Examining The Volcker Rule

Includes: GS, MS
by: Zecco

By Paul Quintaro

On Tuesday the proposed “Volcker Rule” was published.

The rule, named after the former Federal Reserve Chairman, would prevent banks from trading their own accounts. There will be exceptions made for short-term hedging or market making.

The intention of the rule is to prevent banks from engaging in excessive risk taking.

Still, at the same time, it could significantly cut down on the profitability of banks and could trigger a wave of layoffs.

In recent years, trading has driven up to 25% of banks’ profits. A loss of that revenue source could lead to significant reverberations throughout the financial system.

In addition, the implementation of the rule could lead to significant losses as trading desks are forced to layoff employees who can no longer legally work for the companies that employ them.

The combined consequence of the layoffs and sharp reduction in bank profits could be a negative to the broader U.S. economy in the short term, but is it ultimately necessary?

A reduction in risk taking by banks could help to prevent a financial crisis in the future. Proponents of the Volcker rule argue that if it had been in place back before the 2008 crisis it may helped to reduce leveraging by the banks.

That leveraging may have contributed to the financial calamity and resulting recession seen in the U.S. and other economies.

How would the implementation of the rule affect bank stocks?

Bloomberg cites an analyst at Susquehanna Financial, who stated that Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) might go as far as dumping their status as banks should the rule be implemented.

Still, is the Volcker Rule likely to be implemented in its present state?

Cynics may believe that nothing close to the current proposal will ever be implemented. Obviously, the financial industry is well-connected politically. Goldman Sachs, for example, has well known ties to the Federal Reserve and Treasury department (Timothy Geithner and William Dudley are both former Goldman Sachs employees, for example).

If implemented, the Volcker Rule would not take full effect until 2014. Even then, the rule allows for extensions, and so it may not really have an affect on the financials until 2017.

If the current version of the Volcker Rule becomes law, investors may anticipate a dramatic shakeup in the financials and the broader economy. Will that help to make the economy safer going forward? Only time will tell.