The new Volcker Rule’s restrictions on bank proprietary trading and hedge funds will have profound impact on the financial sector as a whole, notes IBISWorld

Volcker Rule Paul Volcker

Stephen Hoopes of IBISWorld points out that in addition to eliminating bank prop trading, the Volcker Rule prevents banks from maintaining or taking ownership stakes in private equity and hedge funds.

Restrictions on banks’ investments

The IBISWorld analyst points out that the Volcker Rule restricts a bank’s investment to 3% of a private equity or hedge fund’s total value and 3% of the bank’s total core capital. Moreover, this portion of the rule further separates the prop trading activities of nonbanking institutions from bank-holding companies.

However, the analyst also points out that that the process of differentiating speculative trading from hedging and market-making can be difficult. Hence, lawmakers have required banks to connect securities holdings with specific hedges and to avoid large ‘portfolio hedges’, which are designed to protect institutions from broad macroeconomic risks.

The analyst also notes market-making or the provision of liquidity by maintaining a market for securities, largely granted an exception from the Volcker Rule. However, the amount of securities held by banks is no longer allowed to exceed ‘the reasonably expected near-term demands of customers’.

Volcker Rule Impact on investment banks

The IBISWorld report notes that Investment Banking and Securities Dealing are the most impacted industry by the Volcker Rule. Sensing the impact, the industry has already taken noticeable steps towards compliance such as Morgan Stanley (NYSE:MS) announcing its decision to spin off its Process Driven Trading, a prop trading unit. Goldman Sachs Group Inc (NYSE:GS) too has shut down two of its prop trading desks prior to the rule’s approval.

The analyst points out Bank of America Corp (NYSE:BAC) CEO Brian Moynihan’s statement that ending trading activities restricted under the Volcker Rule cost the bank nearly $500 million of revenue per quarter.

According to Stephen Hoopes of IBISWorld, the Volcker Rule is still anticipated to further harm both revenue and profit for large investment banks. He notes a number of large banks have already witnessed losing some of their best traders to hedge funds.

However, the analyst points out with rebounding corporate profit and general improvements in the U.S. economy, the Investment Banking and Securities Dealing industry can expect to more than make up for these negative trends. IBISWorld analyst believes the increasing underlying business and trading activity are forecast to push up the industry’s revenue at an annualized rate of 3.2% to $156.1 billion in the five years to 2018.

Impact on private equity and hedge funds

Turning the attention towards private equity and hedge funds industry, IBISWorld analyst notes the impact of Volcker Rule on the industry could be a mixed bag. IBISWorld report points out many opponents of the Volcker Rule question its shift of speculative activity to less-regulated hedge funds and away from heavily regulated investment banks. Similarly, the sale of corporate bonds by large banks is expected to increase the direct trading of these assets between insurers and pension funds, moving this activity farther away from highly regulated areas of the economy.

Interestingly, the analyst points out banks that are now restricted from risky lending opportunities, leaving the market solely to non-banking institutions, such as private equity and hedge funds.

However, private equity and hedge funds that remain after the Volcker Rule’s implementation could experience a windfall thanks to the decreased competition from financial conglomerates. The IBISWorld analyst believes that over the next five years to 2018, revenue for the Private Equity, Hedge Funds and Investment Vehicles industry is forecast to increase at an annualized rate of 3.8% to $107.7 billion.

The following table provides snapshot of the effect of Volcker Rule on these two key industries:

Volcker's industry impact

The IBISWorld analyst concludes that for the financial sector as a whole, the Volcker Rule will be viewed as a success only if its prevention of taxpayer losses outweighs the inadvertent costs of less liquid markets.