NEW YORK ( TheStreet)--One of the key rules aimed at reducing banks' ability to take risks actually increases their likelihood of defaulting on their debts, according to credit ratings firm Standard & Poor's. At issue is the Volcker Rule--one of the parts of the 2010 Dodd-Frank financial reform legislation most hated by U.S. banking giants Goldman Sachs ( GS), Morgan Stanley ( MS), JPMorgan Chase ( JPM), Bank of America ( BAC) and Citigroup ( C). The rule, named after former Federal Reserve Chairman Paul Volcker (possibly President Obama's most hawkish financial markets policy adviser) intends to limit banks' ability to make directional market bets. Its goal is to reduce the risk that banks will require another government bailout. However, Standard & Poor's warned that a more strict interpretation of the Volcker Rule might have the opposite of its intended effect. A strict rule "could significantly hurt some banks' revenues and profits because of a substantial reduction in trading," the credit ratings agency stated in a report published Monday. Most vulnerable, according to the report, are Goldman Sachs and Morgan Stanley, "because they derive a larger percentage of their revenues from trading than the other banks." A stricter Volcker Rule wouldn't make banks riskier, three S&P analysts stressed during a phone interview with TheStreet. "We're trying to assess the impact on ratings, which depend on businesses' market positioning, their level of capital and earnings and a number of other factors. Risk is certainly a part of that," said Standard & Poor's analyst Matthew Albrecht. In other words, ratings don't just measure risk: they measure the ability of a company to pay its debts. You might be excused for wondering what the difference is. It seems that risk, as Albrecht is defining it in the above statement, means market risk--the risk of a sudden massive trading loss, like the $6 billion blow inflicted on JPMorgan by its own traders. Several such losses might begin to impact JPMorgan's ability to pay its debts. But if JPMorgan suddenly lost half its clients, that would also affect its ability to pay its debts. JPMorgan losing clients (and, consequently, profits) is certainly a risk bondholders need to think about, but it isn't what S&P analysts such as Albrecht mean by risk. They would put that in the category of "earnings" or "market positioning."
So, because they fear a strict Volcker Rule could severely hamper Goldman and Morgan Stanley's profitability, it might lead S&P's analysts to reduce their ratings. Here it seems the credit analysts are injecting themselves into a political debate--essentially agreeing with the banks that too-strict rule-making threatens their ability to make a decent profit. Equity analysts do this all the time. They typically take the side of the banks against tougher regulations. But S&P's debt analysts appear less comfortable taking on such a role. They stress that what may be good for the banking system as a whole isn't necessarily good for Goldman Sachs, and that, over time, if Goldman proves it can be profitable and less volatile after the Volcker Rule is in place, they can reassess the ratings. Still, Albrecht acknowledged some skepticism about the history of bank regulation in the U.S. "The U.S. doesn't have a great regulatory history, and that's one of the things that influences our ratings. I think if we see concrete evidence of an improved regulatory track record then that certainly could help the ratings," he said. -- Written by Dan Freed in New York. Follow @dan_freed