When a top banker chooses to tangle publicly with the chairman of the Federal Reserve Board, it can only mean one of two things: strength or desperation.
“We’ve been through two stress tests, one at the Treasury, one at the Fed. I believe most of the banks passed the recent ones with flying colors,” Jamie Dimon, JP Morgan Chase & Co.’s chief executive officer, told Fed Chairman Ben S. Bernanke June 7. “Now we’re told there are going to be even higher capital requirements,” and “we know there are 300 rules coming. Has anyone bothered to study the cumulative effect of all these things?”
One month later, Dimon’s boldness has proven to be less an emblem of power than a cry of frustration. Global banking supervisors are poised to impose higher capital requirements that Wall Street complains will crimp profits, hamstring its fight against foreign rivals and damage the U.S. economy. And Dimon, 55, who kept JPMorgan largely clear of the subprime mortgage fiasco and helped stabilize the financial system in 2008 by acquiring Bear Stearns Cos. and Washington Mutual Inc., will face the same new strictures as the industry’s rogues.
Another indication of the changing regulatory environment took place almost a month earlier and an ocean away. During a May 17 confirmation hearing on his appointment to a new British financial watchdog, Donald Kohn, a former Fed vice chairman, told British lawmakers he had abandoned his belief that bankers’ self-interest would keep markets safe.
“I placed too much confidence in the ability of the private market participants to police themselves,” he testified.
Banker and regulator, Dimon and Kohn represent rival poles in the struggle to reconcile economic growth and financial stability. Their remarks, ostensibly about the details of banking regulations, really concerned the lessons of the worst financial crisis since the Great Depression -- and the danger, say some, that those lessons already are being forgotten. “I see a lot of amnesia setting in now,” Sheila Bair, chairman of the Federal Deposit Insurance Corporation, said last month.
“Unquestionably, there’s a need for higher capital,” said Richard Spillenkothen, the Fed’s director of banking supervision and regulation from 1991 to 2006, now retired. “The industry will never be terribly enthusiastic about that prospect.”
Once known as “Obama’s favorite banker,” Dimon and his Wall Street colleagues long ago lost the battle for public opinion. Taxpayers soured on the banks in late 2008 when called upon to save them from collapse and have stayed sour ever since. In a March 2011 Bloomberg national poll, 19 percent of respondents said banking regulation was too strict; 76 percent said current rules were needed or should be toughened. Kohn and Dimon both declined to comment.
There is scant evidence to support Dimon’s complaint that the prospect of more stringent regulation, aimed at preventing another crisis, is instead slowing a recovery from the last one. Total U.S. bank credit for the week ending June 22 was a seasonally adjusted $9.16 trillion, little changed from a year ago, according to the Fed.
With industry using less than 77 percent of available capacity and almost 14 million workers unemployed, there is little indication that the welter of pending regulations is what is depressing lending.
Kohn’s May 17 testimony, from the man Alan Greenspan once dubbed “my first mentor at the Fed,” was striking for its defense of regulation and its public apology for Fed errors that enabled the 2008 crisis.
In the eyes of its critics, the Fed has much to apologize for, such as trusting the banks to largely police themselves and keeping interest rates too low for too long. In 2000, Edward Gramlich, a Fed governor who worried that mortgages were being extended to so-called “subprime” borrowers who couldn’t afford them, urged Greenspan to investigate the home-loan units of major banks. The Fed chairman refused, and the fuse on the subprime bomb continued to burn.
Greenspan also welcomed financial innovations such as derivatives, which he said in 2002 “appear to have effectively spread losses” from corporate defaults rather than concentrate them. The Fed further fueled the housing and credit bubbles by keeping interest rates low for years before the 2008 panic, say economists such as Stanford University’s John Taylor. In 2001, the Fed cut borrowing costs 11 times, bringing the benchmark interest rate to 1.75 percent, the lowest in 40 years. Greenspan repeatedly dismissed warnings that housing prices were headed for a crash.
Benefits of Stability
At his London confirmation hearing, Kohn, 68, acknowledged that additional regulation means additional costs. “But the benefits of keeping a stable system are huge,” he said. “We have seen the cost of not keeping a stable system.”
The financial and human toll has been immense. More than 8.7 million people lost their jobs in the recession that followed the bursting of the housing bubble, while the recovery so far has created only 1.8 million new ones. In excess of $6 trillion was erased from household balance sheets. And the national debt has ballooned by $4.7 trillion, or almost 50 percent, in the 33 months since the Sept. 15, 2008 collapse of Lehman Brothers Holdings Inc.
Amid a global credit panic, the nation’s largest banks were saved only with capital infusions from the federal government and extraordinary aid from the central bank.
As financial markets have healed -- the Dow Jones Industrial Average is up 93 percent from its March 2009 low -- memories of the post-Lehman Brothers trauma have faded. The banking industry has been able to capitalize on that shift. Regulators’ efforts to implement the Dodd-Frank financial regulation bill Congress passed one year ago are bogged down amid disputes over agency funding and lobbying efforts to weaken constraints on the industry.
“As markets began to get better, the fervor for regulatory reform has diminished,” said Arthur Levitt, the longest serving head of the Securities and Exchange Commission. Levitt, a Bloomberg LP board member and policy adviser to Goldman Sachs Group Inc., criticizes President Barack Obama and members of Congress for buckling to lobbyists and punting the toughest choices to regulators.
On July 21, 2010, Obama signed Dodd-Frank into law, saying “Unless your business model depends on cutting corners or bilking your customers, you’ve got nothing to fear from reform.”
It seemed like the battle over remaking Wall Street was over. In fact, it was just beginning.
In 2010, the securities and investment industry spent $101 million on lobbying, compared with $60.5 million in 2005, according to the non-partisan Center for Responsive Politics in Washington.
The backstage maneuvering burst into public view on June 7, when Dimon rose from the audience at a bankers’ conference in Atlanta. His confrontation with Bernanke was a rare example of a banker publicly challenging his principal regulator.
The CEO’s concerns had been brewing for some time. In an April 4 letter to shareholders, Dimon previewed his argument. Much already had been done to make finance safer: off-balance- sheet vehicles “essentially are gone;” mortgages are written to tougher standards; and bank boards and managements “are more attentive to risk,” Dimon wrote.
Under Dodd-Frank, banks face hundreds of new regulations by federal agencies such as the Fed, the SEC and the Commodity Futures Trading Commission. The greatest industry ire is reserved for a proposal by global regulators for the largest “systemically-important” institutions -- known as SIFIs -- to hold an extra capital reserve of up to 3.5 percentage points beyond the 7 percent Tier 1 capital required by the Basel Committee on Banking Supervision’s so-called Basel III rules.
The aim is to make sure that in any future crisis, losses are absorbed by bank shareholders, not taxpayers.
In the years before the 2008 crisis, the largest U.S. banks grew reliant upon borrowed money to increase their returns. By 2007, Lehman Brothers and Morgan Stanley (MS) had borrowed $40 for every $1 of equity; Goldman Sachs and Citigroup Inc. (C) had leverage ratios of 32-to-1, according to the report of the Financial Crisis Inquiry Commission.
Dimon told Bernanke that capital and liquidity now are “more than double what they were before.” Starting with a 7 percent level, the nine U.S. banks likely to be deemed systemically important could “absorb an instantaneous loss equal to two years of their average losses during the financial crisis -- $203 billion -- and still maintain a 5 percent Tier 1 common capital ratio,” Barry Zubrow, JPMorgan’s chief risk officer, told the House Financial Services Committee June 16.
Requiring banks to hold even more capital is unnecessary and would hamstring U.S. financial institutions in global markets, Dimon said in his shareholder letter.
Those complaints are proving unpersuasive. Bernanke and Bair both say requiring banks to use more capital and less debt to fund their lending won’t hurt economic growth. “I say full speed ahead and the higher the better,” Bair said last month.
Likewise, a December 2010 report by the Basel panel’s Macroeconomic Assessment Group found that each additional percentage point increase in banks’ required capital ratio would lower the level of long-term gross domestic product by 0.22 percent. If applied to the current size of the U.S. economy, that suggests a GDP of $14.978 trillion instead of the actual $15.01 trillion.
“If we settle around 10 percent, that would be digestible and ultimately therapeutic,” said Zandi.
Compared to Dimon’s reassuring assessment, the financial world looks quite different through Kohn’s eyes. A veteran of 40 years in the Federal Reserve system, Kohn was at Bernanke’s side during the crisis, which he described in a 2010 speech as “a difficult learning experience.”
In February, Kohn was named to an interim U.K. Financial Policy Committee, the forerunner of a new Bank of England body designed to curb systemic financial risks. His May 17 testimony before Parliament’s Treasury Committee showed a central banker scarred by crisis.
“I have learned quite a few lessons, unfortunately for the economy I guess, in the past few years,” Kohn testified, later adding: “I deeply regret the pain that was caused to millions of people in the United States and around the world by the financial crisis and its aftermath.”
Where Dimon sees a rebuilt financial industry in which “most of the bad actors are gone” and the survivors are more attuned to risk, Kohn, who declined to be interviewed, says the crisis taught him “people in the markets can become excessively complacent and relaxed about risk.”
Asked how to handle the issue of banks considered “too big to fail,” Kohn embraced the tool that so irks Dimon. “Step number one is to make them much less likely to fail: much higher capital,” Kohn said. “I would include a so-called SIFI surcharge in that, on top of the Basel III capital requirements and I hope that it is a substantial surcharge, on the order of the 3 percent people are talking about.”
The new U.K. panel issued its first recommendations on June 24, including a call for British regulators and banks to build thicker capital buffers. The extra buffers may come in handy some day, as Kohn has learned.
“Everybody relaxed -- in the financial sector, in the regulatory sector -- and it turned out to be a big mistake,” said Kohn. “We need to guard against that.”
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