Posted by on March 30, 2013

You can’t keep a good man down.

That is why I was so pleased to see the CEO of JP Morgan, Jamie Dimon (a.k.a., the “Tallest Midget in the Circus”), back in fine form at a recent analyst meeting in which he suggested that banks in general, and certainly his bank in particular, would soon have too much capital. For good measure, he then took a gratuitous swipe at Mike Mayo, a well-known bank analyst, for suggesting that clients would gravitate to better capitalized banks, an act of lese majeste which earned Mayo the ultimate Dimon put down: “That’s why I’m richer than you”.

At this point, this post could go one of two ways. One way would be to use this as yet another example of how the bankers have learned absolutely nothing from the crisis. I could then bring forth the case of Andrea Orcel, a former colleague of mine who now heads up Investment Banking at UBS. UBS recently trotted out Orcel before a UK Parliamentary Commission on Banking Standards where he pronounced that UBS would now put “integrity over profit”. These words would be merely risible if they had been uttered by anyone else. They rise to the level of the surreal coming from Orcel, whose claim to fame was orchestrating the acquisition of ABN Amro by RBS (acting with Fortis and Banco Santander), a deal that brought $550 million of fees to his employer and a $33.6 million bonus to the man himself. It also brought about probably the most disastrous takeover in history and contributed substantially to the near bankruptcy and partial nationalization of two of his clients. When asked about his role in this unmitigated disaster, which was amply foretold by a plummeting RBS stock price during the takeover battle, Orcel solemnly proclaimed that: “If we’d known what we know today, we would have advised them not to proceed”. This is a little like the captain of the Titanic saying that, with hindsight, he would have steered a little bit more to the south. Except that the Titanic captain went down with his ship, whereas Orcel is recently reported to have received $26 million to jump to UBS.

But let’s get back to Dimon because, as much as I enjoy lampooning pretentious nonsense, the more serious policy issue is raised by Dimon’s claim. It should be noted that, when Dimon beats his chest about JPM’s capital ratio, he is not talking about what you or I might think of as capital. No. He is talking about a far more exotic creature called “risk-weighted capital”, which is a regulatory concept that the banks systematically manipulate and politically influence.

For example, those of us with long memories, or at least memories longer than Jamie’s, recall that way back in May 2012, JPM lost $6.2 billion on a series of derivative trades undertaken by Bruno Iksel, the so-called “London Whale”. (Note to file: Fire immediately any trader that acquires a market nickname, unless that nickname is something like “Bambi”.) Judging from the fact that Iksel was lodged in JPM’s Chief Investment Office (which sounds so much more conservative and better controlled than some wild-assed kids on the trading floor), that he was trading derivatives (and not easier-to-monitor cash instruments) and that his trading was originally characterized as a “hedge”, it is a virtual certainly that Iksel’s trades were designed to minimize JPM’s capital requirements. Although I have never seen the figure published, I am willing to wager a sizable amount that the risk-weighted capital associated with the Whale trades was substantially less than the $6.2 billion loss incurred. Just like the low risk weights assigned to “AAA” rated CDOs, backed by putrid mortgages, similarly grossly underestimated the risk of these instruments.

When Jamie beats his chest about the solidity of his institution, maybe he should be choosing a different benchmark?

For example, some academics from Stanford and Germany’s Max Planck Institute — my God, these people must be nuclear physicists! — have recently published a book (The Banker’s New Clothes) in which they argue that the banks are grossly undercapitalized and this imposes huge costs on society. For them, Dimon’s chest-pounding 9.5% of risk-weighted capital drops to 6% of tangible capital to total assets, and a mere 3.1% of their adjusted asset figures. Now, I don’t know what “adjustments” the academics made, but given that JPM carried its massive book of home equity loans (HELOCs) at nearly par value throughout the financial crisis, when they were clearly worth a lot closer to bupkis, certainly suggests that some adjustments are due.

The academics then go on to suggest that a much higher ratio, something like tangible equity of 20-30% of assets, would be in the public interest. With so little at stake, the academics rightly argue, the shareholders of the banks and their managements have a strong incentive to gamble since they are doing so overwhelmingly with OPM (“other people’s money”). This creates an environment of “heads we win” (the gambles pay off with large profits for the shareholders and managements) and “tails you lose” (the gambles lose and the banks get bailed out by the public). This is not exactly an environment conducive to prudent banking.

Funnily enough, in the 19th and early 20th century, banks routinely maintained equity capital ratios of about this amount. But this was before the Federal Reserve was established as a lender of last resort and deposit insurance was introduced and then extended with the doctrine of “too big to fail”, all of which has removed market discipline from the funding decisions of banks and lenders.

Of course, this proposal has brought howls of protest from the banks. In response, they have held a gun to the head of their favorite hostage: the economy, claiming that the cost of the additional equity would force the banks to increase their loan pricing and this would harm growth.

A couple of points about this argument. The first is that the explicit or implicit guarantee of the banks is a form of subsidy. Like any subsidy, this one has the effect of increasing the size of the beneficiary industry and distorting the allocation of resources. In other words, the bloated financial services industry is in part a result of this policy. This blog has frequently pointed out the tragic misuse of human capital in America resulting from our overextended financial services sector. When a good portion of the already pathetically low production of US engineers and scientists, along with other good quality students, gets sucked up by Wall Street, this greatly harms true economic growth, the kind that comes from the increase in the productive capacity of an economy.

The subsidy also contributes to one of the greatest evils of the US economy, which is its addiction to debt. This addiction is once again at least partially the result of bad policy, beginning with the idiocy of the US tax code which strongly favors debt over equity and consumption over investment. We have just seen the results of these various biases in the financial crisis, and they weren’t pretty. Yet the short-term thrills of debt-driven growth are always impossible for the policymakers to resist.

In addition to causing the excess production of financial services in general, the policy also distorts competition within banking since the subsidy is much greater for banks that achieve the threshold of “too big to fail”. This is, without a doubt, a major factor behind the recent consolidation in financial services that has taken place. I can assure you, having lived within and around these financial behemoths for most of my professional career, they cannot attribute their competitive success to economic efficiency.

Finally, when the bankers claim that rising capital costs will force them to increase loan pricing, they are conveniently ignoring their second highest expenditure: employee compensation. There is no doubt that part of the subsidy provided to the banks has been siphoned into the pockets of their employees. Reducing the subsidy will not have a one-for-one impact on loan pricing because the Jamie Dimons of the world will be given less scope to brag about their relative richness. And this has to be a good thing for a whole variety of reasons, economic and aesthetic.

In summary, in a world where governments have largely removed market discipline from the funding of banks, there is a strong case for greatly increased capital requirements, especially for the larger banks. These changes would:
– provide better incentives for the management and shareholders of the banks;
– decrease the implicit subsidy provided to the banking sector, reducing its bloated size, decreasing compensation and releasing resources to more productive uses;
– help reduce the bias to consolidation in banking;
– reduce the risk of financial crises, both indirectly through better incentives and directly through the availability of a greater loss-absorbing cushion; and
– help wean the American economy off its debt addiction.

All in all, a good day’s work in my opinion.

Roger Barris, Switzerland

PS: I cannot resist pointed out that, once again, my adopted country of Switzerland got it right, or at least got it righter, than the rest of the world. When the rest of the “advanced” world was imposing the minimum international capital standards, the Swiss were increasing the requirements for their banks with the so-called “Swiss Finish”. When the Swiss bankers tried the hostage ploy, complaining that this would make them uncompetitive, the Swiss cried “bullshit” and imposed the higher standards anyway. Now they are leading the charge once more with standards that are high and become progressively higher the larger, and more systematically important, a bank becomes. Rest of the world: more cowbell, please!

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2 Comments on "Jamie and the Whale"

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Well done Roger in spotting what the press has completely missed; the “risk weighted” capital treatment of the “whale” trade, which in my opinion is the elephant in the room here. It is now clear that the trade was an outsized relative value trade (LTCM style) in which the so-called “CIO Office” had a long position in one index against another index or basket. The interesting thing here is that this pair trade was seen as a very low risk or no risk position as theoretically moves in one leg would be offset by moves in the other leg (are… Read more »