A new version of the Volcker rule may force U.S. banks to cede their capital market share in credit, sovereign and emerging market sectors to European capital market banks, notes Bernstein.
Brad Hintz and team at Bernstein Research believe a unilateral prohibition by U.S. regulators regarding OTC market making can radically change the global market shares and competitive positions of the leading U.S. fixed income participants.
New Volcker rule expected on December 10th.
The Volcker rule is a group of special provisions of the Dodd-Frank bill on financial regulation. The rule restrains banks from making speculative investments that do not benefit their customers. The provisions were originally set to be implemented in mid-2012, but delays have pushed the date back.
The rule will address a huge swathe of financial institutions. The most egregiously affected are likely to be the biggest and most complicated banks, including Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C) and JPMorgan Chase & Co. (NYSE:JPM).
Bernstein analysts point out a new version of Volcker regulations is expected to be made public on December 10th by the five major regulators overseeing the U.S. capital markets and the banking system.
Citing Standard and Poor’s estimates, Bernstein analysts point out that the Volcker rule could cost the eight largest U.S. banks a total of $2 billion to $3 billion per year in pre-tax earnings under a less strict regulatory interpretation of Dodd Frank and $8 billion to $10 billion per year if a more strict rule is established.
Institutional equity business would remain attractive
According to Bernstein analysts, even if the most onerous interpretation of Volcker were to be approved, the institutional equity business will remain economically attractive for the bulge bracket ECM underwriters. The analysts believe the highly profitable equity capital markets revenues of investment banking (where pre-tax ECM margin is over 40%) justify maintaining the costly equity secondary trading and execution businesses.
The following graph provides a snapshot of institutional equity trading market shares 2012-13 YTD:
Fixed income would face challenges
Bernstein analysts, however, believe the Volcker rule would remain a major challenge for any fixed income unit, as fixed income employs over 60% of the capital of the trading and investment banking segments. The analysts point out that other than government securities and certain sovereigns and money markets, agency trading of securities is very limited and only an estimated 20% to 25% of trade volume in the credit markets is electronically nettable, while the rest requires a balance sheet. The following graph highlights the massive increases in balance sheet deployment as the fixed income units of Wall Street expanded flow trading activities.
Effective prohibition of flow trading
Bernstein analysts estimate the effective prohibition of flow trading in non-exempt market making books would initially reduce non-exempt fixed income revenues by 20 to 25%. The analysts anticipate that the prohibition of flow trading would impact 55% of total revenue, and with such a revenue decline, the industry FICC pre-tax margin would decline from 24% to an estimated 17%.
Bernstein analysts note approximately 26% of Goldman Sachs Group Inc (NYSE:GS) 2013E revenue is from fixed income and roughly 12% of Morgan Stanley (NYSE:MS)’s 2013E net revenue relate to fixed income sales and trading. The following graph captures the FICC global market share:
The following table captures the potential Volcker rule winners:
The following table highlights Bernstein’s view on the top U.S. banks: