• PART 2: FULLER REVIEW OF DIMONS COMMENTARY ON BANKING CRISIS 2023
• MY INITIAL IMPRESSION from this morning
• complete JP Morgan letter which accompanied the Annual Report 2022 | JPMorgan Chase & Co

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Here are my notes and thoughts on the banking turmoil section of the JP Morgan letter.

The piece of the letter that addresses the Banking crisis is thoughtful and carefully worded. It jumps off the page that Dimon sees a desperate need for agreement between regulators and banks as to role of banks, what we see as their role and finally the need to include shadow banking which form a larger than life part of the financial system. Rana Foroohar of FT wrote on this just yesterday.

When the pandemic hit (2020), non-banks such as hedge funds and open-ended money market funds pulled out of key credit markets, forcing governments to intervene to stabilise things. As Treasury secretary Janet Yellen said in a speech last week, “Put simply, the Covid shock reaffirmed the significance of structural vulnerabilities in non-banks.” Yellen pointed out a number of ways in which US regulators are trying to better monitor hedge fund leverage and address liquidity mismatches in open-ended funds and money markets. These can, when under pressure, “break the buck”, leaving small investors with big losses.

It’s good that policymakers are focusing on shadow banks, because I’d still bet that this is where the real nexus of risk in 2023 and beyond will lie.

Consider, for example, the trouble brewing in commercial property loans, and private equity real estate funds.

I emphasise this last sentence in Rana’s article. Earlier this week Bloomberg noted the mortgage default on office buildings by Pimco’s Columbia Property Trust and Brookfield Corp. They further noted this could be the beginning of a trend tied to the combined impact of reduced rent demand due to “working from home” combined with office building borrowers borrowing at low floating rates. The combined impact highlights an increased risk of default.

Further analysis would be needed to determine if such mortgage defaults are tied to the banking crisis or just have common risk drivers. Either way there is a potential for a growth in the banking turmoil. As Rana points out many of these mortgagees are flush with cash yet defaults are beginning. Two situations is hardly a trend but the mortgagees are two strong players in the unregulated Shadow Banking world.

Back to the JP Morgan annual letter and the commentary on the current banking turmoil.

• BANKING TURMOIL AND REGULATORY GOALS- full text follows my analysis
  

My analysis – full text follows my analysis

1. Overall impression – it is a good commentary with a realistic view of the approach that regulators ought to follow.

1. most of the risks were hiding in plain sight. Interest rate exposure, the fair value of held-to-maturity (HTM) portfolios and the amount of SVB’s uninsured deposits were always known – both to regulators and the marketplace.
   
   2. The unknown risk was that SVB’s over 35,000 corporate clients – and activity within them – were controlled by a small number of venture capital companies and moved their deposits in lockstep.

1. The regulatory stress tests were in adequate and never accounted for higher interest rates (lower bond prices).

1. This is not to absolve bank management – it’s just to make clear that this wasn’t the finest hour for many players.
   
   2. All of these colliding factors became critically important when the marketplace, rating agencies and depositors focused on them

1. The letter notes that as bad as the current crisis is, it is nowhere as bad as 2008. Time will tell but as noted by way of reminder 2008 was bad.

1. In 2008, the trigger was a growing recognition that $1 trillion of consumer mortgages were about to go bad – and they were owned by various types of entities around the world.
   
   2. At that time, there was enormous leverage virtually everywhere in the financial system.
   3. Major investment banks, Fannie Mae and Freddie Mac, nearly all savings and loan institutions, off-balance sheet vehicles, AIG and banks around the world – all of them failed.
   4. This current banking crisis involves far fewer financial players and fewer issues that need to be resolved.

1. Dimon notes thoughtfulness ought to be the order of the day in implementing the inevitable regulatory changes.

1. While this crisis will pass, lessons will be learned, which will result in some changes to the regulatory system.
   
   2. However, it is extremely important that we avoid knee-jerk, whack-a-mole or politically motivated responses that often result in achieving the opposite of what people intended.
   3. Now is the time to deeply think through and coordinate complex regulations to accomplish the goals we want, eliminating costly inefficiencies and contradictory policies.
   4. Very often, rules are put in place in one part of the framework without appreciating their consequences in combination with other regulations.

1. He addresses the need for large complex banks such as JP Margan and makes that case with lucid clarity.

1. We need large, complex banks to continue to play a critical role in the U.S. and global financial system.
   
   2. Large banks are complex not because they want to be, but because they operate in complex global markets. Regional banks simply cannot manage the scale and complexity of transactions in 50 or 60 countries around the world to help some of America’s best and largest companies accomplish their goals.
   3. Think of equity, debt, M&A, research, swaps, foreign exchange, large payments systems, global custody and so on. It takes a global workforce with deep expertise and significant capabilities to provide these services.
   4. These large global banks finance not just the world’s largest companies but the world’s development institutions and even countries.
   5. Having some of the best large, complex banks in the world is essential to the success of America’s biggest companies, its economic system and its global competitiveness, which says nothing against the importance of having great midsized and community banks as well.
   6. And contrary to what some say – to be safe, a global bank needs both huge economies of scale and the strength of diversified earnings streams.

1. He returns to the use of thoughtfulness in considering changes to regulation. He mentions the importance of common agreement as to which institutions are included and which processes need change.
   he touches on product acquisition of what we know as shadow banking ‘would nonbank credit-providing institutions be able to provide credit’ which is a very legitimate question. This question could also be inclusive of Crypto institutions where for example we say interaction between SBF customers which form lending activity outside the banking system and the associated conditions and collateral requirements that Banks adhere to. We are also getting hints of Finance performing similar activity.

1. We should decide a priori what should stay in the regulatory system and what shouldn’t.
   
   2. There are reasons for certain choices, and they should not be the accidental outcome of uncoordinated decision making.
      
      3. Regulatory arbitrage is already forcing many activities, from certain types of lending to certain types of trading, outside the banking system.
      4. Among many questions that need definitive answers, a few big ones would be:

1. Do you want the mortgage business, credit and market-making, along with other essential financial services, inside the banking system or outside of it?
   
   2. What would be the long-term effect of that choice?
      
      3. Under the new scheme, would nonbank credit-providing institutions be able to provide credit when their clients need them the most?
         
         4. I personally doubt that many of them could.

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BANKING TURMOIL AND REGULATORY GOALS

The recent failures of Silicon Valley Bank (SVB) in the United States and Credit Suisse in Europe, and the related stress in the banking system, underscore that simply satisfying regulatory requirements is not sufficient. Risks are abundant, and managing those risks requires constant and vigilant scrutiny as the world evolves. Regarding the current disruption in the U.S. banking system, most of the risks were hiding in plain sight. Interest rate exposure, the fair value of held-to-maturity (HTM) portfolios and the amount of SVB’s uninsured deposits were always known – both to regulators and the marketplace. The unknown risk was that SVB’s over 35,000 corporate clients – and activity within them – were controlled by a small number of venture capital companies and moved their deposits in lockstep. It is unlikely that any recent change in regulatory requirements would have made a difference in what followed. Instead, the recent rapid rise of interest rates placed heightened focus on the potential for rapid deterioration of the fair value of HTM portfolios and, in this case, the lack of stickiness of certain uninsured deposits. Ironically, banks were incented to own very safe government securities because they were considered highly liquid by regulators and carried very low capital requirements. Even worse, the stress testing based on the scenario devised by the Federal Reserve Board (the Fed) never incorporated interest rates at higher levels. This is not to absolve bank management – it’s just to make clear that this wasn’t the finest hour for many players. All of these colliding factors became critically important when the marketplace, rating agencies and depositors focused on them.

As I write this letter, the current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come. But importantly, recent events are nothing like what occurred during the 2008 global financial crisis (which barely affected regional banks). In 2008, the trigger was a growing recognition that $1 trillion of consumer mortgages were about to go bad – and they were owned by various types of entities around the world. At that time, there was enormous leverage virtually everywhere in the financial system. Major investment banks, Fannie Mae and Freddie Mac, nearly all savings and loan institutions, off-balance sheet vehicles, AIG and banks around the world – all of them failed. This current banking crisis involves far fewer financial players and fewer issues that need to be resolved.

These failures were not good for banks of any size.

Any crisis that damages Americans’ trust in their banks damages all banks – a fact that was known even before this crisis. While it is true that this bank crisis “benefited” larger banks due to the inflow of deposits they received from smaller institutions, the notion that this meltdown was good for them in any way is absurd.

Let’s be very thoughtful in our reaction to recent events.

While this crisis will pass, lessons will be learned, which will result in some changes to the regulatory system. However, it is extremely important that we avoid knee-jerk, whack-a-mole or politically motivated responses that often result in achieving the opposite of what people intended. Now is the time to deeply think through and coordinate complex regulations to accomplish the goals we want, eliminating costly inefficiencies and contradictory policies. Very often, rules are put in place in one part of the framework without appreciating their consequences in combination with other regulations. America has had, and continues to have, the best and most dynamic financial system in the world – from various types of investors to its banks, rule of law, investor protections, transparency, exchanges and other features. We do not want to throw the baby out with the bath water.

We should have common goals on how we want the banking system to work.

We want to strengthen regional, midsized and community banks, which are essential to the American economic system. They fill a critical role in small communities, offering local knowledge and local relationships that some large banks simply can’t provide – or can’t provide cost-effectively. Overall, we want to maintain the extraordinary strength this tiered system affords. JPMorgan Chase directly supports this goal as we are one of the largest bankers in America to regional and community banks. We bank approximately 350 of America’s 4,000+ banks across the country. This means we make loans to them or raise capital for them. In addition, we process payments for them, finance some of their mortgage activities, advise them on acquisitions, provide them with interest rate swaps and foreign exchange, and buy and sell securities for them. And we also finance their local communities (think hospitals, schools and larger companies) in ways they cannot.

We need large, complex banks to continue to play a critical role in the U.S. and global financial system. And we need to recognize that they do so in a way regional banks can’t. Large banks are complex not because they want to be, but because they operate in complex global markets. Regional banks simply cannot manage the scale and complexity of transactions in 50 or 60 countries around the world to help some of America’s best and largest companies accomplish their goals. Think of equity, debt, M&A, research, swaps, foreign exchange, large payments systems, global custody and so on. It takes a global workforce with deep expertise and significant capabilities to provide these services. These large global banks finance not just the world’s largest companies but the world’s development institutions and even countries. Having some of the best large, complex banks in the world is essential to the success of America’s biggest companies, its economic system and its global competitiveness, which says nothing against the importance of having great midsized and community banks as well. And contrary to what some say – to be safe, a global bank needs both huge economies of scale and the strength of diversified earnings streams.

We should want a system in which a bank failure does not cause undue panic and financial harm. While you don’t want banks to fail all the time, it should be allowed to happen and the resolution should follow a completely prescribed process. In almost all bank failures, uninsured deposits never resulted in lost money – but the very fear of loss can cause a run on any bank having characteristics similar to a bank that has failed. Resolution and recovery regulations did not work particularly well during the recent crisis – we should bring clarity and reassurance to both the unwinding process and measures to reduce the risk of additional bank runs. It should also be noted that banks pay for any bank failure (through fees paid to the Federal Deposit Insurance Corporation) as they pay for the whole financial regulatory system. And yes, while these costs are ultimately passed on to their customers – that is true for all industries – the cost is just the price of implementing proper regulations.

We want proper transparency and strong regulations. However, it should be noted that regulations, the supervisory regime and the resolution regime currently in place did not stop SVB and Signature Bank from failing — and from causing systemwide issues. We should not aim for a regulatory regime that eliminates all failure but one that reduces the chance of failure and the odds of contagion. We should carefully study why this particular situation happened but not overreact. Strong regulations should not only minimize bank failures but also help to maintain the strength of banks as both the guardians of the financial system and engines that finance the great American economic machine.

We should want market makers to have the ability to effectively intermediate, particularly in difficult markets, with central banks only stepping in during exceptional situations. In the last few years, we have had many situations in which disruptions in the market were, in my opinion, largely caused by certain regulations that did not improve the safety of the market maker but, instead, damaged the safety of the whole system. In addition, many of the new “shadow bank” market makers are fair-weather friends – they do not step in to help clients in tough times.

We need banks to be there for their clients in tough times. And they have been. Banks can flex their capital and provide their clients with a lot of loans and liquidity when they really need it. For example, at the beginning of the COVID-19 crisis in March 2020, banks deployed over $500 billion in liquidity for clients and $500 billion in PPP loans – and this does not include banks’ share of the nearly $2 trillion in loans that entered forbearance. Banks also play a unique and fundamental role in the transmission of monetary policy because deposits in banks can be loaned out, effectively “creating” money. Some regulations and some accounting rules have become too procyclical and make it harder to do this.

Regulation, particularly stress testing, should be more thoughtful and forward looking. It has become an enormous, mind-numbingly complex task about crossing t’s and dotting i’s. For example, the Fed’s stress test focuses on only one scenario, which is unlikely to happen. In fact, this may lull risk committee members at any institution into a false sense of security that the risks they are taking are properly vetted and can be easily handled. A less academic, more collaborative reflection of possible risks that a bank faces would better inform institutions and their regulators about the full landscape of potential risks.

We should decide a priori what should stay in the regulatory system and what shouldn’t.

There are reasons for certain choices, and they should not be the accidental outcome of uncoordinated decision making. Regulatory arbitrage is already forcing many activities, from certain types of lending to certain types of trading, outside the banking system. Among many questions that need definitive answers, a few big ones would be: Do you want the mortgage business, credit and market-making, along with other essential financial services, inside the banking system or outside of it? What would be the long-term effect of that choice? Under the new scheme, would nonbank credit-providing institutions be able to provide credit when their clients need them the most? I personally doubt that many of them could.

We need banks to be attractive investments. It is in the interest of the financial system that banks not become “un-investable” because of uncertainty around regulations that affect capital, profitability and long-term investing. Erratic stress test capital requirements and constant uncertainty around future regulations damage the banking system without making it safer. While it is perfectly reasonable that a bank refrain from stock buybacks, dividends or growth under certain circumstances, it would be far better for the entire banking system if these rules were clearly enumerated (i.e., stipulate that a bank needs to reduce its buybacks and dividend if they breach certain thresholds).

If done properly, banking regulations could be calibrated — adding virtually no additional risk — to make it easier for banks to make loans, intermediate markets, finance the economy, manage a run on their bank and fail if need be. When it comes to political debate about banking regulations, there is little truth to the notion that regulations have been “loosened,” at least in the context of large banks. (To the contrary, our capital requirements have been increasing for years, as our fortress balance sheet chart shows in the introduction.) The debate should not always be about more or less regulation but about what mix of regulations will keep America’s banking system the best in the world, such as capital and leverage ratios, liquidity and what counts as liquidity, resolution rules, deposit insurance, securitization, stress testing, proper usage of the discount window, tailoring and other requirements (including potential requirements on shadow banks). Because of the recent problems, we can add to this mix the review of concentrated customers, uninsured deposits and potential limitations on the use of HTM portfolios. Ideally, new rules and regulations would also make it easier for banks to provide credit in tougher times.

ADJUSTING OUR STRATEGY TO THE NEW REGULATORY REALITY (BASEL III ENDGAME)

The Basel III Endgame (called Basel IV by some) — which, incredibly, has been nearly 10 years in the making — seems likely to increase, yet again, capital requirements for banks in general, through higher operational risk changes, and for trading and capital markets activity in particular, among other things. Whether or not we agree with all these changes (and we’ve discussed these regulations in detail in prior letters), we will simply have to adjust to them immediately. It’s important we describe to our shareholders how we will go about doing that and what it means for banks and, in particular, our bank.

First and foremost, banks must satisfy all of their regulators.

We must satisfy all of our regulators, and, remember, we have regulators all around the world, including more than 10 in the United States alone. Regulations include stress testing, reporting, compliance, legal obligations and trading surveillance, among others. While the business is the first line of defense on all these issues, we also have 3,700 people in compliance, 7,100 in risk and 1,400 lawyers actively working every day to meet the letter and the spirit of these rules along with the final line of defense — audit.

Rules are constantly changing and/or being enhanced and are sometimes, unfortunately, driven by political motivations. Relationships with regulators can often be intense, and, recently, we have lost some terrific people in our firm because of this. Regulators know that when banks disagree, we essentially have no choice — there is no one to appeal to, and even the act of appealing can make them angry. We simply ask respectfully to be heard, but at the end of the day, we will do what they ask us to do.

Banks will play a smaller role in the global financial system.

The chart below shows both the decreasing role and size of U.S. banks relative to the global economy alongside the increasing role and size of shadow banks. The data illustrates this dynamic. We expect this trend to continue for all the reasons I’ve discussed.

Read footnoted information here.

Banks will continue to be guardians of the financial system.

Properly regulated banks are meant to protect and enhance the financial system. They are transparent with regulators, and they strive mightily to protect the system from terrorism financing and tax evasion as they implement know your customer guidelines and anti-money laundering laws. They protect clients’ assets and clients’ money in movement. Banks also help customers — from protecting their data and minimizing fraud and cyber risk to providing financial education — and must abide by social requirements, such as the Community Reinvestment Act, which requires banks to extend their services into lower-income communities. As mentioned previously, unlike the private market, banks do not always choose when to provide a product or service but need to be there for their clients when they need credit or liquidity the most.

Looking forward, we constantly modify our strategies to adjust to our market realities.

It’s always best to adjust to new reality quickly. We really don’t like crying over spilled milk, although we sometimes do. The new reality is that some things — for example, holding certain types of credit — are more efficiently done by a nonbank.

Here are some actions we are taking to help our business succeed in the current and future environments:

1. First and foremost, we must conclude that holding certain types of credit, loans or otherwise has generally become less profitable because of the high levels of capital that need to be held against it — generally more than the market demands. What this means is that some credit is better held in a nonbank. Increasingly, for a credit relationship to make sense, banks need a lot of noncredit-related revenue.
2. Because of various capital requirements, we try to reduce clients’ nonoperating cash deposits.
3. We are seeking to implement much tighter management and execution of business strategies. This includes repricing certain businesses, running off certain unprofitable products, changing the mix of business for a client, and more rigorously evaluating client selection and resource optimization applied to clients.
4. We are exploring new capital optimization strategies, which could include partnerships and perhaps one day more securitizations, among other opportunities.
5. Unfortunately, it is becoming increasingly difficult for banks to stay in the mortgage business, which ultimately hurts everyday Americans. The high costs of origination and servicing along with the complexity of regulations create a costly business with significant legal, reputational and operational challenges. In addition, given capital requirements and the lack of a healthy securitization market, it barely makes sense for banks to hold mortgages or mortgage-servicing rights. Many banks have already reduced much of this business. We are hanging on, continuing to hope for meaningful change.
6. We have the ability to add low-capital or no-capital revenue streams, like providing valuable data and analytics in trading, travel and other relevant offers in the consumer bank, wealth management and payment services businesses, among others.
   

If you review our CEO letters, you will see that we have many growth opportunities in front of us and our plans to attack them. We face the future and the new competition, large and small, with confidence, strength and a dash of humility.

KEEPING AN EYE ON ALL OF OUR COMPETITORS

The growing competition to banks from each other, as well as shadow banks, fintechs and large technology companies, is intense and clearly contributing to the diminishing role of banks and public companies in the United States and the global financial system. The pace of change and the size of the competition are extraordinary, and activity is accelerating. Walmart, for example (with over 200 million in-store customers each week), can use new digital technologies to efficiently bring banking-type services to their customers. Apple, already a strong presence in banking-type services with Apple Pay and the Apple Card, is actively moving into other similar services such as payment processing, credit risk assessment, person-to-person payment systems, merchant acquiring and buy-now-pay-later offers. Large tech companies, already 100% digital, have hundreds of millions of customers, as well as enormous resources, in data and proprietary systems — all of which give them an extraordinary competitive advantage.

We remain confident that as long as we stay vigilant, hungry, adaptable, fast and disciplined, we will continue to succeed in building this great company.