JPMorgan Chase's (JPM 0.06%) CEO Jamie Dimon has not been shy about how he feels about regulatory capital requirements. Not only does Dimon find the requirements to be nonsensical, but he also doesn't think they are in the best interest of the banking system or consumers.
With regulators preparing to finally implement the last remaining capital requirements first inspired by post-Great Recession banking reform, known as Basel III Endgame, banks are bracing for higher capital requirements.
And if you ask Dimon, the new requirements are expected to be a big win for hedge funds and private equity. "They're dancing in the streets," Dimon said on JPMorgan's recent earnings call. Here's why, and how these new capital requirements could impact the nation's largest banks.
Image source: Getty Images.
Bracing for impact
Banks must hold regulatory capital so they can incur unexpected losses and still lend during an economic downturn. Each year, the largest and most complex banks get regulatory capital requirements based on annual stress testing and their size and complexity. Excess capital over capital requirements can be used to return capital to shareholders. Generally speaking, the more capital a bank holds, the lower its returns on equity are going to be.
Basel III is an international framework for bank supervision and regulation developed in the wake of the Great Recession by the Basel Committee on Banking Supervision (BCBS), an international body that takes the lead on global bank regulation. Naturally, these rules have taken years to implement and have seen many revisions. The final revisions are expected to be announced any day now, and the largest banks are bracing for higher capital rules.
In a recent speech, Michael Barr, vice chair for supervision at the Federal Reserve and an advocate for higher capital requirements, said Basel III revisions would be the "equivalent to requiring the largest banks [to] hold an additional 2 percentage points of capital, or an additional $2 of capital for every $100 of risk-weighted assets."
Banks have been building capital to prepare for the new requirements, so hopefully they have already done some of the work, but 2 percentage points of capital is a big deal when you consider that these large banks are operating in billions and trillions of dollars.
Maintaining returns
Banks are obviously not going to want to see their returns go down because it will likely impact their valuations and stock prices, so they will try and protect them as best they can.
JPMorgan Chase's CFO Jeremy Barnum said that the bank will first try and reprice its products to the extent it has pricing power in an effort to generate its targeted returns with the higher capital requirements. But if this doesn't work, the bank may exit some products such as mortgages that no longer make sense to originate from a profitability perspective.
Barnum added:
That probably means that those products and services leave the regulated perimeter and go elsewhere. And that's fine. As Jamie points out, those people are clients. And I think that point was addressed also in vice chair Barr's speech. But traditionally, having risky activities leave the regulated perimeter has had some negative consequences. So these are all important things to consider.
So essentially, the bank will focus on products that they can earn the right returns on and that make sense from a business perspective. The bank will try and raise prices on loans such as mortgages, which will make them more expensive for the consumer. But where the bank lacks pricing power, those activities will be picked up by what Dimon refers to as the "shadow" banking system, which includes hedge funds, private equity, and private credit.
This puts these firms in a better competitive position to offer more traditional banking products. As an analyst on JPMorgan Chase's earnings call pointed out, the large private equity firm Apollo Global Management saw its stock price hit an all-time high during the same week of Barr's speech.
What does it all mean?
On one hand, the new capital rules may make the banking system safer, but it may also have unintended consequences. For instance, post-Great Recession regulation resulted in banks lending less to comply with various regulatory ratios. But this in turn led them to use their excess liquidity to load up on bonds, which they thought were safer. Lo and behold, underwater bond portfolios were at the center of the recent banking crisis this year.
Now, the banking crisis earlier this year does appear to have been much less severe than the Great Recession, and many believe the banking sector is way safer now than ever before. The question is this: Do higher capital requirements push the risk somewhere else? Either way, the new capital rules could very well fundamentally change banking and the types of products banks offer.
