By Telis Demos
Tucked inside a nearly 600-page legislative proposal to overhaul
U.S. financial regulations are 93 words that could provide a
windfall for bank investors seeking heftier dividends and share
buybacks.
The verbiage is contained in the bill to repeal and replace the
Dodd-Frank Act, formally introduced last Wednesday by Texas
Republican Jeb Hensarling, chairman of the House Financial Services
Committee.
The relevant section relates to a somewhat esoteric area of bank
capital known as operational risk, a concept regulators have used
since the financial crisis to measure the possibility that a bank's
own actions, rather than unfavorable economic or market movements,
could sink it. Operational risk is largely influenced by a bank's
previous missteps, such as big legal settlements, and could require
it to hold more capital.
While obscure and technical, the result is that the sins of the
past linger on big-bank balance sheets. Bank analysts at Barclays
PLC estimate $236 billion in capital is tied up in operational risk
at the four biggest U.S. banks alone.
Bankers have become increasingly vocal in urging regulators,
lawmakers and the Trump administration to change the way risk is
measured. They want to free up capital that could be returned to
shareholders or used for more lending.
James Dimon, chief executive of J.P. Morgan Chase & Co.,
lashed out at the requirements in his recent annual letter to
shareholders, saying regulators' approach "should be significantly
modified if not eliminated." At the bank's investor day in
February, he called operational risk a "false number."
The shareholders letter highlights that operational risk in 2016
increased J.P. Morgan's assets adjusted for risk by $400 billion.
Mr. Dimon added that U.S. banks now hold about $200 billion in
capital against operational risk.
One big gripe banks have is the backward-looking nature of the
rules. Citigroup Inc., for example, still holds capital against
operational risks in businesses it has been winding down since the
crisis.
At Bank of America Corp., a big portion of the firm's
operational-risk exposure stems from its purchase of Countrywide
Financial, the defunct subprime lender for which it has already
paid billions of dollars in fines and settlements. Operational risk
accounted for $500 billion of the bank's $1.5 trillion in
risk-weighted assets at the end of 2016.
Bankers said it doesn't make sense to continue holding capital
for such problems. Citigroup's finance chief, John Gerspach, last
year said, "When you incur an operational loss, it has got a
Plutonium-238 half-life."
Others argue the lasting imprint reflects the outsize role banks
played in fueling the financial crisis. "The fines banks paid in
the past may well be indicative of future risk," said Anat Admati,
finance professor at Stanford University's Graduate School of
Business. "There are enormous rates of recidivism in corporate
misconduct. Paying a fine need not lead to significant change."
So how does operational risk impact banks?
By some regulatory measures, the amount of capital a bank has to
hold is based on total assets, which are then adjusted to reflect
their risk. In some cases, this reduces the weighting of an asset
because it is deemed so safe, for example U.S. Treasurys. In
others, though, it inflates the size of an asset because it is seen
as being very risky.
Operational risk does the latter. That ends up forcing banks to
hold more capital.
Consider a bank with $1.5 trillion in risk-weighted assets and a
requirement to have a 10% capital buffer. It would need $150
billion in capital.
Say then that operational risk makes up a third of those
risk-weighted assets. If operational risk was eliminated,
risk-weighted assets would fall to $1 trillion and require capital
of $100 billion -- freeing up $50 billion.
Granted, it is unlikely operational risk weighting would be
eliminated entirely should rules change. But even a modest
reduction could prove meaningful and free up capital.
Operational-risk weightings at five of the biggest U.S. banks
are on average equal to about 29% of their risk-weighted assets.
Combined, their $1.5 trillion of operational risk is equal to about
18% of the banks' total assets.
Ironically, moves by banks in recent years to slash holdings of
assets that carry lots of market or credit risk have increased the
impact of operational risk. In 2014, operational risk represented
just 18% of those five banks' overall risk-weighted assets.
That's a contrast to the trend in banks' legal payouts. At J.P.
Morgan, Citigroup, and Bank of America, litigation expenses were
around $2 billion last year, down from $28 billion in 2014,
according to analysts at Compass Point Research & Trading
LLC.
Banks would like the nature of the rules to change. Mr. Dimon's
recommendation in his letter: "If you are going to have operational
risk capital, it should be forward looking, fairly calculated,
coordinated with other capital rules and consistent with
reality."
Rep. Hensarling's legislation moves in that direction. But the
fate of his bill is uncertain given the size and scope of the
overhaul he is proposing, as well as what appears to be opposition
to much of the bill in the Senate.
Still, the fact that changes to operational risk were included
in the legislation could prompt regulators to rethink the rules or
how they use operational risk for things like stress tests.
For now, all banks can do is let time pass. Citigroup's Mr.
Gerspach told analysts in April that "there is little we can do to
mitigate that number" under current rules. "Sometime over a 10- to
15-year year period you'll eventually see a reduction," he
said.
(END) Dow Jones Newswires
April 30, 2017 08:14 ET (12:14 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.
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