Senators Prepare A Citigroup-Sized Hole In Volcker Rule

Senate negotiators are expected to offer changes today to the financial reform bill that would soften the Volcker rule. On Capitol Hill there is widespread speculation that the Senate negotiators will propose language that would allow banks to invest a small amount of their capital in their internal hedge funds or proprietary trading desks.

Exactly how much capital the banks would be able to commit to their hedge funds and proprietary trading under such a change is not clear. Early reports indicate there may be support on Capitol Hill to allow banks to put 2% of their capital into hedge funds they sponsor or prop trading. Bank lobbyists have been pushing for a higher number, perhaps up to 5% — a level which would allow many banks to escape the Volcker rule altogether.

But depending on which percentage the Capitol Hill negotiators agree to, lawmakers may unintentionally be allowing the banks that needed the biggest bailouts during the financial crisis to escape the Volcker Rule. On the other hand, banks that fared better may be forced to spin off parts of their prop trading and hedge fund businesses.

The Volcker rule, suggested by former Federal Reserve chairman Paul Volcker, would ban banks from trading with their own capital or sponsoring hedge funds. The goal is to prevent banks from engaging in risky or complex trading that could undermine their financial health and require a new round of bailouts.

The Senate approved the rule last month. It was not included in the version of the bill passed by the House late last year. Ironically, it is now the Senate negotiators who are trying to water-down the provision by providing for this exemption, while House members yesterday proposed keeping the original Senate version.

Exactly how the new exemption would operate is unclear. The speculation on Capitol Hill is that the exemption would be based on a percentage of a bank’s regulatory capital. The banks do not currently report what percentage of their capital is invested in their sponsored hedge funds or used for prop trading. It’s likely they do not even measure this in any precise way. But there is some general sense of how much of the annual revenue of some banks is generated through prop trading.

Citigroup, which got a total of $45 billion from TARP plus a government backstop of losses on risky assets, would hardly be affected at all by a Volcker rule that permitted prop trading with 2 or 3% of its capital. Citigroup generates less than 2% of its revenues from prop trading, according to a person familiar with the matter. If you add in hedge funds and private equity, the number climbs a bit higher but never hits 3%.

Bank of America—which also took $45 billion from TARP and got a huge government guarantee—is in a similar situation, a person familiar with the matter said. Any exemption to the Volcker rule would let Bank of America carry on with business as usual.

JP Morgan Chase, which did a much better job navigating through the financial crisis, may have more to lose if the trading exemption is set at the lowest levels being contemplated. Although it is estimated that JP Morgan Chase generates less 1% of its total revenues from prop trading, it also operates the world’s largest hedge fund. A person at JP Morgan Chase who asked not to be identified indicated that the bank would be comfortable with a 5% cap—but might be forced to sell some hedge fund assets if the level was much lower. Officially, JP Morgan Chase declined to break out how much of its capital is used for prop trading and sponsored hedge funds.

Goldman Sachs , which also got through the financial crisis in better shape than many of its rivals, says it generates around 10% of its revenue from prop trading. Even under a generous exemption, Goldman is well over the line. Goldman would be forced to either spin out some of its hedge funds and trading operations or drop its status as a bank with access to the Federal Reserve’s discount window. Goldman became a bank holding company at the height of the financial crisis in 2008.

We’ll know more when we actually see new proposed language, which could be unveiled as early as this evening.