Will the Volcker Rule crush Goldman Sachs?

December 9, 2013: 5:00 AM ET

Goldman has traditionally made more of its money trading than other Wall Street firms, putting the bank at particular risk depending on how the final version of the Volcker Rule is structured.

Paul Volcker: His rule may finally pass

Paul Volcker: His rule may finally pass

FORTUNE -- Wall Street may have a bigger Volcker problem than it's letting on.

Most Wall Street firms have spent the past few years shedding businesses that clearly don't comply with Volcker, which is supposed to limit the banks' ability to make money on risky, in-house trading. What's more, most big bank CEOs say their firms have been Volcker-compliant for a while now.

Nonetheless, this week's vote on the Volcker rule, which is supposed to come on Tuesday, has some worried. Bloomberg reported that the nation's five Wall Street firms -- JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and Morgan Stanley (MS) -- generate as much as $44 billion a year from trading. A lot of that money, though, is not really at risk. That number includes some of the fees the firms get from executing clients' transactions. That business is not banned by Volcker.

Earlier: Goldman still earns its money in soon-to-be-banned ways

It looks likely that the final rule could ban so-called portfolio hedging, which are broad trades that are supposed to protect a bank against a macro-risk, like an economic downturn. JPMorgan has said the failed London Whale trade, which lost the bank $6 billion, was a portfolio hedge.

But banks will still be allowed to hedge. There could be some good news for the banks in the final rule. The draft of the rule said that all non-client trades had to be "reasonably correlated" to offset a risk the bank was taking for a client. Some advocates of more Wall Street regulation pushed for that to be reworded to "highly correlated."

But, sources say, in a win for Wall Street, that the final rule regulators will vote on next week says nothing about correlation. That requirement is out all together. Instead, regulators will use other measures to try to limit non-customer trading. It's not clear those measures will be effective.

Also, the $44 billion figure is down significantly from what it was before financial reform law Dodd-Frank was passed, despite the fact that the stock market has come back and the bond market has been relatively stable. That suggests that the big banks have jettisoned much of their non-client trading businesses.

Still, the question is how much of that $44 billion is generated by the big banks in trading that will eventually be banned. Surely, when the final rule is enforced by regulators, it will be more restrictive than the way in which banks have been policing themselves.

MORE: Why Universities are money pits

And the impact will be bigger for some firms than others. In a research note out last Wednesday, Morgan Stanley analyst Betsy Graseck said Goldman would be the most affected among Wall Street banks. Goldman declined to comment.

Goldman has traditionally made more of its money trading than other Wall Street firms. And a big drop in its currencies business in the past quarter has reignited concerns about Goldman's trading operations.

Graseck says that Goldman generates about half of its revenue from trading. Another 17% of its revenue comes from direct investments, some of which are made through Goldman private equity or hedge funds. The Volcker Rule is expected to significantly limit how much money banks can put in those investment vehicles as well. And my colleague Dan Primack has detailed how Goldman has been slower than other banks to exit those investments. All told, Graseck says Goldman is at risk of losing 25% of that revenue because of the Volcker Rule, or nearly 17% of its overall revenue.

But the impact could be larger than that. Unlike other firms, Goldman does not break out the profits it gets from its various lines of business. Typically, trading revenue tends to be more profitable than other lines of business. So, a 17% drop in revenue coming from that business could lead to a bigger drop when it comes to the actual bottom line, say 20%.

Like other banks, Goldman has struggled to get its return on equity, a key metric for financial firms, back to where it was before the financial crisis. Last quarter, Goldman's ROE was just over 10%. The hit from Volcker could take Goldman's ROE down to 7% next year, well below the 20% it used to regularly report before the financial crisis.

MORE: How to bet against the Bitcoin megabubble

"The question is whether Goldman takes on more directional risk than others, and whether they will still be able to do it," says Glenn Schorr, an analyst at Nomura. "It's a fair question."

One answer: Every quarter, firms report a figure called value at risk, which is supposed to track how much money a bank stands to lose trading each day. Goldman's VAR is down from what it was a few years ago. But it is still higher than most of its rivals. In the most recent quarter, Goldman's VAR averaged $80 million. That compares to an average of $68.5 million at Goldman's closest rivals, suggesting that Goldman is conducting riskier trading than Morgan Stanley, JPMorgan, and others.

That might not be the case. Many say VAR isn't a reliable stat, and firms have leeway in how they report it. Goldman doesn't disclose enough about its business to figure all this out. But with the Volcker Rule now back on track, we may soon find out.

  • Make $377,000 trading Apple in one day

    A Berkeley professor finds out just how much a certain type of high frequency trading costs the average investor.

    By Rob Curran

    FORTUNE -- Two recent studies of latency arbitrage suggest the stock-market structure needs a remodel if it's ever going to stop billions of dollars going from unwitting investors into the pockets of high-speed trading firms.

    "Latency" refers to the time it takes for a stock quote to get from an MORE

    Aug 30, 2013 8:31 AM ET
  • Tweet Retreat: Did high-frequency reading crash the market?

    Wall Street's algorithms can read fake tweets faster than you can.

    FORTUNE -- As Wall Street predictions go, Jamais Cascio had a good one. A little less than a year ago, Cascio, a distinguished fellow at think tank Institute for the Future, in a blog post, predicted that retweeting Twitter bots combined with a fake news story posted by hackers on a major media website would cause a market crash. That's MORE

    - Apr 25, 2013 5:00 AM ET
  • Academics: Academia destroys stock picking strategies

    If you want a stock trading strategy to work, keep it to yourself.

    FORTUNE -- Academics are very good at identifying characteristics that can predict stock performance. They also are good at publicizing their findings. And therein lies the problem.

    Professors David McLean (MIT) and Jeffrey Pontiff (Boston College) set out to learn what happens after academic papers on new trading strategies are published, and found that the strategies quickly lose efficacy.

    "Our results MORE

    - Nov 2, 2012 11:57 AM ET
  • SEC puts the light on dark pools

    The SEC goes after dark pools and finds its first target in Pipeline Trading, a network run by a former Nasdaq president.

    FORTUNE -- If you own 10 million shares of a company, it'll be pretty obvious if you want to sell them all. For that reason mutual funds like to divvy up their trades among what are known as dark pools. Dark pools are private trading networks where big institutions MORE

    - Oct 25, 2011 11:35 AM ET
    Posted in: ,
  • The ultimate fear profiteer

    Every day traders play the VIX -- the market's fear index. But the Chicago Board Options Exchange wins whether it's up or down.

    FORTUNE -- When traders want to know if the sky is falling, they look to the VIX index. It's Wall Street's greatest fear gauge. Technically the index tracks stock options to gauge the market's expected swings both up and down. But mostly it grabs the attention of investors MORE

    - Aug 11, 2011 3:38 PM ET
  • The good news in the corn craze

    Corn prices are popping again, but there is a morsel of good news too for those who fear corn flakes inflation.

    Corn futures surged 3% in trading Thursday after the government slashed its corn planting forecast and raised its price projection. The Agriculture Department now expects corn to fetch a record $6 to $7 a bushel this year, which is 50 cents above its previous forecast.

    The latest spike shows "the balance sheet MORE

    - Jun 9, 2011 12:06 PM ET
    Posted in: , ,
  • Tranquil trading buffets banks

    The casino isn't paying off the way it used to for the big banks, but don't count them out just yet.

    So says Sanford Bernstein analyst Brad Hintz. He says Goldman Sachs (GS), JPMorgan (JPM) and their peers are headed for another profitable quarter, but warns that trading riches are making themselves scarce.

    "Trading volumes look a little light," Hintz said Monday on Bloomberg Television. "Will trading be a much smaller business MORE

    - Mar 7, 2011 3:22 PM ET
  • The big deal about the NYSE's big deal: Derivatives

    As regulators start to scrutinize the proposed combination of the NYSE and the Deutsche Börse, they'll need to take into account much more than just equity trading.

    By Cyrus Sanati, contributor

    The battle for the soul of Wall Street continues as the fate of the New York Stock Exchange remains up in the air. The NYSE's tentative $10 billion sale to Germany's Deutsche Börse will need to pass through a regulatory gauntlet MORE

    Mar 2, 2011 10:13 AM ET
  • 'Mass affluent' are strapped too, BofA finds

    The mass affluent aren't as affluent as they're cracked up to be.

    That's one conclusion you might draw from a Bank of America Merrill Lynch survey released Monday. The bank is pushing a Web-based trading and advice service called Merrill Edge. It's pitched at educated, online-savvy customers with investable assets of between $100,000 and $250,000.

    That sounds like a decent-size nest egg and, by extension, a potential gold mine for BofA's wealth managers. MORE

    - Jan 24, 2011 10:53 AM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by VIP.