In his much anticipated and widely read annual letter, JPMorgan Chase's (JPM -0.30%) Chief Executive Officer Jamie Dimon touched on a wide variety of issues facing the country right now, including higher inflation, rising interest rates, and Russia's invasion of Ukraine. Pertaining specifically to the bank itself, Dimon warned investors of a "drag" on the bank's return on equity because of regulatory capital rules that he has long criticized. Let's look at what Dimon is referring to and how it may impact the stock.
Holding more capital diminishes returns
All banks must hold a certain amount of capital to prepare for unexpected loan losses so that they can continue to lend money and serve consumers, families, and businesses during a severe downturn. One, if not the most important, of the regulatory capital ratios is the common equity tier 1 (CET1) capital ratio, which takes a bank's core capital expressed as a percentage of its risk-weighted assets such as loans.
The CET1 ratio is composed of three components: the bare minimum 4.5% base requirement, the stress capital buffer, and for the largest, global systemically important banks another buffer level known as the G-SIB surcharge.
Image source: JPMorgan Chase 10-K annual report.
There are a few different calculations, but the middle bar above shows JPMorgan's current minimum CET1 requirement. The G-SIB charge in recent years rose from 2.5% to 3.5%, and management on recent earnings calls said the bank will eventually hit 4.5% in the next few years unless the way G-SIB is calculated changes. Dimon, in his letter, said there was supposed to be a recalibration, but it never happened.
G-SIB capital requirements were supposed to be modified to account for the increasing size of the global economy and the smaller size of banks in relation to that global economy -- this simply has not happened. So JPMorgan Chase will be required to hold 2% more common equity Tier 1 capital as a consequence.
Dimon added that the additional capital requirements would effectively cut return on equity by about 15% from whatever it would have been if the bank didn't have such a high G-SIB charge. Here's a very basic look at how JPMorgan would be affected by the higher G-SIB surcharge based on financial results from 2021.
| G-SIB | CET1 Capital (millions) | Risk-Weighted Assets Q4 2021 (millions) | CET1 Requirement | Net Income 2021 (millions) | ROTCE |
|---|---|---|---|---|---|
| 2.5% | $167,178 | $1,639,000 | 10.2% | $48,334 | 28.9% |
| 4.5% | $199,958 | $1,639,000 | 12.2% | $48,334 | 24.2% |
Data source: JPMorgan Chase Q4 earnings materials. Chart by author. ROTCE = return on tangible common equity.
Now, keep in mind that the bank's current G-SIB surcharge is 3.5% and that a bank would never just hold enough capital to meet its minimum CET1 ratio spot on (they usually hold more). But as you can see, with a 2.5% G-SIB surcharge, JPMorgan has a 10.2% CET1 ratio requirement and, therefore, is only required to hold about $167.2 billion of CET1 capital based on its risk-weighted assets at the end of 2021.
With a 4.5% G-SIB, JPMorgan Chase's total CET1 ratio requirement rises to about 12.2%, forcing the bank to hold about $33 billion more in CET1 capital. By holding that extra capital, JPMorgan's return on tangible common equity (ROTCE) -- which is shareholder capital after removing intangible assets, goodwill, and preferred stock -- is about 4.7 percentage points, or roughly 16%, lower than it would be based on net income of $48.3 billion in 2021, thus illustrating Dimon's point.
Image source: JPMorgan Chase.
Furthermore, in his letter, Dimon said hypothetically, the bank's current medium-term ROTCE target of 17% would be 20% without the higher capital requirement, tying it with Morgan Stanley for the highest financial return targets of any large bank. Higher capital requirements also make it harder for JPMorgan to buy back stock and raise the dividend.
For all these reasons, Dimon said that the bank has found itself in a dilemma: "Do we restrict our growth and our ability to serve our clients in order to reduce our capital requirements over time and seek a higher ROE or do we invest our capital to grow with our clients (and in many cases remain competitive) and accept a permanently lower ROE?" asked Dimon in his letter.
Meeting investor demand
Bank stocks these days rarely have the allure of other sectors, not that the largest banks like JPMorgan don't get their fair share of love from the market. JPMorgan trades at about 200% of its tangible book value, or, essentially, its net worth. By any standard, this is a strong valuation.
Management at JPMorgan has been preparing analysts and investors for higher regulatory capital requirements, and its 17% ROTCE target is based on being in the higher 4.5% G-SIB bucket in the future. Still, facing higher expenses due to investment and inflation, the higher capital requirements could come at a bad time, with everything potentially hitting the economy in the near future.
