Reply #19: Financial Regulation: The Devil in the Details

[Roland99]

Financial Regulation: The Devil in the Details

(Roubini email)

The SEC’s case against Goldman Sachs has revitalized the regulatory reform dialogue and renewed concerns of earnings volatility and valuations. The outcome is of little consequence now that Goldman Sachs, and by association other large banks, have been publicly vilified. The case has demonstrated the logic behind Glass-Steagall, calling into question the remit and obligations of entities that operate under the protection of implicit federal assistance.

The Volcker rule aims to unbundle highly risky activities from the institutions we entrust with our savings by pulling the shadow banking system under the scrutiny of regulation. However, it could fall victim to “soft-touch” habits by allowing financial institutions control of its interpretation. Ideally, universal banks would be disaggregated into smaller specialized entities whose risk profiles could be more accurately priced by investors while insured deposit-takers would be restricted in their activities. Removing the expectation of federal assistance would reduce the impact and frequency of failures. Yet we are a long way away from such a potentiality.

The core dilemma in regulatory reform entails a choice between a robust financial system and leverage-fueled economic growth. Derivatives that allow banks effectively to “shed” risk, to free capital, and to grow more and faster, have become a focal point. Current proposals, aimed at decreasing the counterparty risk of individual participants or banning certain products, fail to combat the mispricing of risk, which enabled significant leverage. Legislation though, is only one step and the devil will be in the details.

Greater regulation will potentially alter relative valuations and should reduce price volatility across the capital structure. In its most “effective” form, it should reduce potential leverage/credit growth and lead to more sustainable macroeconomic growth. The bulk of the impact will affect equity through repeated bouts of volatility due to earnings uncertainty on the back of litigation risk and political/regulatory risk as completed legislation gives way to debates on specific standards.

In isolation, these rules would have a marginal effect on the largest U.S. banks, but in aggregate, they could account for anywhere from 10-25% of annual earnings, depending upon asset allocations and the cycle, which should have a negative effect on sustainable earnings power and ROE (and therefore equity valuations). These potential effects do not consider the impact of potential size caps nor do they capture the ancillary, albeit potentially significant effect on earnings and credit extension implicit in a systematic reduction of leverage in the financial system. The full extent of the impact will depend upon the details of implementation. This rule would have the most significant impact on brokers, but universal banks would face negative repercussions as well.

The Volcker Rule is a step in the right direction in that it aims to withdraw federal assistance expectations from entities that engage in risky activities, therefore reducing moral hazard and bringing parts of the shadow banking system under regulation. It would reduce a volatile form of income, but falls short of addressing conflicts and the continued leveraging of insured deposits in securities underwriting. Its utility and potential loopholes will rely upon how prop trading is defined. While there is no such Volcker rule on the table in the EU, there is a strong impetus in the EU to bring alternative investments under greater regulatory oversight (to the chagrin of the UK). Recent proposals envision significantly increased disclosure requirements, minimum capital and liquidity requirements, and greater investor protections. Stopping short of a ban could limit the earnings impact associated with passage of the Volcker rule in the United States. However, should a Volcker rule be implemented in Europe, earnings in the European “core” (UK, France and Germany) and Switzerland would be most affected, given that these countries have the largest universal/investment banks.

RGE believes that more radical reforms like eliminating the “too-big-to-fail” card and adopting Glass-Steagall-like regulation that unbundles different types of financial activity is necessary to ward off asset bubbles and combat systemic risks, but may not be feasible for political reasons. In the event of a Glass-Steagall type separation, we would expect a divergence in credit spreads between banks with and without insured deposits (a differential that would fluctuate with the credit cycle, and would be tighter at the top), but expect the cost of credit for depository institutions to be very close to sovereign risk. On the flip side, dilution risk will be concentrated in depository institutions. We could see higher PEs/ROEs in the non-depository institutions, though the ability to increase leverage will be dependent upon the level of regulation of non-depository institutions. All of this, of course, rides upon the credibility of regulatory agents and the utility of the reform.