Steven Kelly is a Senior Research Associate in the Financial Stability Program at the Yale School of Management.
It’s always fun when Jamie Dimon is hip. He’s one of the few people in business who effectively serves tenure. Remember when he said JPMorgan would survive the Chinese Communist Party? It was first class entertainment from the person who, love him or hate him, is the quintessential banker of our time.
Last week he made waves before Congress with comments that “the continued upward trend” in capital requirements for large banks posed “significant economic risk.” He went on:
This is bad for America as it hampers regulated banks at just the wrong time, causing them to suffer from capital constraints and reducing growth in areas like lending when the country hits tough economic conditions. […] Strong and resilient banks that can sustain America’s economy through a crisis are key to America’s growth and competitiveness.
An excellent FTAV contribution by George Steer quoted Prof. Jeremy Kress, who rightly criticized Dimon for complaining about the amount of capital he had to “set aside”.
As Kress notes, capital (equity) is not money sitting in a safe deposit box, as it might mean “set aside”; it’s just a different type of funding. Even so, it almost doesn’t matter if it’s a stack of cash, because then this hypothetical lockbox money could apply to liquidity regulations, which also limit banks’ potential use of balance sheets.
In fact, “set aside” isn’t exactly the worst wording for a large bank with moderately restrictive capital requirements. Banks and market participants today consider banks to be overcapitalized in most cases. (In most cases. Sorry, Credit Suisse, the market just isn’t buying it.) Banks would prefer to run leaner — meaning make more payouts to shareholders — and have more balance sheet freedom to step in when a market achieved a liquidity boost – ie, have a more countercyclical capital requirement and are able to self-determine an appropriate level of risk-taking.
So, Dimon looks at his total equity and allocates it to different buckets. When the winds are, say, turning in the Treasury market and arbitrage opportunities abound, it would be profitable to enter buying, repo lending and prime brokering to capture the arbitrage. However, given the rigidity of capital regulation, this would require withdrawing capital from one of its other buckets. “allot”, “put aside” . . . six from one, half a dozen from the others.
Couldn’t he just raise new equity? Sure, and that’s a nice story for an ever-growing rental book. But by the time those funds land, every market that has faced a balance sheet shortage has already exploded, not moved and scaled down risk, or required government intervention. Putting risk into vehicles that investors want to hold, like deposits or repos, is indeed the basic business of banks.
We rely on banks to absorb (or at least price in) economic and financial risks in the global economy. When the US housing market started to turn sour in 2006 and infected the financing markets in 2007, the banks helped keep the system stable for a while. For example, as the Financial Crisis Inquiry Commission later reported, Citigroup’s balance sheet leverage increased from 22:1 to 32:1 in 2007 alone as it absorbed risk onto its balance sheet. Lehman Brothers (among many, many others) kept its balance sheet intact as long as it drastically shortened the duration of its liabilities to make them palatable to investors given the risks on the asset side of the balance sheet.
Then in 2008 the financial system collapsed. Traditional monetary policy and discount window lending could no longer sustain it, and the undesirable side effects of banks taking on such large risks were becoming apparent. As a result, officials enacted regulations that limited banks’ leverage and strengthened their balance sheets by requiring more capital and liquid assets.
But these rules also, by definition, constrain banks’ ability to act as banks by limiting balance sheet expansion.
Ideally, banks would remain sufficiently well capitalized that they can effectively provide a floor for financial stability. In an episode where we need an elastic balance sheet, they would spring into action and scale down their capital ratios as they expand to meet market moments. And they would have enough capital that the market would watch them and see the banks as having enough capital both to stem market instability (and thus buy the decline) and to maintain capital ratios that are at least comfortably far from zero. And the Fed would simply guarantee bank liquidity, not feed the market with balance sheets.
The problem is that 2008 has shown the very real risks of letting banks make these decisions themselves. For one thing, the market could stop believing that the necessary capital for the functioning of the banking system is available.
Financial crises take a far greater human toll than other types of economic disruptions and recessions. Post-crisis legislation and regulation reduced the likelihood of future meltdowns by enforcing much stricter capital requirements.
While more capital at the heart of the system increases its resilience, it also increases the rate of return that banks must offer: Investors are less eager to offer banks equity than money liabilities. It seems reasonable to think that the $2.6 trillion currently sitting in the Fed’s reverse repo facility would fund repos at JPMorgan rather than buy their equity. . . It often doesn’t matter how big a discount is due to risk mandates from investors. In 2008 we realized how tight the system’s bank capital was. We’ve generally solved this problem, but possibly at the cost of creating a new deficiency: balance sheet.
The returns from a bank that intervenes in a crisis can be enormous when it can intervene, but these crises do not occur often enough to justify holding significant shareholder capital. Furthermore, giving banks a choice in when to intervene would require shareholders to be better placed than regulators to analyze the potential risks and opportunities. If a bank became undercapitalized as a result of regulation, the market would understand this as a result of the bank stepping into the breach and taking on a number of highly diversified, low-risk deals. This works most of the time – but it will never work all of the time.
Regulation has given banks “buffers” to do such things, but there are still regulatory costs associated with using them. And getting banks to use them has proven less effective than just granting temporary regulatory exemptions. (The additional leverage ratio exemption for reserves that the Fed introduced during COVID seems likely to return permanently, but the return of the same exemption for Treasuries looks more uncertain — and not unreasonable.)
While Dimon’s phrasing wasn’t perfect, he seems mostly right that banks are less able to “support” in a crisis [the] Economy” than before the GFC. Banks’ capital requirements limit their ability to prepare balance sheets just-in-time – because these types of balance sheets are leveraged. Raising equity takes time.
Commodity markets after February were a case study. Commodity traders have made profits since Russia invaded Ukraine. And yet they asked for government help. Despite the lack of viability concerns, banks have edged up only a little (in JPM’s case by not forgetting Tsingshan during March’s nickel short squeeze) and have not fully met markets’ liquidity needs. Eventually, when governments failed to heed calls from commodity market participants to intervene, banks and traders opted for a combination of additional leverage and some balance sheet reduction – the latter of which only exacerbated problems in commodity markets.
The European electricity crisis is playing out in a similar way, this time with strengthened governments: Despite soaring electricity prices, electricity suppliers across Western Europe need government support to meet liquidity needs in economically healthy positions.
Where does that leave us? Well, economic crises that don’t collapse the financial system are orders of magnitude less damaging—both economically and politically—than financial crises. That said, to the extent that banks’ ability to intervene in moments of volatility reduces the likelihood of a collapse, it’s a good idea.
But the cost of avoiding more financial crises may be more “market crises” – cracks that we used to cover up by tightening banks’ balance sheets and easing monetary policy. If states want someone to transfer risk, they may need to give banks more regulatory concessions or just do it themselves.