Is JPMorgan's Dimon Right—Are New Bank Capital Rules 'Anti-American'?

No, the rules are prudent and won't put the U.S. at a disadvantage

600 dimon globe REUTERS Lucas Jackson.jpg

These days, big banks have a lot to complain about. They've got hundreds of new rules to deal with, thanks to last year's Dodd-Frank regulation bill. They're also being sued by dozens of investors over mortgages. But today, JPMorgan CEO Jamie Dimon made news whining about the new Basel III capital rules that global regulators seek to impose on his and other big banks. He calls the rules "anti-American." Is he right?

The Complaint

Tom Braithwaite and Patrick Jenkins of the Financial Times break the news. Here's the money quote:

"I'm very close to thinking the United States shouldn't be in Basel any more. I would not have agreed to rules that are blatantly anti-American," he said. "Our regulators should go there and say: 'If it's not in the interests of the United States, we're not doing it'."

In particular, Dimon is concerned about two things.

First, the rules impose higher capital requirements on very large banks. The end in mind here is to reduce systemic risk in the global financial system. The idea is that additional capital cushion should be put in place at large institutions to reduce the likelihood that a market shock could create a financial crisis due to several of giant banks quickly burn through a too-thin capital cushion. Regulators broadly agree that if banks had additional capital in 2008, then the crisis would not have been as severe.

Second, the new Basel III rules provide covered bonds -- securities used to finance mortgages that are popular in Europe -- preferential treatment over U.S. mortgage-backed securities.

Limiting Profits Isn't the Same as Limiting Growth

Dimon may appear to be sort of trivially correct: if the biggest banks face higher capital requirements, then they will necessarily see their profits decline. The U.S. has several banks that will easily be among those facing the strictest capital requirements, which will be between 1% and 2.5% higher than those smaller banks face.

But here's the thing: limiting the profits of a couple of firms isn't the same as limiting the growth of a nation's entire industry. Currently, the sizes of these large banks provide significant advantages over smaller banks. First, big banks enjoy lower relative costs. For example, a new regulatory burden that costs each bank the same amount of money to absorb will reduce a big bank's revenue by a much smaller percentage. Second, many in the market still view very large institutions as too-big-to-fail and subject to government support in a pinch. That provides them with lower financing costs than smaller banks. In a way, these new capital requirements will help to level the playing field.

So if you believe that stronger competition leads to higher long-term growth (and I do), then forcing giant banks to face higher capital requirements would actually boost growth -- not restrain it. The fact that big banks' size provides them a competitive advantage over smaller banks in the U.S. might actually result in lower growth than a more competitive landscape could produce.

Big Banks Always Have a Choice

Dimon also needs to a reminder: big banks have it within their power to sidestep these relatively higher capital requirements. If they wish to instead adopt the lower capital requirements that smaller banks face, then they can take action that would allow them to do so. How? They can break themselves up.

These banks like being so big for a reason. As just explained, their size provides them with a competitive advantage. If Dimon or other big bank CEOs see the new relatively higher capital requirements they face costing more than the additional revenue that their competitive advantage provides, then the logical solution would be to split up their institutions.

This might not seem like a reasonable alternative, but it's precisely what the new capital requirements get at. They are being put in place because these banks are believed to pose a systemic risk. If they are broken up, then that risk would disappear -- and so would the motivation for their relatively higher capital requirements.

Covered Bonds versus Mortgage-Backed Securities

What about covered bonds? Is the U.S. being penalized because they simply finance mortgages differently than Europeans? Yes, but again the reason why makes sense: covered bonds actually happen to be safer than mortgage-backed securities.

With an MBS, if mortgages begin to default at a rate higher than anticipated, then investors will incur a loss. But if the mortgages in a covered bond pool begin to default, then one of two things can still prevent a loss. First, the bad mortgages are swapped out with good ones to maintain the lower loss rate envisioned. Second, even if swapping out mortgages isn't enough, the bank must stand behind the bonds and pay investors out of their other revenues.

So Dimon's complaint that covered bonds shouldn't be viewed as safer than MBS doesn't really make sense: they are safer than MBS, as the two types of securities have very different structures. Dimon is right, however, that the Basel's treatment of covered bonds versus MBS does put the U.S. at a disadvantage. But his criticism here shouldn't be directed at global regulators, but at the U.S. government. At this time, regulatory barriers are preventing the U.S. from forming a robust covered bond market. But some legislation is pending in the House that would make this possible.

The new Basel III capital requirements aren't anti-American: they're anti-instability. If they disadvantage the U.S. financial system relative to its global competitors, then this means that the U.S. financial system is more likely to experience instability in a time of market stress than the financial sectors of other nations. Since the financial marketplace is global, regulators are right to impose stricter rules on the banks in a nation if its industry could more easily trigger a global financial crisis.

Image Credit: REUTERS/Lucas Jackson