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

Under US accounting rules, JPMorgan is the fourth largest in the world with total assets of $2.3 trillion and capital equal to roughly 7% of total assets. The big banks point out that US rules allow them and their trading partners "to add up all contracts they have with each other and show what would be owed if all contract had to be settled suddenly."

James Pethokoukis
February 20, 2013, 8:57 am
AEIdeas

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.

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