Will Financial Reform Work?

| Tue Oct. 5, 2010 1:36 AM EDT

Will financial reform help create a safer banking system? Last week I said that a key sign would be falling profits, since safer banks ought to be less profitable banks. Unfortunately, banks seem pretty bullish about profits, a sign they don't really think all the new regulations will change their business practices much.

Today, the Wall Street Journal begs to differ:

Investor presentations by top bank executives in London last week, combined with increasingly dour projections for the third quarter that ended Thursday, are crystallizing the challenges banks face. "The business models on the Street are going through dramatic changes," says Clayton Rose, professor of management practice at Harvard Business School, based on the most drastic shifts in the "political, regulatory, and economic environment since the 1930s in the financial industry."

....Return on average equity for the major investment banks, a key barometer of profitability, could be halved from the 20% range a few years ago, according to SNL Financial. And costs are rising, leading to expected waves of industry job cuts.

Morgan Stanley and Goldman, the two major firms that derive most of their earnings power from Wall Street businesses, are expected to earn about $12.1 billion in profits this year — 23% less than in 2006, their peak earnings year, according to Thomson Reuters. Their revenues are still largely dependent on trading, with about 60% of 2009 and estimated 2010 revenues coming from trading, according to Sanford Bernstein.

It's too early to know for sure how this is going to turn out, so for now consider this just another data point. On the one hand, a big part of this anticipated profit crunch is due to lower volumes of stock trading, something that wasn't really affected by the financial reform bill. So that doesn't mean much. On the other hand, the Journal story suggests that higher capital requirements, curbs on prop trading, and derivatives rules are also a big part. If that's the case, maybe the new rules will really have some bite. Stay tuned.

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