How Far Will Banking Reform Go?

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. President Obama unveiled his vision for financial reform, sending big bank stocks tumbling. I'm here with associate director of Equity Research Matt Warren to talk about what the fuss is about. Matt, thanks for joining me.

Matthew Warren: Good to be here.

Glaser: In a nutshell, what is President Obama's vision for financial reform?

Warren: You know I guess you'd call it kind of revamping of Glass-Steagall, like an updated or more modern version is what it seems to be. And this line of thinking was mostly driven by Paul Volcker, who is one of his advisors.

And essentially what it is, is taking some of the proprietary trading, the hedge fund investments, the private equity investments and taking that out of deposit-insured banks. That's the driving factor behind it. It also kind of goes towards reducing the "too big to fail,"try to limit the growth and size of some of the biggest banks in the country.

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Glaser: Are the biggest banks the ones who then potentially could be hurt the most by this potential legislation?

Warren: Yeah, absolutely. Regional banks that do plain vanilla banking would largely be unaffected in most cases, and the bigger banks with large investment banks with their own proprietary trading divisions would be the most impacted, clearly, by this regulation if it were to pass.

Glaser: Do you think the big banks could find a way around it, through subsidiaries or through off balance sheet transactions, that this would all just be window dressing?

Warren: The devil is definitely in the details. The way that a lot of things have gone lately is there is a big bold introduction and then things either don't happen or get watered down. So let's start there.

But then even if it were to pass, there's a lot of ways to work around this, so it's a very fuzzy line between proprietary trading and client focused trading. And I'm sure the I-banks will try to define everything as client-focused tradings if this were to pass.

With the hedge fund investments and the private equity investments, they could take a lot of that investing and try to gear it more towards asset management where they are earning a fee and not actually having those assets on their balance sheet.

So that could be less control and maybe less profitable but still have a lot of involvement in these types of activities, even if it's with other people's money more explicitly.

Glaser: You just mentioned that a lot of these proposals are getting watered down. It seems like the House has a plan, the Senate has a plan, and now Obama has a plan. Do you think any of these are more likely to happen, less likely to happen, or is it still just too fluid to figure it out?

Warren: Well, the House passed their version of financial reform already late last year. The Senate has multiple bipartisan groups working on their version of the bill. Obama is coming in with these and painting it as additional reforms that he wants to add to the total package.

So there's a lot of room for this to move around. There's a lot of room for lobbying to push back. And then on the other hand, there's an awful lot of populist angst that the administration could kind of play off of if they want to, and that could end up going pretty far if they ride that wave all the way to shore.

Glaser: So just because the focus of this package, Obama's package, seems to be on the big banks, there still could be impacts on regional banks and other banks, with ideas like the Consumer Protection Agency or more consumer controls that could come through the other houses or through other packages of legislation?

Warren: Yeah. The consumer stuff, most consumer lending is the market share is dominated by the large banks, so they would be the most impacted on some of those measures as well, but the regional banks are involved there as well.

And then the regional banks would be affected by new capital standards and things like that as well. So there is differing impacts on different sized banks, but it looks like everybody has been affected to some extent or another.

Glaser: From an investment perspective, if you're looking to buy into a bank right now, should you be terribly worried about this legislation that's coming through, or do you think it is going to be mostly a wash?

Warren: That's an interesting question. You saw the large banks were off pretty big yesterday and that was a knee-jerk response. I think a lot of these activities that are being addressed right now, the proprietary trading and such, it is 5% to 10% of revenue in a lot of cases at these large banks.

So from a size standpoint, it's not tremendously material, but I think the bigger focus is you had the bank fee that was introduced a week ago, now you have this coming to the fore shortly after a political event, so it looks highly politically motivated.

I think the worry as a bank investor now is" how far does this go? The uncertainty ramped up quite a bit in the last week, I'd say.

Glaser: So something to keep an eye out for?

Warren: Absolutely.

Glaser: Matt, thanks for joining me today.

Warren: Sure thing.

Glaser: For Morningstar.com, I'm Jeremy Glaser.