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November 14, 2023

“It’s like déjà vu all over again.”

by Mike Trippitt, Financials Analyst

It’s like deja vu all over again

On 11 September 2023, Jamie Dimon, the Chairman and CEO of JP Morgan Chase & Co (JPM), spoke at a Global Financial Services Conference in New York. With customary frankness and candour, he provided an informative assessment of the economic outlook and the challenges facing the financial services industry.

Mr. Dimon posed a question that jumped off the page: “But all of this honestly – do they want banks ever to be investable again?” ‘They’ are the US Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, following the July publication of some 1,100 pages of regulatory amendments, dubbed the ‘Basel III Endgame’ in the US.

The Basel III Endgame requirements in the US and the Basel 3.1 requirements in the UK will be introduced mid-2025, phased-in over several years. Additional requirements focus on risk-weighting (the denominator of the Common Equity Tier (CET) 1 ratio) in particular, improving the measurement of risk in internal models and standardised approaches to risk-weighting.

Mr. Dimon’s high-level assessment was that the increased regulation would increase JPM’s Risk Weighted Assets (RWA) by some 30%. The conference host suggested this would reduce JPM’s target Return on Tangible Common Equity to 14% from 17%.

The impact of regulation on the investibility of banks returns to the agenda.

Eleven years ago, Robert Hingley, the then Investment Affairs Director of the Association of British Insurers (ABI) and I published a report, The Investibility of UK Banks (ABI – December 2012). Having emerged from the Global Financial Crisis and Eurozone crisis, UK banks were grappling with the intricacies of implementing Basel III requirements for regulatory capital and liquidity. Prior to publication, public debate on banks’ capitalisation had reflected the views of regulators, politicians and policymakers, but not the providers of capital, i.e. investors. The ABI report voiced the concerns of UK investors and UK banks’ management regarding the uncertainty surrounding the scale and timing of the regulations, and also in certain cases the applicability of the new rules.

Regulators never seem concerned about investibility, but perhaps they should be – the agendas of investors and regulators are, after all, quite aligned. Investors are the providers of a bank’s CET 1 capital. Deployed effectively, CET 1 capital generates loss-absorbing capital, finances RWA growth, and maintains or improve CET 1 ratios. Investors want banks to be appropriately regulated, with clear requirements and timescales for implementation. Regulation impacts investor confidence and banks’ valuations – therefore it really does impact investibility. So how do we define appropriate?

Regulation shouldn’t simply be about increasing CET 1 capital. According to the Bank for International Settlements, the world’s Group-1 Banks (defined as banks with tier 1 capital above €3 billion that are internationally active) had an aggregate 12.7% CET 1 ratio at mid-year 2022, up substantially from just 7% in mid-2011, during the Basel III regime implementation period. UBS’s takeover of Credit Suisse earlier this year was described by UBS’s Chairman as an emergency takeover. Credit Suisse was one of thirty Globally Systemically Important Banks (G-SIBs) and had a 14% year-end 2022 CET 1 ratio. Credit Suisse’s capital wasn’t the problem, but confidence in management was – 4Q 2022 deposits fell by 37% from 3Q, and by 41% for the year. Assets under management fell by 8% and 20% in the same periods. The Swiss National Bank (SNB) remarked: “The crisis at Credit Suisse has shown that meeting capital requirements is necessary but not sufficient to ensure market confidence.” (SNB Financial Stability Report 2023)

As for the 2023 US regional bank turmoil, “…most of the risks were hiding in plain sight…” (Jamie Dimon, letter to fellow shareholders, April 2023). The banks had substantial deposit funding concentration risk in their deposit books, and Silicon Valley Bank (SVB) was running with substantial interest rate risk in the banking book. The three US regional banks – SVB, Signature Bank and First Republic – suffered classic deposits runs, facilitated by technology, and fuelled by social media. Capital wasn’t the problem.

Regulators must consider impacts on customers and businesses. NatWest’s Chief Financial Officer recently commented that the UK’s blueprint for rolling out stricter international capital standards were too harsh. In particular, NatWest has expressed concerns around SME Lending, infrastructure and ‘green lending’.

Regulation must be complemented by effective supervision. The International Monetary Fund (IMF) recently published a report, Good Supervision Revisited: Lessons from the Field (IMF Working Papers September 2023).  In relation to the March 2023 US banking turmoil, the report commented that: “…when supervision fails, poor risk management practices will fester, and problems will eventually ensue…” The IMF commented further that capital regulation, or indeed regulation in general, cannot be the only answer. Banks must manage their own risks and supervisors must intervene when necessary. To return to Jamie Dimon: “We used to have real conversation with regulators. There’s none anymore in the United States, like virtually none.”

Regulation must not drive banking into the ‘shadows’. The impact of higher capital requirements on the feasibility of some loan products may drive business from the regulated bank sector to Non-Bank Financial Intermediation (NBFI) firms. The Financial Stability Board (FSB) defines NBFI as all financial institutions that are not central banks, banks, or public financial institutions. NBFI accounted for just under half of global financial assets ($486.6 trillion) at the end of 2021. The FSB’s narrow measure of NBFI contains firms that pose ‘bank-like’ financial stability risks, and account for almost $68 trillion of assets. The sub-sector contains lenders that are dependent on short-term funding, including finance companies, leasing/factoring companies and consumer credit companies. “The last crisis started in the banks – it stayed in the banks. This one is going to start in the shadow banks and the companies.” – Douglas Diamond, Professor of Finance, University of Chicago Booth School of Business, October 2022.

Investibility is not simply about the influence of capital on valuations. When major banks raise concerns about the logic of regulatory change, and the impact of regulation on businesses, on investibility and on transfer of risk to NBFI, regulators should listen.

This communication is provided for information purposes only, and is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. Investors should seek advice from an Independent Financial Adviser or regulated stockbroker before making any investment decisions. Progressive Equity Research Ltd (“PERL”) does not make investment recommendations.

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