High Profits Signal Danger for Big Banks

By Simon Johnson
New York Times, July 18, 2013

In their latest earnings reports, the biggest banks in the United States are reporting eye-popping levels of profitability that surprise even Wall Street analysts. Goldman Sachs’s profit doubled in the second quarter of this year from the comparable quarter a year ago. JPMorgan Chase could make $25 billion for the whole year. Bank of America reported that net income rose 63 percent. Even Citigroup, so often the sick man of American megabanks,managed its best results since 2007, with $4.2 billion in net income in the quarter.

These results create a major political problem for the big banks, a point that Tom Braithwaite has made in The Financial Times (subscription required). Executives at these companies have spent most of the last four years asserting that stronger regulation in the United States, including higher capital requirements, will result in lower profits, a reduced ability to lend and a slower economic recovery for the nation.

Yet higher capital requirements are already in place, with further steps in the works, including a tougher leverage ratio at the initiative of the Federal Deposit Insurance Corporation (so the country’s biggest banks would need to finance themselves with relatively more equity and relatively less debt). And regulation has tightened to some degree. There is also more political scrutiny – hence executive compensation is being held below the levels that were previously associated with this much profit.

In Europe, regulation remains weak, and the banks are floundering. In the United States, the rules are tightening, and the big banks are doing great. Once American politicians and regulators reflect further on exactly why the banks have become so profitable, this will only reinforce the latest push for more reform.

The banks have easy funding. The very largest banks can borrow cheaply – this is, in fact, a key part of the unconventional loose monetary policies being pursued by the Federal Reserve. To be fair, the Fed wants lower interest rates for everyone, but the biggest banks benefit the most.

As Senator Sherrod Brown, Democrat of Ohio, emphasized at a recent hearing, there is also an implicit government guarantee for these banks, a point now acknowledged by Treasury Secretary Jacob J. Lew.

Despite everything that has happened in the last half decade, the very largest banks, including JPMorgan Chase, Goldman Sachs and Citigroup, can engage in some very risky business.

This is a great deal – a government backstop for your cheap funding combined with the ability to take a lot of risk (e.g., metal warehouses, where JPMorgan Chase and Goldman Sachs are big investors, or emerging markets, where Citigroup has a great deal of exposure.)

These very large banks do not have much equity in their businesses; it is all about the leverage (meaning they fund their loans and other asset holdings mostly with debt). For example, at the end of the second quarter, JPMorgan Chase had shareholder equity of just over $200 billion and a total balance sheet of around $2.5 trillion (under the generally accepted accounting principles used in the United States ) or closer to $4 trillion (using international accounting standards, which treat derivatives exposure in a different way). So JPMorgan Chase had from 5 to 8 percent of its balance sheet, depending on which accounting measure you prefer, funded with equity and the rest with debt (read the long version of its earnings release to see this clearly).

JPMorgan Chase is a very highly leveraged business, and the same is true of other megabanks. When things go well, such highly leveraged companies make high returns – measured in terms of return on equity (unadjusted for risk). For example, trading securities can sometimes help increase profits; this was the experience of Citigroup in the latest quarter and before 2007 (and also for JPMorgan Chase and Goldman Sachs).

Charles Prince, the former chief executive of Citigroup, famously remarked, “But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” This was in July 2007 when, really, the music had already stopped (the subject of a commentary from Yves Smith at nakedcapitalism.com at the time).

The banks are lifted now by the (partial) economic recovery. But what happens when the economy weakens in the United States or somewhere else in the world? What happens also when money is lost on securities trading or on loans to emerging markets or on complex derivatives that no one in management fully understands? More highly leveraged businesses go up faster and come down further.

At the same time, a deeper political shift is under way, with a big step toward bipartisan agreement that structural change is needed in our largest banks. Specifically, Senator John McCain has joined forces with Senators Elizabeth Warren, Maria Cantwell and Angus King to push for a 21st century Glass-Steagall Act.

Speaking with Yahoo Finance this week, Senator King, an independent from Maine, made a common-sense and compelling case that the United States needs to limit reckless gambling using insured deposits – and the only way to do this is with structural change, separating out boring banking from high-risk trading activities (see also this interview with Elizabeth Warren on CNBC).

Thomas Hoenig, vice chairman of the F.D.I.C., also explains clearly that breaking up the banks along functional lines would be helpful – we should aim to separate relatively risky “broker-dealer activities from the federal safety net.” (I have also contributed to this debate in recent days, including in a column for Bloomberg News, in my baselinescenario blog and an NPR interview.)

Whenever global megabanks report huge profits, think about the risks they are not reporting and who will bear the costs. The good news is that leading senators are starting to think along exactly these lines. Regulators will take note.

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

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