Updated from 8:22 a.m. ET with comment from Peter Tchir of TF Market Advisors.
NEW YORK (TheStreet) -- The regulators really don't want your bank to be your broker.
The Federal Reserve, U.S. Treasury and other regulators are set to "vote" Tuesday morning on the finalized set of regulations to implement the Volcker Rule, which is part of the Dodd-Frank banking reform legislation. The regulators first proposed the rules way back in October 2010, and after more than two years struggling to define Volcker's terms and "exceptions" to the ban on short-term proprietary trading by the nation's largest banks, nobody expects any "no" votes over Volcker.
The Volcker Rule -- named after former Federal Reserve chairman Paul Volcker -- was included in the the landmark Dodd-Frank bank reform legislation signed into law by President Obama in July 2010. The rule seeks to ban "proprietary trading" by systemically important financial institutions in the U.S. The idea of Volcker is that banks gathering insured deposits shouldn't be "gambling" with that money.
The nations' largest banks are all in investment banking and brokerage businesses. These banks maintain inventories of securities in order to serve as "market makers" for their customers, while also engaging in hedging activities to protect from losses on the securities held in inventory.
The Federal Reserve in April 2012 announced that banks would need to be in full compliance with the Volcker Rule by July 2014, even though the new regulations weren't close to being completed. Even before that announcement, many of the largest banks, including JPMorgan Chase (JPM), Bank of America (BAC) and Morgan Stanley (MS) began to shut down their proprietary trading operations.
Much of the debate over Volcker over the past two years has centered around the precise languages of the exceptions to the trading ban that will allow the banks to continue functioning as brokers.
How big a deal is Volcker?
"Currently, there is more than $100 billion of trading revenue generated annually at U.S. bank holding companies, with the largest five banks [including JPMorgan, Bank of America, Morgan Stanley, Goldman Sachs (GS) and Citigroup (C)] accounting for more than 90% of that amount," KBW analyst Frederick Cannon wrote in a note to clients on Sunday.
The text of the final set of regulations to enforce the Volcker Rule was leaked to the Wall Street Journal yesterday. According to the Journal, banks will no longer be allowed to engage in "portfolio hedging." This means hedge trades will have to be specific, protecting against loss on one particular security, or possibly against loss on one issuer. JPMorgan will no longer be allowed to engage in the type of market hedging activity that led to the "London Whale" trading losses in its Chief Investment Office (CIO), which exceeded $6 billion during 2012.
According to the Journal, bank CEOs will have to sign-off on compliance with Volcker. The banks may also face a high burden in documenting their historical volume of securities trades for their clients, in order to justify the inventory levels they maintain.
It would appear that the big banks will face quite a compliance burden from Volcker, which could lead some or all of them to give Washington what it wants. This would be a series of spinoffs of affected businesses, creating new investment banks and brokers, while leaving the largest bank holding companies with traditional commercial banking businesses. A transformation of this sort could benefit investors, unlocking value currently trapped within huge companies trading at low multiples to earnings.
There was plenty of reaction to initial reports of the Volcker regulations late on Monday and early Tuesday.
Donald Lamson, a partner in the global Financial Institutions Advisory & Financial Regulatory Group, of Shearman and Sterling and a former OCC official who has advised JPMorgan's independent directors on its CIO trading loss, expects the banks to sue the regulators, especially if the language and exemptions in the Volcker Rule are different than what was asked for during the commentary process following the initial proposal in 2011. "People are already suing the CFTC on the extra-territoriality of swaps," he says.
Lamson is creating an internal compliance product for banks that seeks to replicate what an examiner's procedure might look like.
"There is always a way to live with the rule. The question is whether living with it will hurt. I think it will," Lamson says.
Mayra Rodriguez Valladares, Managing Principal of MRV Associates and a former proprietary trading desk analyst for JPMorgan says Volcker "will be one of the biggest wastes of time." However, she is "very encouraged" by other requirements of Dodd-Frank, including the strengthening of capital ratios and liquidity, as well as the requirement for orderly liquidation plans.
"What was the real problem with Lehman? It was leverage and liquidity," she says.
Rodriguez Valladares is skeptical that bank regulators will be able to enforce the Volcker Rule effectively and doesn't believe it will add transparency for investors. For instance, investors aren't likely to get further insight into bank balance sheets, or granular details such as the level of activity in a bank's trading book, or the jurisdiction where trades are booked in.
FBR Capital Markets analyst Edward Mills in a client note on Tuesday wrote, "As with any rule this complex, we will have to wait until the final release and enforcement to determine the specific impact." He added that "the key debatable point will be how much of this rule will be a desire of regulators to generate headlines that it will prevent a repeat of the London Whale or whether this rule marks a shift toward stricter banking regulations in a post-nuclear-option Senate."
Pretty harsh words, but as we have seen over the past few years, the regulators love to generate headlines, leaking to the press at various stages of each enforcement action, negotiation and settlement.
Looking at investment bank stocks, Mills wrote that his firm continues "to favor MS over GS given the former's more diversified revenue mix that is not directly affected by the implementation of the Volcker Rule."
KBW Washington analyst Brian Gardner struck a similar tone, writing in a client note late Monday that "the actual text and definitions in the Volcker rule will be how regulators enforce it and on this point only time will tell. In the short term, we think the final rule will not be the worst possible outcome for banks and this could be seen as a positive for banks merely because it removes an issue that was hanging over banks for years."
I know we are supposed to care more about this convoluted rule, but we just can't," Tchir wrote in his daily client note, the T-Report. "The concept that somehow 'prop' trading brought down the banks seems silly. The idea that market making desks were a dangerous part of the equation is ludicrous," he added.
According to Tchir, Congress, through Dodd-Frank, could have lowered banks' trading trisks "with a few simple changes, but that would have meant some blame would have had to be shifted onto the regulators."
"In the end, banks are taking less risk because they don't want to. If and when they want to, they can probably find a way. The Volcker rule is overly complex. Banks will shy away from activities for now. That is probably bad for bank stocks at the margin but remains good for bank credit as tail risk is pushed off (at least until they get bloated on bad loans, but that is years away)," Tchir wrote.
-- Written by Philip van Doorn in Jupiter, Fla., and Antoine Gara in New York