How Banks May Game the Volcker Rule

Includes: BAC, C, CS, DB, GS, KBE, MS, UBS
by: Stone Street Advisors

Recently, there’s been a fair amount of speculation that the big banks are reorganizing their proprietary trading and internal alternative asset operations in response to the Dodd-Frank Financial Reform bill . One such rumor is that Goldman Sachs (NYSE:GS) is planning on moving its prop desk to its asset management division, where the firm’s traders would manage client funds instead of the firm’s.

I find this painfully hard to believe, quite simply, because Goldman would be giving up a metric ton of money if they were to take that route. The money Goldman would make on asset management fees would be a mere fraction of the profits from prop trading, which accounted for 76% of profits last year (pg 7), to the point that they’d have to raise an enormous amount of money on which to generate fees to be even remotely close to the money they make from prop trading (note: this isn’t just prop trading, as it included principal investments as well).

What I think would make more sense, and be quasi-legal within the framework of this new regulation, would be for Goldman, etc to take their prop employees and form new, separate hedge/private equity funds in which Goldman would be the sole or at least primary investor (in the fund, not in the sponsor or management company).

Title VI of the Bill, specifically section 619 (see pg 250 in the link above) says:

‘‘(a) IN GENERAL.—
‘‘(1) PROHIBITION.—Unless otherwise provided in this section,
a banking entity shall not—
‘‘(NYSE:A) engage in proprietary trading; or
‘‘(NYSE:B) acquire or retain any equity, partnership, or other
ownership interest

This way, banks would avoid the additional capital requirements and other onerous regulatory limits imposed by paragraph (2) of that section, but still retain the economic benefits of their existing prop trading operations. By reorganizing their prop operations in such a way, banks could also avoid completely the effort its going to take to convince regulators that activities that are effectively prop trades are actually part of firms’ market-making or hedging operations. The only problem I can see with this approach would be that it may (I’m not exactly sure yet) a latter section (pg 256) of the bill, which says:

‘‘(A) IN GENERAL.—No transaction, class of transactions, or activity may be deemed a permitted activity
under paragraph (1) if the transaction, class of transactions, or activity—
‘‘(i) would involve or result in a material conflict of interest (as such term shall be defined by rule as provided in subsection (b)(2)) between the banking entity and its clients, customers, or counterparties;
‘‘(ii) would result, directly or indirectly, in a material exposure by the banking entity to high-risk assets or high-risk trading strategies (as such terms shall be defined by rule as provided in subsection (b)(2));
‘‘(iii) would pose a threat to the safety and soundness of such banking entity; or
‘‘(iv) would pose a threat to the financial stability of the United States.

The remaining language that discusses the limitations on permitted activities seems to have some vague/poorly-crafted language. In one clause or section, the Bill says banks can’t (effectively) invest in hedge fund firms/sponsors, but later effectively says that firms can’t make (large, majority) investments in hedge funds themselves. I’m not sure in the grand scheme of things how such rules/language will be interpreted by firms and their regulators, but a cursory read-through of the bill suggests that at least some of the rumors of prop desk restructuring don’t make much, if any sense.

To me, one thing is certain: There is zero chance the banks won't find a way to game new financial regulations; there's simply too much money at stake.

If nothing else though, it seems we can rest assured the likes of Sullivan & Cromwell have plenty to keep them busy for the foreseeable future.

Disclosure: No positions