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Devil in the Details: Do Banks Really Need $221 Billion of New Capital?

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Today's NYT Dealbook headline reads (underlines added for emphasis):

Top banks will need an extra $221 billion of capital and see annual profits slump by $110 billion if all proposed regulations to reform the industry are brought in, leading analysts said on Wednesday, Reuters reported.

If all the initiatives from regulators are implemented it would cut the average return on equity to 5.4 percent from 13.3 percent next year, hurt economic growth and raise costs for bank services, JPMorgan analysts warned, according to the news service.

"The cumulative impact of all the proposed regulation suggests that there is a real risk that we may move from a system that was under regulated to one that is over regulated and that that could cause a significant increase in lending costs and a negative impact on the economy," Nick O'Donohue, head of research at JPMorgan, said in a research note.

This saddens me in that it appears much like a threat levied against the entire non-banking economy if we allow the "extreme" case (using the article's words) of regulation to pass. I believe this plays into the continued vitriol that hurts American discourse and foments distrust as a theme we feel about our media, our representatives and now our banking system. I've even dedicated an entire post to wishing that Elizabeth Warren would also tone it down in her rhetoric.

It should additionally be noted that the simple math here is both interesting and misleading as presented. For example, I would wonder if anyone at JPMorgan has modeled what a roughly 20% reduction in year-end bonus compensation would do to erase portions of this hypothetical shortfall. Perhaps it might even exceed it within certain parts of the industry. (I'm confident in fact they have done this, they just aren't sharing it publicly).

In financial analysis we learn that the devil is in the details. In investment banking we carefully negotiate small terms because those terms translate into big dollars for our clients. In financial modeling, the law of GIGO ("Garbage In, Garbage Out") is an important rule we should never forget.

If lending costs go up, rational individuals may choose to view this as the unfortunate new cost of living safely in a post-crisis world. This is my own personal view.

However, I suspect that the actual outcome would be more complex than this article represents, and competitive pressures would drive compensation down almost as much as they would allow banks to collectively exert pricing control. In economics, one likely sign that an oligopoly exists is when a group of companies have the carte blanche power to pass 100% of cost increases directly to customers. In healthy competition, cost increases would either be absorbed by the firm, shared by the firm and customers, or cause innovation to occur.

In general markets are very good at sorting out the details when we let them function safely and properly.

-- The author is an independent corporate advisor at Belstone Capital and editor of the blog Polifinance.com, where this article has been co-published.