J.P. Morgan, Citigroup, Bank of America: A Banker's Paradox

Banks like J.P. Morgan (JPM), Citigroup (C) and Bank of America (BAC) entered a period of historical transition starting in 2008 with the financial crisis. JPM absorbed Bear Stearns and Washington Mutual, with legacy costs now hopefully known. Similarly, BAC absorbed Merrill Lynch and Countrywide with risks and costs now also hopefully known. C wasn't in a position to absorb weaker banks, but essentially got absorbed by the Federal government, along with some automakers.

Federal Reserve's monetary easing continues to support economic stability. Also created by monetary easing is a low interest rate environment, putting bank interest income into decline since 2008.

From excessive leverage leading up to 2008, bank regulators have sought standards that make banks build equity capital and liquidity, while decreasing assets. Risk of new rules look to reduce return on equity for banks. Still, regulatory regime makes equity the major source of capital for banks.

Proposed regulations involve a Supplementary Leverage Ratio (SLR) and a Liquidity Coverage Ratio (LCR). These proposals add confusion over how cash and government securities will be treated in a bank's capital structure.

Five years after the financial crises, JPM, BAC and C continue to transition, with little visibility of where transition might lead. Poor visibility comes primarily from SLR, LCR and persistently declining interest income.

A paradox comes from these banks having to choose between increasing capital or reducing assets when neither presents a practical solution for maintaining earnings.

Basel III Capital Ratio Increase Already Part Of Banking Balance Sheets

Banks, having been familiar with Tier I Common Capital Ratio, and having adapted their balance sheets accordingly are basically in compliance with Basel III Capital Ratios. Basel I, II and III are international banking standards created by the Basel Committee. Central banks and sovereign bank regulators enforce Basel standards.

Tier I Common Capital Ratio is a risk based standard measuring a bank's ability to absorb loss on assets by relying on equity. By dividing common equity and retained earnings against risk weighted assets (RWA), one finds Tier I Common Capital ratio under Basel III at a 7% requirement, versus a Basel II standard of 4.5%. Also, when judged appropriate by regulators, Basel III has a countercyclical buffer that may be imposed of 0-2.5% on top of 7% Tier I Common Capital. This buffer applies when excessive credit growth generates added risk, such as in years leading to 2008.

JPM, C, and BAC have no problem meeting a 7% Basel III Tier I Common Capital ratio. JPM, for instance, has Tier I Common at 10.5% under Basel II. Under Basel III, JPM currently projects 9.3%. BAC is similar, having a current Tier I at 11%, and a projected Basel III at nearly 10%. C is now at 12.7% reasonably suggesting a Basel III ratio of at least 10% if not 11%.

Suggested by major banks exceeding Basel III Tier I Common Capital is their ability to meet countercyclical buffers.

Supplementary Leverage Ratio Is Different From Previous Leverage Ratio And Introduces New Items

Non-risk based leverage monitoring isn't unusual in U.S., but is new to Basel III framework and, therefore, new also to European banks. Though leverage ratios aren't new in U.S., Bear Sterns executives testified regarding the financial crisis that their leverage was high as 40 to 1.

U.S. leverage ratio historically, and under Basel III, considers defined capital against total assets without weighting value of assets according to risk--usual for a leverage calculation. However, new for U.S. leverage calculation is SLR proposing to include cash and government securities as leverage, together with off balance sheet holdings.

Addressing lax leverage monitoring born out of a real estate bubble, in August, 2013 Office of the Comptroller of the Currency (OCC) issued a notice of proposed rule making announcing SLR. According to OCC, SLR will divide Tier I Capital (which adds convertible debt and preferred shares to Common Capital) against "total leverage exposure". Previously, leverage ratio was Tier I Capital divided by "total on balance sheet assets". Changing denominator from on balance sheet assets to total leverage exposure is consistent with Basel III. It also would have revealed excessive banking leverage in 2008 with off balance sheet derivatives.

Real issue with SLR is its inclusion of cash and government securities as leverage. Reasoning is currencies have variable values, and when interest rates rise, treasuries will decline. No risk weighting of assets is considered. Essentially, bank holding companies like JPM, BAC and C must have a ratio of 5%. To be well capitalized, a ratio of 6% and a minimum of 3%.

Supplementary Leverage Ratio Forces Choice Between Raising Equity Or Cutting Assets

Banking industry representatives provided comments pointing out problems with the proposed SLR. Banks say including cash and government securities unrealistically increases leverage exposure. Also, given that return on currencies and government debt can be small, but still used in SLR without risk weighting, banks would be encouraged to move out of cash and government securities and into higher yielding and more risky assets.

Estimated effect on banks is either raising $200B in additional capital (equity) or eliminating $1.7T in assets to bring banks into compliance with the ratio.

Regulators, in their measurement, identify 2018 to be the compliance deadline. They estimate a shortfall of $63B to $113B in Tier I Capital across six Bank Holding Companies, which includes C, JPM and BAC. Also estimated by regulators is a yearly cost of $474M to $694M due to lost tax benefits from deducting interest payments on debt. (Federal Register (2013), p. 51111 to 51112). Regulators foresee banks changing their capital structures moving further into equity and more out of debt.

FDIC vice-chairman, Thomas Hoenig, indicated late November that excluding cash from leverage exposure could be acceptable, but expressed resistance to excluding treasuries. Should regulators include cash and treasuries as leverage, banks will have to transition by making a choice between expanding equity against cash and treasuries, or move out of cash and treasuries to decrease their leverage exposure.

Either approach isn't attractive from an equity investor's perspective. Expanding equity results in share dilution, while moving out of cash and treasuries hurts liquidity and increases risk. SLR presents a paradoxical situation where equity investment in banks becomes less attractive. Without banks being able to attract equity investment, they become impaired in ability to meet, maintain or increase Basel III Common Capital.

Also implicated is reduced liquidity in government security and money markets by impairing market making should banks chose to cut cash and government security holdings. Added to the regulatory paradox is LCR, which encourages cash and government security holdings.

LCR Contradiction With SLR, Focus On Deposit Funding And Banker's Paradox

OCC issued a notice of proposed rule for LCR on November 29. LCR is a part of Basel III and proposes banks such as C, JPM and BAC hold High Quality Liquid Assets (HQLA) in sufficient quantity to equal net cash outflow over a 30 day period of stress. Such proposal grows out of 2008 bank liquidity melt down due to insufficient liquid assets.

HQLA are assets capable of being converted into cash with little or no loss in value during a period of liquidity stress. OCC says cash, government securities and certain corporate securities qualify. However, such assets can be a source of penalty under SLR.

Holding enough HQLA to meet 30 days of cash outflow, under liquidity stress, essentially means having enough cash and/or treasuries to self fund operations for thirty days. Stress scenarios include deposit withdrawals, with customers having an operational relationship with the bank withdrawing less than those without a relationship. Hope is to encourage banks to lend to depositors thereby creating an operational relationship. Depositors are expected to be a primary source of bank funding as opposed to wholesale short-term borrowing.

Regulators propose phasing in LCR with banks meeting 80% HQLA to 30 days cash outflow by January, 2015 and 100% by 2017. Currently, regulators estimate a HQLA shortfall of $160B among the 16 bank holding companies covered under the rule. (Federal Register, p. 71853). With banks moving into lower yielding HQLA to reach compliance, regulators estimate a decline in net interest margin of between 10 to 15 basis points. Associated cost is estimated at $160M to $241M in lost yield.

Where SLR can make raising equity difficult with cash and treasuries being a source of penalty, banks very well could chose to cut cash and treasuries. Banks will be hesitant to cut higher yielding though more risky assets due to seeking yield. But LCR requires 30 days of unencumbered cash and treasuries to fund operations.

Banker's paradox is whether to raise expensive equity in a harsh regulatory environment or cut assets.

Appearance for banks is to maintain Tier I Common Capital ratio by carefully balancing higher yielding assets against bare need of cash and treasuries to meet LCR requirements. Such approach optimizes yield, while at least meeting contradictory needs between SLR and LCR.

Bank Earnings Drive Ability To Increase Bank Equity, Earnings Have Enough Pressure Without Regulatory Contradiction Driving A Paradoxical Choice

Current earnings reality for C, JPM and BAC is declining interest income since 2008 despite faster declines in interest expense over the same period. This dynamic has forced banks to seek income from alternate sources.

Making JPM a strong institution in 2008 was diverse streams of income. When interest income fell due to default, JPM obtained 42% of total revenue from noninterest income. BAC obtained 38% of total revenue from noninterest income and C saw their declined interest income helping to absorb noninterest income loss. Trailing Twelve Months (TTM) shows JPM's noninterest income at 55% of total revenue. BAC's TTM noninterest income is 51% of total.

C continues to acquire up to 62% of revenue from interest despite nearly 5 years of declining interest income. Saving C is capping noninterest expense in 2012 and TTM. Also, C raised noninterest income 11% TTM, thereby reversing previous trend of decline. Consequence is highest EPS for C in several years.

While noninterest income has generally offset declines in interest income, saving all banks are major reductions in credit loss provision, which allows more revenue to flow down income statement to shareholders. JPM is making the least provision for credit loss currently at .08% of revenue TTM v. 2012 at 3.5%. BAC is 6.3% TTM v. 9.8% for 2012. C's credit loss provision is 11.5% v. 15.4% for same period.

Until interest rates move up, further declines in interest income can be expected. Gaining progressively more income from noninterest sources turn banks into service companies, blunt desire of banks to loan, and have restructuring costs. Once credit loss provisions wind down, banks will no longer have released reserves to support earnings. Risk of financial sector regulation is declined demand for bank equity, due to a difficult earnings environment and contradictory regulations, with associated costs.

Fundamentally, SLR requires raising more equity capital against cash and treasuries, while changing capital structure in a way that increases tax liabilities. LCR requires banks to increase HQLA, locking up assets in low yielding instruments, and costing lost yield. Both regulations can result in reduced returns on equity. While SLR and LCR are new and proposed concepts, both look to challenge banks on top of known issues.