banks might not be able to lure experienced talent from funds and could be less inclined to develop or retain those in capital markets--unless those banks become securities firms.

In the meantime, what can MBA's do--students and those with experience and continued interest in finance?

1. Follow what's going on, if only to be in tune with the continuing reformation or reinvention of financial institutions.

2. Understand the rule's basics for now; don't get too bogged down in the complexities unless you have impassioned view.

3. Understand how the rule might cause financial institutions to restructure or revamp themselves or even re-orient their approaches to clients and business. Decide how and where you fit in this new environment.

4. And most of all, be perceptive of opportunities, because often in finance, when the rules change, when there is rampant rearranging or restructuring, opportunities (new positions for people with old talents and skills) come to the surface.

Tracy Williams

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