(Reuters) – A sweeping regulatory reform package moving through Congress will force some major banks to change the way they deal in derivatives businesses.
Once enacted, big banks such as Citigroup, JPMorgan Chase and Bank of America Corp won’t be able to sell swaps on most commodities, equities and credit through entities connected to their commercial banks. Instead, they’ll have to set up new units, or do away completely with that type of trading.
Still, the spinoffs will add to bank holding companies’ business and funding costs.
Below are scenarios for the method banks will use to purge the trading of “bad” derivatives from their banking businesses.
A “BAD” DERIVATIVES AFFILIATE (Likely)
There’s a good chance big banks will set up one new legal entity to deal in all kinds of risky derivatives. This would be the most cost-effective way of dealing with a change that will inevitably be expensive to make.
Richard Levinson, a former Citibank treasurer and current senior partner at Canaras Capital Management in New York compared the general principles of the new legislation to the system in which he governed Citi’s capital allocations in the early 1990s, when a firewall still existed between commercial and investment banking. He said the first investment banking subsidiaries allowed inside bank holding companies were commonly called “Section 20″ companies, a shorthand for a law that let banks like Citi establish them.
“Assuming we are going back to that structure, the underwriting and trading activities of a bank which are now moved to this other affiliate are not going to have access to their own bank funding and they’re going to have much more difficult access to third-party funding,” he said. “This is going to take a lot of risk out of the system.”
A separate entity would need to be capitalized by investors who knew that if it ran into trouble it would not get help from the rest of the conglomerate.
But Levinson said it was possible the separate entity would be able to use traders and equipment from other parts of the bank, which would charge a service fee. In that way, the companies would not have to do much new hiring. Overhead costs would be lower.
Assuming there are no drastic changes to the size of counterparty trading lines, customers might not notice the difference. They would still be able to use an affiliate of Citigroup, for instance, as a market-maker for a commodity derivative. The sales force — and possibly even the traders — working on the deal would be the same as before. There would simply be a contract with a new company to sign.
“On the surface I think it’s going to have less impact on customers and more of an impact on how regulators monitor the businesses,” said Jay Langan, the head of the financial services mergers and acquisitions team at Deloitte & Touche in New York.
Adhering to regulators’ capital requirements without making use of capital from other businesses would be the tricky part for the bank.
FOREIGN-LISTED AFFILIATE (possible)
One former executive at a major bank said that a dealer could set up a bank listed overseas, and capitalized entirely by third-party investors.
Under this scenario, the larger bank could then collect a fee for referring derivatives trading business to the newly created smaller bank, similar to the relationship between an insurer and an agent that works exclusively with the insurer.
One difficult element of this plan would be getting customers comfortable with the credit of the smaller bank, but if the subsidiary is publicly listed and its financial statements are disclosed, that problem can be surmounted, the executive said.
MULTIPLE AFFILIATES (unlikely)
Banks also have the option of creating several new derivatives affiliates specializing in one asset each. Citigroup’s former energy trading business Phibro is an example of this structure. But the cost of setting up multiple entities could make this option unattractive.
Levinson pointed out that while Phibro made billions of dollars for Citigroup, the willingness of counterparties to trade with it was based in part on its connection to Citibank — a connection that wouldn’t exist under the new legislation.
“Phibro was minting money but a lot of their trading activity was based on the strength of Citibank,” he said. Citi sold Phibro to Occidental Petroleum and Levinson said the move could have meant an instant decline in its profitability. “There would be very close scrutiny of the support Occidental was providing to Phibro,” he said.
Also, running each derivatives business separately would add unnecessarily to overall costs.
“Managing legal entities is just a pain,” Levinson said. “You’ve got to have a board; you’ve got regulatory filings … You’re creating three times the overhead in doing that (for three separate asset classes),” he said.
But if clients demand them, separate businesses may still spring up.
“On the other side of that you may have big counterparties who say I want to trade with a more focused business,” Levinson said. “You may get a market pushback in the other direction.”
EXITING THE BUSINESS (Unlikely)
Big banks could simply stop selling customers derivatives products in the risky areas the legislation identifies. Doing so would save them the cost of setting and capitalizing new legal entities.
But according to their own lobbyists’ arguments, exiting the riskiest derivatives businesses would also cost the banks customers. Even though smaller competitors may have an easier time in derivatives — the legislation only applies to “major swaps dealers,” a definition that will be written sometime down the road by the Commodity Futures Trading Commission and the Securities and Exchange Commission. Major banks will want to stay in the game so they don’t lose business in other areas.
Some kinds of risky derivatives trading may grow rarer, however. Non-investment grade CDS won’t exist in abundance anymore.
“I’d think you’d have that affiliate business do it occasionally,” said Langan. “In the long-term it’s going to be a capital-eater.”
Langan said more non-investment grade CDS could be traded in Europe.
(Reporting by Emily Flitter, Dan Wilchins and Karen Brettell; Editing by Alden Bentley)