New Financial Rules Will Lower Bank Profits

This article was originally published by the Fiscal Times on Friday, July 2, 2010.

The landmark financial overhaul legislation will raise banking industry regulatory costs, lower their profits and limit their use of their own assets in risky investments.

By Katherine Reynolds Lewis

A major overhaul of financial regulations that cleared the House this week will put the banking industry on course for higher regulatory costs, lower profits and a renewed emphasis on more traditional activities like taking deposits and making loans.

The landmark legislation awaiting final action in the Senate later this month stops short of banning banks from investing their own assets, dealing in highly speculative derivatives or investing in hedge funds and private equity firms, as many reformists had urged. But the complex web of new rules in the 2,000-plus-page document will add an estimated $11 billion to the industry’s regulatory costs in the coming years. And it would put a crimp in the industry’s activities and shed more light on their activities with the use of clearinghouses and data repositories.

Rather than marking the finish line in marathon legislative negotiations, the new law's approval is more of a handoff in a relay race. Regulators will receive the baton and a mandate to write dozens of new rules to restrict banks' activities, increase capital requirements, protect consumers from fraud, and impose more oversight to prevent a repeat of the problems that caused the near meltdown of global financial markets and triggered a worldwide recession.

Once the financial industry emerges from the near-term pain of that transition, the new regulatory structure could facilitate measured growth in a new environment with less moneymaking potential but greater transparency and protection from failure, analysts said.

"In the long run the industry will be safer, people will be more confident and the spreads will be narrower," said Robert Litan, vice president for research and policy at the Kauffman Foundation. "The bill is sweeping in nature but a lot of the details have yet to be filled in" by regulators, Litan noted. "We don't know whether that's going to be a heavy touch or light touch."


The House voted 237-192 on Wednesday to approve the final version of the bill, which emerged from the House-Senate conference committee earlier in the week. The sweeping legislation would, among other things, set up an independent consumer bureau within the Federal Reserve to protect borrowers from lending abuses, establish oversight of the vast derivatives market, and enable the government to wind down large, failing firms.

Last-minute opposition from Sen. Scott Brown, R-Mass., to a $19 billion fee on financial institutions forced the conference committee on Tuesday to drop the fee and instead raise $5.7 billion from banks alone, through higher contributions to the federal deposit insurance fund and unspent funds in the $700 billion Troubled Asset Relief Program. Despite continued opposition from banking and business lobbying groups, analysts expect Senate approval in mid-July.

The Pendulum Swings
"It's tough but manageable, and it's also an indication that the pendulum is swinging toward a much more regulated environment for the banks," said Frederick Cannon, a banking analyst at Keefe Bruyette & Woods Inc. Cannon estimates that the new restrictions would lower bank earnings by about 10 percent, or a loss of $5.7 billion in projected 2011 revenue for the 185 banks that Keefe Bruyette covers. That brings the bill's price tag for the banking industry to about $11.4 billion.

The legislation, the broadest financial overhaul since the Great Depression, would:

• Limit banks' proprietary trading or investment of their own assets, through a 3 percent cap on capital devoted to hedge funds or private equity investments, a provision known as the Volcker Rule. A variation of this rule was proposed by former Federal Board Chairman Paul Volcker, an adviser to President Obama. Banks would have two years to divest the tens of billions of dollars worth of investments covered by this provision.
• Require banks to use a separately capitalized subsidiary for over-the-counter derivatives based on commodities, equities and riskier credit default swaps. A derivative is a financial instrument or agreement between two parties that has a value linked to the expected future price movements of the asset to which it is linked. Banks would still be able to directly deal in derivatives based on interest rates, gold and silver, currencies, and cleared credit default swaps, which represent the bulk of the $117 billion worth of outstanding contracts held by U.S. banks.
• Force the vast majority of the OTC derivatives market onto exchanges, swap execution facilities or clearinghouses – adding a cost but also increasing transparency. Banks could trade derivatives for their own accounts only to hedge a real risk associated with their business – but not to speculate.
• Give federal regulators the power to take over and unwind troubled firms and create a new federal council to oversee nonfinancial companies that might pose a threat to the markets, such as hedge funds. Hedge funds open to a limited range of investors undertake a wider range of investment and trading activities than other investment funds.
• Increase capital requirements for banks, on top of new margin requirements for derivatives trades. The specific capital rules will be worked out by banking regulators in conjunction with counterparts from other countries participating in Basel III negotiations.
• Protect individuals through a new consumer agency, tough new rules for mortgages and limits on the interchange fees charged when people use a debit card.

"Banks are supposed to be staid, boring institutions," said Dan Crowley, a partner at K&L Gates representing financial services firms. "This puts banks back into the role of being banks -- with some extension into trading where it's necessary for customer service or to hedge their own risk, but not to be the profit engine."

The biggest banks, such as Bank of America Corp. and JPMorgan Chase & Co., would be hit hardest by the most onerous provisions. But those measures would be phased in over several years, giving institutions time to restructure and sell their holdings in now-prohibited businesses. Revenue from proprietary trading and derivatives is likely to fall 10 percent, according to a Morgan Stanley research report.

The largest U.S. banks could see earnings drop by 13 percent, with Citigroup hurt the most, at 27 percent, according to a research report by Goldman Sachs Group Inc. But revenue reaped by exchanges, where most OTC derivatives will be traded and cleared under the legislation, should climb by $1.5 billion, he said.

Global financial institutions are unlikely to escape the new law by moving activities overseas, analysts said. "When you read the Group of 20 report that came out over the weekend, what we're doing with derivatives here is likely to be copied throughout the world. By definition, the over-the-counter derivatives market is going to shrink because a lot of the activity will come onto exchanges," Cannon said.

With banks making less money and meeting tighter lending restrictions, they'll naturally extend less credit to consumers, predicted Bob Bishop, chief investment officer for fixed income at SCM Advisors LLC, which holds bank bonds among its $3.5 billion in assets under management. The government's new resolution authority adds uncertainty to anyone who lends to banks, whether directly or by purchasing bonds. "It introduces a huge amount of risk, which increases the cost of capital, and that's going to make it tough for all borrowers," Bishop said.

Ultimately, history will judge whether the cost of the legislation is worth the protection it aims to provide to the economy, financial markets and the American people.

"It is worth giving up a modest amount of economic growth in the good years to avoid the terrible downturns like the one we just experienced," said Douglas Elliott, a fellow at the Brookings Institution. "The bill will not eliminate financial crises, but it will make them less frequent and considerably milder, which is all we can realistically accomplish."

Image credit: Nick Bhardwaj/The Fiscal Times