Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets,highlights how FRB and FDIC fail the living will test.

FRB And FDIC Fail The Living Will Test

My visits to Washington in recent months have convinced me of two points:

  • The people who work for the various financial agencies are high quality, dedicated individuals seeking to fulfill the goals set for them by the Congress.
  • They believe that this means making banks safer and sounder no matter what the consequences to the financial system or the economy.

When regulations are promulgated and put in place, no one asks what the consequences of these actions are likely to be? Further, no attempt is made to coordinate the actions of the regulators with that of other parts of the bureaucracy focused on seeking growth.

The Living Wills are a perfect example of this. The core concept behind the Living Will regulation is that banks should have a reasonable plan to dissolve themselves in times of stress so that the government is not required to provide assistance.

Thus, U.S. banks are the only companies in the only industry in the world that are being asked to focus their efforts not on their ability to grow but on their ability to disband themselves. This difference in a company’s mission has a considerable impact on the way the business is operated.

For example, a bank that has an unusually large amount of its assets dedicated to investments in Federal Funds and Treasury securities can find it easy to dissolve itself in stressful periods. However, if a bank structures itself in this fashion it means that the institution is not making many loans on a relative basis.

Yet loans are the source of economic growth in two key fashions:

  • Every loan creates deposits which is money. Lending increases the nation’s money supply and, therefore, has a positive impact on economic growth.
  • Second, the funds provided when a loan is made are used to buy a widget or build a business. This also creates economic growth.

Forcing a bank to shift its resources away from lending and toward investing in liquidity slows the earnings growth of the institution, which itself is a problem, but more to the point, it slows the growth in money supply, economic expansion, and job creation. It is not good for the United States and it does not increase the safety and soundness of the banking system.

Even more to the point, the agencies that are making the decisions concerning the growth of the banking system/economy are immune to the will of the American people. They are not run by elected officials. Congress has no control over any actions that they take. They are free to act as they choose.

As indicated they do so without ever requiring an answer to the question of “what if?” What if this regulation is put in place? What will happen to the economy? These bureaucrats see no reason to ever answer this question and they are not required to.

In this regard, they are supported by the press. In all of the articles written today about living wills, I did not see one that questions the actions of the government. The press, much like Pavlov’s dogs, simply salivates and writes about the failings of the banks.

JPMorgan Chase (JPM/$61.94/Buy)

JPMorgan Chase is one of the banks that failed to meet the regulatory agencies demands under the Living Will statutes. I have read a copy of the agencies’ complaint against the bank (which has been heavily redacted by the agencies). Here are some noteworthy points:

  • JPMorgan is being complimented for reducing multiple cross-border sweep arrangements. Is this good for America? JPMorgan has unilaterally closed accounts of both foreign companies and individuals and pulled away from international arrangements to meet the U.S. agencies’ requirements. JPMorgan is one of two banks that support the U.S. dollar across the globe. How does it help by forcing this company to pull away from foreign activities?
  • The bank is also complimented for pulling away from short term funding markets. In essence, the biggest bank in America is reducing liquidity in the wholesale funding arena where multiple companies borrow money. How is this beneficial to the economy?
  • A key complaint being made by the agencies is that JPMorgan is not using its liquidity properly and that it may not have enough liquidity.
    • Apparently the agencies have forgotten that in the 2008 financial crisis JPMorgan bought Bear Stearns and Washington Mutual to help bail out the United States banking agencies.
    • They also may have failed to look at the bank’s balance sheet which is overloaded with excess liquidity. It has $378 billion in pure cash; $285 billion in basically short-term securities; and a trading book of $296 billion in liquid holdings.
    • The agencies want the bank to hold more high quality liquid assets – i.e., Treasuries. This shifts money away from lending toward the government. This is consistent with many bank regulations which are oriented toward forcing the banks to lend to the government.
    • The agencies want liquidity applied to specific risk areas. The bank prefers to keep liquidity in a pool and move the funds where they are needed when they are needed. Following the agencies direction would force the bank to hold more liquidity, make fewer loans and buy more government securities. It is not an efficient use of funds.
  • The agencies also object to the company’s legal structure. They believe it is too complex and that this will impede disbanding the business. It is likely that the complexity in the business is a direct result of the regulatory and other legal pressures on the company. Usually a complex structure is created to resolve problems not create them. I estimate that JPMorgan has up to 20,000 people who are employed to deal with government regulations. If the agencies want to reduce complexity, they should look inward first.
  • Another complaint is that the derivatives holdings of the company cannot be wound down in an efficient manner. This is a direct attack on the business. It is really forcing the company to lower its involvement in the most complex – i.e., most profitable — portions of the derivatives markets.
  • The final set of objections to JPMorgan’s plan relates to the company’s so-called “playbooks.” These playbooks are used to keep management and the Board informed of areas where assistance may be needed due to economic reversal.

Living Will Test

Conclusion

Nowhere in the communication is there any request for a “what if” scenario as to what may happen if all of the agencies requests are honored. Rather we have another example of the government micro-managing the industry that it now has total control over. In its leak to the Wall Street Journal it made sure that banks and everyone else understands the penalties the sector faces if the banks do not toe the government line. These go all the way up to shutting down individual companies.