Sympathy for the Dimon

Steven Kelly is a senior research associate at the Yale School of Management’s Program on Financial Stability.

It’s always fun when Jamie Dimon is trending. He’s one of few people in business who effectively have tenure. Remember when he said JPMorgan would outlive the Chinese Communist party? It was top-notch entertainment from the person who — love or hate him — is the quintessential banker of our time.

Last week, he made waves with comments to Congress that “the continued upward trajectory” of large banks’ capital requirements pose a “significant economic risk.” He went on:

This is bad for America, as it handicaps regulated banks at precisely the wrong time, causing them to be capital constrained and reduce growth in areas like lending, as the country enters difficult economic conditions. […] Strong and resilient banks that can support the American economy through a crisis are key to American growth and competitiveness.

An excellent FTAV post from George Steer quoted Prof. Jeremy Kress correctly critiquing Dimon for complaining about the amount of capital he has to “set aside.”

As Kress notes, capital (equity funding) is not money that sits in a lockbox as “set aside” might imply; it’s simply a different style of funding. Even so, it almost doesn’t matter if it were a stack of cash, because then this hypothetical lockbox money could apply towards the liquidity regulations that also limit banks’ potential balance-sheet use.

In fact, “set aside” isn’t really the worst phrasing for a large bank with decently restrictive capital requirements. In most cases these days, banks and market participants consider banks to be overcapitalised. (Most cases. Sorry, Credit Suisse, the market just isn’t buying it.) Banks would prefer to run leaner — ie, do more shareholder distributions — and have more balance sheet freedom to intervene when a market hits a liquidity bump — ie, have more countercyclicality in their capital requirements, and be able to determine appropriate levels of risk-taking by themselves.

So Dimon is looking at his total amount of capital and allocating it to different buckets. When the winds change in, say, the Treasury market and arbitrage opportunities abound, it would be profitable to swoop in with buying, repo lending and prime brokering to capture the arbitrage. But, given capital-regulation rigidity, that would require taking capital out of one of his other buckets. “Allocate”, “set aside” . . . six of one, half dozen of the other.

Couldn’t he just raise new equity? Sure, and that’s a nice story for a steadily growing lending book. But by the time those funds land, whatever market was facing a shortage of balance sheet has already blown up, failed to move the risk and downsized, or required a government intervention. Packaging risks into vehicles investors want to hold, such as deposits or repos, is indeed banks’ fundamental business.

We rely on banks to absorb (or at least price) economic and financial risks in the global economy. When the US housing market began to turn sour in 2006 and infect funding markets in 2007, banks did help keep the system steady for a time. For example, as the Financial Crisis Inquiry Commission later reported, Citigroup’s balance-sheet leverage went from 22:1 to 32:1 in 2007 alone, as it absorbed risks on to its balance sheet. Lehman Brothers (among many, many others) kept its balance sheet intact as long as it did by drastically shortening the maturity of its liabilities, to keep them palatable to investors given the risks on asset side of the balance sheet.

Then the financial system broke in 2008. Standard monetary policy and discount-window lending could no longer keep it standing, and the undesirable side effects of letting banks take on such large risks became clear. As a result, officials imposed regulations that limited banks’ leverage and made their balance sheets stronger by requiring more capital and liquid assets.

But these rules also, by definition, limit banks’ ability to act as banks, by limiting balance sheet expansion.

Ideally, banks would stay very well capitalised to the point where they can effectively provide a floor on financial stability. In an episode where we need some elastic balance sheet, they would jump into action and run down their equity ratios as they size up to meet the market’s moment. And they would have enough capital that the market would watch them do this and view the banks as having enough capital to both arrest the market instability (and thus buy the dip) and maintain capital ratios that are at least comfortably distant from zero. And the Fed would simply underwrite bank liquidity, not provide the market with balance sheet.

The problem is that 2008 demonstrated the very real risks to letting banks make these judgments on their own. For one, the market could stop believing the necessary capital exists for the banking system to function.

Financial crises carry a much greater human toll than other types of economic disruptions and recessions. Post-crisis legislation and regulation reduced the odds of future meltdowns by enforcing much stricter capital requirements.

While more capital at the heart of the system increases its resilience, it also raises the return banks need to offer: Investors are less eager to offer banks equity capital than money liabilities. It seems reasonable to think that the $2.6 trillion currently sitting at the Fed’s reverse repo facility would more readily fund repos with JPMorgan than buy its equity . . . often, because of investor risk mandates, it doesn’t matter how steep a discount. In 2008, we realised how short of bank capital the system was. We’ve generally solved that problem, but possibly at the expense of creating a new shortage: balance sheet.

The returns to a bank that intervenes in a crisis can be massive when they are able to step in, but these crises don’t happen often enough to justify holding on to substantial shareholder capital. Plus, allowing banks to choose when to make such interventions would require assuming that shareholders can analyse the potential risks and rewards better than regulators. Where regulation would see a bank becoming undercapitalised, the market would understand it as the result of the bank stepping into the breach, and picking up a bunch of high-spread, low-risk business. That works much of the time — but it’ll never work all the time.

Regulation has given banks “buffers” to do this kind of thing, but using them still comes with regulatory costs. And nudging banks to use them has proven less effective than just giving temporary regulatory exemptions. (The supplementary leverage ratio exemption for reserves that the Fed implemented during COVID seems likely to return permanently, but the return of the same exemption for Treasuries looks more uncertain — and not unreasonably.)

While Dimon’s wording wasn’t perfect, he seems mostly right that banks have less ability in a crisis to “support [the] economy” than they had before the GFC. Bank capital requirements limit their ability to engage in just-in-time manufacturing of balance sheet — because that kind of balance sheet is created with leverage. Raising equity takes time.

The post-February commodity markets have been a case study. Commodities dealers have been minting profits since Russia invaded Ukraine. And yet, they still asked for government help. Despite the lack of profitability concerns, banks only stepped up a bit (in JPM’s case, by not margin calling Tsingshan into oblivion during March’s short squeeze in nickel), and haven’t been meeting markets’ full liquidity demands. When the sovereigns didn’t heed commodities players’ calls to step in, banks and traders ultimately settled for a combination of some additional leverage and some balance-sheet downsizing — the latter of which only exacerbated problems in commodity markets.

The European power crunch is playing out similarly, this time with governments stepping up: despite power prices rising drastically, power utilities across Western Europe have needed government assistance to meet the liquidity demands on economically sound positions.

So where does that leave us? Well, economic crises that don’t bring down the financial system are orders of magnitude less damaging — both economically and politically — than financial crises. That is, to the extent that crimping banks’ ability to intervene in moments of volatility reduces the chance of them going down too, it’s a good idea.

But the cost of avoiding more financial crises might be more market “crises” — cracks we used to paper over by flexing bank balance sheets and easing monetary policy. If sovereigns want someone to move risk, they may find themselves making more regulatory concessions to banks, or simply doing it themselves.