Wednesday, February 16, 2011

Does the Banking Industry Have Too Much Capital?

In a recent investor presentation, Jamie Dimon of JP Morgan argued that inside of twelve months the US banking system will have too much capital.

Prove it!

By the end of the year, it should be possible to make available to all market participants on a current basis all the assets held by JP Morgan.  Then credit and equity market analysts, as well as competitors, can analyze these assets and determine if the value of JP Morgan's assets exceeds its liabilities.

With this data also being made available by all of JP Morgan's competitors, JP Morgan can identify and avoid the dumb competitors who, despite having lots of capital, take on too much risk.

As MarketWatch reported: [emphasis added]
By early next year, the U.S. banking industry will have too much capital, rather than too little, J.P. Morgan Chase & Co. Chief Executive Jamie Dimon said Tuesday during an investor presentation. 
“I’m worried about how much capital is going to build up in the system in the U.S.,” Dimon said. “In 12 months we’re looking at a lot of capital we can’t use. That may make people do stupid things.” 
A lack of capital and liquidity in the industry turned a housing market slump into a global financial crisis in which hundreds of banks failed and governments committed hundreds of billions of dollars to save some of the largest financial institutions in the world.
According to the Financial Crisis Inquiry Commission report, the issue that triggered the freezing of the capital markets was that neither market participants like banks or regulators knew which financial institutions were solvent and which were not.

As this blog has long maintained, the only way to know if a financial institution is solvent is to be able to analyze and value the assets the financial institution currently has and see if this exceeds its liabilities.
Since then, regulators have pushed banks to increase capital so that the industry has more of a cushion for future crises. Basel III is the latest effort, although some of the details have still to be finalized. 
To paraphrase the Bard, Basel III is a lot of sound and fury signifying nothing.

In the absence of marking all of the assets to market, what exactly is the value of reporting a high level of book capital?  Lehman Brothers showed this does not prevent bankruptcy.
Citigroup Inc. (NYSE:C)   Chief Executive Vikram Pandit said Tuesday that the minimum Basel III requirement is for a core tier one capital ratio of 7%. Citi plans to operate with a ratio of 8% to 9% and aims to comply by 2012, the CEO added. 
In contrast, J.P. Morgan’s Dimon said a Basel III ratio of 7% is “completely sufficient.”
“We agree with higher capital and higher liquidity. We just don’t think it should go any further,” Dimon added. “Most of all I want it to be finished.” 
... If J.P. Morgan can’t find good ways to use excess capital, it may hold on to it, Dimon added. 
This is also the end of the ability of regulators to require higher capital levels.

Sometime next month, the US Treasury and Federal Reserve are going to announce the results of the latest stress tests of the Too Big to Fail Banks.  The results are already known.  The banks are going to be found to be adequately capitalized and therefore they can begin paying dividends again.

For banks in the UK or elsewhere, this is great news.  They can make the argument that there needs to be a level playing field and they should not be required to hold more capital than US banks.  If the regulators, like Mervyn King and David Miles disagree, too bad.  The banks now have much more leverage behind their threat to leave to force the regulators to back down.

As this blog has repeatedly said, focusing on the issue of bank capital is a mistake.

Regulators need to fulfill their obligation under the FDR Framework and focus on and assure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

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