Typically, investors reward banks for significantly growing their deposit base, especially if they can get those deposits without having to pay out too much interest on them. But JPMorgan Chase's (NYSE:JPM) growing deposit base and ballooning balance sheet could quickly turn into a headache for the bank due to capital regulations the bank must follow. If the regulations are not changed, or certain exclusions are not extended, the bank may be forced to take actions that will not benefit shareholders.

Massive influx of deposits

All banks, not just JPMorgan, are dealing with a flood of deposits. On JPMorgan's most recent earnings call, CFO Jennifer Piepszak attributed the issue to the Federal Reserve's quantitative easing program, in which the central bank has purchased government bonds and other securities in order to inject money into the economy and boost activity. There has also been unprecedented government stimulus adding money into the system. As a result, Piepszak notes there has been $3 trillion of domestic deposit growth across U.S. commercial banks.

The exterior of a JPMorgan Chase branch on a city street

Image source: JPMorgan Chase.

Normally, this would be good for JPMorgan, in the sense that it has helped the bank's deposit base and funding costs. Interest-bearing deposits at the bank grew 32% in 2020, and because the Fed's benchmark federal funds rate is practically at zero right now, those deposits are very cheap. Additionally, non-interest-bearing deposits grew 41% in 2020. That's the best kind of deposit for any bank because they don't cost anything, and they tend to stick around when the Fed raises interest rates.

The cost of JPMorgan's interest-bearing liabilities at the end of last year fell to 0.23%, down nearly a full percentage point from the end of 2019. The problem is that this influx of deposits has played a major role in JPMorgan growing its balance sheet roughly 22%, from $2.78 trillion in assets at the end of 2019 to nearly $3.4 trillion in assets at the end of 2020.

Regulatory issues

Regulators have always required banks to retain a certain amount of capital so they can absorb unexpected loan losses in times of duress and still continue to lend to individuals, families, and businesses. For obvious reasons, these capital rules got much more complex following the Great Recession. As a result, banks now have many capital requirements and ratios they must maintain or stay above in order to comply with the regulations.

JPMorgan's ballooning balance sheet has begun to put stress on one of these ratios called the supplementary leverage ratio (SLR), which looks at a bank's capital compared to its total leverage exposure. Total leverage exposure includes total assets and off-balance sheet items such as derivatives, repurchase agreements, and other lending commitments or exposure. The equation is a bank's tier 1 capital divided by total leverage exposure.

The problem with deposits began in early 2020. Regulators saw the issue, and in order to make sure that banks were not impeded during the pandemic, approved an exclusion that would allow banks to exclude U.S. Treasury securities and deposits held at Federal Reserve banks from the total leverage exposure. This would prevent the denominator in the SLR equation (total leverage exposure) from far exceeding the numerator (tier 1 capital) and therefore the ratio from falling too fast.

JPMorgan must maintain an SLR of 5% or higher. With the exclusion in place, its SLR easily meets this criteria, and it ended 2020 at 6.9%. However, the bank noted in its earnings materials that without the exclusion, the SLR would have been 5.8%.

What could happen

The exclusion is currently set to expire on March 31, and JPMorgan's leverage exposure has continued to grow. Between the third and fourth quarters of 2020, total leverage exposure grew from $3.25 trillion to nearly $3.4 trillion. Piepszak said that management expects the bank's balance sheet to stay elevated for some time.

If the exclusion is not extended, then JPMorgan could soon be faced with some very difficult decisions to avoid falling under the 5% SLR threshold. Piepszak said these options include reducing or flat-out turning away deposits, issuing preferred stock, or retaining more common equity than the bank would normally need to.

Having the bank turn away deposits is not good for its business, especially as it's still expanding and growing its presence in new states. Issuing preferred stock could dilute shareholders, or at the very least dilute dividends. And retaining more equity means that more of the bank's capital will not be generating any return, and could slow the pace of share repurchases or dividend increases. As Piepszak noted, retaining equity or issuing preferred stock are a "negative ROE [return on equity] proposition in today's ultra-low rate environment."

Ideal scenarios

Hopefully, bank regulators will extend the SLR exclusion or simply implement a new way to calculate it. JPMorgan CEO Jamie Dimon has continually expressed frustration with how many of the capital ratio requirements are calculated based on the bank's size and are not risk-weighted. Even though JPMorgan's balance sheet has ballooned, the bank has had very little loan growth due to the uncertain economic outlook, and therefore has plenty of capital and liquidity.

Also frustrating for the bank is that despite its strong performance in the Great Recession and through the pandemic thus far, outperforming its main competitors on both occasions, its regulatory capital requirements have increased more so than its competitors'. While regulations seem to have done their job in keeping the banking system safe, they also seem to have a more outsized and negative impact on JPMorgan than the rest of the industry. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.