Broadly speaking, how will the new regulations in the long-awaited financial reform bill affect the financials sector?

There remains much uncertainty over the exact implementation of the new financial reform bill, which will take many months or years, making it difficult to be precise on the likely impact on the financial sector. However, the focus of the new regulations is to improve oversight in the banking system in order to reduce the risk of future financial crises and ensure that taxpayers will never again have to suffer the experience of the recent financial crisis. Banks, primarily broker-dealers, will likely endure the most negative effects, as many previously profitable, and riskier, activities will be regulated under the new proposals. However, a positive aspect is that although the industry may in general be less profitable than in the past, it may also be less volatile and less risky.

The exchanges are likely to be the biggest net beneficiaries as some derivatives previously traded over the counter will now be traded through exchanges and centrally cleared.

The new rules would impose limits on derivatives trading at banks. How might these limits have an impact on the institutions?

The limits on derivatives operations are less onerous than feared leading up to the final announcement of the bill, particularly regarding the initial proposal of forcing banks to operate all derivatives trading through a separately capitalized affiliate. In fact, the legislation only requires approximately 20% of the over-the-counter derivatives market to be traded through separately capitalized affiliates, with the rest remaining within the bank. This includes commodities, equity, and high-yield credit default swaps (CDS), which represent a small — albeit riskier and highly profitable — part of the total derivatives market.

There will likely be some negative effect on broker-dealers. It is unlikely to be significant in the context of large diversified financial institutions. In the past, similar structural changes have resulted in lower profit margins, but improved volumes and increased visibility and transparency have helped enhance liquidity, which helps mitigate the impact of lower margins.

Finally, the clearing of certain derivative transactions via third-party clearinghouses should increase the cost to financial institutions in the form of the likely need for initial and daily margin requirements. Although profit margins for structuring and trading derivatives are likely to fall, specifically for investment banks, the positive is that the capital requirements are reduced for a bank involved in a derivative transaction that is centrally cleared, as the counter-party risk, or default risk, will now reside within a central clearing house, and not on the balance sheet of the bank.

The Act gives the Federal Reserve the authority to limit interchange fees, the fees that retailers pay to banks to cover the cost of transferring money when debit cards are used. How could this affect banks and the financials sector as a whole?

Our analysis indicates that the impact of the interchange amendment is manageable and not a significant issue for U.S. banks. We estimate the impact to be 1%–2% of total profits for U.S. banks. The definition of “interchange fees” does not include the fees charged by the networks, including Visa and Mastercard, but only includes the interchange received by the issuer of the card, such as the bank. The fee will be set after adjusting for costs, which the Fed has yet to define. Also, the Fed has included the cost of “fraud prevention” in the calculation of the transaction cost, as opposed to just the marginal operating cost as some had feared. This will help reduce the likelihood of significant interchange fee reductions for the banks.

The Act creates a Consumer Financial Protection Bureau (CFPB) to monitor credit and mortgages, and a Financial Stability Oversight Council (FSOC) to watch for systemic risk. How might this affect financial firms?

The CFPB, one of many new agencies to be created from the legislation, has not yet been formed or staffed, so it is premature to predict its impact. But it is safe to assume that it will regulate product safety and promote consumer awareness to reduce the risk of the egregious excesses of the recent subprime mortgage crisis re-occurring in the future.

The FSOC will monitor and make recommendations to regulators of any activity that it deems poses a risk to the financial markets, which should help stave off another financial crisis. We view the creation of this agency as one part of the overriding aim of the new legislation to reduce risks within the banking system, to rebuild confidence, and to promote a more stable economy in the future. Part of the cost of this process for the banking system is potential lower profitability than the past, but also lower risk.

The Act also creates a Federal Insurance Office (FIO) at the Treasury to monitor insurers, and mandates a study to recommend further industry overhaul. What is the likely impact from this move on the insurance industry?

The creation of the FIO is unlikely to have a significant impact on the insurance industry, at least in the near term because the thrust of the U.S. regulatory reform has been primarily focused upon the banking system, and because the FIO will have 18 months to submit to Congress a report on improving U.S. insurance regulation. The insurance industry has long requested a federal regulator given the industry’s need to operate within different and inconsistent state laws, so this development is potentially a positive for the industry.

Insurance companies are excluded from the Volker rules on proprietary trading and hedge fund ownership and investment limits. One possible negative consequence resulting from the new regulations is that the insurance industry has not received an end-user exemption regarding new derivative legislation, which potentially means the cost of hedging and other risk management strategies will increase as a result. Still, in summary, I believe the impact on the insurance industry is relatively insignificant.

The views and opinions expressed are those of David Morgan, Managing Director and Portfolio Manager of the Putnam Global Financials Fund, as of July 16, 2010, are subject to change with market conditions, and are not meant as investment advice.