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Financial reform won't hit the big banks anywhere near as hard as Wall Street wants you to believe
06/25/2010 8:30 am EST
The bank, which has emerged from the financial crisis as one of the strongest big banks in the United States, is pressing ahead with discussions to buy a big Brazilian hedge fund and private equity group. JPMorgan Chase is in talks with Gavea Investimentos, which manages about $5.3 billion in assets.
Yet the U.S. Congress is pressing ahead with a financial reform bill that includes the Volker Rule, which in its strictest form would ban banks from trading on their own account and limit their ability to invest in or sponsor hedge funds and private equity vehicles.
JPMorgan Chase already controls Highbridge Capital Management, a $21 billion hedge fund, and private equity group One Equity Partners.
Does JPMorgan Chase just have a lot of faith that the banking industry’s army of lobbyists will once again prevail and remove anything truly dangerous to the status quo from the bill now in front of a joint House-Senate committee working to reconcile separate bills from the two houses?
Or does JPMorgan know that the fix is already in and no matter what our elected representatives vote to do, when the rules are finally written by the folks who theoretically regulate the financial sector, the result will be change that banks can believe in.
I’d pick the latter. The financial industry knows they get two shots at this. The first in the halls of Congress is likely to result in something with a few teeth—enough so that Representatives and Senators can tell voters in November that they fought for them against big, bad Wall Street. (Not so many, of course, that members of Congress will jeopardize their ability to fund their campaigns with Wall Street money or get employment in the financial industry once their term in office is over.) The second, out of public view, will take place in the halls and offices of the regulatory bodies that actually write the rules that implement the often vague laws that Congress writes. JPMorgan Chase and other big banks are betting that when the rules are finally written, they will permit the activities that banks deem crucial.
On the track record the big banks are almost certainly right. If that’s true, and you’re cynical enough, that means there are some bargains out there among bank stocks that have been sold off because investors think that financial regulation might have some real teeth.
Let me start this column by explaining why financial regulation with teeth is unlikely. And then end by naming three U.S. bank stocks to put on your watch list for purchase during the summer doldrums to come. (To keep track of my watch list, called cleverly enough Jim’s Watch List go to http://jubakpicks.com/ )
The so-called Volcker Rule, first proposed by former Treasury Secretary and current Obama economic advisor Paul Volker back in January is a great example of why the damage to financial industry profits is likely to be less than many investors now fear.
The original proposal would restrict proprietary trading by banks for their own accounts unrelated to customers' needs. It would bar them from sponsoring hedge funds and private equity funds. The stakes would seem to be huge. More than a quarter of all private equity investments between 1983 and 2009 involved bank-affiliated private equity groups, a recent study from Harvard Business School and global business school INSEAD found.
Banking lobbyists are fighting hard for a carve out. Big banks such as State Street (STT), Goldman Sachs (GS), Morgan Stanley (MS), and, yes, JPMorgan Chase want the rule changed to allow de minimus investments by banks in private equity deals.
No big deal right? Allowing minimal investments by banks wouldn’t add significant risk to the financial system and it would allow banks to invest in deal alongside clients. And that would convince bank customers that such deals were safe since the bank had its own money at risk. The interests of customers and banks would be aligned, the banks argue.
It’s hard to imagine that even the banks buy that argument. If the investment is truly minimal, so minimal that it wouldn’t increase a bank’s risk, then how could it possibly convince the participants in a deal that the bank had significant skin in the game?
But every exemption a banking lobbyist can get into the bill in Stage One, the legislative process, the more room for maneuver banking lobbyists will have in Stage Two, the regulatory process.
Just to take this example, if legislators follow their usual practice, they’d leave it up to the regulators who write the rules to define de minimus. The definitions of de minimus in a legal context include “inconsequential, insignificant, meager, moderate, modest, negligible, of minor importance, of no account, paltry, petty, obscure, scanty, slight, trifling, trivial, and unworthy of serious consideration,” according to “Burton’s Legal Thesaurus.
Lots of room for interpretation there. Exactly how would you set a limit for bank investments in private equity deals given that guidance? Should the investment be “modest” or “negligible,” “moderate” or “trifling”? And what exactly, in dollars, is a “modest” or “trifling” investment for a Goldman Sachs or a JPMorgan Chase?
The influence of lobbyists on Senators and Representatives gets all the attention—of the relatively meager amount of attention that we pay to how the legislative sausage is stuffed, anyway. And lobbyists at this level are immensely influential, both in dollar terms and in terms of personal connections.
The U.S. Chamber of Commerce, to take just one example, spent $148 million on lobbying Congress in 2009 and the first quarter of 2010, according to the Center for Public Integrity. It’s hard to get a precise estimate of how much is spent on lobbying on a specific issue, but the Center calculates that the top 10 lobbying companies in Washington collected $30 million in fees for lobbying on financial reform and other related issues. (The center’s estimate is based on a study of lobbying companies’ financial disclosure forms that contained key words or bill numbers related to financial reform legislation.)
The volume of personal connections between lobbyists and Congress is perhaps even more overwhelming. According to research by Public Citizen and the Center for Responsive Politics 56 financial industry lobbyists once worked on the personal staff of the 43 Senators and Representatives sitting on the financial reform conference committee. A total of 1,447 lobbyists for the financial industry once worked for the federal government and 73 are former members of Congress.
But lobbying Congress is only part of the game. Congress writes the laws but it leaves it up to the regulators to write the rules. In a mid-June review of the text of the financial reform legislation, the Chamber of Commerce counted 399 rulemakings and 47 studies required by lawmakers.
Each one of these, like the proposed de minimus carve out of the Volcker rule, would be settled by regulators operating by and large out of the public eye and with minimal public input. But the lobbyists for the financial industry who once worked at the Federal Reserve, or the Treasury, or the Securities & Exchange Commission, or the Commodities Futures Trading Commission, or the Federal Deposit Insurance Corp. know how to put in a word with those writing the rules. Need help understanding a complex issue? A regulator has got the name of a former colleague now working as a lobbyist in an e-mail address book. Want to share an industry point of view with a rule maker? Odds are a lobbyist knows who to call to get a few minutes of face time.
The regulatory battles range from issues like the precise way to calculate de minimus to membership on the list of banks that need extra regulation because they represent a systemic risk to the financial system. (Define that one. Go ahead. I dare you. Best of luck to the Federal Reserve.)
No wonder that one of the most contentious battles has been over amendments offered by Senator Jeff Merkley (Dem-Ore.) and Senator Carl Levin (Dem.-Mich.) to restrict the discretion that regulators would have in implementing the Volcker rule.
Estimates of the cost of the financial reform legislation are designed to terrify legislators and voters. We’re in danger of destroying one of the few globally competitive U.S. industries, the anguished cry goes. (Of course, that globally competitive industry played a key role in creating a financial crisis that took the world close to another Great Depression, but never mind.) Some banking industry analysts have estimated that financial reform as now written could reduce profits at big banks by 12% to 35%. Earnings at Goldman Sachs would fall 23%, at Morgan Stanley 20%, at JPMorgan Chase 18%, and at Bank of America (BAC) 16%, according to a June 16 investment report from Citigroup.
Sorry but I think those estimates completely over-estimate the power of words in a Congressional bill to produce actual change on corporate bottom lines. (And, of course, it is to Wall Street's political benefit to moan that it has been mortally wounded when it's barely been scratched.) The words will have been lobbied over until they offer the most room for discretion possible to the actual rule makers who will then be lobbied some more, out of public sight, to bend the rules in industry’s favor as far as possible without actually breaking with the original Congressional intent. Whenever it happens to be clear.
The current legislation gives rule-makers up to 18 months to finish their work. But remember that rules in Washington are seldom completed on time. Count on 2012 to be well advanced before the bulk of rules actually hit the industry.
By then, the banks that I’m adding to Jim’s Watch List today, Goldman Sachs and Morgan Stanley—and JPMorgan Chase, which I added to the Watch List on June 8—will have massaged the rules so that they can certainly live with them without major changes to their business models. And maybe their lobbyists will have even found a way to turn some of those rules into weapons to use against competitors.
It wouldn’t be the first time that reform worked out that way.
Full disclosure: I don’t own shares in any company mentioned in this post.
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