Investors bail on Too Big to Fail

In his Wall Street Journal Heard on the Street column, David Reilly confirms that investors reward transparency in banking and that this form of market discipline will drive the Too Big to Fail to shrink.

Regular readers know that your humble blogger has said that requiring that banks provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details would have the beneficial impact of allowing market discipline to drive the shrinkage of the Too Big to Fail banks.

Having the WSJ provide independent third party confirmation is terrific.

J.P. Morgan Chase's more than $2 billion trading loss has reignited the political debate over too-big financial firms and whether they are too big to control. 

But investors are already voting with their wallets. Some smaller, less complex financial firms with more predictable earnings command higher valuations than bigger rivals. That, more than politics, may have a bigger impact on the future shape of J.P. Morgan and peers such as Bank of America,Citigroup, Goldman Sachs and Morgan Stanley . 

Please re-read the highlighted text as Mr. Reilly reaffirms the important point that the easier it is for an investor to assess the risk of an investment, the more the investor is willing to pay for a $1 of earnings.

The more complex, and complexity is a form of opacity, the less the investor is willing to pay.  Hence, there is already market discipline pushing on the Too Big to Fail banks to provide much more transparency.

Consider the valuation for J.P. Morgan, with $2.3 trillion in assets, and regional lender U.S. Bancorp, with about $340 billion in assets. The day before the disclosure of its trading debacle, shares in J.P. Morgan were valued at about 0.9 times book value. Stock in U.S. Bancorp traded at about 1.9 times book. 

Of course, big banks in particular were laid low by the financial crisis. Yet, over the past 10 years, U.S. Bancorp has always traded at a valuation premium to J.P. Morgan, according to data from FactSet Research Systems.... 

Smaller banks may be enjoying greater stock-market favor for a number of reasons. 

For one, they don't suffer a conglomerate discount. 

They also don't have big investment-banking or trading arms. Investors have grown less enamored with results from these more-volatile, often opaque businesses. 

Smaller banks also tend to be more U.S. focused. That can be a negative given concentrated exposures to things like housing or commercial real estate. 

But right now, the U.S. is a bright spot in the world economy. And it makes them easy for investors to understand. 

For banking giants, in contrast, they have to delve into how interconnections from derivative exposures may leave big banks vulnerable to a European meltdown. 

Finally, though smaller banks are themselves prone to stumbles, they are still a lot less complex than the likes of J.P. Morgan. That makes them easier for investors to understand, and value. 

It also gives investors greater confidence that executives can grasp the risks they are taking. J.P. Morgan has acknowledged that its efforts to unhedge hedges of its vast loan and securities holdings simply became too complex.... 

But if valuation gaps persist, boards at too-big banks may have to consider whether their business models still make sense. Whatever the outcome of political debates in Washington, the real decision might be made by traders on the NYSE.