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Leaked Volcker Draft Leaves Questions (Update 1)

Volcker story update with additional commentary

NEW YORK ( TheStreet) -- A leaked draft of federal regulators' proposed set of regulations to implement the Volcker Rule sheds light on the coming fight between lawmakers and the industry before the rules are finalized at year-end.

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act -- signed into law by President Obama last July -- the Volcker Rule prohibits bank holding companies from engaging in most forms of proprietary trading while severely limiting banks' investments in private equity funds and hedge funds. The rule was proposed by the president and supported by former Federal Reserve Chairman Paul Volcker.

Paul Volcker

Investment banks Goldman Sachs (symbol) and Morgan Stanley (symbol) are facing a major upheaval to their business models, as the firms have relied on private trading as a profit center over recent years.

Other large holding companies, including Bank of America (symbol), JPMorgan Chase (symbol), Wells Fargo (symbol) and Citigroup (symbol) will also be affected as they eliminate most proprietary trading, while facing mounting pressures on revenues in other areas, including narrowing interest rate spreads in the wake of the Federal Reserve's "Operation Twist", reduced fees on credit cards and checking account overdrafts, and a significant reduction in the interchange fees the banks charge merchants to process debit card purchase transactions.

In January, before the Federal Reserve issued its draft proposal to implement the Volcker Rule, JPMorgan Chase's Europe Equity Research group, estimated that the average decline in earnings per share for "a normal year" for Goldman and Morgan Stanley from the rule's "limits on 'pure' proprietary trading alone," would be 14%, with possible revenue declines of 15% for Citigroup and 14% for Bank of America, depending on how the regulator's final rule would restrict banks' market making activities.

At that time, the potential limiting of market-making activity based around the regulatory interpretation of "expected near team demands of clients, customers, or counterparties" was at the center of debates among regulators and the banking industry.

A key question -- according to JPMorgan analyst Kian Aboulhossein -- was how regulators would interpret the terms "near term" when used in the context of "trading accounts" and "market making permitted activities." The analyst said that if the new rules wouldn't allow banks to hold securities inventories for long periods, "trading activities were likely to be impacted materially."

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