Like the financial equivalent of Winterfell, JPMorgan’s “fortress balance sheet” is an evocative turn of phrase used by Dimon and his lieutenants to describe the sturdy financial foundation of the bank.
At the base of that foundation, is a layer of equity—that is, the bank’s own money, not money it borrowed—which is supposed to be plush enough to cushion the bank against losses on assets such as securities and loans. In general, the more equity, the safer the bank. For years, JPMorgan’s balance sheet has been seen as one of the sturdiest in the US financial system. And phrase “fortress balance sheet” is intended to conjure the image of an impregnable citadel, able to withstand a financial crisis with the destructive power of a marauding Dothraki horde.
Except that it’s not. At least, the Federal Reserve doesn’t seem to think it is.
In fact, the Federal Reserve says that in order to be considered “well-capitalized” going forward, JPMorgan—and all the other large US banks—might have to put more money into its capital cushioning over the next couple years. (This all has to do with the Fed’s new new leverage requirements—or to humans, limits on using borrowed money.)
Why did JP Morgan not look sufficiently “well-capitalized” enough to the Fed? After all, the bank had roughly $211 billion in equity at the end of 2013. That’s a lot of money. But is it enough?
Traditionally, to figure that out, you look at capital as a share of assets. In other words, you look to see how much of a blow the capital cushion would have to withstand if something went wrong.
And this is where what the Fed did was important. The new US rule demands that banks hold the same amount of capital against all of its assets. Banks have long preferred to measure their capital against “risk-weighted” assets. When a bank risk-weights assets, it basically tries to describe how risky different assets are, in other words how much of a cushion they deserve. Critics say the the process of risk-weighting assets is too opaque and subject to manipulation and abuse.
Under the Fed’s proposed new rule, the cushion is measured against all the assets on the bank’s books. Perfectly hedged credit default swaps? Throw ’em in. Off-balance sheet entities? Yes. Super safe Treasurys. Yep.
And using that broader measure of assets, the consensus seems to be that JPMorgan needs to add a flying buttress or two to the fortress balance sheet. Credit Suisse analysts think JPM’s capital cushion is about $15 billion to skimpy. The New York Times estimated that it was about $30 billion short of the level it would need under the new rules, which don’t go into effect until 2018.
Now in a sense, this isn’t really a big deal. JP Morgan can fluff up its capital cushion relatively easily by simply retaining a bit more of its earnings than usual. (It could also meet the leverage ratio by cutting back on some of its assets here and there.) But in another way it is a very big deal.
The Fed’s new leverage ratios mean that, going forward, it won’t be enough just to tell people you have a “fortress balance sheet.” You’ll really have to show it. And that’s a major step to a safer financial system.