While Jamie Dimon made headlines with the warning that "something is wrong" with America, to which he dedicated a substantial portion of his latest annual letter to shareholders, a less discussed declaration by the JPM CEO was that the too-big-to-fail problem, one which clearly impacts his own bank, JP Morgan, has been solved. It was this that Neel Kashkari took offense with, and in a post on Medium, today the Minneapolis Fed president who has long waged a crusade to warn Americans that US banks remain very risky, he said that Dimon’s claims about the too-big-to-fail banking problem being solved and banks being over-capitalized are “demonstrably false." To wit:
At 46 pages, Mr. Dimon’s letter includes a lot of interesting commentary. In this essay, I am going to respond to two of his main points because I strongly disagree with them. First, Mr. Dimon asserts that “essentially, Too Big to Fail has been solved?—?taxpayers will not pay if a bank fails.” Second, Mr. Dimon asserts that “it is clear that the banks have too much capital.” Both of these assertions are demonstrably false.
Addressing the first part of Dimon's argument, the "solution" of the too big to fail problem, Kashkari says that “Mr. Dimon repeatedly points to various regulatory schemes that all have the same unrealistic feature: In a crisis, bondholders will take losses rather than taxpayers. It sounds like an ideal solution. The problem is that it almost never actually works in real life."
We learned from past financial crises, including the 2008 financial crisis, that nothing beats equity for absorbing losses. Equity holders have long taken losses in the United States and thus expect that outcome. Moreover, equity holders cannot run during a crisis. In contrast, debt holders of the most systemically important banks in the United States and around the world have repeatedly experienced bailouts and likely will expect such an outcome during the next financial crisis. Indeed, the most recent crisis showed that even some debt holders who had been explicitly told that they would take losses during a crisis got bailed out.
While we would disagree that equityholders expect losses, especially in light of policies enacted by the institution of which Mr. Kashkari is part of, we tend to agree in principle, especially with his next statement that "governments are reluctant to impose losses on creditors of a TBTF bank during a crisis because of the risk of contagion: Creditors at other TBTF banks may fear they will face similar losses and will then try to pull whatever funding they can, or at least refuse to reinvest when debt comes due. This is why, regardless of their promises during good times, governments do not want to impose losses on bondholders during a crisis. History has repeatedly shown this to be true and, while we can hope for the best, there is no credible reason to believe this won’t be true in the next crisis. Only true equity should be considered loss-absorbing in a crisis. The largest banks do not have enough equity today to protect taxpayers. Too big to fail is alive and well. Taxpayers are on the hook."
What we found more amusing was Kashkari's takedown of the second part of Dimon's argument, namely that banks hold too much capital, where - again somewhat ironically - Kashkari mocks the very stress test that the Fed (Kashkari's employer) has implemented to prove to the public how capitalized banks are:
To make his argument that banks have too much capital, Mr. Dimon points to losses estimated by the Federal Reserve’s stress test and compares them to banks’ combined equity and long-term debt. Again, Mr. Dimon unrealistically assumes that debt will absorb losses in a crisis. As explained above, that is extremely unlikely. In addition, stress tests are just hypothetical scenarios. By definition, regulators (and bankers) won’t see the next crisis coming, and it will almost certainly look different from past crises, or scenarios modeled in a stress test.
Regulators such as... the Fed.
However, the most amusing aspect of Kashkari's takedown was the allegation that current rules are restraining bank lending despite growing loan demand. To this his response is rather witty:
Mr. Dimon argues that the current capital standards are restraining lending and impairing economic growth, yet he also points out that JPMorgan bought back $26 billion in stock over the past five years. If JPMorgan really had demand for additional loans from creditworthy borrowers, why did it turn those customers away and instead choose to buy back its stock?
Here he is spot on, as is his follow up:
The truth is that borrowing costs for homeowners and businesses are near record lows. If loans were scarce, borrowers would be competing for them, driving up costs. That isn’t happening. Nor do other indicators suggest a lack of loans. Bank credit has grown 23 percent over the past three years, about twice as much as nominal gross domestic product. Only 4 percent of small businesses surveyed by the National Federation of Independent Business report not having their credit needs met.
This matters because what Kashkari is effectively saying is that the reason behind the collapse in loan creation, which as we showed two weeks ago is crashing at the fastest pace since the financial crisis...
... is not lack of supply but lack of demand, which then throws the whole "recovery" narrative into the trash.
Kashkari ends on another gloomy note,repeating his recent warning that the odds of a bailout in the future are at roughly 70%... a bailout which most likely will again be borne by taxpayers:
Capital is the best defense against bailouts. Although capital standards are higher than before the last crisis, they are not nearly high enough. The odds of a bailout in the next century are still nearly 70 percent. Large banks need to be able to withstand around a 20 percent loss on their assets to protect against taxpayer bailouts in a downturn like the Great Recession, according to a 2015 analysis by the Federal Reserve. Unfortunately, regulators have taken it easy on the large banks, which today have only about half of the equity they need.
End result: absolutely nothing will change as a result of this "stump speech" by Kashkari, who until recently was angling for a career in politics, and will likely revert to it after his stint at the Fed ends. As to bank capital: expect more buybacks, more dividends to shareholders, and - once the global tide of excess liquidity goes away - more bailouts.