Looming Rules Pressure Big Banks

The big-bank business model that Wall Street fell in love with over the past 20 years is under assault by an incoming regulatory regime aimed at reining in the risk-taking that nearly brought down the financial system three years ago.

Some believe new capital and liquidity requirements combined with restrictions on banks’ ability to bet with their own money could eventually cause the largest financial services companies like Bank of America (NYSE:BAC) to spin off or sell more chunks of their nontraditional banking businesses.

“There are a lot of good regulations that have been coming out, but not all of them are good for the current business model of the big banks,” said Darrell Duffie, a finance professor at Stanford University.

To be sure, few analysts are predicting U.S. banks will be forced to completely break themselves up to cope with the new regulatory world they live in. It’s also not clear how or when all of the upcoming rules will be implemented.

Volcker Rule Looms

However, it is clear U.S. banks have a plethora of new rules to brace for, most of which are being written based on the Dodd-Frank financial reform overhaul that was signed into law last year.

In particular, some are fretting about the proposed Volcker Rule, which is aimed at limiting proprietary trading, or trading done by banks with their own cash.

“I wouldn’t be surprised if over the next decade or so, particularly in light of the proposed Volcker Rule, to see a significant movement of market-making activities outside of the big banks,” said Duffie, who urged regulators to carefully consider concerns about the proposed rules.

Even before the final rules have been released, a number of big banks have spun off “prop trading” businesses. For example, as a result of the Volcker Rule, Morgan Stanley (NYSE:MS) announced plans to sell its FrontPoint hedge fund and spin off its prop trading business into an independent firm. Also, earlier this year Goldman Sachs (NYSE:GS) reportedly closed its Global Macro Proprietary Trading desk and JPMorgan Chase (NYSE:JPM) shut down its commodity prop-trading group.

It’s possible more changes could be in store as some of the largest financial-services companies may decide to spin off their nonbank affiliates such as broker dealers or significantly scale back their nontraditional banking activities.

“Bank of America, JPMorgan and Citigroup (NYSE:C) are not going to stop being banks because they have very large core commercial banking activities, but they could further reduce or spin off their nonbanking activities at some point,” said Duffie.

Mother Merrill on the Block?

The idea is that if these big banks can’t enjoy the fruits of these often lucrative businesses anymore, they may at least be able to sell them off and receive a one-time gain while simultaneously boosting capital. In 2009, Goldman relied on proprietary trading for as much as 10% of its $45 billion in revenue.

“We may see people preemptively say we need to divest this or that because we know the more stringent capital requirements are coming,” said Frances McLeod, managing partner of consultancy Forensic Risk Alliance.

One option that has been floated is Charlotte-based Bank of America, which is seen as one of the weaker of the troubled big banks, could spin off Merrill Lynch, which it acquired in 2008.

BofA has already been shedding assets to raise capital ahead of the new capital requirements, a process that caused it to lose its perch as the No. 1 U.S. bank by assets to JPMorgan. In October BofA unloaded half of its stake in China Construction Bank, boosting its Tier 1 Common Capital under Basel I by $3.5 billion and cutting its risk-weighted assets by $7.3 billion.

“A Bank of America sale of Merrill Lynch would provide air cover for some other banks that are considering spin offs, but are worried that the public will interpret the sale as a sign of desperation,” Cam Harvey, a finance professor at Duke, said in an email.

Harvey said he believes such moves are needed irrespective of the upcoming rules because U.S. banks are undercapitalized and European banks are insolvent.

However, increased financial-market turbulence caused by the European sovereign debt crisis may complicate huge asset sales like these.

“It is better to do this sooner rather than later. If European blows up, it will be difficult to sell Merrill Lynch,” said Harvey, who sees a 50% chance of a Merrill sale.

Big Banks Brace for Extra Capital Requirements

Adding to the regulatory uncertainty, banks are searching for clarity on Basel III, the global framework requiring banks to boost their capital levels. On top of the 7% of extra capital that all institutions will have to hold, the biggest banks will be mandated to hold as much as an extra 2.5% of capital as a percentage against risk-weighted assets.

While the Federal Reserve has embraced Basel III, some are skeptical the rules will be implemented in their current form because of the troubles in Europe’s financial system.

“I don’t think Basel III will ever go into effect because the Europeans will prevent it from happening and I can’t imagine the Fed and the United States will put the U.S. banks at such a tremendous disadvantage,” said Dick Bove, banking analyst at Rochdale Securities.

Banks have pushed back against the new capital and liquidity requirements, arguing they will ultimately hurt the U.S. economy by decreasing the amount of loans banks are able to offer consumers and businesses.

“I don’t buy that at all. What’s hurt the economy is reckless trading by the undercapitalized banks [involved in] nontransparent highly risky trading,” said Michael Greenberger, a law professor at the University of Maryland and former director of the Commodity Futures Trading Commission’s division of trading and markets. “These banks don’t want to eliminate capital rules to lend more money. They want to trade for their own book.”

However, Bove said if the rules do go forward, he sees big U.S. banks having little trouble raising the necessary cash because the extra capital cushions aren’t expected to take effect until 2019.

“I don’t think the American banks are going to have to do anything dramatic. They’re not going to have to break themselves up,” said Bove.

Yet the new rules and higher capital requirements are sure to create headaches for the big banks, which grew accustomed to holding less capital and relying on prop trading for revenue growth.

“What these guys now have to do is go back to the model that was thrown out 10 to 15 years ago,” said Bove.