Volcker Already 'Baked-in' Bank Earnings

NEW YORK ( TheStreet) -- Regulators haven't yet issued their final interpretations of the Volcker Rule, but analysts say that shares of some of the most familiar names on Wall Street already reflect lower profit margins in the future. 

Moshe Orenbuch of Credit Suisse's Multinational Banks equity research group estimated in a January 6 report that "the financial regulatory reform bill could negatively impact earnings by approx. 10%+" for large cap banks on average, he also said that "the impact is largely factored into analysts estimates." 

The Volcker Rule prohibits U.S. banks from engaging in proprietary trading on their own behalf, or owning or investing their own money in private equity funds or hedge funds. 

Frank Mayer -- a partner with Pepper Hamilton LLP of Philadelphia and a former senior attorney with the FDIC and senior counsel for the Resolution Trust Corporation who has been involved in discussions with members of Congress and industry over various aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act -- told TheStreet that "the legislation itself is just the first chapter," and with a new Congress and the industry's continuing negotiations with regulators, "you have a lot of things currently in play." 

This hasn't stopped analysts from predicting the possible effects of the Rule on revenue and earnings for large bank holding companies. 

In a report released on January 12, JPMorgan Chase's ( JPM) Europe Equity Research called European investment banks the clear winners "as Volker Rule provisions are unlikely to be implemented by the EU/Swiss," and estimated that Goldman Sachs ( GS) and Morgan Stanley ( MS) would take significant hits to their bottom-line results in 2012, when the final rules are implemented by the Federal Reserve.  

While agreeing that "the final earnings impact of the Volcker rule depends on the 'final' rule making," JPMorgan analyst Kian Aboulhossein's group estimated "average -14% impact on 2012E EPS from the limits on 'pure' proprietary trading" alone, in a 'normal year.'"  

The potential limiting of market-making activity based around the regulatory interpretation of "expected near team demands of clients, customers, or counterparties" is the center of ongoing debates among regulators and the industry.  

According to Aboulhossein's report, what is unknown is how regulators will interpret the terms "near term" when used in the context of "trading accounts" and "market making permitted activities."  If the new rules don't allow banks to hold inventories for long periods, "trading activities are likely to be impacted materially." 

The JPM group also said that the limiting of market making activity "will have a negative impact on liquidity and volumes, with the end users of all products ultimately bearing the increased cost." 

According to Aboulhossein, the "potential impact on limiting prop trading in client market making activities for US IBs" from the Volcker Rule's " not to exceed the reasonably expected near term demands of clients..." is quite significant.  Aboulhossein's bank research group estimates that "52% of 2011E IB revenues for GS and 40% for MS would be impacted by the market making limitations."  According to the report, Goldman Sachs would take the largest hit on the group level with 46% of its estimated 2011 revenues "impacted," followed by 20% for Morgan Stanley.  For large-cap banks, the estimate was that Citigroup ( C) would have 15% of revenues impacted, followed by 14% for Bank of America ( BAC), with the report of course excluding JPMorgan Chase.  

Aboulhossein said that the Volcker Rule would ultimately represent "material positive earnings potential for European IBs entering the market making 'liquidity gap,'" adding that European investment banks like UBS ( UBS) and Credit Suisse ( CS) seemed to be 'behind the curve' in seizing the opportunity."  Goldman Sachs "is the best in class liquidity provider today, but potentially has the most to lose from the new regulation." 

For JPMorgan Chase, Orenbuch estimated that the ban on proprietary trading would only cause a 2% decline in earnings based on 2012 estimates, and that there would be "a manageable impact to EPS for the large commercial banks given that most activities should qualify as either market making or liquidity as defined by the regulator," adding that "'pure' proprietary trading operations targeted in this provision represent a manageable portion of total revenues for BAC, C and JPM." When looking at the total effect on earnings for the fully-phased-in provisions of Dodd Frank - which could take several years - the potential reduction to earnings for large banks, according to Orenbuch, ranges from a low of 9% for Citigroup to a high of 18% for Bank of America. For JPMorgan, he estimates the total effect of the fully-implemented Dodd-Frank could be to reduce earnings by 14%.  

Calls to JPMorgan and Morgan Stanley requesting comment for this article weren't returned. A spokesman for Goldman Sachs told TheStreet his company was unable to comment. A Bank of America spokesman said that his firm was unable to comment, since the Volcker Rule was still being discussed by regulators. Citigroup also declined comment.  

Frank Mayer cautioned against over-reacting and said "the exceptions" to the Volcker Rule "are important, and will continue to be developed."  He added that "there's another year and a half and then a two-year phase-in period."  

Of course, with so much in play and the perceived potential for large U.S. banks to lose significant business because of the Volcker Rule to foreign banks, hedge funds and private equity firms, "the psychology of what might happen might be enough to result in diminished earnings from the proprietary desks at the banks," according to Mayer.  

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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