The Simple Reason JPMorgan Chase Could Soon Make a Lot More Money

By Markets Fool.com

Image source: Wikipedia Commons.

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It's still too early to know exactly what the incoming Trump administration will mean for the nation's biggest banks, but if it follows through on its designs to deregulate the financial industry, then JPMorgan Chase (NYSE: JPM) could be on the verge of making a lot more money.There are a number of reasons for this, but the biggest all of could come from changes to bank capital requirements.

The regulatory pendulum

In the wake of the financial crisis, regulators scaled up the type and amount of capital that banks have to hold against the assets on their balance sheets. It was believed that by doing so, banks could survive the next crisis without needing to be bailed out by the government.

Not only would banks have to hold more capital than they did previously, but the quality of the capital would need to be better. No longer would debt instruments and even certain types of preferred stock count as loss-absorbing capital. That role could now only be filled by common equity.

The impact was particularly severe for the nation's biggest banks -- those like JPMorgan Chase, Bank of America, and Citigroup. Because these banks are now designated as global systemically important banks, or GSIBs, they're obligated to hold even more capital than their smaller, simpler peers in the regional banking space.

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JPMorgan Chase must maintain a so-called GSIB surcharge of an added 3.5 percentage points' worth of high-quality capital relative to its risk-weighted assets. Bank of America and Citigroup's surcharges come out to 3.0 percentage points above non-systematically important banks.

The net result is that capital requirements have more than doubled for large banks. Going into the crisis, JPMorgan Chase faced a Tier 1 capital ratio of 4%. Now, after all the current rules are phased in, that figure is 10.5%.


Data source: JPMorgan Chase. Chart by author.

JPMorgan Chase alone holds so much capital now that it could absorb the combined losses of America's 31 largest banks under the most extreme version of the Federal Reserve's latest stress test. As CNN noted earlier this year:

The Federal Reserve's stress tests estimate that JPMorgan alone would lose $55 billion in a worst-case economic situation. But the government has forced big banks to stock up on lots of capital. JPMorgan now has $350 billion of loss-absorbing resources. That means the banking giant actually has enough capital to swallow the losses of the next 30 banks, which is estimated at $167 billion.

Because this reduces the amount of leverage banks like JPMorgan Chase, Bank of America, and Citigroup can use, it weighs directly on their bottom lines. It's one of the main reasons that banks are struggling nowadays to earn their costs of capital by generating returns on equity above 10%.

Higher liquidity requirements, too

To make matters worse, regulators also now require banks to keep a larger share of their assets in high-quality liquid assets than they did before the 2008 crisis. The thought process is that these assets can be readily converted to cash in the event of a bank run, similar to what brought down Bear Stearns and Washington Mutual in 2008.

At the end of the third quarter, JPMorgan Chase had $539 billion worth of high-quality liquid assets. To put that in perspective, that's only slightly less than the $587 billion market cap of Apple, the largest company by market cap in the United States.

The problem is that highly liquid assets yield less than loans. The $409 billion that JPMorgan Chase kept as an average balance in deposits at other banks last quarter yielded only 0.44% on an annualized basis. Meanwhile, its average loan yielded 4.23%.

This means that for every $100 billion that JPMorgan Chase allocates to highly liquid assets as opposed to loans, it forgoes almost $1 billion worth of interest income each quarter. That's a lot of money when you consider that the New York-based bank tends to earn around $6 billion on a quarterly basis.

Dismantling Dodd-Frank

The good news for JPMorgan Chase is that all of this could change under a Trump administration, which has promised to "dismantle" the provisions of the Dodd-Frank Act that empowered regulators to raise both capital and liquidity requirements.

Trump's camp has been notoriously scant with details about possible changes to financial regulations (or, for that matter, anything), but we can get a sense for their thinking by looking at the Financial CHOICE Act proposed by Republican Representative Jeb Hensarling, who's purportedly being considered for Treasury Secretary in the incoming administration.

The central component of the proposed legislation would be to exempt banks from many of the heightened capital and liquidity requirements so long as they maintain a base level of capital. One could argue that this would reduce the soundness of the banking sector, as it almost certainly would, but there's little doubt that it'd serve as a potent stimulant to banks' bottom lines, and few more so than JPMorgan Chase.

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