The 93 Words That Could Unlock More Than $200 Billion in Trapped Bank Capital

Tucked inside a nearly 600-page legislative proposal to overhaul U.S. financial regulations are 93 words that could provide a windfall for bank investors seeking heftier dividends and share buybacks.

The verbiage is contained in the bill to repeal and replace the Dodd-Frank Act, formally introduced last Wednesday by Texas Republican Jeb Hensarling, chairman of the House Financial Services Committee.

The relevant section relates to a somewhat esoteric area of bank capital known as operational risk, a concept regulators have used since the financial crisis to measure the possibility that a bank's own actions, rather than unfavorable economic or market movements, could sink it. Operational risk is largely influenced by a bank's previous missteps, such as big legal settlements, and could require it to hold more capital.

While obscure and technical, the result is that the sins of the past linger on big-bank balance sheets. Bank analysts at Barclays PLC estimate $236 billion in capital is tied up in operational risk at the four biggest U.S. banks alone.

Bankers have become increasingly vocal in urging regulators, lawmakers and the Trump administration to change the way risk is measured. They want to free up capital that could be returned to shareholders or used for more lending.

James Dimon, chief executive of J.P. Morgan Chase & Co., lashed out at the requirements in his recent annual letter to shareholders, saying regulators' approach "should be significantly modified if not eliminated." At the bank's investor day in February, he called operational risk a "false number."

The shareholders letter highlights that operational risk in 2016 increased J.P. Morgan's assets adjusted for risk by $400 billion. Mr. Dimon added that U.S. banks now hold about $200 billion in capital against operational risk.

One big gripe banks have is the backward-looking nature of the rules. Citigroup Inc., for example, still holds capital against operational risks in businesses it has been winding down since the crisis.

At Bank of America Corp., a big portion of the firm's operational-risk exposure stems from its purchase of Countrywide Financial, the defunct subprime lender for which it has already paid billions of dollars in fines and settlements. Operational risk accounted for $500 billion of the bank's $1.5 trillion in risk-weighted assets at the end of 2016.

Bankers said it doesn't make sense to continue holding capital for such problems. Citigroup's finance chief, John Gerspach, last year said, "When you incur an operational loss, it has got a Plutonium-238 half-life."

Others argue the lasting imprint reflects the outsize role banks played in fueling the financial crisis. "The fines banks paid in the past may well be indicative of future risk," said Anat Admati, finance professor at Stanford University's Graduate School of Business. "There are enormous rates of recidivism in corporate misconduct. Paying a fine need not lead to significant change."

So how does operational risk impact banks?

Operational risk does the latter. That ends up forcing banks to hold more capital.

Consider a bank with $1.5 trillion in risk-weighted assets and a requirement to have a 10% capital buffer. It would need $150 billion in capital.

Say then that operational risk makes up a third of those risk-weighted assets. If operational risk was eliminated, risk-weighted assets would fall to $1 trillion and require capital of $100 billion -- freeing up $50 billion.

Granted, it is unlikely operational risk weighting would be eliminated entirely should rules change. But even a modest reduction could prove meaningful and free up capital.

Operational-risk weightings at five of the biggest U.S. banks are on average equal to about 29% of their risk-weighted assets. Combined, their $1.5 trillion of operational risk is equal to about 18% of the banks' total assets.

Ironically, moves by banks in recent years to slash holdings of assets that carry lots of market or credit risk have increased the impact of operational risk. In 2014, operational risk represented just 18% of those five banks' overall risk-weighted assets.

That's a contrast to the trend in banks' legal payouts. At J.P. Morgan, Citigroup, and Bank of America, litigation expenses were around $2 billion last year, down from $28 billion in 2014, according to analysts at Compass Point Research & Trading LLC.

Banks would like the nature of the rules to change. Mr. Dimon's recommendation in his letter: "If you are going to have operational risk capital, it should be forward looking, fairly calculated, coordinated with other capital rules and consistent with reality."

Rep. Hensarling's legislation moves in that direction. But the fate of his bill is uncertain given the size and scope of the overhaul he is proposing, as well as what appears to be opposition to much of the bill in the Senate.

Still, the fact that changes to operational risk were included in the legislation could prompt regulators to rethink the rules or how they use operational risk for things like stress tests.

For now, all banks can do is let time pass. Citigroup's Mr. Gerspach told analysts in April that "there is little we can do to mitigate that number" under current rules. "Sometime over a 10- to 15-year year period you'll eventually see a reduction," he said.

(END) Dow Jones Newswires

April 30, 2017 08:14 ET (12:14 GMT)