When Bank of America (BAC 3.35%) purchased Merrill Lynch at the trough of the financial crisis, the latter's capital markets (i.e., trading) operation was one of the draws. That has since changed, however, as new regulations have curtailed banks' abilities to trade on their own accounts.
In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and John Maxfield dig into the role that the Volcker rule has played in Bank of America's subpar performance over the past eight years.
A transcript follows the video.
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This podcast was recorded on May 9, 2016.
Gaby Lapera: You would think Bank of America would be able to, like you said, take advantage of the synergies -- I sound like a consultant now -- between the merger between Merrill Lynch and Bank of America, and leverage that to really profit from it. You're basically sitting here saying, economies of scale, right? Why aren't they making more money? Costco makes more money because they're bigger, and they can pass on savings. It doesn't work that way.
John Maxfield: Yeah. One of the main issues is that, going into the crisis, one of the ways that Merrill Lynch made a lot of money was through its trading operations. Well, another part of the post-crisis regulatory regime is that the regulators have really constrained what banks can do when it comes to trading. In 2010, for example, Bank of America earned something like $10 billion worth of revenue from trading, and that was from the Merrill Lynch operations that it had acquired in 2008. Well, last year, it was down to something like $6.5 billion. It decreased something like 36%.
You have this change in the regulatory regime that basically eviscerates Bank of America -- to a certain extent, large swathes of the Bank of America's trading operations. And it bought Merrill Lynch, thinking, "Oh, the trading operations are so profitable." And now, those trading operations have basically been taken away, and the only reason that banks can trade nowadays, for the most part, is in order to hedge their own risk, to hedge identifiable risks; or two, in order to make a market for clients. That means a bank can no longer trade on its own behalf, which was how they really made money.
Lapera: Yeah. This is part of the Volcker rule which is, which is a ban on proprietary trading, which is what Maxfield just described. It also prohibits banks from owning or investing in hedge funds or private equity. And it came with a slew of liability limitations. So, it really curtailed the bank's ability to do what banks have been doing before, which is good, in terms of financial stability, but bad in terms of them being able to make money, because, as always, the riskier the proposition, the bigger money you could make.
Maxfield: Right. And here's one other piece to this whole puzzle. Because Wall Street operations, trading, mergers and acquisitions, advisory work, stuff like that, it has a tendency to be much more volatile than just your traditional commercial banking operations like taking deposits and making loans. Because of the enhanced volatility in these types of operations, traders give banks with both types of operations, much lower multiples on their stock. And when a bank has a lower multiple on its stock, if it wants to eventually use that stock to make an acquisition, its money doesn't go as far. So not only is this hurting your profitability at a bank, but it's also impacting a bank's valuation, which impacts its cost of equity.
Lapera: Yeah. Another really interesting aspect to this rule that I was reading about was that, for certain big banks, because of the Volcker rule, some of their top traders just left, because they felt like they couldn't do their jobs anymore. So they went off and started their own hedge funds. It hadn't even occurred to me that it might cause a brain drain from banks.
Maxfield: Yeah. It's been a big deal for banks since the financial crisis, with their trading operations in particular, to your point, leaving banks because they're so heavily constrained, going into hedge funds, which don't have the same type of regulatory oversight.
