Goldman To Gain The Most From Fed’s Five-Year Extension On Volcker Rule Compliance

Earlier this week, the Federal Reserve announced its decision to grant U.S. banks an extension of five years to dispose of their investments in illiquid funds. ^[1] Under the Volcker Rule, U.S. banks are prohibited from investing more than 3% of their own cash in hedge funds and private-equity funds, and have until July 2017 to comply with the requirement. This posed a problem for some of the largest banks, which had sizable investments in various illiquid funds before the Volcker Rule was implemented, as unwinding their stakes quickly would trigger losses for them.

The Fed’s extension gives Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) considerable legroom in reducing their investments in these funds in an orderly manner. Goldman in particular gains the most, given that the bank had at least $6 billion of its cash tied-up in illiquid funds at the end of Q3 2016.

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In the aftermath of the economic downturn of 2008, the U.S. sought to reform the excessive risk-taking attitude of the country’s banking sector by implementing the Dodd–Frank Wall Street Reform and Consumer Protection Act. One of the key rules adopted under the Act, which went into effect in early 2014, was the Volcker Rule, which spelled out the restrictions on all speculative investments by banks that do not directly benefit consumers. The Volcker Rule prohibits banks from indulging in proprietary trading activities, limits the amount of its own cash that a bank can invest in private-equity funds or hedge funds to 3%, and also imposed limits on the liabilities the largest U.S. banks can hold.

Over the years, all U.S. banks – especially the largest ones with significant investment banking operations – worked towards compliance with the Volcker Rule by shuttering their proprietary trading units and slashing their investments in relevant funds. The largest banks, however, ran into a problem with their investments in illiquid funds that come under the purview of the Volcker Rule. As a bulk of the investments in these funds had been negatively impacted by lower valuation since the downturn, reducing their stake would result in losses for the banks. And even if the investments had improved in value, the illiquid nature of these funds would result in a sizable mark-down if the banks attempted to sell them quickly with an eye on the July 2017 deadline.

The chart below captures the total investments in restricted funds for the largest U.S. banks at the end of 2015 as well as Q3 2016 as disclosed by each of them in their quarterly SEC filings.

As seen here, the five largest investment banks had almost $15 billion in investments in restricted funds at the beginning of the year, that they needed to reduce to comply with the Volcker Rule. While the banks have done well to reduce these investments by 20% to $12 billion at the end of Q3 2016, the pace is clearly not enough to meet the July 2017 deadline – especially for Goldman, which accounts for almost 60% of the total relevant investments for these five banks. Although not all the investments in restricted funds as shown above are in illiquid funds, much of it definitely falls into the illiquid category. This is why these banks requested an extension on the deadline from the Fed in August. ^[2]

The Fed’s acceptance of the request for illiquid funds means that the banks can pace their divestment over the next five years. As a result, investment revenues for these banks will not be hurt by losses which would have accompanied expedited sales. In fact, the overall improvement in market conditions should help revenues from these investments rise steadily till the banks dispose of them. Add to this the fact that the Trump administration is expected to take some of the bite off the more contentious issues that exist in the Dodd-Frank law, and it looks like these banks will be able to eke out some more profits from these and similar investments in the near future before finally retiring them.

Goldman reports these revenues in its income statement as a part of its Investment & Lending division. You can see how changes in these revenues impact Goldman’s share value by modifying the chart below.

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1. Federal Reserve Board announces additional details regarding how banking entities may seek extension to conform their investments in a narrow class of funds that qualify as “illiquid funds” to the requirements of the Volcker Rule, Federal Reserve Press Releases, Dec 13 2016 [↩]
2. Wall St. banks ask Fed for five more years to comply with Volcker rule, Reuters, Aug 11 2016 [↩]