JPMorgan Slimming Down Means Dodd-Frank Is Working

October 16, 2015

A remarkable thing happened: one of the largest banks slimmed down just a bit because of Dodd-Frank’s capital requirements. It’s another piece of evidence that the core parts are working, and if scaled up could make a dramatic structural change in the financial system.

In July, the Federal Reserve finalized its rule on the special surcharge required of the largest banks. (Sherman and Sterling have a good rundown of the rule.) Let’s graph it out:

There’s the normal Basel III in blue. This is the regular equity plus the capital conservation buffer, which is meant to force the bank to take prompt corrective action to fix itself if its capital gets too low. The next level is the SIFI surcharge in red. This is extra equity funding required by the largest banks, because of the extra risk they pose to the economy as a whole.

The surcharge will vary, because it’s calculated by a fascinating formula and process that takes into account the size of each bank as well as the riskiness of its funding. Firms get a score, and as the graphic shows, that score turns into a surcharge. Larger size and more short-term funding each means a higher score, which turns into a higher surcharge. The United States’ formula is more aggressive than the European Basel version of the equation because it more aggressively targets short-term lending. But both scores are taken, and the higher one is applied.

The Federal Reserve announced in July what banks had which levels, and thus what surcharge would be required. I put them in the graphic above. As you can see, JP Morgan had the highest number, and was subject to a 4.5 capital surcharge.

Now Emily Glazer and Peter Rudegeair at the Wall Street Journal are reporting that JP Morgan’s “assets declined by $160 billion in the six months ended Sept. 30 to $2.42 trillion, a 6% drop.” Why is that? “The bank is trying to become smaller because the Federal Reserve is preparing to apply new capital surcharges that will be more costly to a bank the larger and more complex it is. On Tuesday, J.P. Morgan executives said they think they have made enough moves to reduce its surcharge to 4% from 4.5%.”

J.P. Morgan couldn’t justify its size and risk to the market and its shareholders when it required that extra 0.5 percent capital requirement. So it slimmed down. It’s still massive, of course, but it shows what capital requirements can do.

Four points:

Neoliberalism and “The Market”

I want to reiterate the point that one of the brilliant insights from the neoliberal political project is that if you want to do something brutal that politics won’t sustain, you have “the market” do it. Then it is seen as a natural outcome, even if “the market” here is just the continuation of politics by other means. This is the insight of Greta Krippner’s Capitalizing on Crisis, and we need to be able to turn it on its head.

There is no way Congress could pass a bill saying that a firm the size of JP Morgan should slim down 6 percent. Yet setting up the market to require tougher but appropriate regulations for the largest and most dangerous players does the work. It is also seen as fair and natural in a way that direct regulation wouldn’t.

Next Steps

Another SIFI surcharge pushing this up would cause more downsizing, rebalancing the financial system towards a less systemically risky position. This should continue to be a major priority. For those who want structural reform, this shows capital requirements are a viable strategy in this direction.

Sorry Conservatives….

This is another point of evidence that disproves the conservative talking point that Dodd-Frank protects the largest players. Here we can see it scale upward with size and risk. The capital requirements also have bite at the top end, a bite that nudges firms to be less risky. The same was true with GE Capital being sold off because it had to play by the actual rules of banking institutions. It’s not enough, but it’s clear what direction this points.

Risk-Adjustment (Wonkish)

This is a risk-adjusted capital requirements, and risk-adjusted capital requirements are important. There’s an argument out there in which they don’t matter because Wall Street will simply juke and manipulate them, and we should only look at leverage ratios which aren’t adjusted for risk.

But JP Morgan thinks it couldn’t simply juke away this requirement, and adjusted its size downward. Risk-adjusted capital is the perfect complement to go alongside leverage requirements, as they each measure an important element of what is going on in the balance sheet. They should each go up going forward.

All in all, a good development.