Why Wall Street Will Love The 3% Solution in Reform Bill
Senior Editor, CNBC.com
The new limits on proprietary trading and hedge fund investments may actually benefit big banks more than harm them—especially in the hedge funds they market to clients.
The Obama administration had proposed an outright ban on banks engaging in proprietary trading and sponsoring hedge funds. The ban—nicknamed the Volcker rule because it was championed by former Federal Reserve Chairman Paul Volcker—was softened last night as lawmakers reached agreement on a major financial overhaul bill.
Under the final version of the bill, banks will be allowed to invest up to 3 percent of their own capital in proprietary trading or a hedge fund they operate for clients.
"Prop" trading, as it is often called, is when banks risk their own money to invest in financial markets. Though it has been very profitable for banks, the practice was blamed for helping to cause the 2008 financial crisis.
The 3 percent limit, which seems restrictive, actually isn't. The reason is that most of the biggest banks — including Bank of America, Citigroup, and Morgan Stanley — already are within that range on propriety trading, so not much will change.
Goldman Sachs may be one of the few banks that will have to reduce its proprietary trading or perhaps spin off prop trading operations into separate hedge funds. However, it could avoid the restrictions altogether if it stopped being a bank holding company, which it only became in 2008.
The 3 percent limit also doesn't have a big impact on the hedge funds that banks own—and may actually be an unintended benefit. That's because banks are far more interested in the management fees they charge for in-house hedge funds—usually 2% of the total assets and 20% of the trading gains—than any profits the funds generate for the bank's bottom line.
This is one of the reasons banks have increasingly turned toward managing hedge funds instead of pure proprietary trading, which is a lot riskier.
The new limit will now give the banks an excuse to reduce the amount of capital they commit to a hedge fund, which was mostly done to convince clients that the banks had "skin in the game." In fact, banks were being forced to commit more and more money to the funds to compete against other funds.
At Goldman Sachs, for instance, some hedge funds were pitched to outsiders as very attractive because the company and its employees were the largest investors in the fund.
By creating a ceiling of 3% in any single fund, the Volcker rule will now allow banks to say they have fully committed the legal maximum amount of capital to the fund. Customers will not be able to demand a larger commitment. The arms race stops at a stake of just 3%.