Will regulation cut investment banking profits by a third?

A JPMorgan Chase (JPM) analyst believes that regulation of the investment banking industry could cut its profits by a third. As a result, he thinks investors should dump their shares of investment banks and buy those of traditional commercial banks.

I'm not sure how this analyst, Kian Abouhossein, reached his conclusions, which are included in a JPMorgan study released Wednesday, but I think he grossly underestimates the power of those investment banks to influence regulation and find their way around it to make more money for themselves.

Nevertheless, Abouhossein had the courage to put some numbers on his predictions. He believes that Deutsche Bank's return on equity (ROE) -- net income divided by shareholders' equity -- will decline from 10 percent today to 6.7 percent in 2011; Goldman Sachs (GS)'s ROE will shrink by 4.4 percentage points and Barclays' by 4.3 points.

Abouhossein expects banks to be required to hold more capital and to move more derivatives trading onto exchanges. And he thinks that the only way that banks will be able to make up for the lost revenues will be to pay people less. Meanwhile, JPMorgan upgraded the shares of Morgan Stanley (MS) on the strength of its lesser dependence on borrowing money to trade -- a feature of Goldman Sachs' business strategy.

Abouhossein's analysis seems to be predicated on the idea that global governments will be able to rein in Goldman Sachs. And yet the last several decades of actual outcomes suggest that it's the other way around. That's why I think his analysis is wrong.

Goldman Sachs will either thwart the passage of regulation that prevents it from making money trading, or it will find a way around that regulation. Meanwhile the more conservative banks will continue to lag.

Peter Cohan is a management consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter. He has no financial interest in the securities mentioned.

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