- The world’s most important central banks helped develop common standards to regulate JPMorgan Chase and other financial institutions critical to the health of the global economy. However, if the Fed is allowing U.S. banks to flout some of those norms, experts told Fortune, other countries have little incentive not to let their big lenders do the same.
It turns out JPMorgan might not want to boast about the size of its book. In fact, a whistleblower has alleged the world’s largest bank, along with several of its peers, has deliberately underreported the scale of its trading activity to minimize capital requirements the industry has long argued are onerous. JPMorgan, for its part, has called allegations it is evading capital requirements completely “false.”
The requirements at issue are aimed at ensuring banks can survive if they sustain heavy losses, and they were tightened in the aftermath of the 2008 financial crisis. Regulators from around the world developed what is known as Basel III, or common standards to safeguard the health of so-called “globally systemic banks”—many of which required controversial government bailouts to avoid economic catastrophe. But if the Federal Reserve is allowing JPMorgan and other competitors to defy some of those norms, experts in corporate finance and administrative law told Fortune, other countries have little incentive not to let their banks follow suit.
“It kind of diminishes the meaning of the rules and the extent to which people are going to take them seriously going forward,” said Itay Goldstein, who chairs the finance department at the University of Pennsylvania’s Wharton School.
The Bureau of Investigative Journalism broke the allegations in January, citing a former JPMorgan employee who said the bank was improperly reporting its long and short positions in certain securities, obscuring the true size of its trading business. The publication also quoted another banker familiar with the matter, who said the Federal Reserve has given tacit approval for other U.S. banks to do the same.
JPMorgan, meanwhile, has been adamant that it is following the law and referred Fortune to its previous statements on the matter.
“We are confident in our methodology, which is fully transparent to our regulators,” the bank said. “We comply with all capital regulations, and claims suggesting otherwise are false.”
The Federal Reserve, meanwhile, declined to comment. The central bank previously told the Bureau that American lenders are subject to higher capital requirements than their international counterparts but did not directly address the allegations.
The Fed treats its supervisory relationship with banks as confidential, said David Zaring, a professor of legal studies and business ethics at Wharton, to avoid exposing lenders’ sensitive information to competitors and trading counterparties.
“Totally makes sense to me,” he added, “but it means that you often aren’t really sure what they’re looking at when they tell you, ‘We’re comfortable with this bank’s derivative book of business and how [the bank is] accounting for it.’”
What is netting, and why does it affect capital requirements?
Netting refers to the process of consolidating and offsetting multiple financial obligations to reduce overall risk. Rules around netting are relevant because the size of a bank’s balance sheet and the risk profile of the investments it contains helps regulators determine how much of a lender’s assets should be financed by equity that can sustain losses.
“Once the equity is wiped out, there’s nothing to absorb the loss,” Goldstein said. What’s left, he added, “is going to fall on the debt holders or the government.”
That’s why several banks are deemed “too big to fail,” a term that gained in popularity after the U.S. government spent $700 billion to save Wall Street banks and other financial institutions critical to the nation’s economy. All of America’s largest banks are subject to a minimum 4.5% capital requirement, with additional buffers mandated based on the Fed’s stress tests of bank balance sheets. Then, finally, there’s a capital surcharge for banks deemed to be “globally systemic,” termed G-SIBs.
JPMorgan sits alone atop the list, subject to an additional 50 basis point requirement compared to its closest peers, Citigroup and HSBC. The Bureau’s reporting suggested the G-SIB surcharge would be higher, however, if the Fed enforced international standards to which the central bank previously agreed.
As Goldstein explained, there is often a strong economic rationale to netting, or allowing long and short positions in the same security to offset each other. In a simplified example, if a long is equivalent to a short, they cancel each other out on the balance sheet.
“It is as if you don’t hold anything,” Goldstein said.
But there are several reasons why regulators might want to see the whole gross position, or the longs added to the shorts, Goldstein said. On one side of the trade, for instance, there might be a higher possibility that the other party could default on its obligations.
That’s why the Basel Committee on Banking Supervision instructs G-SIB’s not to net longs and shorts for securities that, “if sold quickly during periods of severe market stress, are more likely to incur larger fire-sale discounts or haircuts to compensate for high market risk.” Each country’s central bank, however, is ultimately responsible for enacting this standard.
Banks have been very successful at pushing back on the Fed’s efforts to fully implement Basel III. The Fed scrapped its initial proposal last year, which would have raised capital requirements by 19%, and vice chair of supervision Michael Barr later stepped down to let President Donald Trump make his own pick for the role.
“The idea of entering into an international agreement in the current administration, even an informal one, is pretty unpopular,” Zaring said.
In other words, cooperation among the Fed and foreign regulators may be undermined by several factors. Just add this issue about netting to the list.
