The Side Effects of Financial Reform

Proposed rules aimed at curbing Wall Street abuses may crimp corporate earnings and returns for investors, too

By Ben Levisohn and Mark Scott

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Lawmakers and regulators across the globe are scrambling to corral banks and other culprits of the financial crisis. But companies and small investors may find themselves ensnared, too, because proposed and new rules could crimp corporate profits and investment returns.

Reformers aren't oblivious to the potential consequences. They just figure the benefits outweigh any side effects. Even so, says Simon Gleeson, a partner at law firm Clifford Chance, the perceived pitfalls "don't win politicians any gold stars for policymaking." And they won't make it any easier for companies and investors to dig out of the recession.

Consider the proposed rules for derivatives. Both U.S. and European regulators want to clamp down on the use of the complex financial instruments, whose values are tied to the performance of an underlying security or benchmark. The deals got a bad name last fall when an especially esoteric and risky version—credit default swaps—blew up, prompting huge losses at insurer American International Group (AIG) and other companies. The pending reforms are meant to prevent another disaster.

But corporations could end up paying a price. Many companies buy basic types of derivatives to protect their earnings against fluctuations in interest rates, commodity prices, or currencies—a process known as hedging. "Hedging is an important weapon in any company's arsenal," says John Grout, policy and technical director at the Association of Corporate Treasurers, a trade group. American Airlines (AMR), for instance, controls its fuel costs with derivatives. Packaged goods maker Kraft Foods (KFT) uses them to keep grain expenses in check.

Any new rules may pressure companies to move their derivative deals to a regulated exchange, where trading is more transparent and oversight is stricter. (Right now almost all hedging contracts are created in private transactions with investment banks on the over-the-counter market.) Exchange-based derivatives cut into cash reserves. Under current requirements, companies have to fork over 3% of a contract's value as collateral up front in case the transaction goes south. They also have to pony up extra funds should conditions change—say, when commodity prices rise or fall dramatically.

If the proposals go through, companies that use derivatives would have less money to invest in their operations. European manufacturing giant Siemens (SI) reckons it will need an extra $1 billion in cash reserves, and engine maker Rolls Royce (RYCEY) figures its tab would total $4 billion.

The changes could also make derivatives a less effective tool for controlling expenses. Derivatives sold over the counter are tailored to a company's individual needs, while exchange-traded contracts are standardized. With custom contracts, corporations can lock in their prices through any date, say Dec. 12, 2010. A standard exchange contract only has certain dates—typically near the end of the month—leaving businesses vulnerable to price movements in the interim. "Any reduction in the access to nonstandardized derivatives would…add volatility and risk to quarterly earnings," Michael W. Connolly, Tiffany's (TIF) treasurer, told Congress last month. The jeweler uses derivatives to manage the cost of silver and other metals.

Businesses are rethinking their strategies in response to the proposed rules. Some executives have stopped using these sorts of risk-management techniques for now, fearful that rule changes would void existing contracts. Automakers and manufacturers, big users of derivatives, have been hesitant to enter into new deals because making changes to them could be costly. "It's causing treasurers to lose sleep," says Tim Sangston, managing director at consultancy Greenwich Associates.

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