Wall Street and Washington are busy chewing over the proposal put forward last month by President Barack Obama to reform the financial system. The so-called Volcker rule — named for Paul Volcker, the former Federal Reserve Board chairman and current trusted Obama financial adviser who for months has been pushing for harsher banking reform — would, in effect, mark a return to the days of Glass-Steagall. That is the legislation passed in response to the 1929 stock market collapse that separated commercial from investment banking, preventing lenders that take deposits from engaging in risky trading activities. In the most recent postcrisis era, lawmakers have identified their particular bogeyman as proprietary trading, though Obama has also proposed strict limits on how much commercial banks can invest in hedge funds and private equity firms.
Wall Street is on edge, to put it mildly, but many industry onlookers are applauding. “I think it is a positive step,” says former Securities and Exchange Commission chairman William Donaldson, who has also advised Obama on the proposed financial reform. The main intent, says Donaldson: “Going against the obvious conflicts of interest entailed with prop trading by a firm that has access” to the U.S. Federal Reserve’s discount window.
Proprietary trading has become an increasingly important source of revenue for all major banks. Goldman, Sachs & Co. CFO David Viniar has said his firm gets approximately 10 percent of its revenue from prop trading and investing, which includes profits from its hedge fund and private equity investments. Taking away the ability of banks to trade for their own accounts will eliminate a significant potential revenue source, but Donaldson and others argue that such a rule will drastically reduce the threat of another near-collapse of the entire financial system.
One thing is clear: Such reform will accelerate a trend already well under way, of prop traders moving to hedge funds. “There is going to be a tremendous amount of talent that gets displaced from bank prop desks,” says Howard Eisen, co-founder of New York–based hedge fund advisory firm FletcherBennett Group.
The proposed reforms dovetail with what other countries are advocating, notes Donaldson. “It is very much in line with what the [Group of 30] came out with,” he adds, referring to the report on financial regulation released at their January 2009 global summit calling for strict limits on proprietary trading. Sanford C. Bernstein & Co. analyst Brad Hintz concurs: “Indeed, the tone of the G-30 report clearly resembles the commentary out of the Obama administration yesterday as it is not supportive of banks taking large trading risk,” he wrote in a report published one day after the president’s announcement.
But the details are still fuzzy, Hintz points out. For example, how will proprietary trading be defined? Will banks be able to take risks as part of their market-making activities? If not, then they effectively can’t function as commercial banks and operate a fixed-income and commodities trading business.
After Obama made his remarks, the focus turned to Goldman, which has the largest prop trading business among the banks; its stock price fell by $6.75 a share the next day. The proposed reforms, says Hintz, will likely “force financial institutions to choose between depository and nondepository charters — essentially, the proposal is a closet Glass-Steagall.”
For Goldman, however, which had yet to truly embrace being a commercial bank despite having become one in September 2008, at the height of the financial crisis, such reforms would likely mean reverting to its status as an investment bank. Or, as Hintz suggests, “a new securities industry would emerge as the capital markets businesses of the universal banks would be spun off (much like Morgan Bank spun off its bond department in the Great Depression to form Morgan Stanley), with Goldman Sachs as the clear industry leader.”
So, in the end, much to the chagrin of an economically struggling public still fuming over the bank’s recent windfall, this could turn out to be a win for Goldman — especially since Obama’s proposed reforms will likely hurt its competition a great deal more.
