Our Outlook for Financial Services
The Volcker Rule is finalized, so now banks need to worry about complying with it.
Quarter-End Insights
- The Volcker Rule is important. Financial institutions have spent and will continue to spend substantial amounts of time ensuring compliance with the Volcker Rule over the next few years.
- Volcker’s key provisions include guidelines on proprietary trading and market making. The changes around proprietary trading and hedging should effectively curtail a repeat of the "London Whale" saga, while preserving market making as an important Wall Street liquidity and profit source.
- The most important measures of success: enforcement. Regulators have obviously missed major blowups in the past as the events from 2008 and 2009 show as well as the London Whale fiasco. How the Volcker Rule is enforced by the multiple agencies in charge will determine its success.
Why The Volcker Rule Is Important
Five years after the turbulent days of late 2008, and after years of political infighting, the long-awaited Volcker Rule has been finalized. For many U.S. financial institutions, including Goldman Sachs (GS), JPMorgan Chase (JPM), Morgan Stanley (MS) and many others, ensuring compliance with this rule and dealing with enforcement-related activities will be a constant thorn in their side over the next few years. The rule was originally proposed by former Federal Reserve Chairman Paul Volcker to restrict speculative trading activity, which included derivatives, by commercial banks. Financial institutions must comply with the new rule by July 21, 2015, but good-faith efforts, including initial reporting efforts for the largest banks (greater than $50 billion in assets) starts on June 30, 2014. Firms with between $10 billion and $50 billion in assets will have staggered compliance dates in 2016, while community banks won’t need to comply with the rule at all.
The overarching goal here was to ensure that a clear bright line was drawn between the acceptable activities for commercial banks, hedge funds, private equity funds, and investment banks. Overseeing the implementation of the rule will be five regulatory agencies: the Federal Reserve, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Deposit Insurance Corporation. A large part of why the rule took so long to be finalized is that the agencies struggled to reconcile their different missions and views on the Volcker Rule's key provisions.
Key Provisions
The rule is primarily meant to address proprietary trading, where banks use their own capital to speculate on short-term price movements. For example, the trades that led to JPMorgan’s now famous London Whale debacle that occurred last year, causing a loss of $6 billion for the firm, was a real-world test case that regulators studied carefully. Despite earlier concerns that the type of portfolio hedging that led to the loss would be banned, the final rule allows portfolio hedging but forces the banks to identify specific risks as well as perform a correlation analysis between the risk and the hedge. Banks will also be required to document each transaction, explaining the rationale for any potentially riskier moves, while ensuring that compensation does not reward traders for finding ways around the new rules. In short, despite not prohibiting the activity that led to the London Whale incident, by requiring banks to much more closely monitor and document what kind of trades are being placed, the odds of another large wayward hedge position are a bit lower. That said, Volcker will also allow market making (a key source of liquidity for financial institutions), with the provision that the firm demonstrate it is making trades based around its historical customer demand. In other words, if a bank is holding millions of shares of Google (GOOG), it needs to show regular customer demand for those shares or regulators will determine the position to be proprietary.
A second major focus of the rule was to address banks’ ownership of hedge funds. The rule prohibits banks from owning and sponsoring private equity funds, with the exception of SEC-approved investment companies, acquisition vehicles, joint ventures, and wholly owned subsidiaries. All ownership interests may not exceed 3% of a bank’s Tier 1 capital. While several banks are over this limit, they have until mid-2015 to be in conformance. Additionally, we believe that the winding down of the stakes will be value neutral to the companies, as they should be able to liquidate their positions at a fair market value, which takes into account the future lost revenue.
Another key provision is the insertion of a CEO attestation. CEOs now must attest in writing that their banks are engaging in processes to monitor, enforce, and review compliance programs, but they do not have to state that the bank is not engaged in proprietary trading. The attestations force executives to be more aware of risky trading activities within their companies and helps ensure that CEOs are setting the right tone throughout the company regarding compliance. However, at the same time, by not requiring a more definitive statement on proprietary trading, it provides some cover for potential trading-related mishaps that could still occur under the Volcker provisions. In other words, CEOs could still plausibly avoid personal responsibility from a legal perspective (the CEO still could be forced to resign, though) if a multibillion-dollar trading loss occurs on their watch.
A final important provision was around foreign trading activities. Foreign banks and countries were worried that the rule as originally proposed would prevent foreign banks from making proprietary trades, essentially broadening the rule’s impact to the global markets rather than just U.S. entities. The final rule let foreign banks make trades as long as the risk and trades occurs and is held outside of the United States. There’s also an exemption granted to foreign operations of U.S. banks. In short, if a foreign bank is trading through a New York operation, or if the U.K. operations are trading with a U.S. entity, then it is covered under the rule, but two overseas offices trading between each other are fine.
Enforcement
The biggest banks have been planning for the Volcker Rule for years as it wound its way through the rule-making process. Citigroup (C) and JPMorgan among others have already shut down or spun off proprietary trading desks and private equity and hedge fund arms. Banks have also been rewriting compliance manuals and computer programs as well as retraining employees to better comply with the new rule. At the same time, Goldman Sachs is reportedly studying whether it can invest in business development companies, which appear exempt from Volcker requirements, as a way around the rule.
However, the ultimate impact of the rule will really depend on how strongly it is enforced by bank examiners. For example, the FDIC, which is widely recognized to have some of the toughest examiners, is not traditionally involved in capital markets activity, which is the focus of the Volcker Rule. As the rule stands, it appears the banks will have to provide far more documentation regarding their trading operations going forward. However, banks are still largely defining whether their trading practices will comply with the new rules, and regulators are only double-checking their efforts. There does not appear to be any explicit limits on trading levels or a detailed specification of what constitutes a “high-risk” asset, meaning there is still substantial discretion required on the part of the bank examiner to determine whether a bank’s compliance plan is reasonable and safe. At this point, it seems like the best ways to measure Volcker’s effectiveness is to look at trader attrition and compensation levels, as well as potentially trading levels in fixed income, currency, and commodities. A reduction in private equity and hedge fund investments will also be fairly straightforward to observe as well.
Our Top Financial-Services Picks
Long-time favorites such as Capital One Financial (COF) and Berkshire Hathaway (BRK.B) are reappearing on the list this quarter. However, we’re also adding insurer Aegon (AEG), and Lloyds (LYG). For Aegon, we think it is being treated more like a European insurer when it generates the majority of its profits within the United States and it has yet to receive substantial investor recognition for its turnaround efforts. We see potential in Lloyd’s as it moves beyond its legacy issues toward a brighter future in the cozy U.K. banking market.
| Top Financial-Services Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Aegon |  | $11.00 | None | Very High | $5.50 |
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| Berkshire Hathaway | | $143.00 | Wide | Medium | $100.10 |
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| Capital One | | $90.00 | Narrow | High | $54.00 |
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| Lloyds | | $6.10 | Narrow | High | $3.66 |
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| Data as of 12-13-13. |
Aegon (AEG)
We believe that the market does not fully understand the company's operations, which is ultimately being reflected in its share price. While the firm generates more than 70% of its profits from its U.S.-based Transamerica franchise (with the rest coming from the U.K. and the Netherlands), investors continue to treat it like it is a European heavy insurer with limited growth opportunities. The company has also received little recognition for its turnaround efforts in the aftermath of the financial crisis, which have involved derisking its business and making a gradual shift toward a more fee-based revenue model. As such, Aegon has been trading at around 0.5 times book value, not much higher than the 0.4 times book value seen on average between 2009 and 2012, and well below the average price/book multiple of 1.2 times from 2003 to 2008.
Berkshire Hathaway (BRK.B)
We remain impressed with Berkshire Hathaway's ability to generate growth in book value per share in excess of its benchmark, believing it will take some time before the firm succumbs to the impediments created by the sheer size and scale of its operations, as well as the longevity of Warren Buffett and Charlie Munger. The company’s shares continue to trade at a discount to our fair value estimate, providing investors with the potential for double-digit upside from today’s market prices. We would also note that Berkshire has effectively created a floor under the company's stock price by announcing that it would buy back both Class A and Class B shares at prices up to 120% of reported book value (which stood at $126,766 per Class A share and $84.50 per class B share), implying downside protection for investors at prices 10%-15% below current trading levels.
Capital One (COF)
We think Capital One is undervalued because of the following factors: loan growth in automotive and commercial lending is not being considered in valuation and underappreciation of the firm’s credit quality as total nonperforming loans represent only 1.5% of total loans. Capital One is still a top five credit card issuer in the world, but it is also a misperceived company in transition. Credit card loan growth will be challenging as Capital One repositions its portfolio to more traditional commercial bank lending. However, Capital One has good prospects for loan growth in automobile lending with its national platform, and commercial lending done locally in high-density markets like New York and Washington, D.C. In addition, funding is not an issue as CapOne completed the acquisition for $83 billion in online deposits from ING’s U.S. operations (now called CapitalOne 360) during 2012, which has significantly helped liquidity, adding lower-cost funding.
Lloyds (LYG)
We've long seen the U.K.'s concentrated banking market as particularly attractive, and we think that Lloyds, as the only U.K. retail-focused bank, is poised to prosper as the U.K. economy recovers. We're encouraged that Lloyds has run off 60% of its noncore portfolio since 2010, and that credit quality in Ireland finally seems to be turning the corner--as result, we think that the strength of Lloyds' core businesses, rather than losses from legacy businesses, will be the primary driver of profits going forward. We're also impressed with Lloyds' strengthened capital position, which we think may allow the bank to pay a nominal dividend for 2013 and will almost certainly allow for a substantial dividend in 2014.
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