Views on the integrity of global capital markets
15 June 2011

Big Banks, Big Risks

Posted In: Systemic Risk

When Washington policy wonks and Wall Street high-finance geeks get together, it’s no surprise that the discussion quickly devolves into acronyms and esoterica that make often complicated issues even less approachable.  So a letter to shareholders by JPMorgan Chase CEO Jamie Dimon, and response from Stanford University professor Anat Admati are fascinating for their description in (relatively) plain language of the perplexing issues around systemic financial risks.

As is usually the case with these sorts of things, there’s something for everyone on all sides of this debate. Dimon echoes some of the criticisms he lobbed at Federal Reserve Chairman Ben Bernanke at a conference in Atlanta earlier this week, especially that efforts to “fix” systemic risk might very well snuff out any glowing embers of economic recovery.  He contributes significantly to the lexicon of wonkiness by introducing the acronym “MDBFBDB” (for “Minimally Damaging Bankruptcy for Big Dumb Banks”), which is as entertaining as it is appropriately descriptive as an aspiration for resolution policy. Increased capital requirements seem especially irritating to the JPMorgan Chase CEO, or at least what he considers to be arbitrary requirements for increased capital. Dimon points with pride to his bank’s weathering of the crisis with adequate capital, and also cites pro forma performance of the bank in stress-test modeling. He makes a case for protecting the dominance of big U.S. banks in the global financial architecture, warning of ill effects on the American economy if banks are hamstrung by reform efforts borne of the crisis. In the dawn of the 2012 political silly season in the U.S., steering away from obstacles to economic revitalitization is sure to draw cheers.

But not so fast. Professor Admati does a nice job of refuting some of Mr. Dimon’s concerns.  In particular, she discusses the relationship between capital structure of banks (and in particular, the degree of leverage allowed) and return on equity, making the point that investors should be able to discern de-risked balance sheets and adjust required returns appropriately. She also points out, rightly, the distorting effects of both debt subsidies (through our tax code) and the moral hazard of government bailouts. Dimon argues that the market didn’t assign any particular benefit to implicit guarantees by the government, given spreads on debt that persisted relative to government-sponsored enterprises (GSE) spreads.  But the financial opacity of banks and the uncertainty of the crisis might have had something to do with that. 

How Much Equity Capital Is Enough?

Admati’s argument for less bank leverage (and by extension, higher equity capital that buffers catastrophic financial blowouts) is compelling. The disagreement between Admati and Dimon centers on the degree of equity capital required, with Dimon focused on his perception of the arbitrary nature of setting capital requirements. Some work out of New York University would suggest that Dimon’s pride in how his bank weathered the storms of the crisis may be falsely reassuring given continued exposure to systemic risks.  As reform efforts around resolution of systemically important financial institutions (SIFI) and derivatives trading and clearing plod along, market participants have to consider how “big dumb banks” and other counterparties could swamp their fortress balance sheets quickly through counterparty exposure.  After all, big banks are in the business of being big counterparties.

Beyond addressing solvency, I wish Admati and Dimon both had devoted a bit more attention to proposed liquidity requirements (for example, the liquidity coverage ratio proposed in Basel III). Tinkering with the type of assets held by banks in support of adequate liquidity (as opposed to the capital structure in support of solvency) seems more likely to have impact on lending, either through pricing or availability of loans, or both.  And although policymakers shouldn’t turn a blind eye completely to the policy objectives of minimizing systemic risk or spurring economic recovery, nor should they ignore larger issues around global coordination of financial services regulation. The Europeans seem inclined to insist on higher levels of capital for banks, and failure to agree on a common framework would damage the prospects for the international coordination that is widely viewed as essential.

Dimon? Admati? Who makes the better argument? And what didn’t they talk about that they should? Liberate your inner wonk or geek and offer your comments below.

About the Author(s)
Bob Dannhauser, CFA

Bob Dannhauser, CFA, is head of global private wealth management at CFA Institute.

2 thoughts on “Big Banks, Big Risks”

  1. Manuel Royo, CFA says:

    Anyone who uses “the distorting effect of debt subsidies” (ie tax deductibility of interest paid on debt) as a main argument for greater capital requirements automatically loses the argument. So Jamie Dimon wins this debate. Every firm has an intrinsic obstacle towards too much leverage: It is called the costs of financial distress. Last thing we need is a bunch of ill-educated liberals running around in the halls of power lobbying against the “evils” of interest tax deductibility. Its bad enough that dicidends suffer double-taxation in half the developed countries.

  2. Bob Dannhauser, CFA says:

    So is the problem (or more likely, “a” problem among many!) that using the tax code is too blunt policy instrument that ends up being inconsistent? Distorting effects seems to me to be part of that argument.

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