Dear JPMorgan Chase Directors,
I own some JPMorgan Chase (JPM) shares through mutual funds in my retirement account. I have read Mr. Dimon's recent letter to Shareholders and some of his public comments. I write to urge you to reconsider JPM's actions related to capital regulation. For the overall economy as well as for JPM, these actions are misguided.
Why I am writing
The economic pain from the financial crisis was substantial and is still being felt. A major cause of the crisis was the excessive leverage used and the risky investments made by many financial entities. The resulting distress of large institutions was extremely costly and disruptive to the economy.
Bank debt involves legally-binding promises. Shareholders, by contrast, do not have fixed claims but are entitled to the residual after debt is paid, the "spread." A drop in the value of the bank's assets can lead to difficulties in fulfilling its debt obligations. The more debt is used relative to equity, i.e., the higher the leverage, the more likely this is to happen.
High leverage makes the financial system fragile. One institution's distress can have severe implications for the entire system, causing market freezes, runs and lending contraction.
Requiring banks to operate with much-reduced leverage, using significantly more equity to fund their investments even beyond currently proposed regulation, is likely the most straightforward and cost-effective approach to improving the health and stability of the financial system and preventing future crises. It must be the key ingredient in any meaningful financial reform and can reduce the need for other, more costly measures. This would greatly benefit the economy and JPM.
Flawed reasoning
Mr. Dimon claims that higher capital requirements would increase JPM's cost, but his reasoning is flawed.
It is critical first to distinguish capital and liquidity requirements. Capital requirements are not about what banks "hold." They do not mandate that banks passively "set aside," or "hold in reserve" funds, not putting them to productive uses. Banks' investments are not constrained by capital requirements. Capital requirements refer only to how banks fund themselves. It is investors, not the banks, who hold the debt and equity (so-called "capital") claims that banks issue. Liquidity requirements, by contrast, do constrain the types of assets banks hold, and they can be costly. Capital and liquidity requirements refer to different sides of the balance sheet.
A flaw in Mr. Dimon's argument concerns the "market-demanded return on capital" that he claims banks must earn. In a well-functioning financial market, investments in Treasury bills "demand" a lower return than investments in risky mortgages. The required return on capital depends on the risk to which it is exposed. When funding with a mix of debt and equity, the lower the leverage, the lower the riskiness of equity per dollar invested, and therefore the lower the return investors require as compensation for bearing the equity risk.
According to Mr. Dimon, the reduction in the required return on equity as a result of reduced leverage is "not likely to be materially significant." Is he suggesting that sophisticated investors who can value complex derivatives and other securities are unable to value JPM's equity properly? This is hard to believe. JPM's overall funding costs, averaging the required return on the various debt claims it issues (some of which might decline if JPM is better capitalized) and the required return on equity, need not change just because more equity is used.
Mr. Dimon's letter displays JPM's return on equity (ROE). ROE does not measure shareholder value because it is affected, through the market, by leverage and risk. Reaching a target ROE can be helped by leverage and risk without benefiting shareholders. Thus, if increased capital requirements lead to lower average ROE, this need not mean lower value, because it reflects the reduced riskiness of equity.
Subsidized debt funding
JPM's overall funding costs will likely increase somewhat if it reduces its leverage, but the key reason for this is that government subsidies make debt more attractive than equity as a source of funding.
First, using more debt can save on corporate taxes because interest payments are tax deductible.
Another source of subsidy for debt relative to equity is due to underpriced explicit and implicit government guarantees. Such guarantees allow JPM to borrow at rates that do not fully reflect the riskiness of its assets. Mr. Dimon argues that JPM does not benefit from subsidized guarantees, but credit-rating agencies such as Moody's explicitly state that government support is built into the debt ratings of large US banks, including JPM.
Does this system make sense?
Since high leverage increases systemic risk, subsidizing debt funding and leverage is paradoxical and distortive. This is akin to providing subsidies to a polluting input (high leverage) when there is an otherwise equally costly "clean" input (more equity) for producing the same product (funds). It makes no sense to subsidize pollution when there are cheap alternatives.
Removing the preferential tax treatment of debt relative to equity, and even giving incentive for better capitalization would make for a healthier system. For the US economy, however, if JPM's pays more taxes, this is not a true cost. Any additional taxes JPM pays can be redirected to the economy, possibly reducing taxes elsewhere.
The "safety net" of the financial system, created to maintain stability and prevent inefficient panics and runs, has broadened since the crisis. It is widely believed that a "systemic" institution will likely receive government support in a crisis.
Excessive guarantees create significant and corrupting distortions, including unnatural growth, distorted competition, and reduced incentives to manage risk properly.
It is difficult to remove implicit guarantees since it might be better in a crisis to provide support. Increased reliance on equity creates more "self insurance" through the private markets, properly placing more downside risk with shareholders who benefit from the upside. It is the most direct approach to addressing the "too big to fail" problem and the moral hazard it creates.
Capital regulation under Basel III
Basel III requires that, in normal times, equity represents at least 7 percent of "risk-weighted assets." Capital ratios measured this way, which ignored AAA-rated securities (effectively pretending they were cash), provided little clue of looming problems leading to the crisis. Many banks, including Lehman Brothers just prior to default, appeared reasonably well capitalized. When off-balance sheet items, contingent claims and the real market value of holdings were included, many banks turned out to have only 1-3 percent equity relative to total assets.
Basel III mandates a minimal leverage ratio of 3 percent equity relative to total assets. Contrary to Mr. Dimon's claims, Basel III requirements are dangerously low and allow the financial system to remain excessively fragile.
JPM "fortress balance sheet" has about 8 to 9 percent equity, depending on whether the book or market value of equity is used. Behind and "off" the simple-looking balance sheet is a massively complex set of assets with trillions of dollars in notional amount. A major shock that would reduce JPM's assets significantly, possibly stemming from difficulties its counterparties realize, can create distress even for a relatively well positioned bank such as JPM.
Policy bottom line
The overriding policy objective in the United States must be a stable and healthy financial system that supports the American economy without imposing unnecessary risks and costs on its citizens. Insisting that banks are better capitalized is among the best approach towards this goal. Banks can perform all of their functions and support the economy, earning economically appropriate profits, with 20 percent or more equity funding. High leverage is not inherent to banking.
The crisis exposed the flawed design and poor enforcement of prior capital regulations. Basel III is insufficient. It also maintains a problematic system of risk weights. US regulators should advocate re-examining Basel III; meanwhile, US banks should withhold equity payouts.
Removing distortive tax incentives for financial institutions to choose high leverage that hurts the economy is critical. If banks remain highly leveraged, additional approaches must be found to address "too big to fail" distortions.
Many provisions in Dodd-Frank focus on how to handle crisis situations rather than on prevention and ongoing system health. Resolving a large global institution would remain disruptive and costly. If multiple institutions are distressed, the economy may again suffer severe consequences. Prevention must be the key.
Bottom line for JPM
In his letter, Mr. Dimon proposes that surviving banks should pay to resolve a fellow bank to avoid using public funds. This has some merit, but since JPM is a relatively strong bank, it would expose JPM shareholders to the risk of having to cover the resolution costs of "dumb banks" (to use Mr. Dimon's language). Requiring that all banks be better capitalized would serve the interests of the economy and also those of JPM.
Relative to other proposed regulations that can be truly costly to JPM and possibly to the economy, increased equity requirements do not entail significant costs. If the tax effect is neutralized and implicit guarantees are insignificant, as Mr. Dimon claims, then JPM funding costs will be essentially unchanged. With lower leverage, there may be less need for onerous liquidity requirements or breaking up banks.
JPM should support well-designed regulation that further reduces leverage in the financial system and urge regulators to enforce it effectively. JPM should advocate changes in the tax system to remove the advantage of debt over equity. Doing so would provide JPM and Mr. Dimon the opportunity to help lead the debate on capital regulation to a conclusion that will strengthen JPM, the banking system and the economy.
Sincerely,
Anat Admati
Originally published by Thomson Reuters-GRC, June 14, 2011.
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"Mr. Dimon is not disillusioned about the facts or economic rationale. Rather, as a self-interested CEO and spokesperson for the industry, he carefully weaves his story to raise doubt. It's not necessary for him to prove out the arguments. As long as his comments raise more questions and dissension among regulators, he has done his job of clouding their judgement and muddling the requirements."
Leverage and risk go in the same direction, when any person be it corporate or individual takes on debt for funding its expenses then it must take higher risk than earlier state to service the debt. The trap is made easy to outwit by the government subsidies such as preferential tax treatment and various financial research done purposely to mislead such as MM Theorem, Jenson Theory etc. etc.
Having an ethical, moral and financial obligation to the people does not translate into doing what's right. Similar to comments below, without punitive and criminal charges, their behavior is unbounded. Good regulation starts with jail time as a deterrence.
Find out how to disrupt the financial services industry by shifting the power to the people: http://amyx.co/
Honey we are to hell and gone from this. Your note would have been timely a decade ago, but now the horses are out of the barn and on to other pastures to die. Both this and the other article slammed in this article are far from the reality faced today. The banks have been making far too many risky investments to begin to afford to cover. The credit bubble has helped pushed the price of goods to a point where you need credit to buy anything. And yet it has destroyed jobs and lives and making America homeless! Maybe it is time the financial district found out just how badly this nation needs saving and how much these ideals and philosophies that only benefit the banking industry's top buddies needs to go away!
buffet called them weapons of financial mass destruction ------they exploded and destroyed the economy ----
just like nukes--------they have not yet been banned
If they aren't "capitalized" by now, when they are part of the 1 percenters, with any deal they want from any treasury in the world that they want...
YOU ARE DEALING WITH GAMBLING DEGENERATES.
Dancing around this issue is no longer tolerated...as this author is doing.
Where's the sledge hammer?
to find jobs and housing, it is even more important that we should not allow another blow-up in our business
cycle. We have had too many of these busts already in the past 2 decades. The last economic meltdown is
obviously due to the mistaken belief that free martket capitalism cannot go wrong if left alone. We are now suffering the consequences of such misconception. Some Republicans are still advocating doing away with the Fed and perhaps, any government regulation and control of businesses. And bankers like Dimond can
only think of himself and his bank. Let's hope America is smarter than that.
Please read it carefully (along with the footnotes). Other than blowing hot air at congressional committees, they are essentially autonomous.
Until the DOJ starts filing "RICO" charges against the Wall Street "Bonus Boys" and send them up the river to Hard Time prisons for ten year sentences, no "Country Club" prisons . Is Fredo Gonzalez & Liberty U Law school still in charge of DOJ?
THERE IS NO JUSTICE AT JUSTICE!
The banks are double dipping and only for the sake of America's "Almighty Profit" notion - "ta hell with any civic responsibility"! They could set back the principle to market value, after all, that's JUST what we did with the bail-out. They could easily re-negotiate interest only payments reducing them to a manageable level without having to incur foreclosure, saving themselves the incurred costs and the homeowner from having to hit the street, even suspending payments for up to 24 months with the accumulation of interest.
But NO! They want to take a huge paper loss to write-off against those profits,
shuffling foreclosure into a profit and then ending-up selling the property at market value or less. This ruins the owners credit, adjusts market principle and value and all in a tidy little paper profit package that they planned all along.
Then that loss is thrown against tax obligation, depriving government of its fuel to fund programs, and VOILA! C'est robber barron method for the new R.E. Raider Method.
I'd like to see the following people join Bernie Madoff in jail:
Alan Greenspan
Larry Summers
And all the rest of the "President's Working Group" economists who attempted to silence reports way back in the 90's about the need to regulate the rotten-at-its-core credit derivatives market.
Greenspan said not to regulate it, that the market would take care of it, and de-regulation was the source of all this booming economy.
Oh yeah, it boomed alright. Boomed all THOSE guys into gazillionaires, while it left the rest of us poor sucker taxpayers with empty pockets and quite a few of us foreclosed on and homeless.
Though I'd rather fix the problem....sending those guys to jail would at least make me feel like somebody's in some small way, paying.