Despite having to reorganize and sell off some business, spend millions more on compliance, and lose high-performing traders, the two largest remaining investment banks will not be severely affected by the Volcker Rule, Standard & Poor's said today.
The rule, a provision of the Dodd-Frank financial reforms, was designed to prevent banks from trading for their own profit while enjoying implicit taxpayer protection. While Bank of America and JPMorgan Chase are diversified businesses with big consumer units doing home lending and credit cards, Goldman and Morgan Stanley were thought to be more at risk from the regulations that restricted trading, which has traditionally driven Wall Street profits.
The Volcker Rule was inspired by former Federal Reserve chair Paul Volcker, who had long criticized banks that have access to federally insured bank deposits and other forms of government support for also being able to run risky trading businesses for their own profits.
But S&P said in a report today that it was upgrading the outlook for debt issued by some subsidiaries of Goldman and Morgan Stanley from "negative" to "stable," saying, "we no longer believe that these firms' businesses will be hurt by the rule and its various interpretations."
The final version of the Volcker Rule was unveiled by a group of regulators in December of last year, but banks had been preparing for its strictures for year. Goldman especially had lost traders to hedge funds before the rule was finalized.
But the overall business has not been much affected, S&P said. The two big investment banks "have been able to maintain strong global investment banking and capital markets franchises despite many of the regulatory developments we've seen over the past few years, many of which have focused on sales and trading activities."
The large banks that have to comply with the rule are still making big profits from trading — but not pre-financial crisis profits — and are still able to maintain sizable businesses even if the work is done on behalf of their clients, not for their own book. While there were worries in the last year that trading, especially lucrative bond trading, had run into a permanent lull, volatility in the markets picked up in September and October. Goldman Sachs even had its highest-volume trading day ever on Oct. 15.
One area hit by the rules has been investment funds started by banks for their clients or employees. The Volcker Rule prohibits banks from sponsoring such funds, and minimizes their possible ownership stake in them to 3%.
While Morgan Stanley has scaled back its bond-trading business, citing its high-risk and increased regulatory requirements (mostly separate from the Volcker Rule), it has adjusted to the rule's restrictions on banks investing in the investment funds they run for clients. "We've been very pleased to migrate the approach to the funds to be Volcker consistent. In other words, the new fund launches are looking at no more than 3% of our equity in the fund," the bank's chief financial officer, Ruth Gorman, said at a banking conference in September.
Goldman is in the process of winding down its own fund investments. The deadline for implementation of the entire rule is July 2015, although some of it could be extended to 2017. In May, Goldman President Gary Cohn said at a conference that of Goldman's $14 billion in fund investments, it needs to sell off $9 billion. The bank said in a regulatory filing that it has $11.4 billion invested in private equity, credit, real estate, and hedge funds, down from $14.3 billion. Since March 2012, Goldman has redeemed $2.55 billion of its hedge fund investments, the bank said in a regulatory filing.
Both Goldman and Morgan Stanley have had good performance recently in the types of trading businesses that analysts expected to be most affected by Volcker. Morgan Stanley's fixed-income trading revenue in the most recent quarter was $1.1 billion, up from $694 million a year before, while Goldman had $2.2 billion in fixed-income trading revenue, up from $1.2 billion. Morgan Stanley's fixed-income business, however, generated only 13% of its total revenue, while for Goldman it was 26%.
"We view the operating trends for both firms as relatively stable and see less downside risk as regulatory proposals are finalized and these companies maintain top market shares in key businesses," S&P analyst Matthew Albrecht said. "This is in contrast with our initial expectation that regulations, particularly the Volcker Rule, could have had some negative impact on their business profiles."