June 28, 2010 - Chris Wain-Lowe

US Banks - Updates on the financial reform bill

Volcker rule: Originally the Volcker Rule proposed restrictions and/or an outright ban on proprietary trading and principal investing including the management, sponsorship, and investing in a hedge or private equity fund. The revisions allow a bank to utilize a de minimus amount of its own capital, 3% of Tangible Common Equity, to invest in its own alternative investment products. No exemption was made for proprietary trading although what constitutes proprietary trading versus market making was left up to the discretion of regulators. More importantly, we interpret that banks can retain their role as money manager although as an added restriction the bank can also only invest up to a maximum of 3% of any individual fund's capital. The time to implementation could take 6 years.

The timeline is as follows: Regulators conduct a study for 6 months and then have 9 months to write the rules. The financial institutions will then have two years to become compliant, but there is also the potential to receive 3 one year extensions. All in, it could be as long as 6 years – a welcome period to adjust as banks with  private equity investments ( like JP Morgan) can now manage down their investments over the course of the next few years and either IPO the businesses or sell them individually.
Derivatives: Interest rate swaps and FX swaps can stay in the bank which represents the bulk of their derivative earnings.  Credit default swaps are excluded and existing derivatives at the bank can stay at the bank via a ‘grandfathering’ agreement. There will be a two year implementation period.

Bank Tax: Its smaller than thought, just like the UK. Originally, it was potentially as high as $120 billion, but has been reduced to $19 billion. Currently, financial institutions over $50bill in assets would be responsible for the fee and hedge funds over $10bill would be included as well. But, it remains to be seen who is included under the definition of “financial institution”.
Timing: Both the House and Senate have to sign it in its current form…. the goal appears to be getting it to the President’s desk for signature around July 4th.

Bottom Line: The bill still comes down on the banks, but it is not as bad as once feared and the longer timeline relieves a lot of near term pressure to exit the impacted businesses. We view the finality of this Financial and Regulation as a positive catalyst for the large-cap banks we own and that hopefully markets will now get back to studying their fundamentals.

Global Banks – Update on reform
Plans by global regulators to compel banks to set aside significant extra capital to cope with future crises are now expected to be pared back after intense lobbying by the industry…. the most significant change to the proposed Basel committee reforms is that there is now unlikely to be a ‘net stable funding ratio’ wherein the maturity of assets and liabilities were to be much closer aligned… instead a form of oversight will be considered… so averting the concern that funding costs / borrowing costs would need to be raised to cope with the extra demands for liquidity. In addition, the overriding aim to seek a level competitive playing field still means – in our view – that any agreed actions will be given several years to adopt … much like is now evident in the US reforms mentioned above.