Economics, Free Enterprise, Pethokoukis

Why the biggest US banks are even bigger and riskier than you think

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Just how big are the biggest US banks, and how safe are they? When trying to figure all that out, it makes a big difference if you are analyzing them according to US accounting standards or international ones. The latter makes lenders account for a greater portion of risky derivatives on their balance sheets.

Take JPMorgan, for instance. Under US accounting rules, the bank is just the fourth largest in the world with total assets of $2.3 trillion and capital equal to roughly 7% of total assets. But under international rules, where lots of off-balance sheets assets like derivatives are accounted for, according to Bloomberg, JPMorgan would be the largest in the world with assets of $4.5 trillion and capital equal to less than 4% of assets. The higher that capital ratios are, the less likely banks are to face liquidity and solvency problems.

Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., would prefer using stricter accounting standards. “Derivatives, like loans, carry risk,” Hoenig said in an interview with Bloomberg. “To recognize those bets on the balance sheet would give a better picture of the risk exposures that are there.”

The big banks point out that US rules allow them and their trading partners “to add up the positions they have with each other and show what would be owed if all contracts had to be settled suddenly.” Thanks to this “netting” practice, US bank asset size is, in reality, a lot less. Unless there’s, you know, some sort of crisis – as Anat Admati and Martin Hellwig explain in the must-read The Bankers’ New Clothes:

For example, in the final phase of the Bear Stearns crisis, the attempts of derivatives counterparties to close their positions or pass them to others played an important role and contributed to the run on the bank. Similar dynamics were observed in the case of Lehman Brothers. These experiences suggest that if JPMorgan were to become distressed, the bank’s enormous derivatives positions could be a major source of instability for the bank and for the financial system.

Not only do Admati and Hellwig argue for international accounting rules, but also that banks be forced to hold dramatically higher levels of equity capital against their assets. In other words, more of the funding for banks’ loans should come from equity — whether from reinvested earnings or the stock market — rather than from borrowing.

How much equity capital should banks hold? Something in the range of 20% to 30% would be a solid start. Higher equity requirements would also make it more likely that banks would shrink on their own. Admati and Hellwig: “Higher equity requirements would therefore alleviate the problem of banks being too big, too interconnected, or too political to fail. Not only would banks be less likely to fail, they would bear more of their own losses should they incur losses.”

Capping bank size, limiting bank activities, higher equity capital requirements — all tools in the toolbox for eliminating the crony capitalist subsidy of the US financial system by government.

12 thoughts on “Why the biggest US banks are even bigger and riskier than you think

  1. Most of the derviative exposure is governed by ISDA contracts that permit the parties to terminate all the contracts if the other counterparty is in default. Additionally those contracts are secured with collateral agrements with relatively low thresholds, so the net owing counterparty typically delivers cash daily to secure the exposure. I agree with you that the size of banks should be limited, but i don’t think using this argument is valid.

    • I think it’s very valid. As we learned during the financial crisis, the actual netting of the deriviative exposure during a time of crisis was far less harmful than the fear and distrust between counterparties which caused the entire financial system to grind to an almost complete halt. The higher the exposure the greater the fear, the greater the fear the larger the effect.

      • No, that is not what we learned. What we learned, or what those of us who know what we are talking about learned, is that writedowns caused the entire financial system to collapse. Not some mysterious, oogedy-boogedy “fear and distrust.” Actual loss of money. That loss of money was caused by mark-to-market, not miscreance by the financial sector. Government. Admit it, Pethokoukis!

        • financial deriviatives are tools for creating fraudulent schemes of circular insurance, aka counterparty risk. This is what we have learned. As long as these instruments are allowed to exist, the financial system will blow up periodically.

  2. It is rather painful, mentally, to read such articles.
    Banksters create crony capitalism.
    Crony capitalism created super banks.
    Super banks created political hegemony.
    Political hegemony is in bed with banksters.
    And, the cycle repeats itself ON THE BACKS OF FOOLS (aka taxpayers).
    “… banking institutions are more dangerous to liberty than standing armies…) Thomas Jefferson
    I will just add to it that from the “necessary evil” that the banks are known to be, the super banks have become pure EVIL…
    The rest is hogwash.

    • Thomas Jefferson never said that.
      http://www.snopes.com/quotes/jefferson/banks.asp
      “Super banks” did not create “crony capitalism” or “political hegemony.” The people who advocate big government and more interference in the markets, like Pethokoukis, create those. If you are sincere about wanting to stop bailouts, I suggest you start with Pethokoukis and his very anti-American AEI, or prove yourself to be anti-American.

      • Did you even read your link? “I sincerely believe, with you, that banking establishments are more dangerous than standing armies” Close enough?

      • WM,
        Your comments seem to be reasonable, for a 5 year old.
        If you are older, I would suggest to educate yourself.
        If you are educated, I suggest you stop taking your drugs. Seek another psychiatrist…

  3. This 20% to 30% capital reserves proposal is not some reasoned conclusion. It is deliberate crackpottery. It is occult anti-Americanism unhinged from any contact with reality. This idea would destroy the financial system. I mean literally destroy – you would have to be an idiot or completely ignorant about the financial system to not realize this. Pethokoukis realizes it. He just doesn’t care. Why doesn’t he care?

    Because his neocon superiors at the AEI reward him with extensive PR exposure for intellectualizing and promoting their propaganda (Pethokoukis was really a no-name before the neocons found him). And all the while these brazen, psychotic porcine individuals have the gall to call themselves the “American Enterprise” Institution. They actually tell themselves that our effective national destruction, population decline, and impoverishment from such a policy would make us a better nation by causing us to return to more simple values. Yes, they really believe this. They really are that psycho.

    Pethokoukis, I don’t know what you think you are doing, but did you really think that by parroting your neocon elders’ sick, psychotic agenda, they will accept you into their elite? Did they make you feel like you were somehow special? Hint: YOU WERE NOT BORN INTO THEIR GROUP. THEY WILL NEVER, EVER ACCEPT YOU AS THEIR EQUAL. YOU ARE AN APPARATCHIK, THAT’S IT. That’s how these things work.

    The neocons are on their way out of influence. If you want to be a pathetic hanger-on, a barnacle to a dying movement, be my guest. You will go down with that rickety, filth-infested old ship as well. You have been warned.

    Tick tock.

    • Wow. Have you tried the decaf?
      Not really getting the ‘neo-con’ angle on this either.
      Although I do think you have the better argument his is just an idea. It’s not going to happen tomorrow.

  4. This argument is just wrong. I am no fan of FASB, have criticized many of FASB’s positions. But FASB is right on this. Netting out the exposures is exactly the right approach if you want to measure the real assets at risk.

    As Peter Wallison has well explained in other places, failure to net out exposures produces these preposterous and meaningless numbers about the total volume of swaps and other derivatives in the economy (the hundreds of trillions of dollars in value). Were all of the underlying real financial instruments upon which swaps were built to default all at once, the real value of derivatives at risk would shrink down like water on cotton candy. Each derivative used to hedge another’s risk does not expand the basic underlying risk, it merely transfers it. To add it all together without netting is to create a ridiculous distortion of the value of what is really going on. If you and I were to pass a $10 bill back and forth in rapid succession we could create thousands of dollars of value in trade without creating any new economic activity; the only real exposure would be who had the ten spot at the moment and who did not, and would never be more than $10.

  5. The problem is folks like you failing to understand that mathematics is hard and unyielding and fails to respond to the post-modern whims of progressives.
    This system has no mathematical chance of success. I am the sole breadwinner for my family of five and don’t qualify for insurance through work. I procure my own insurance. It has a $4500 deductible and costs $4800/yr. It pays 100% of costs after $4500. If my kid gets hit by a bus then it will cover $295K of the $300K bill. For day to day medical care I pay out of pocket. I shop around, I’m efficient in my medical purchases. I get steep discounts from doctors for paying cash, because so much of their cost is in billing insurance.
    Under Obamacare, insurance for my familiy goes up 400% to $20K per year. It only covers 70% of costs. If my kid hit get hits by a bus it only pays $210K of the $300K bill. Regular medical care costs the same. There are no more steep discounts for cash, so I pay almost the same amount I was paying before in copays.
    From a cost standpoint, Obama insurace is utterly absurdly costly, and completely unaffordable. So what is a dad to do? Well, this dad will have no insurance for his family. I will pay for regular medical care with cash like I always have. I will pay the stupid $2000 tax penalty.
    If my kid gets hit by a bus I will sign up for Obamcare insurance that can’t exclude pre-existing conditions, and be unable to pay the $90,000 co-pay tanking my credit. Afterwards, I will cancel the insurance.
    All-in-all I will save $2800/yr but get a horrible reduction in medical cost coverage, but ultimately what makes sense for me financially will crash the system when it makes sense for others.
    It is a distortion to equate insurance with care. Having insurance does not get you care. Lacking insurance does not prevent your care. Insurance doubles the cost of most routine care. (If you don’t believe me ask for the cash discount.)

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