Federal regulators recently unveiled a proposed Enhanced Supplementary Leverage Ratio rule, which would increase the leverage ratio at the nation's largest banks and their bank holding subsidiaries to 5% and 6% respectively. The rule triggered the usual negative response from big bank lobbyists. They warn of dire consequences to the economy, industry and their shareholders should the rule be enacted.
These types of debates usually degenerate into irreconcilable partisan positionsthat hamper progress. An alternative, and potentially more useful approach, is to see how impartial investors responded to the announcement. The market response, in general and for the eight institutions in particular, was a nonevent. Apparently, markets do not share the big banks' concerns. This independent unbiased assessment provides powerful evidence that their warnings are suspect.
The first warning is that higher capital requirements will curtail lending and endanger the nascent economic recovery. The stock market response, both for the week prior to the announcement and the week following the announcement, however, was positive.
Many factors underlie the market's rally, but there, nonetheless, appears to be no widespread belief in an economic downturn triggered by a tougher leverage ratio. This makes sense for several reasons. The tougher leverage ratio applies only to eight banks: JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley, Bank of New York and State Street, which all have assets exceeding $700 billion or more than $10 trillion under custody.
Of these eight banks, only four – JPM, B of A, Citi and Wells – have meaningful commercial banking operations. Goldman Sachs and Morgan Stanley are essentially traditional investment banks, while Bank of New York and State Street are primarily custody institutions. Scores of other well capitalized banks stand ready to satisfy any unmet loan demand should these eight firms curtail lending. Furthermore, these institutions already have low loan-to-deposit ratios due to weak loan growth. Given these low ratios, it seems unlikely they would reduce lending and further weaken their market positions.
Next, many big banks and their proponents allege the higher leverage ratio would decrease their return on equity, dampen their share price and hamper their capital raising ability. Investors, however, focus on the spread between ROE and a bank's cost of equity and not on nominal ROE alone. Any ROE decline is likely to be offset in whole or in part by a corresponding decline in a bank's cost of equity. As their capital levels improve, financial risk falls and cost of equity declines, offsetting at least, in part, any ROE decline.
The real problem for the eight banks is not capital structure, but business model related. Banks like JPM suffer from depressed trading multiples. JPM's share price to book value is barely above one, and consistently trails smaller and better capitalized regional banks like U.S. Bancorp. Some of these firms may be suffering from aging business models that can no longer be covered up by leverage. The game has shifted from financial to operating leverage based on operating efficiency. This is illustrated by Wells, which along with B of A, already satisfies the new leverage ratio requirements. Wells has a price to book multiple 50% higher than JPM, despite having a more conservative capital structure.
The final criticism, as articulated by JPM's Chairman and CEO Jamie Dimon, is that the higher leverage ratio will place the big banks at a competitive disadvantage to their foreign, primarily European, peers who face a lower Basel III leverage ratio requirement. Dimon is now supporting the same Basel III framework that he called "anti-American" in 2011. Does he really want to be like his less well-capitalized peers including Deutsche Bank and Barclays, which trade at price-to-book multiples of 55% and 75% respectively.
Also, how do you reconcile the even tougher Swiss capital rules with the higher price-to-book multiples at UBS (132%) and Credit Suisse (92%)? It appears stronger capitalization may actually be positive for undercapitalized megabanks. Perhaps, John Mack, former Morgan Stanley CEO, put it best when he stated in 2009 that sometimes regulators have to step in and control Wall Street, which at times is unable to control itself.
The new leverage ratio is a relatively modest proposal. It can be easily addressed without material capital raises or changes in distribution policy for the few institutions that do not currently meet the requirements.This is the reason why markets view the new requirements as a nonevent. It seems the only barking taking place is that of the eight banks (not investors) that seem to be crying wolf.
J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at Loyola University Chicago.