JPMorgan Wants Another Financial Crisis

Does JPMorgan want another banking crisis? That's certainly how it appears. If the investment bank and its competitors have their way, it will only be a matter of time before taxpayers are forced to rescue the banking system again.

JPMorgan leads the "counteroffensive"
Last Thursday, the bank sent its chief risk officer to Congress to request that lawmakers block new global rules that would impose a capital surcharge on banks that are "too big to fail," on top of the 7% minimum ratio of common equity to risk-weighted assets agreed to under Basel III. The latest figures under discussion by global regulators would impose an extra 2.5 percentage points on at least eight global banks, including JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC), and Citigroup (NYSE: C), for a minimum ratio of 9.5%. In the next group down, Morgan Stanley (NYSE: MS) and Goldman Sachs (NYSE: GS) would face a surcharge of 2%, for a 9% minimum.

How do these banks stack up presently? The following table contains my estimates of tier 1 common equity ratios under the Basel III standard:

Source: Company filings. "Titanic fleet" refers to the combined figures of the five banks. 
*JPMorgan's own estimate.

What's all the fuss about? Citi, Goldman, and Morgan Stanley are already close to or above the proposed minimums including the surcharges. JPMorgan has a shortfall of 2.2 percentage points, but according to estimates from research firm Morningstar, the bank could close that gap out of earnings alone in less than two years -- well ahead of the Basel III timetable. 

The fundamental problem is that the capital surcharges that regulators are discussing, far from being punitive, are much too low. Here's the evidence.

Sensible ratios are much higher
In a paper published this year, three Bank of England economists estimate that the optimal capital ratio is somewhere between 16% and 20%, based on a cost-benefit analysis with regard to GDP loss -- and that was when they ignored the threat of extreme crises like the one we've just been through. When they included those, the optimal ratio increased to 45%!

Bankers might object that these figures are just the product of a statistical model that has nothing to do with the real world. Not so. Some basic observations concerning the crisis we have barely exited show the range of 16% to 20% is spot-on. As Sebastian Mallaby pointed out in the Financial Times this month:

The sweet spot [for the ratio of equity to risk-weighted assets] is somewhere between 15 and 20 per cent... First, recall how much equity can be destroyed in a crisis. The International Monetary Fund calculates that credit losses at US banks between 2007 and 2010 amounted to 7 per cent of assets, so banks must be in a position to lose that much again and survive. Second, consider how much residual equity banks must have left after a large hit. Here the answer is about 8 percent of assets – that is the amount that the top four US banks felt it necessary to hold in early 2010 in order to retain market confidence. Third, remember that capital is held against risk-weighted assets, and that the calculation of risk weights is notoriously treacherous, so banks should hold a further buffer against "model error", aka geeks who screw up. Adding these factors together, a 20 per cent equity capital ratio seems reasonable, even if some of this may take the form of "coco" bonds that convert to equity in a crisis.

An Alexandrian solution to calculating capital ratios
The third point is very important. For the sake of argument, let's do away with risk-weighted assets and calculate the common equity ratios on the basis of a more straightforward number that can be found on the balance sheet: total assets. That will yield robust measures of capital and leverage that are better suited to gauging the potential impact of a crisis of extreme severity, in which all assets become risk assets. ("Risk-free" isn't what it used to be, after all.)

Sources: Company filings and Capital IQ (a division of Standard & Poor's). "Titanic fleet" refers to the combined figures of the five banks.

Crisis? What crisis?
Under the harsh light of this assumption, our top-heavy financial system starts to look a lot shakier -- a 6% across-the-board decline in asset values wipes out all the common equity at our five banks and starts to eat into lower-quality capital. It should be clear to any impartial observer that regulators have already given up too much ground to bankers, whose attitudes are the height of irresponsibility. Less than five years after the fact, it's as if the latter have forgotten that there was ever any credit crisis at all. The crisis was all too real -- and regulators should make a serious effort to reduce the severity of the next one.

We're not out of the woods yet -- " Watch This Before the Market Crashes ."