Restructuring Wall Street

By Emma Nelson

The by-product of nearly 1200 mergers, JPMorgan Chase & Co. is in the business of expansion.

In 2000, J.P. Morgan & Co. merged with the Chase Manhattan Corp and later with Bank One in 2004, thus creating an industry behemoth with tentacles spread across all sectors of investment and retail banking. In an era before the repeal of the Glass Steagall Act, a bank of this size and market exposure would be inconceivable. This trend of financial consolidation, however, culminated in the financial crisis of 2008 where giants such as Bear Stearns, Lehman Brothers, and AIG came tumbling down. Seven years later, the questions remain: in a future banking crisis, is J.P. Morgan too big to fail or too big to bail? Does size matter to the investors or the Federal Reserve?

According to a recent report from Goldman Sachs, J.P. Morgan could be worth up to 25% more if split up. The proposal would take the firm in its current state and create a “New Chase Bank” for its consumer banking transactions and maintain a separate investment banking function. New Chase would command $650 billion in assets, a fraction of the immense balance sheet of $2.6 trillion assets that J.P. Morgan currently controls. This hypothetical New Chase could conceivably be valued at $100 billion based on capital projections and the performance of industry rivals, such as Wells Fargo.

Despite recent debate over the size and stability of J.P. Morgan, CEO Jamie Dimon remains resolute that the current model is working. The fundamental theory that has spurred relentless consolidation in the financial industry is the notion that as firms grow, new lines of business and markets grow, creating opportunities to cross-sell products and serve clients for all their financial needs. “The synergies are huge, both expense and revenue synergies and some, not all, disappear on the various schematics of a break-up,” said Dimon. These “synergies,” however, are largely a product of separate transactions within the investment bank and commercial bank according to Goldman analyst Richard Ramsden and therefore do not require the union of these two business practices in order to experience success.

But the real question remains: whose problem will it be if the principle of “too big to fail” fails again? Certainly not Jamie Dimon’s, who in the case of a J.P. Morgan bankruptcy would most likely join the ranks of the Lehman Brothers top executive team that escaped their company’s complete meltdown rather unscathed. Dick Fuld, the former CEO of Lehman, who has been called the “most hated man in America”, would be the first to speak to the hardships, legal battles, and lost billion-dollar fortune he experienced following Congress’s public vilification from his $19 million compound in Sun Valley, Idaho. No, if J.P. Morgan were to fail, it would be the American taxpayers who would pay the price for the company’s failure. Through loss of jobs, a possible bail-out, and forfeiture of financial stability, the people that would truly be affected by another “too big to fail” failure, as the United States saw in 2008, currently have no say in the debate that may shape the American economy for years to come.

In 2008, J.P. Morgan stood as one of the healthiest institutions during the financial crisis. The company participated in the Troubled Asset Relief Program (TARP) at the request of the Secretary of the Treasury because it had agreed to acquire Bear Stearns and that company’s toxic mortgage-backed securities. In the wake of this meltdown, Congress passed numerous policies in the form of the Dodd-Frank Act in order to more strongly regulate the financial sector to compensate for the weak regulatory environment pre-2008. A main tenet of this program is the efforts of the Federal Reserve to increase the amount of capital held at big banks in order to offset risky transactions and liabilities. Under a newly proposed regulation, J.P. Morgan and other similar-sized banks will need to meet an 11.5% ratio between core equity capital to total risk-weighted assets. Thus, J.P. Morgan’s book-value will be negatively impacted by this new change because the increased level of capital requirements will diminish J.P. Morgan’s ability to earn greater return.

This issue does not solely apply to J.P. Morgan, but rather the entire financial industry. The new limitations on banks in a post-crash world “have substantially reduced the amount of risk they can take,” according to former Treasury secretary Timothy Geithner, who went on to add that the Dodd-Frank measures have “cut the profitability of banking roughly in half.” Recent actions within the industry have supported Geithner’s claim—shrinking bonuses, revenue growth stagnation, and risky trading, and billions of dollars in legal settlements have negatively impacted financial conglomerate’s profits. For instance, Morgan Stanley recently paid $2.6 billion as a settlement over their risky trades involving mortgages. And, this is just the beginning. Attorney General Eric Holder has imposed a new deadline on the Justice Department to come up with new civil or criminal prosecutions against Wall Street for risky sales of mortgage-backed securities in the years leading up to the financial crisis.

The profitability of many firms before the financial crisis were the result of risky trades that increased leverage while maximizing returns. In 2006, the value of 41% of assets increased from trading in the nation’s leading banks, but according to the International Monetary Fund in 2013 this number has shrunk to 21%. Therefore, regulators have fundamentally changed how Wall Street is run. Mike Mayo, a proponent for the J.P. Morgan break-up, argues, “You are hard-wiring a change into the banking industry. When we look back 10 years from now, we are going to say the biggest impact was from capital rules.”

The J.P. Morgan debate has emerged because of its underlying problem of defining what exactly is the purpose of a well-run bank. Are banks solely driven by profits? Jobs? Or should there be consideration for mitigating systematic risks to the public and investors? Following the 2008 financial crisis, it would seem that the latter objective has been emphasized through the work of regulators, however, if profitability still remains a driving force for banks, why is upper management and the Board of Directors clinging to this large model despite opportunities to unlock hidden potential in a smaller structure? Despite disappointing fourth quarter earnings, billion dollar settlements with foreign-exchange regulators, and systemic long-term issues dealing with the mortgages inherited from the Bear Stearns deal, Dimon remains convinced that banks like J.P. Morgan should continue to operate on a global scale. Where once there was specialty in the finance industry, J.P. Morgan has co-opted the Wal-Mart business strategy, where bigger is better and quality seems to be of little concern. And that’s where the real risk comes from in a bank of this size; this lack of supervision and coordination creates opportunities for risky deals and potential losses.

Change is coming to Wall Street. This change started the moment Bear Stearns declared bankruptcy in March of 2008 and will most likely culminate in the path that J.P. Morgan will take moving forward in 2015. Wall Street has stagnated since the crash. The desire to keep banks in check and hold them responsible for the risky practices that led to a taxpayer bailout of the nation’s richest institutions has driven regulators and even Wall Street titans like Sandy Weill, former CEO of Citigroup, to call for the end of the “too big to fail era”. The division of J.P. Morgan into smaller and simpler units would not only increase returns, but also unleash new jobs and reduce systemic risks to the economy. It’s unclear if J.P. Morgan, in its current ever-expanding mode, will ultimately be the victim of its own unsustainable growth. Unfortunately, like the shock wave that hit that the American economy in March 2008, we won’t know the true scope of the damage inflicted by a J.P. Morgan implosion until it actually occurs.