Banking Reform - Much Ado About Quite Little

So, now we see the compromise bill on banking reform/overhaul, and it's really not that big of a deal after all. For all of the blustering of the likes of Barney Frank, very little changes. Banks will be allowed to stay in the swap business, more or less, as only non-investment grade credit, equity, and commodity swaps are going to be pushed into non-bank subsidiaries. Moreover, the parent banks can still guarantee those subsidiaries.

All in all, then, all the talk about forcing banks out of the derivatives business was basically just noise. Then again, the whole idea was largely noise - of the banking industry, Bank of America (NYSE: BAC), Citigroup (NYSE: C), JPMorgan (NYSE: JPM), Goldman Sachs (NYSE: GS), and Wells Fargo (NYSE: WFC) comprised something like 97% of derivative holdings (according to the OCC), so it was never a "bank issue" anyway. It was an issue for those quasi-bank/brokers, and only the biggest ones at that.

Another area of concern was the "Volcker Rule" that was going to severely limit banks proprietary trading (that is, trading for their own account) and ability to invest in hedge funds and private equity. According to this bill, banks can invest in these up to a total of 3% of their Tier 1 capital. At that level, it's not going to have a major effect on anybody so far as I can tell (that's nearly a $4B limit for JPM and nearly $2B for Goldman). Then again, that's a 3% limit on investing in funds *AND* prop trading, so maybe Goldman will find that limitation a bit constraining, as prop trading is such a large part of their business historically.

In a strange way, this might actually be good news for some of these banks. See, there's a LOT of money in marketing and running these funds, but investors often want to see the manager keep some skin in the game. Now, though, these banks have a built-in excuse for making only very modest investments in their own funds. "Gee, sorry ... we'd like to, but there's that 3% limit we have to obey". Now, instead, the banks may be able to just collect the "2 and 20" (that is, a 2% management fee and 20% of profits) and not worry about having a lot of their own money tied up. Pretty sweet, huh?

Other details seem pretty positive too. There was a fear that the banking sector was going to be made to pay for the wind-down of Freddie Mac and Fannie Mae (maybe $400B - $500B), but that seems to be off the table. Congress also dropped the idea of creating a $150B bailout/wind-down fund (again, paid for by banks, but all of us ultimately through higher fees and interest rates) to be used in seizing and winding down failed banks.

Still, there will be a new tax of about $19B and a change to the regulatory framework will allow the Fed to impose greater capital requirements on individual banks if the regulators decide the underlying risk warrants such a move. Regulators will also now have more authority and discretion to step in, seize, and restructure or wind down banks - ideally before they get themselves into truly dangerous messes. In addition, there will be limits on certain financial transaction fees (like the ones charged by Visa or MasterCard to merchants). 

All in all, this is about as good of a deal as the industry could have hoped. There will be a few constraints on their activities and some higher costs, but nothing that will dramatically impair their ability to get back to doing very profitable business for years to come. Now, it's not a done deal yet, but I would be pretty surprised if the bill doesn't pass. It does end up looking like a normal compromise - nobody is going to be all that happy with it, but both parties will probably acknowledge that it's the best they can come up with for now.

The biggest banks, especially those with proprietary trading desks and large derivative businesses, come out of this great. Banks that are more like "normal banks", BB&T (NYSE: BBT), US Bancorp (NYSE: USB), PNC (NYSE: PNC), and so on will arguably see some higher costs and regulatory burdens, but aren't really getting any perks from the deal either.

There are plenty of reasons to be cautious on banks, lending activity is weak and credit quality is still iffy, but at least regulatory/legislative risk is now largely resolved.

Disclosure: I own shares of JPMorgan and BBT.