Which Bank Will Financial Reform Hit Hardest?

The SEC's fraud charges against Goldman Sachs (NYSE: GS) has given a fresh impetus to lawmakers wanting to pass legislation on financial reform. In that context, bank share investors need to ask themselves which banks have the greatest exposure to regulatory risk. Indeed, the answer is not as obvious as it appears. Although Goldman has attracted the most negative publicity for its behavior leading up to and during the crisis, there may be reason to believe it isn't the bank that has the most to lose from regulatory reform.

The shortlist rule
First, let's define our shortlist. I'm only interested here in systemically important ("too big to fail") institutions, i.e., those with at least $100 billion in total assets. Second, it should be clear that banks with the most to lose are those with significant capital markets activities. Finally, I'm going to focus on banks only in this discussion, which excludes three wards of state: insurer AIG and mortgage market Chernobyls Fannie Mae and Freddie Mac.

The equity imperative
In evaluating which organizations could suffer the greatest decline in profitability due to financial reform, the quality of current capital capitalization is a critical indicator, because banks will need to raise the proportion of equity on their balance sheets.

The credit crisis proved that banks were perched precariously on mountains of leverage (perhaps a sand dune is a better metaphor, as credit lines that were firm one moment "gave way" unexpectedly the next). While all the banks in the table have done share offerings (preferred and/or common) in order to bolster their capital strength, they remain insufficiently capitalized to mitigate the risk of loss to taxpayers. I expect the new legislation to set tougher capital standards for all institutions that are "too big to fail."

Charging for risk
But capital ratios alone don't tell the full story; indeed, different activities merit different capital "charges." Not all bank activities are equally risky: Proprietary trading is riskier than fee-based activities such as asset management or brokerage, for example. The former should be supported by higher levels of capital than the latter (if it should even be allowed within a bank -- more on this later). Lawmakers may even raise requirements above norms established on a strictly actuarial basis, and actively discourage activities they deem too risky by making them prohibitively expensive in terms of capital.

Regardless of how lawmakers implement this principle, the greater a firm's exposure to capital markets businesses, the greater their exposure to regulatory change (in other words, Goldman and Morgan Stanley (NYSE: MS) -- the two remaining pure-play investment banks -- are "marked men").

Ranking criteria: capital adequacy and trading risk
In order to assess the top five U.S. banks along these two criteria, I've put together a table that ranks them according to capital adequacy and exposure to trading risk. The daily VaR (Value-at-Risk) is an estimate of the maximum amount a bank can lose on its trading positions with a 95% confidence, i.e., there is a 5% chance that the daily loss could exceed the VaR figure. I have scaled the VaR against the banks' common shareholders' equity to compare risk of loss across banks on a consistent basis:

Source: Company releases.
*NA: not available.
**VaR at Dec. 31, 2009.

The biggest loser
These results turn up a surprise: Goldman Sachs is actually the least levered of the five banks; meanwhile, Morgan Stanley has the highest normalized exposure to trading losses -- despite a common equity ratio that is a third less than Goldman's. On that basis, I'm forced to conclude that it is Morgan Stanley, rather than Goldman Sachs, whose profitability could suffer the most from regulatory reform.

It's worth pointing out a few caveats: One, we know that banks reduce their debt at quarter-end in order to report lower leverage, so I'm assuming that all banks engage in this window-dressing to the same degree (and that regulators are able to monitor banks' leverage on an intra-quarter basis).

A doomsday scenario for Goldman
Second, although I think it's unlikely (yet desirable), I think it's still possible that authorities will mandate that banks jettison all purely proprietary activities, which could be spun off into separate entities (i.e., private equity and hedge fund groups with no recourse to government support. Last Thursday, Bank of America announced it was selling its $1.9 billion portfolio of investments in private equity funds). If that were to occur, it would put into question the entire business model Goldman has pioneered, which has the firm wearing a two-faced mask: on one side, an intermediary to its clients and on the other, a principal.

Due to three sweeping changes on Wall Street, now's the time to invest in these stocks.