The Biggest Loser From Financial Reform? Could Be Goldman Sachs

As experts and analysts pore over the details of the 2,000-plus-page Dodd-Frank financial regulation bill, some winners and losers are beginning to emerge. Investment bank Goldman Sachs (GS), for example, will potentially be the largest loser with the bill's caps on the bank's own activities in private equity investments and hedge funds. But it could also take a long time before those losses are realized.

The Dodd-Frank law was adopted by the House of Representatives on Wednesday by a vote of 237 to 192 and now goes to the Senate, where Democratic leaders are searching for four Republican votes to win passage following the death of Sen. Robert Byrd (D-W.Va.).

Weakened Volcker Rule

One of the key compromises in the bill was in the part called the Volcker rule, after former Federal Reserve Chairman Paul Volcker, who suggested it.

Volcker, who is now an economic adviser to President Barack Obama, had proposed banning banks from engaging in risky behavior such as making any bets with their own money. While some media reports have said Volcker is privately unhappy with the legislative compromise, he has publicly endorsed it.

The law now states that defining what bets banks may make with their own money -- so-called proprietary trading -- will be up to the regulators to decide. It also places a ceiling on the amount of hedge funds and private equity a bank can own instead of an outright ban. That ceiling is 3% of Tier 1 capital, the crucial reserves a bank is required by law to hold as protection against sudden losses.

Substantial Earnings HitPossible

Analyst Keith Horowitz at Citigroup (C) reckons that Goldman Sachs has the most to lose from the limits on hedge fund and private equity investments. Horowitz says Goldman has about $29 billion of such investments in April, but the 3% limit is only $2 billion, meaning that it would have to sell off $27 billion.

In a note to clients, Horowitz estimates this means Goldman Sachs will see a $1.55 per share earnings reduction from the Volcker rule. Goldman is expected to earn $3.24 in the quarter ending Wednesday, so it will be a substantial hit.

In contrast, banks such as JPMorgan Chase (JPM) and Bank of America (BAC) have much less exposure as a percentage of their capital, Horowitz says. JPMorgan is estimated to lose 12 cents per share in earnings under the new restrictions while BofA would suffer only a 5 cent loss, he says.

Long Lead Time for Compliance

One reason bank stocks have not suffered heavily as a result of the bill is that it provides a long lead time to implement. The legislation allows for six months to study the law, and regulators have another nine months to issue the rules. Banks would have up to two years to comply and then have the possibility of three one-year extensions. So-called Illiquid investments like private equity funds could get a five-year extension.

This means banks could have until June, 2016, to comply -- but be allowed until 2018 if they have illiquid investments.

The delay in implementing the Volcker rule is one of the legislation's major flaws, according to Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C.

"You're talking about a decade before this really starts to bite," Baker says. "There's no guarantee that the law won't be pushed back even further."

Judging Banks' Intent When Investing

Douglas Elliott, a fellow at the Brookings Institution, says he has been opposed to the Volcker rule since the beginning because it will cause economic harm without doing any particular good.

"The law purports to deal with excessive investment risk, but if you were doing that you would look at the level of investment risk, which the Volcker rule doesn't in any way do, and you'd look at the ability of the institution to handle the risk."

The legislation forces regulators to judge the intent of banks when making an investment, which Elliott says is very hard to do.

Deeper Impact Than Realized

But Andrew Freeman, executive director of the Deloitte Banking Center in New York, says he thinks the Volcker rule may have a more profound impact on banks than anyone realizes at the moment.

"I think the overall implications are going to mean a series of complex operational and capital allocation decisions and, in some cases, quite big changes to business models," Freeman says.

The key issue, he says, is deciding when a bank is representing a customer's interests and when its interests are in making trading profits for itself. "You're going to be much clearer about where that line needs to be drawn," he says.

It will depend to a great extent on which regulator draws up the rules at the beginning of the process, which Freeman says will "define the economics and the capital allocations of all these activities."