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How Wall Street Will Beat the New Financial Regulations

Wednesday, 28 Jul 2010 | 10:15 AM ET

Banks will beat FinReg four ways: Outsmarting the government; going overseas; making customers pay more, and getting bigger

The new laws contain numerous loopholes that Wall Street lawyers will find and exploit.

Weep not for Wall Street: Even though the nation's big financial institutions will get hit by the new financial reform regulations, they already have begun figuring out ways around them and are setting the path for more profitability in the future.

Analysts who feared the new rules might cripple the backbone of the American financial system have relented since President Obama signed the Dodd-Frank reforms into lawlast week.

The new lawestablishes tighter requirements for capital and restricts risk-taking. It also contains a significant consumer watchdog component and seeks to prohibit banks from becoming too big too fail.

But crafty financial veterans already are finding loopholes in the lawand banks likely will profit both in spite of and because of the reforms.

Wall Street
Wall Street

"What the law did was force the banks to rethink their business lines, their pricing strategies, their methodology for maintaining their balance sheet," banking analyst Dick Bove of Rochdale Securities said in an interview. "When they rethink it all, they will be able to offset all of the costs of this bill."

The banks' course of action likely will break down into four strategies:

1. Outfox the foxes

A harsh critic of the law, Bove is among the analysts who nevertheless believe banks will thrive. One big reason is because he thinks industry executives will show that they're smarter than the legislators who crafted financial reform, also known as FinReg.

"If you had anyone who knew anything about the financial industry writing this law, that's one thing," said Bove, who has called the law one of the worst in US history. "But if you have a bunch of hysterics who were looking for political gain, you get something that was an abortion. All it did was increase the cost of banking in the United States relative to the cost of banking in other countries."

One of the loopholes will be challenging the government to decide what is "proprietary trading." Normally considered that trading which institutions do for their own benefit rather than their customers, observers have speculated the government will have a tough time enforcing an exact definition.

The same could go for the much-touted Volcker Rule—named after White House economic adviser and former Federal Reserve Chairman Paul Volcker—which restricts to 3 percent of Tier 1 capital the amount banks can hedge or put into private equity.

But Bove said banks like Goldman Sachs can sell private equity funds to a third party and then establish a management contract in which Goldman would run those funds and take a percentage of the increase in value "which presumably would be equal to the profit you were getting for holding the funds in the first place."

"Although banks will be limited in how much they can invest in the funds along side with investors, managing the fund is still expected to garner meaningful management and incentive income," analysts at Keefe, Bruyette & Woods wrote of the 3 percent restriction.

2. Going Overseas

As Bove stated, Congress enacted FinReg unilaterally—foreign banks don't have to abide by the US rules, and US banks doing business overseas also can skirt FinReg in certain instances.

"The US is the world's largest economy and has the largest and deepest capital markets. There's no way for any big bank to avoid the US," said Doug Landy, banking partner at Allen and Overy in New York. "But I think people are re-looking at what business they do here and what business they do elsewhere."

While banks will have to be cautious not to cross regulatory restrictions, Bove said there are plenty of ways for financial companies to take their business outside the US.

Under the new rules, "You run the risk of the Federal Reserve saying, 'You're interconnected, we're going to regulate you,'" he said. "Or you can do it through a consolidated subsidiary in Switzerland. Nobody sees it, so there's no regulation. So why should you do it here?"

As customers pay price, banks will get bigger

3. Take it Out on the Customers

This is what Bove considers the most odious part of FinReg—the increased costs through regulation and restrictions will simply, he said, be passed onto customers.

Free checking will not exist anymore and customers likely will have to pay $10 to $12 a month to maintain their accounts, he said, meaning some on lower incomes may be forced to close their accounts.

He used Wells Fargo as an example of how banks will find numerous ways to pass costs onto customers.

"We have no doubt that the banks are actively looking at the best possible ways to rework their current business models to take advantage of inconsistencies in this legislation." -Partner, Allen and Overy law firm, Doug Landy

"Wells Fargo claims they have 86 specific businesses. That means there are about 80 businesses that they can increase prices and charges on, which they've already done" Bove said. "Wells Fargo has not been slow to make adjustments to its costs in order to make sure customers bear the burden of increases in regulatory costs."

A host of large banks already have warned that their earnings could be impacted by the new law.

"They're going to find more ways to make it. They're going to put more fees on customers," said Andrew Neale, partner at Fogel Neale Partners in New York. "That's obviously the first line of defense."

4. Be Big

Perhaps the great irony is that a bill designed to prevent banks from becoming too big to fail— a la Lehman Brothers and Bear Stearns—almost ensures the future of behemoth banks.

Banks that lack the capital to survive will be absorbed by their larger brethren, as has already happened 103 times in 2010. The financial crisis provided plenty of templates: JPMorgan Chaseswallowed Bear Stearns and ; Bank of America took in Merrill Lynch; Wells Fargo ate up Wachovia.

"One unforeseen victor is banks are actually much bigger than they were five years ago. Rather than being broken apart, they're bigger and stronger," said Landy, of Allen and Overy. "What it leaves is a situation where you have six huge banks, a bunch of regional banks and thousands of small banks."

A new ratings system on the banks promises to be kinder to the bigger well-capitalized institutions than those struggling their way through the recession, said Chris DiAngelo financial services partner at Dewey and LeBoeuf ion New York.

"The more the government stands behind the bigger banks the better their ratings will be, thus the lower their costs will be," DiAngelo said.

FinReg provides a resolution mechanism to seize and blow up banks that become too big to fail. But Wall Street is betting it stays at least a step ahead of the Washington regulators.

"We have no doubt that the banks are actively looking at the best possible ways to rework their current business models to take advantage of inconsistencies in this legislation," Landy said. "That's their job and that's what they're good at."

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