Banks' Glass-Steagall Walls Quietly Rebuilt (Update 1)

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Updated with commentary from KBW in paragraphs two and 20.

NEW YORK (TheStreet) -- During the Occupy Wall Street protests last fall, it was not unusual to see signs urging the return of the 1933 Glass-Steagall Act.

But according to panelists at the Securities Traders Association of New York on Thursday, the landmark Depression-era law that separated commercial banks, securities firms and insurance companies, undone in 1999 by legislation known as the Gramm Leach Bliley Act, is now effectively back on the books. And on Monday, financial services-focused investment bank Keefe, Bruyette & Woods chimed in with its own argument that big bank breakups may not be far off.
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The difference this time around is that regulators and legislators are phasing the changes in gradually, according to Sean Owens, director at capital markets consultant Woodbine Associates.

Two of the key changes affecting U.S. banks come from the 2010 Dodd Frank legislation. Those include Title VII, which brings a host of new rules to previously unregulated derivatives markets, and the Volcker Rule, which places strict limits on banks' ability to make directional market bets. Another sea change comes from Basel III, Swiss-based international banking rules that will require banks to hold a larger cushion against possible losses.

The vast bulk of this new rulemaking is still in relatively early stages. Basel III will be phased in over several years. Many of the derivatives rules have still to be written. And a softening of Volcker, which was the main subject of Thursday's discussion, is likely, the panelists agreed.

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Still, even if Volcker is watered-down, they believe it and the other rules may fundamentally alter the financial services landscape so that the largest five U.S. securities dealers--JPMorgan Chase JPM , Morgan Stanley MS , Bank of America BAC Goldman Sachs GS and Citigroup C exit businesses widely thought of as central to their operations.

Of course the major business these banks will exit, if they haven't done so already, is proprietary trading. Many prop traders at Goldman, JPMorgan, Morgan Stanley and Citigroup have already anticipated the rule and left the company to set up hedge funds.

More surprising and controversial, however, is the argument that these institutions will exit fixed income market making.

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A market maker is merely a go-between: buying a bond or some other product from one party and selling it to another. A proprietary trader, on the other hand, takes a directional bet on which way the market is headed.

Volcker is aimed at getting banks out of prop trading, but Sanford Bernstein analyst Brad Hintz argued during the panel discussion Thursday that it may push them out of many critical aspects of market making as well.

Hintz, who covers Goldman and Morgan Stanley but not Jefferies Group JEF says he has a yellow post-it note with the name of the mid-sized securities dealer affixed to his computer screen.

"Will Jefferies come in and take the place of Goldman Sachs, JPMorgan, Bank of America and Citigroup? In time it may happen. What's happened to the economics of the business is pretty clear. As currently written, the Volcker Rule does a very significant negative job on fixed income," Hintz said.

Goldman Sachs CFO David Viniar argued in an investor presentation last month Goldman's return on equity would be helped by the Volcker Rule.

However, Hintz said in an interview following Thursday's the panel discussion that Viniar was "being cute," because while return on equity may be unchanged, he left out the fact that Goldman will, according to Hintz, allocate significantly less equity to fixed income trading.

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In addition to Jefferies, Hintz expects "non-bank broker dealers to jump in," to provide what traders refer to as "liquidity," which refers to bonds trading in large quantities with relative ease and predictability.

Hintz said the new liquidity providers will be "Jefferies immediately," though he also mentioned private equity players Apollo Group APOL and KKR & Co. KKR .

As a member of the audience asked whether hedge funds might also fill voids in the market left behind in the dealer community, Ed Provost, chief business development officer at the Chicago Board Options Exchange, was not overly optimistic.

"In the options business we love hedge funds, but I'd not look to hedge funds as a group I'd rely on. You need an organization whose primary role is the provision of liquidity. With all due respect, the hedge fund community is opportunistic," he said.

Rather than bringing in new players, another approach discussed by the panelists would be spinning off the securities arms of the giant banks just as Morgan Stanley and First Boston were spun out of banks in the wake off Glass Steagall. Such a move, however, would likely require Congressional intervention, argued James Brigagliano, a longtime Securities and Exchange Commission attorney now at Sidley Austin.

Regardless of the form it takes, breaking up the largest institutions is clearly on the minds of many who follow financial services companies as on Monday, financial services-focused investment bank Keefe, Bruyette & Woods chimed in with its own prediction of big bank breakups.

"At some point in the future, we would expect the current cycle to include public debate on the reduction in financial services and cuts in subsidies, particularly to Fannie Mae FNMA.OB and Freddie Mac FMCC.OB . We believe that the historical analysis suggests that investors should be prepared for the possible eventual break-up of the largest financials, including Bank of America, Citigroup and JPMorgan," the report stated.

At the moment, this discussion is still very hypothetical. Many of the largest institutions to emerge from the 2008 crisis are even larger now than they were at the time. But they are not immune to the new rules coming their way. There is lots of scrambling going on beneath the surface, and, for better or for worse, the financial services giants may be less powerful and immutable than they appear.

-- Written by Dan Freed in New York.

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