Banks 1, Regulators 0

What will the financial reform law mean for bank stocks? I recently asked Motley Fool Income Investor advisor James Early.

Mac Greer: At the risk of oversimplifying the new, 2,300-page financial reform law, what will financial reform mean for the future of bank stocks, in four sentences or less.

James Early: It'll lower their returns while making them safer.      

Greer: You've still got three sentences.

Early: You said "or less." This new financial reform doesn't fundamentally fix too-big-to-fail -- its original goal -- but it heavily crimps banks' ability to stick you with fees, and lightly crimps banks' ability to trade in complicated things like derivatives. Both have been banks' profit engines over the past decade.

So you'll probably see banks like Bank of America (NYSE: BAC  ) , which once prided itself on minimal customer service, becoming more friendly as they look for new fees. But on derivatives -- an actual cause of the financial crisis, unlike overdraft fees -- the reform appears to require banks to spin off their swap desks, which sounds devastating for big derivatives players like JPMorgan Chase (NYSE: JPM  ) and Goldman Sachs (NYSE: GS  ) , until you learn that interest rate swaps are exempted -- and they account for over 80% of swaps. So on swaps, it's Banks 1, Regulators 0.

Greer: OK, James, another big profit driver for Wall Street banks is proprietary trading, where a bank buys and sells securities on its own account. The new Volcker rule restricts proprietary trading, so banks will have to spin off their proprietary trading units. What will that mean for the bottom line?

Early: There are many shades of prop trading. The Volcker rule tackles the most overt, which is banks' investing in hedge funds or trading in hedge-fund-like capacities. Those investments are limited to 3% of Tier 1 capital (roughly, a bank's equity capital), and similarly, a bank's investment can't constitute more than 3% of a fund. Goldman has around 10% of equity capital in such investments now, so it will presumably spin off some trading.

The other banks are around or below the threshold, but Citigroup (NYSE: C  ) and Morgan Stanley (NYSE: MS  ) are both rumored to be planning similar spinoffs. This will reduce the bottom line in good times for these banks, but improve it in bad, as banks won't have to contend with losses. And it's really aimed at a few big Wall Street banks, meaning banks like Credit Suisse (NYSE: CS  ) or even Wells Fargo will be a lot less affected. Of course, thanks to market-making activities like taking the opposite sides of certain positions, banks do many other things that expose them to trading profits (and losses) despite the Volcker rule. Still, it's a risk reducer for the biggest banks.

Greer: You mentioned Goldman. According to a recent LA Times article, Goldman executives have told analysts that Goldman doesn't expect to lose any revenue from the new financial reform law. What does that tell you about financial reform, and does it make you more inclined to invest in Goldman?

Early: Goldman is like the Yankees: I'd never bet against them. And if Goldman indeed lost no revenue -- although to be fair, they could still see lower profits on the same revenue -- it would be the perfect symbol of this ineffective reform. The goal wasn't to cost Goldman revenue, but the fact that Goldman has already worked around the limitations says something good about Goldman and something bad about the regulation. Simply put, if you ask Congress to regulate something they don't understand, you get this.

Greer: So if you had to invest in one of these big banks, where are you investing?

Early: You'd have to put a gun to my head. If you did, I'd go with Goldman, but I'd much rather wait a few years because thanks to a weird accounting rule change, many banks are sitting on worse assets than it appears. Once the economy recovers, I'd consider investing in well-run banks that operate outside the Wall Street fizz, such as US Bancorp (NYSE: USB  ) and BB&T. Both are former recommendations of my newsletter (as is Bank of America), and Warren Buffett is also a big fan of US Bancorp.

Fool contributor Morgan Housel says bank shareholders are getting some justice.

Looking for another investment idea? James has some thoughts on one oil stock that could produce gushing returns.

Neither James nor Mac owns any of the stocks discussed. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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