Large Banks: Much Noise, Little Action

Even after recent pullbacks of 3% to 6%, the biggest U.S. bank stocks have largely performed with the market in 2013. Citigroup(C) has exceeded on the upside (+13% compared with 9.6% for the S&P 500), Wells Fargo(WFC) and JPMorgan Chase(JPM) have netted 7% to 8%, and Bank of America (BAC) after a monster 2012, has been allowed only halfsies at 5%.

Nevertheless, investors have been given a lot to digest in the banking sector in the past month. And fears of how recent events might affect U.S. bank regulators and lawmakers alike -- including the notion of reopening the big-bank/Too-Big-to-Fail (TBTF) policy debate - may have contributed to the Big Four's collective drop since March 15.

My partners and I are sanguine as we watch this dialectic, and we would argue that the biggest damage so far has been reputational (to JPMorgan in particular); that the biggest risk is that of incrementally hardened final regulatory rule makings on the Volcker rule and derivatives; and also that legislative risk -- notionally the most damaging of all -- is likely to be quite low.

Meanwhile, fresh conversations with money managers in New York and Boston have given us another reason to expect the Big Four to be held modestly in check. But they won't be forced to scale down or exit major lines of business because of the U.S. strategic imperative to remain competitive globally.

What's With the Big Banks?

Making the most news, of course, has been the following:

• The March 15 release of the Senate Permanent Investigations Subcommittee report and hearing on the JPM "London Whale" trading abuses;
• The "Too-Big-to-Jail" cacophony prompted by Attorney General Eric Holder's March 6 comments before Senate Judiciary Committee;
• Dallas Federal Reserve President Richard Fisher's invitation to speak before Republicans at their annual Conservative Political Action Committee conference, after he loudly made the case for breaking up the big banks in a D.C. speech back in January;
• This week's unsettling optics re squashed depositors and capital controls in Cyprus.

As Gretchen Morgenson chronicled in The New York Times, the Whale Report "showed that traders in the bank's (JPM) chief investment office hid money-losing derivatives positions, if only temporarily; that risk limits created by the bank to protect itself were exceeded routinely; that risk models were changed to minimize losses; that bank executives misled investors and the public; and that regulations are only as good as the regulators enforcing them."

During the hearing, Chairman Carl Levin (D., Mich.) was joined by Sen. John McCain (R., Ariz) in asking whether top management should be held to account -- prompting questions we encountered at virtually every stop in visiting with institutional clients this week: Might JPM Chairman and CEO Jamie Dimon, or the firm, itself, be indicted?

Holder had earlier caused a stir before the Senate Judiciary Committee by fretting that "the size of some of these institutions becomes so large that it does become difficult for us to prosecute them," given fears regarding "a potentially negative impact upon the national economy, perhaps even the world economy." Because "some of these institutions have become too large," he added, there has been "an inhibiting influence" upon regulators and law enforcers alike.

The comments gave newly-elected Sen. Elizabeth Warren (D., Mass.) and other anti-bank crusaders the opening to mint the "Too Big to Jail" slogan. The wave was made to seem an irresistible bipartisan force by the 99-0 Senate floor vote on the non-binding Vitter (R.,-La)-Brown (D., Ohio) amendment. That amendment expressed support for the notion of eliminating subsidies or funding advantages for Wall Street banks that have more than $500 billion in assets.

Sen. Sherrod Brown's (D.,Ohio) co-sponsorship of that bill was then perceived as more significant as a result of this week's news that he may have a strong shot at replacing current Senate Banking Chairman Tim Johnson (D., S.D.) when Johnson retires after 2014.

The matters mentioned above only re-stoked TBTF arguments laid out by Fisher on Jan. 16. Fisher said that "megabanks not only threaten taxpayers with bailouts," but, in backing out the flow of deposits to more willing-to-lend community banks, they are "also thwarting the Fed's efforts to jump-start the economy by keeping interest rates low."

 Fisher concluded: "I submit that these institutions, as a result of their privileged status, exact an unfair tax upon the American people. Moreover, they interfere with the transmission of monetary policy and inhibit the advancement of our nation's economic prosperity."

Almost two months to the day later, Fisher, a Democrat, was invited as a headline speaker at the CPAC conference, which the Washington Post noted as "primarily viewed as a stage for the Republican Party's biggest stars."

I doubt that Dimon would be charged, much less that JPMorgan itself might be sued, in no small part because of the high-profile chairman's Democratic connections. This prompts skeptical comparisons among our sources to former New Jersey Sen. and Gov. Jon Corzine's escape from prosecution, as well as long memories of the economic fallout from Arthur Anderson's targeting and resulting destruction a decade ago. There is serious conjecture that the Securities and Exchange Commission could claim that JPMorgan misled shareholders and thus violated securities laws. But how far up the chain the blame might go remains questionable.

Democrats might scream that these observations underscore their "TBTJ" arguments perfectly, and to some extent they do. But when it comes to taking the "too-bigs" down a peg, they run into a slight problem: They have pride of authorship in the Dodd-Frank Act, which purported to arm regulators with everything they needed to end TBTF. Many of them (including former Treasury Secretary Tim Geithner) have defended this notion, in the face of Hill Republicans' persistent efforts to force DFA amendments, some weakening the Act but most designed to label it as a failure.

When it comes to notionally dealing with TBTF again legislatively, Democrats will likely go slowly -- not only to defend their past hand but also to avoid giving Republicans a vehicle on which to try to add other politically charged amendments, relating to everything from Fannie-Freddie reform to CFPB restructuring.

It is a bit alarming to see Republicans trying to belie stereotypes that they're toadies of the banks, as evidenced by Vitter's success with his amendment to the Senate Budget Resolution and, even more so, Fisher's speech at CPAC.

There are sound reasons to suspect that the fever will pass, or at least not reach a critical stage. In a way, I see the conservatives taking a strategic move toward populism because they can -- or because the Democrats' defensive positioning and other factors make them unlikely to have to tip the scale decisively toward a result they'll later regret. Call it a "free" vote of non-support for the megabanks, on the way toward the GOP's continuing embrace of small bankers and broader efforts to recast the party's image for the 2014 and 2016 elections.

Beyond still-solid reasoning that diversification makes U.S. banks stronger, perhaps the most intriguing argument for the Big Four's persistence in their current mode and form came from a wise money manager with whom we communed. As he noted, the biggest Chinese banks are on a path toward earning as much as $50 billion in annual profits within a few short years -- more than twice where the U.S. Big Four are today. The thought of what that kind of relative pricing power might beget in global financial markets, perhaps affecting the entire world economy, makes "unilateral disarmament" on the part of the U.S. seem crazy.

For all of these reasons I'd probably stay sanguine on the banks, or ready to give them another look in the event of weakness, even though they face a "fluid" environment in which the SEC, bank regulators and Department of Justice all feel the need to prove anew that they're willing to be tough. As my colleague Joe Engelhard has chronicled, this could lead to incrementally tougher final regulations to implement the Volcker Rule, or the newly emerging derivatives regime. These regulations at their worst could impinge upon bank market-making and hedging while shrinking margins on potentially-reduced swaps trading volumes. Even with Dodd-Frank politics, another major scandal or big trading loss could engender a legislative reaction.

The Cyprus banking debacle may increase the relative strength of the dollar, and make U.S. securities and financial institutions seem even better investment havens for foreign interests. But there is still a prominent new speed bump for investors to measure. Specifically, regulators will need to clarify the limits of their new orderly liquidation authority, giving investors as well as account holders an upfront understanding of how much bail-in debt might be required.

Finally, the already agreed-upon SIFI buffers, once implemented in the EU and U.S., will not only send signals about the banks' cost of capital in the post Dodd-Frank environment but also make clearer that the largest banks no longer benefit from a lower cost of funding. This should allow the Fed and banking regulators to be more generous in future CCAR/stress-tests -- as an old mentor might say, "a good thing."