London, 27 January 2010

Goldman Sachs and Morgan Stanley depend more heavily than other banks on revenues from trading as well as income and carried interest from a range of proprietary investments that could be barred by the " Volcker Rule".

While neither provides an overall figure, their financial statements make clear that there are significant prop trading, private equity and hedge fund activities within both institutions. Exactly how much of this would be prohibited depends on where the line is drawn. Both will need to lobby intensively if their business model is not to be totally upended by the president's plan.

FINANCIAL HOLDING COMPANIES

Prior to the financial crisis both Goldman Sachs and Morgan Stanley were regulated by the Securities and Exchange Commission (SEC) as Consolidated Supervised Entities (CSEs). But on September 21, 2008, the Federal Reserve Board approved applications from both firms to become Bank Holding Companies (BHCs) regulated by the Fed under the Bank Holding Company Act.

BHC status made it easier for Goldman Sachs and Morgan Stanley to receive support from the Federal Reserve Bank of New York's primary credit facility and other liquidity facilities. Ordinarily it would also have prohibited them from engaging in business activities other than banking and certain closely related activities under the Fed's Regulation Y. Both firms had a two-year grace period ending September 22, 2010 to dispose of non-banking activities not permitted under the BHC Act, with the possibility of applying for a maximum three one-year extensions, pushing the deadline back to 2013.

Instead both elected to become Financial Holding Companies (FHCs). Morgan Stanley became an FHC in September 2008 and Goldman Sachs in August 2009.

FHC is a designation created by the Gramm-Leach-Bliley Act 1999 (GLB Act) permitting bank holding companies to engage in a wider range of financial and related activities, including underwriting, dealing and making markets in securities, insurance, and merchant banking investments in non-financial companies.

Crucially, the 1999 Act contains a special provision (12 USC 1834(o)) permitting a firm that was not a bank holding company previously, and becomes a financial holding company after November 1999, to engage in certain commodities activities otherwise impermissible for bank holding companies.

The conditions are that the company was engaged in these activities prior to September 1997, and assets held pursuant to these activities do not constitute more than 5 percent of the consolidated assets of the bank holding company.

The "grandfather clause" allows traditional securities houses to continue commodity trading activities unchanged upon conversion. They "may continue to engage in, or directly or indirectly own or control shares of a company engaged in, activities related to the trading, sale or investment in commodities and underlying physical properties".

VOLCKER RULE APPLICABILITY

The administration has not yet published details about how it intends to prohibit banks from engaging in proprietary trading, private equity and hedge-fund activities unrelated to serving their customers.

But it seems clear the formulation would capture activities undertaken by both firms as financial holding companies.

The administration's language has not always been clear, with some senior advisers suggesting the rule would apply to "commercial banks". But the official statement made clear the restrictions would apply to a bank or financial institution that contains a bank. One official stated openly it was "a limit on the scope of activities that banks, bankholding companies and financial institutions that own banks can engage in".

Goldman Sachs and Morgan Stanley could try to circumvent the new restrictions and retain their proprietary trading and investment interests by giving up their BHC/FHC status and revert to being consolidated supervised entities (CSEs). Both could still benefit from Fed support in an emergency.

The Fed provides credit at the discount window to member banks under Section 13.2 of the Federal Reserve Act. But it can provide discount facilities to "any individual, partnership, or corporation" "in unusual and exigent circumstances" under Section 13.3 provided at least five members of the Board of Governors agree.

In theory, the two firms could achieve the best of both worlds: giving up bank status to evade restrictions, while relying on a continuing implicit guarantee from the Fed in a crisis, since both are too big and too interconnected to be allowed to fail. In practice, such lycanthropy would enrage regulators, and likely lead to an enforced break up or an open statement that neither would be supported in a crisis.

HOW MUCH ACTIVITY IS AT RISK?

There is no overall figure on how much activity would be caught by proposed restrictions, but the two firms' filings with the SEC and Fed provide some clues.

Goldman says it has "formed numerous nonconsolidated investment funds with third-party investors". It generally acts as investment manager and receives management, advisory, incentive fees and overrides from these funds. Fee income amounted to $1.80 billion in the first nine months of 2009, down from $3.14 billion in 2008 (twelve months ending November), $3.62 billion in 2007 and $3.37 billion in 2006.

In addition, the firm invests its own money alongside thirdparty investors in certain funds. The carrying value of these investments was $13.73 billion at the end of September 2009, compared with $14.45 billion at end Nov 2008 and $12.90 billion at the end of November 2007. Goldman shareholders' total equity in the firm was valued at $65 billion at the end of Q3 2009, so the carrying value in these nonconsolidated funds was significant.

Finally, Goldman earns other fees from securities lending, trade execution, custody and acquisition and bridge financing with these funds.

Morgan Stanley reported losses of $1.288 billion in the first nine months of 2009 from investing as a principal, and $4.192 billion in the twelve months ending November 2008, "primarily related to net realised and unrealised losses from limited partnership interests associated with the Company's real estate funds and investments that benefit certain employee deferred compensation and coinvestment plans and other principal investments". The company has been seeking to reduce prop trading since the crisis.

The company reported significant revenues from trading as a principal, including $6.304 billion in the first nine months of 2009, and $5.452 billion in the twelve months ending November 2008, though most of this was from marketmaking activities.

Morgan Stanley also engages in the production, storage, transportation, marketing and trading of several commodities including industrial metals, farm products, crude oil and refined oil products, natural gas, electricity power, coal, freight and LNG, as well as owning six electricity generating facilities in the United States and Europe, and has an interest in the Heidmar shipping and logistics group.

WHERE THE VOLCKER LINE IS DRAWN

How much will still be permitted depends on where regulators draw the line. President Barack Obama's senior adviser Austan Goolsbee has indicated prop trading will still be allowed provided it is "client-based".

At one end, holding prop positions to make markets for customers will (presumably) be allowed in some form. At the other, nonconsolidated investment funds using the firm's own money will presumably be barred. But what about funds where the firm invests alongside third-parties or funds invested on behalf of senior employees?

Would assets owned directly by the bank for commodity production, sales, storage and trading count as prohibited "private equity"? Stringent regulations would force both firms to divest significant businesses -- or become unrestricted hedge funds and securities dealers, giving up bank status and access to the Fed. In contrast, if they can secure language that gives a generous definition of market making and allows coinvestment of proprietary or employee funds alongside third parties much of it would remain possible.

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FACTBOX-Banks, commodities and US reform plan

U.S. President Barack Obama's proposed plans to reform trading at banks follows a sustained period of expansion in the commodities and energy sectors by financial institutions.

Goldman Sachs is the biggest bank in commodities measured by the amount of money at risk on any given day, known as Value at Risk (VaR). JP Morgan Chase is the second largest. It is currently in exclusive talks to buy the RBS Sempra commodities joint venture in a deal worth about $4 billion, people familiar with the matter said.

The following are some facts about banks' commodities business.

Morgan Stanley

Global head -- Simon Greenshields and Colin Bryce

History -- Expanded rapidly in recent years . Is the third largest bank in the sector by VaR.

Focus -- Crude oil, oil products, natural gas, power, base metals, emissions.

VaR -- Around $25 million

JP Morgan Chase

Global head -- Blythe Masters

History -- Acquired Bear Stearns in March 2008 and increased the bank's commodities business. Expanded its presence again in February 2009 when it completed the purchase of key parts of UBS commodities.

Focus -- Actively trades oil, refined products, power, nautral gas, coal and emissions. Also active in agricultural commodities such as palm oil and cocoa and base metals.

Growth plan -- To be a top-tier franchise globally.

VaR -- Has moved into second place with a commodities market VaR of just over $30 million on average last year.

RBS Sempra

Global head -- Kaushik Amin. He joined in May 2009 and formerly worked for Lehman Brothers as global head of liquid markets.

History -- The commodities joint venture between the Royal Bank of Scotland and Sempra Energy was created in April 2008. European Commission state aid requirements will force RBS to divest its share over the next four years.

Focus -- Mainly active in physical markets and its main markets are crude oil, base metals, European power gas and coal and North American gas and power. It also trades U.S. agricultural products and emissions.

VaR -- Average of £16.7 million pounds ($26.95 million) for Q3

Goldman Sachs

Global head -- Isabelle Ealet

Staff -- Has more than 200 commodity professionals in locations throughout the world, such as New York, Calgary, Houston, London, Sydney, Singapore and Tokyo

History -- Entered the commodities business in 1981 with the purchase of J. Aron.

Focus -- Serving corporate clients and financial investors ranging from hedge funds to institutional investors and private equity firms. It is one of the few investment banks in the world that physically trades and ships crude oil.

VaR -- Goldman Sachs is the biggest bank in commodities with a VaR of around $40 million for the past two years.

Bank of America/Merrill Lynch

Global co-heads -- David Goodman and Rob Jones, based in London and Houston.

History -- Merrill Lynch acquired the energy trading businesses of Entergy-Koch, LP.

Focus -- Commodities business includes structuring, trading and marketing natural gas, power, crude oil, refined products, coal, emissions, metals, commodity indices, and structured notes. The company is involved in both financial and physical markets.

Growth plan -- In August 2009, the company announced that it intends to expand its commodities team by 25 percent over the next two to three years in anticipation of a strong demand for commodities.

Deutsche Bank

Global head -- David Silbert

History -- Launched a five-year expansion plan in commodities and energy in 2007.

Focus -- Deutsche is active in oil, refined products, metals, gas, power, agriculture and carbon markets, financial investor products. Has a spot presence in metals and uranium but not active in the physical oil business.

Growth plan -- It hs increased its headcount by 15 percent in 2009 and plans to continue hiring in 2010. It recently opened a new office in Houston, Texas and started trading U.S. power and gas. A bank spokesman said it had experienced "spectacular" growth in Asia. The bank said it has launched 11 new commodity indices, three new commodity systematic mutual funds and one new commodity exchange traded fund this fiscal year.

VaR -- Average of 15.4 million euros ($21.70 million) for Q1-Q3 2009

Societe Generale

Global head -- Edouard Neviaski since 2008. He joined SocGen in 1989 as an energy trader.

Staff -- SocGen has between 300 and 400 commodity professionals, including 10 for research alone, based mainly in Paris, London and New York and other locations throughout the world such as Singapore, Hong Kong, Sydney, Houston and Calgary.

History -- Started in commodity derivatives in 1988 and in commodity financing 30 years ago.

Focus -- Crude, refined oil products, natural gas, coal, CO2, base and precious metals, plastics, grains, sugar and livestock.

Growth plan -- Being among the top five banks and in the commodities realm and double revenues by 2012. Hiring globally and increasing the number of clients by more than 20 percent. The bank also plans to develop its offering for investor clients on flow business, indices and structured products.

BNP Paribas

Global head -- Lincoln Payton

Staff -- Over 1,000

History -- Started in commodity derivatives more than 20 years ago and in commodity financing 50 years ago.

Focus -- Active in trading crude, oil products, natural gas, European power as well as base metals and soft commodities. Traditionally strong in structured financing and helped finance oil major Total's Yemen LNG project.

Growth plan -- The bank said in an e-mailed statement it is expanding its derivatives business to cater to hedge funds. It is expected to double revenues in commodity derivatives by 2012, supported by the acquisition of activities from Fortis, a bank executive told the Financial Times.

VaR -- 5 million euros in Q3 2009 ($7.05 million)

Barclays Capital

Global head -- Benoit de Vitry

Staff -- The bank had 240 people in commodities at the end of the last fiscal year.

History -- Started trading commodities in 2000.

Focus -- Active in oil, refined products, metals, power and gas, coal, agriculturals, emissions and investment products.

Growth plan -- Aims to increase the number of staff in commodities by over 30 percent to 320 by the end of the fiscal year. The main area of growth is physical markets. Barclays created a shipping division called Pendle in March to support its physical oil trading operations.

Credit Suisse

Global head -- Adam Knight, who joined in 2007 from Goldman Sachs where he was head of global metals trading.

Staff -- At the end of 2008 it had more than 130 staff globally.

History -- Entered the business in 2005 and has accelerated its expansion since 2007.

Focus -- The bank is active in oil and refined products, coal, metals and agricultural commodities such as wheat, soybeans, milk and sugar. Has a large presence in the physical market through its alliance with Swiss commodities trading house Glencore.

Growth plan -- Has hired 100 people since 2007 and plans to add another 100. It is in the process of closing its U.S. power business but has now started trading European gas and power in-house.

Standard Chartered

Global head -- Vincent Van Pelt. He joined in 2008 from Bear Stearns where he spent 14 years, mostly as co-head of European equities.

History -- The bank started its commodities business three years ago. It tripled its customer base in 2008 from the previous year.

Focus -- It offers commodity-linked financing and structured products in precious metals, base metals, energy and farm products.

Growth plan -- The bank plans to expand its coal trading operations by hiring more people and will aim to start trading physical commodities trading in 2010. It is keen to expand its presence in sugar and palm oil.

Macquarie

Global head -- Andrew Downe

Staff -- 680 in commodities and treasury combined.

History -- Macquarie has provided trade financing and risk management services across the commodities complex since the early 1980s. It is one of the longest standing providers of agricultural over-the-counter derivatives and tailored risk management services in the financial sector.

Focus -- Macquarie is active in metals, agricultural commodities, oil, products and natural gas.

Australia and New Zealand Banking Group

Global head -- Christophe Renaud. He joined in 2006 from Societe Generale where he was a commodity derivatives trader.

History -- Started in gold in 1996 and expanded into base metals and agricultural commodities in late 2000. Since 2000, it has entered the oil, thermal coal, electricity and emissions markets.

Growth plan -- It has hired 12 people in Asia since the start of 2008.

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By John Kemp, Reuters columnist. The views expressed are his own.