The differences in investing in regional commercial banks and the “Big Four” investment banks of JP Morgan and Chase Co. (JPM) , Bank of America (BAC) Citigroup (C) and Wells Fargo (WFC) is that the investment banks have not always acted with shareholders in mind, taking opaque, overleveraged risks that put their entire business in jeopardy in the search for increased profits. However, investment bank’s ability to make ultra-risky securities trades of the variety that caused the 2008 financial meltdown have been largely eliminated, thanks to the Dec. 11 enactment of the Volcker Rule.
The rule, an expansion of the powers granted by the Dodd-Frank Act, will force investment banks to more closely resemble their smaller commercial counterparts, transparent balance sheets and all.
While it seems counterintuitive, this law will not significantly affect investment bank’s bottom lines, and will keep their most profitable lines of business intact.
The Volcker Act, which is named after former Fed Chair Paul Volcker, puts an end to the complex securities trading that both created record profits for the major investment banks, but also nearly collapsed the global economy. Furthermore, the banks will no longer be allowed to gamble with client’s money on risky trades, and must instead use capital from their own coffers.
Unsurprisingly, the banks fought this hard, arguing that leveraging creates wealth for the entire nation’s economy. But banks are breathing a sigh of relief in knowing that their most lucrative line of business should remain unchanged.
Prop Trading Out, But Market-Making Stays Alive
Investment banks make their money via three main lines of business: hedging, or making sure their traditional loan-and-interest business remains profitable; market-making, or creating markets for investors to essentially gamble on and then making money off the spread; and prop trading, or trading securities.
The Volcker Rule largely eliminates prop trading, which can be quite profitable but is also the one revenue stream that puts banks directly at risk. The banks had feared that market-making was vulnerable as well. But that appears to not be the case, and the banks are thrilled.
“Market-making is the biggest of the three,” Equities.com analyst Nicholas Bhandari explained. “Prop trading divisions are where most of the risk came from, and has been either eliminated or extremely limited.” But the banks will retain the surefire market-making segment, in which the banks profit no matter how the market goes.
As far as the prop trading, the investment banks had already seen the writing on the wall, and many are already on their way out. JP Morgan put their commodities desk up for sale back in July, and the other investment banks will likely follow suit. “You’ll see banks spin off their trading divisions into investment funds,” Bhandari said.
While the Volcker Act will help safeguard against a repeat of the 2008 crisis or the London Whale debacle, banking's most profitable division will remain alive. Though the decree to do so did not come from within and instead is the result of government intervention, stockholders in investment banks can take comfort that the riskier trades will be severely limited, while the safest revenue streams remain intact.
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