New derivative rules would cost big banks billions

There will be winners and losers if financial regulatory reform passes. Giant banks will be stung; smaller ones will win out.

By Jamie Dlugosch Apr 30, 2010 5:10PM

Now we know why Wall Street lobbyists are out in force in the fight against financial regulatory reform.

 

The New York Times is reporting that new rules with respect to trading of derivative securities would cost banks billions.

 

Of course this issue boils down to big dollars. For too long Wall Street firms have operated in a shadow environment whereby the rules were fast and loose. As a result of market inefficiency with respect to complex financial derivatives, big bucks were made.

 

 

To the extent regulations are passed those profits could evaporate, hurting the biggest banks of the world. But that pain will benefit the smaller banks that I will mention below.

 

No wonder Goldman Sachs (GS) is down more than 20% since the SEC brought fraud charges against the company. That sideshow may be interesting to watch, but investors ought to be more concerned about the potential loss in its derivatives trading business.

 

According to the study by Bernstein Research mentioned in the New York Times article, Goldman Sachs could lose up to 41% of its earnings under tighter regulations. That is a substantial hit to profits that has yet to be fully priced into Goldman’s stock.

 

To be fair the study makes some fairly broad assumptions, but it is reasonable to assume that dollars made in a market under the regulatory spotlight would be lower. Transparency tends to lower costs.

 

Who will be the winners with large banks under such regulatory risk?  Clearly the winners will be the smaller regional banks.

 

Those smaller banks tend to operate under a simpler model of collecting deposits and making loans. The regional banks did not get involved with derivative trading and as a result will not be exposed to losses caused by tighter regulations.

 

I suggested buying small community banks in the middle of January. Since that time the five names on that list have all appreciated significantly more than the overall market.

 

The big winner from the list so far is Zions Bancorp (ZION). That stock is up approximately 75% since the middle of January.

 

The other names like United Community Banks (UCBI), TCF Financial (TCB), Associated Bancorp (ASBC) and Sun Trust (STI) are all doing well and should continue to do so.

 

With the large banks under attack, investors would be wise to steer clear of the group and instead focus on the regional names. The government is clearly working hard to give the smaller banks a competitive edge.

 

Investors should jump on that assistance and ride the wave to profits.

 

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