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Volcker Rule Could Trigger Big-Bank Breakup

NEW YORK (TheStreet) -- It's almost time for the Volker Rule to be finalized, possibly forcing earth-shattering changes at the largest U.S. banks.

The Federal Reserve, along with the U.S. Treasury, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. are expected to complete their rule changes next week to implement banning "proprietary trading," as required under the "Volcker Rule," which was named after former Federal Reserve chairman Paul Volcker and included in the Dodd-Frank banking reform legislation signed into law by President Obama in 2010.

The regulators rolled out their proposed rules to implement Volcker way back in October 2011. The rules aim to prohibit bank holding companies from engaging in most forms of proprietary trading while severely limiting their ability to invest in private equity funds and hedge funds. The rule includes "exemptions" to the short-term trading ban will be the scene of a major battle between the large banks, the regulators and members of Congress.

The Volcker Rule is meant to include "exemptions" from the ban on short-term proprietary trading, in order to allow banks to hold sufficient inventories of securities to fulfill their roles as market makers, however, a major problem with the proposed rules was the lack of a definition on what "short-term" actually means. Definitions of "hedging" and "market making" were also vague.

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The Federal Reserve in April 2012 announced that banks would need to be in full compliance with the Volker Rule by July 2014. Even before that announcement, many of the largest banks, including JPMorgan Chase (JPM), Bank of America (BAC - Get Report) and Morgan Stanley (MS) began to shut down their proprietary trading operations.

But the finalized Volcker Rule will still be very important to the big banks.

"A broad definition of prop trading (with narrow exemptions) that is aggressively enforced could be the worst outcome for the largest banks," according to KBW Washington analyst Brian Gardner.

In a note to clients on Wednesday, Gardner wrote that the finalized rules could "accelerate the dis-intermediation of the Global SIFIs, pushing business to PE firms such as BlackRock, the shadow banking systems and to smaller brokers such as Jeffries."

SIFI stands for Systemically Important Financial Institution. These are the banks that are subject to Volcker as well as the higher capital requirements under Basel III. In addition to the three banks mentioned above, U.S. SIFIs include Citigroup (C - Get Report), Goldman Sachs (GS), Bank of New York Mellon (BK) and State Street (STT) of Boston. These banks have large prime brokerage operations and/or large asset management and custody operations.

KBW's analyst team believes a significant portions of SIFIs' business could be pushed to "PE firms such as BlackRock (BLK), the shadow banking systems and to smaller brokers such as Jeffries."

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