FORTUNE — Brad Hintz believes in free markets. The one-time treasurer of Morgan Stanley and current equity analyst covering brokers, exchanges, and trust banks for Bernstein Research is as much a defender of an unshackled financial services industry as Dick Bove. So it should surprise no one that Brad Hintz thinks the Volcker Rule could be the death of all things cherished on Wall Street.
If you thought the story of the financial crisis was a harrowing one, then you should listen to Hintz trying to figure out a future with a Volcker Rule that’s looking like it might be more onerous than previously thought. “We had originally estimated that the Volcker rules would reduce trading revenues by 10%,” Hintz says. “Even if non-client pure risk-taking businesses were banned, that number was still relatively small.” He’s talking about proprietary trading desks, the majority of which have been closed down or spun off in the last two years. (See such actions by: Goldman Sachs (GS), Morgan Stanley (MS), and JPMorgan Chase.)
But new rules floated for industry consideration earlier this month were far more restrictive than previously expected. Even the ex-Fed chief himself is a little concerned about the growing complexity of the thing. In the original Dodd-Frank legislation, the rule was ten pages long. When the Office of the Comptroller of the Currency released the latest version for public comment between now and January 13, 2012, it was 298 pages, with more than 1,300 questions on 400 topics. At root is the issue of just what constitutes “proprietary trading” by banks, especially as it relates to the issue of making trades in securities on behalf of their customers. The simple goal that Volcker was trying to achieve was making sure that deposit-taking banks are forbidden from making proprietary bets with those deposits. But it gets really thorny when you try to define just what constitutes a proprietary bet.
Hintz argues the rules are taking dead-aim at the ability of investment banks to act in their vital role as market makers. “They will change the very business model of fixed income,” he says.“Risk-taking is very broadly defined and severely limited, and virtually all of the fixed income business is a risk-taking business. If banks are forced to shift to an order-taking business, revenue will drop 25% and margins will fall by a third.”
Here’s the thing, though: The proposals include an exemption for “bona fide” market-making on behalf of clients. If banks can’t demonstrate why they’re not making a house bet but instead acting on behalf of customers (i.e., “order-taking”), then they just might be engaging in the kind of risk-taking that got us in this mess in the first place. Sure, the request for comment is paint-peeling in its detail and legalise, but it’s not as complicated as critics would have us believe.
Still, JPMorgan Chase (JPM) chief Jamie Dimon is concerned too. On a conference call with analysts this month, Dimon uttered another one of his unfiltered jewels. “The United States has the best, deepest, widest, and most transparent capital markets in the world which give you, the investor, the ability to buy and sell large amounts at very cheap prices. That is a good thing. I wish Paul Volcker understood that. Okay? Now we understand why there is no proprietary trading. That was fine….[But] we have to be in a position to do proper market-making for our clients…Most of our business is market-making…I hope all of you on this phone understand how important this is, not just for your own business but for future of the United States.”
When Hintz is talking, it’s just an industry under siege. When Dimon chimes in, he not only schools one of the country’s most respected former chiefs of the Federal Reserve, but he also puts us on notice that nothing short of the future of the country is at risk. Really, Jamie? Come now.
Because fixed income uses about 60% of the capital committed to Wall Street capital markets activities, Hintz concludes that the decline in revenues and margins will challenge firms to even earn their cost of capital. “The changes then necessary will be expense reductions and balance sheet shrinkage,” he says. “And with 50% of net trading revenues being paid out in compensation, we know which expense line will be cut!” Even so, he argues, that won’t be enough. What will? A reduction in “inventory” of 20% to 25%, the result of which will be a less liquid U.S. corporate bond market, wider bid-offer spreads for corporate borrowers, and a migration of issuance to offshore markets not crimped by overzealous regulators.
In other words, it’s bad news for all of us. Actually…not quite all of us. Hintz points out that the U.S. government “conveniently exempted” Treasury bonds from the ban of proprietary trading in the new proposed rules. And why not? When you’re the one making the rules, you don’t normally screw yourself in the process.
But don’t believe all the doomsaying. Most companies in need of financing can just tap another market. Couldn’t the bank loan market pick up the slack? Or lending by hedge funds? Or even equity issuance? “Sure, the analogy of a balloon being squeezed comes to mind,” says Hintz. “But not every player in the capital markets is equally good in every market. So the overall cost of financing could be driven up. And that could hurt economic growth.”
Like many things in the capital markets, the argument put forth by Hintz and Dimon makes sense, at least on paper. The more liquid a market, after all, the more smoothly it should function. But what about in practice?
“The Devil is obviously in the details,” says Andrew Milligan, Head of Global Strategy for Standard Life Investments. “On the one hand, the majority of companies issuing corporate debt could do it in any market they want to. Wal-Mart can raise money in sterling or yen, and then swap it back into dollars. On the other hand, if the rules do have what appears to be the desired effect of discouraging investment banks from being market makers, then we lose a shock absorber. Regulators are looking to reduce ‘big’ volatility—like that of 2008—at the expense of what might be increased volatility in the short-term. We’re trading long-term volatility for higher short-term volatility.”
There are others who think Hintz is merely sounding an alarm—that the Volcker Rule will prevent so-called “flow trading”—that has no business being sounded at all. “When is [the] last time the financial industry didn’t see a regulation that they [said] was going to cause a recession?” economist Simon Johnson asked The Wall Street Journal.
If you accept Hintz’s first premise, then his numbers might make sense. If you don’t, then his catastrophic conclusions are irrelevant. Could constraining the behavior of dealers in the short-term have a negative impact on financial markets and therefore financing costs? Sure, it could. But reform isn’t free, and it’s not the end of the world. Even Brad Hintz knows that.
