What's really at stake for banks in the Goldman SEC suit

04/23/2010 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

It might be just coincidence that the SEC filed civil fraud charges against Goldman Sachs (GS) in the midst of a contentious debate in Washington over legislation to reform Wall Street.

But it’s sure as God made little green apple no coincidence that the SEC announced its charges on the same day that comments closed on what’s called Basel III.

You’re probably up to your eyeballs in speculation about what the charges against Goldman will mean for the Wall Street bank that everyone fears to hate. And you’re probably desperately trying to tune out the empty rhetoric that passes for debate over the financial reform bill in the Senate these days. (Let’s just say that when Connecticut Senator Chris Dodd (Dem.) said his Republican colleagues were acting like teenagers, I sprang to my feet at home to launch an impassioned defense of teenagers from such slander.)

And you’ve quite possibly never even heard of Basel III. But I think the other two much more public stories are simply sideshows to the action in the main ring that’s Basel III. And without going too far out on the fringe with Dr. Walter Bishop, I think Basel III is the behind the scenes story in the current political and regulatory drama.

Okay, so what’s Basel III and why is it so important?

This set of new regulations for the international banking industry will determine the profitability of banks for the next decade.

Simple as that. And that’s something that neither the SEC charges against Goldman or the financial reform legislation in Congress can claim.

The Basel III rules, so named because they follow on sets of international banking rules called Basel I and Basel II that were also drawn up in the Swiss city of Basel, will set much tougher guidelines for Tier One bank capital than the earlier sets of rules. That was inevitable in any set of rules drawn up in the aftermath of the global financial crisis.

No one is sure how tough these rules will be. The comment period on the draft rules only closed on April 16. But just about every national banking industry in the world is worried that the rules will, if not put it out of business, crush profits and put it at a deep disadvantage to banks from other countries.

The worry isn’t really over how high the Basel Committee on Banking Supervision will set capital requirements. Banks are pretty much resigned to being forced to raise more capital and to keep higher levels of reserves. It’s hard to argue that excessive leverage (and inadequate reserves) didn’t play a major role in turning a global financial problem into a very close encounter with global financial meltdown. The need for higher reserves has been bolstered by the example of countries such as Spain where the real estate market blew up as disastrously as anywhere in the world, but where the banking system walked away from the wreck with relatively minor injuries because the Banco de Espana, Spain’s Central Bank, had imposed higher reserve requirements as the bubble inflated.

No, what keeps bankers from Tokyo to New York up at night is worry over how Basel III will define Tier One capital. The Basel II rules said that banks had to hold at least 4% of their risk-adjusted assets (for a bank an asset is a loan, remember) in Tier One capital, supposedly the safest of all capital, and limited Tier One capital to equity and equity-like holdings. One big loophole in Basel II exposed by the global financial crisis was in the nature of these equity-like holdings. Some weren’t as safe and liquid as they needed to be. Some equity-like holdings turned out to be in essence debt. The effect was to lower Tier One capital to as little as 2% of risk-adjusted assets. And that just wasn’t enough margin of safety when the global financial crisis hit.

So the draft proposal has tightened up the definition of Tier One capital. Great in theory. But in practice the proposed rules throw out whole asset classes that individual national banking industries depend on for a major part of their capital.

So, for example, the draft rules propose tough new rules on limiting how much cross-shareholding—that is when banks own shares of each other—could count toward Tier One capital requirements. That proposal comes down really hard on European banks, which routinely own big hunks of each other. The French Banking Federation said in its comments on the rules that the draft proposal would confront euro zone banks with a $503 billion deficit in Tier One capital.

U.S. banks would take their own hit from the proposed Tier One capital rules in Basel III. For example, the rules would require that banks maintain an amount of long-term loans and deposits equal to their financing needs for 12 months—including off-balance sheet commitments and anticipated securitization. That would force many U.S. banks to move away from using the capital markets to raise funds and to increase their reliance on deposits. In general U.S. banks are moving in that direction but Basel III, now scheduled for implementation by the end of 2012, would speed up the trend.

It’s hard to believe some of the numbers being thrown about. Lobbyists for U.S. banks claim that the rules would force banks around the world to raise $6 trillion in new capital. Since the Basel III rules will be enforced by national regulators, who wouldn’t rush to put their national banking system out of business, I think that number is nonsense.

I have seen one number that does express the effect of Basel III on banks: According to an analysis by UBS, the stricter definition of capital and higher capital requirements in Basel III would reduce lender’s return on equity to 12.9% from an estimated 13.8% in 2012.

That may not seem like a lot but the difference between the return on equity at JPMorgan Chase (JPM) and Bank America (BAC), a very well-run bank and a not so well-run bank, in 2007 was only slightly larger at 12.86% for JPMorgan Chase to 10.77% for Bank of America.

Now what does all this have to do with the SEC fraud charge against Goldman and the financial reform bill in Congress?

First, notice that while the banks and regulators may be adversaries in the SEC/Goldman suit, they’re more like co-conspirators when it comes to Basel III.

 If banks are going to head off any parts of Basel III that they find especially onerous, they’re going to need national banking regulators to make their case with the Basel Committee on Banking Supervision.

In fact the U.S. Federal Reserve called just such a meeting in the week before the SEC filed its case. Executives from JPMorgan Chase, Wells Fargo (WFC), and Fifth Third Bancorp (FITB) met regulators from the FDIC (Federal Deposit Insurance Corp.), the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Reserve Bank of New York who listened as the banks raised their objections to Basel III. None of the regulators defended Basel III, Bloomberg Business Week reported.

From that point of view—that of seeing regulatory agencies and regulated banks not as opponents but as allies—ask, What do banks have to offer to make regulators go to bat for them?

The list isn’t long but it is significant.

Banks can offer to let national regulators—the Federal Reserve, the FDIC, etc.—regulate them instead of the international agencies in Basel and at the IMF. No regulator wants to lose authority over any part of the regulated realm.

Banks can offer to make regulators look good by agreeing to significant rules or legislation that would increase the regulators prestige and visibility.

Banks can offer regulators increased responsibility by agreeing to new regulation over un- or under-regulated parts of the market.

So think about the financial reform bills, then, as a careful balancing act by banks, regulators, and legislators (who have their own desire for prestige, etc.). Each side wants something of value that they’re willing to pay for but no side is willing to pay too much.

So regulators and legislators want to increase their territory by increasing regulation of derivatives and by forcing trading in some derivatives to exchanges. That will cost banks by increasing collateral requirements and by lowering fees. Banks may not want to pay all that legislators and regulators want here but they’re certainly willing to pay something in exchange for support on Basel III. For example, JP Morgan estimates that what it calls even-handed derivative regulation would cost it about $300 million in annual revenue a year. That’s not much to pay for regulators’ support on Basel III. But worst case derivatives rules might cost the bank $3 billion in annual revenue, the BreakingViews column in the New York Times estimates.

Hence we have the current argument over how much of the derivative market will be exempt from regulation.

This is one reason that I’m just about certain that some financial reform bill will pass—something with enough teeth in it so that regulators and legislators can brag but not so many that it’s too painful for banks.

Think about the SEC civil fraud charges in the context of this triangulation.

By bringing the suit, the SEC enhanced its own power but more importantly it created critical leverage for its allies in Congress that were working to extend regulators’ powers and reputation.

The cost to the banking industry? Modest pain for a rival that many banks wouldn’t mind seeing cut down to size.

And so far, at least, Goldman looks like it’s going to get an expensive slap on the wrist, but not one so painful that it will endanger Goldman’s place in the Wall Street hierarchy.

It’s by no means certain that the SEC will win its suit against Goldman Sachs. The case will rest on proving that the hedge fund Paulson & Co., which was betting that the mortgage-backed securities market would drop, had material involvement in deciding what mortgage-backed securities went into the Abacus offering and whether Goldman failed to disclose that involvement to buyers of Abacus. If the SEC prevails, Goldman will face a fine in the range of $100 to $300 million (petty cash for Goldman), restitution of the $1 billion in losses (real money certainly but remember that Goldman just reported earnings of $3.5 billion for the first quarter of 2010) and a hard to guess level of punitive damages. The punitive damages could be 3 times the $1 billion loss; they could be capped at a 1:1, or they could be even less. And they’re likely to be appealed for years. So this thwack is hardly the kiss of death for Goldman or even major damage to its business model. (For more details on the SEC suit see my post http://jubakpicks.com/2010/04/16/the-sec-case-against-goldman-punctures-wall-streets-act-of-god-defense-the-agency-says-the-global-financial-crisis-was-somebodys-fault/ )

Sure ,everybody from European financial regulators to attorneys for banks on the losing end of Goldman deals will pile on. But I have to believe that the SEC picked the case that it thought it was most certain to win. That means other potential plaintiffs from American International Group (AIG) to Royal Bank of Scotland (RBS) may face cases that they can’t win.

But remember that this is a conspiracy based on largely unexpressed mutual interest and not on some plan articulated by the participants and then carefully laid out. The momentum of a situation like this can quickly get out of hand if some party gets carried away by the moment and forgets the interests of the other parties or miscalculates its own interests.

There are signs that this could happen.

Anger among voters is so high that some legislators are in danger of actually pushing for reforms that would be exceedingly costly to banks. The Volcker rule that would require banks to divest their proprietary trading units is still in the Dodd bill in the Senate, for example.

The SEC is known to have sent subpoenas in 2009 to Bank of America, Citigroup (C), Credit Suisse (CS), UBS (UBS), Morgan Stanley (MS), and Deutsche Bank (DB) besides Goldman Sachs. If the agency files suits against a wider swath of the banking industry, banks may find that they’re facing a tidal wave of public anger that makes it impossible for them to control the trade-offs in Congressional reform legislation. Two Democratic members of the House of Representatives, Peter DeFazio (Ore.) and Elijah Cummings (Md.) have asked the SEC to broaden its probe of Goldman Sachs and to refer any criminal misconduct to the Department of Justice. DeFazio and Cummings are especially interested in the $12.9 billion in taxpayer money that American International Group paid to Goldman Sachs to settle derivative positions. (For a different take on who might be next see my post http://jubakpicks.com/2010/04/20/an-intelligent-guess-at-whos-at-risk-after-the-sec-charges-goldman-sachs/ )

This all could still get out of hand. Let’s hope, anyway.

Full disclosure: I don’t own shares of any company mentioned in this story.
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