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As Reform Takes Shape, Some Relief on Wall Street

Eric Dash and Nelson D. Schwartz|The New York Times
Monday, 24 May 2010 | 8:05 AM ET

The financial reform legislation making its way through Congress has Wall Street executives privately relieved that the bill does not do more to fundamentally change how the industry does business.

Despite the outcry from lobbyists and warnings from conservative Republicans that the legislation will choke economic growth, bankers and many analysts think that the bill approved by the Senate last week will reduce Wall Street’s profits but leave its size and power largely intact. Industry officials are also hopeful that several of the most punitive provisions can be softened before it is signed into law.

Outside the New York Stock Exchange in lower Manhattan.
Photo: Oliver Quillia for CNBC.com
Outside the New York Stock Exchange in lower Manhattan.

Though there is anger in some quarters, other financial executives seem resigned to the changes, acknowledging that after the industry’s excesses set the stage for the deepest recession since the 1930s, there were bound to be major reforms.

“While I don’t agree with everything in the bill, given everything that’s happened during the financial crisis, it was inevitable that new regulation would come to Wall Street,” said Donald B. Marron, the former chief executive of PaineWebber and now the head of Lightyear Capital, a New York private equity firm. “Despite these new rules, Wall Street will continue to provide the same important business services because the same needs are still there — creating liquidity; financing governments, corporations and individuals; and providing financial advice and products.”

Many executives spent the weekend trying to assess the impact of the legislation, which has yet to take final form. With some crucial differences between the House and Senate versions of the bill remaining, lawmakers will confer over the next few weeks and try to reach a final version before Congress’s Fourth of July recess. But Wall Street’s initial verdict seems to be that it could have been much more draconian.

“If you talk to anyone privately, there’s a sigh of relief,” said one veteran investment banker who insisted on anonymity because of the delicacy of the issue. “It’ll crimp the profit pool initially by 15 or 20 percent and increase oversight and compliance costs, but there’s no breakup of any institution or onerous new taxes.”

The reaction of the market to the legislation echoed that view. Stocks of financial institutions performed well on Friday, with shares of JPMorgan Chase and Morgan Stanley each up 5 percent.

Richard Ramsden, an analyst for Goldman Sachs, estimated that the bill passed by the Senate on Thursday would initially cut profits by as much as 20 percent, a sizable bite, but hardly catastrophic given the sharp rebound in earnings since the depth of the financial crisis. Big banks and brokerage firms, experts said, will adjust to the changes, creating new revenue streams to make up for reduced profits, and find ways to work around the new regulations.

In other words, the industry’s landscape may not be facing an earthquake, after all.

“The health care bill is going to transform the structure of health care exponentially more than this legislation on financial regulation is going to change Wall Street,” said Roger C. Altman, the chairman of Evercore Partners and deputy Treasury secretary in the Clinton administration. “It’s not even close.”

There is still much in the bill to irritate big financial firms, like a ban on owning hedge funds, as well as stepped-up oversight and scrutiny of things as varied as derivatives trading and debit card fees. “We aren’t crying poverty,” said Scott E. Talbott, a lobbyist for the Financial Services Roundtable, an industry group representing big financial firms. “We are crying overreaction and overregulation.”

Still, it could have been worse. The Senate rejected rules that would have broken up huge banks considered “too big to fail,” or imposed limits on their size. Caps on how much banks can charge credit card holders to borrow also fell by the wayside. And the long-established wall between trading and commercial banking, which was torn down in 1999, will not be going back up.

Epic Tax Fight
An epic tax debate is being waged between Congress and investment fund managers, with Gerry Langeler, OVP Venture Partners.

Another reason for relief, several bankers said, is that neither the Senate version of the bill nor the one passed by the House in December includes more populist provisions that have gained a foothold in Europe, like a tax on financial transactions or on individual bonuses.

It is also possible that the new regulations could actually benefit Wall Street by saving it from some of its worst instincts. The big bets that undid Lehman Brothers and Bear Stearns, and forced the government to step in to save companies like the American International Group , will be harder to make, because of new regulatory agencies with beefed-up powers and higher capital requirements to protect against losses.

Some experts predict that Wall Street, like water overcoming a dam, will easily adapt to the new regulations, or at least exploit what loopholes do remain and thrive again.

When Congress split off commercial banking from investment banking in the early 1930s, after the Crash of 1929, there were predictions that Wall Street was hamstrung and businesses would not be able to raise capital as a result, said Charles Geisst, a professor of finance at Manhattan College.

“Almost all of the same arguments that you’re hearing today were made then,” Professor Geisst said. “It’s hard to keep them down, they ultimately find a way. I’m sure they’re finding a way to work around these new rules even before they’ve passed.”

AP

The business that is likely to change most is the trading of derivatives, the complex instruments considered to be among the main culprits of the financial crisis.

These securities, largely traded in the shadows rather than on exchanges like stocks, propelled an outsize portion of trading profits at firms like JPMorgan, Goldman Sachs and Morgan Stanley in recent years. But the lack of disclosure and the absence of standard prices also meant that derivatives increased risk and volatility, while also making companies dangerously intertwined in the event of a crisis.

A Senate proposal calls for Wall Street firms to wall off their derivatives businesses and place them in subsidiaries requiring substantially more capital. That would be a major blow — but this provision faces opposition from the both the financial industry and federal banking regulators, and is likely to be shelved or watered down before final passage.

The most likely outcome, according to industry officials, is a compromise that would allow banks to continue offering derivatives to clients in order to hedge risks. Trading would be shifted to clearinghouses or onto exchanges, and banks would be required to put up more collateral to cushion against losses.

These changes would make the system safer and more transparent, but they would erode profitability in what had been one of Wall Street’s most lucrative areas. Mr. Ramsden, the Goldman analyst, estimates that the legislative changes could reduce the financial industry’s earnings by 4 percent, though individual firms could be hit harder.

Still, the derivatives sector is simply too much a part of Wall Street to just simply vanish, according to John R. Chrin, a former financial services investment banker and teaching fellow at Lehigh University.

“This legislation is not going to kill the business,” Mr. Chrin said. Even if profit margins are reduced, he added, they will still compare favorably to more traditional banking activities like commercial lending. Wall Street firms are already investing money to upgrade the computer systems that drive derivatives trading in order to make them more efficient, as a way to compensate for what are almost certain to be leaner times ahead.

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