JPMorgan Only Bank to Pay Heavy Price from Fed's Surcharge Plan

WASHINGTON — The Federal Reserve Board issued a proposal Tuesday that detailed for the first time exactly how it plans to institute capital surcharges on the country's biggest banks, while saying it plans to keep exact figures under wraps because of fears it could reveal proprietary information.

That desire for secrecy didn't even survive the Fed's meeting to vote on the plan, however, as a top central bank official inadvertently revealed that only one bank would face a capital shortfall if the plan were in effect. JPMorgan Chase would have to raise and additional roughly $22 billion over the next three years, according to Fed Vice Chairman Stanley Fischer.

It's "quite a powerful impact," Fischer said during a question and answer session on the proposal. "It is a big bank and $22 billion short; that seems a pretty impressive shortfall… So there was something in the capital structure of JPMorgan which is a firm that is going to have to come up with more capital which made it different than the others."

Fed staff did not confirm or deny Fischer's comments, but earlier had indicated that most of the eight banks that have to comply with the plan already have enough capital to meet its requirements. Fed staff said there was a roughly $21 billion shortfall across all institutions.

A spokesman for JPMorgan said the bank is "still reviewing the Fed's proposal," adding that "we are well capitalized and intend to meet their requirements and timeframes while continuing to deliver strong returns for our shareholders."

To be sure, JPMorgan will have plenty of time to raise the required capital. The proposal is subject to a three year phase-in beginning in January 2016.

The proposal would currently apply to eight banks, including Citigroup, JPMorgan Chase, Bank of America and Wells Fargo, but could eventually include more institutions if they increase their risk and complexity.

Though the reasons for JPMorgan's outlier status were not specifically addressed, it appears to be because the bank relies more heavily on short-term wholesale funding, an area the central bank specifically targeted in the plan. Fed staff indicated at the meeting that its estimates on a capital shortfall were complicated by the difficulty of collecting information on short-term wholesale funding.

It is not a surprise, however, that JPMorgan would likely pay a higher capital surcharge than other U.S. banks. The plan effectively lays out two tracks for U.S. banks deemed "globally significant financial institutions" to assess their capital surcharges, with banks bound by the more stringent of the two.

The first method is identical to that detailed by the Basel Committee on Banking Supervision in 2011, which requires all G-SIBs to hold extra capital of between 1% and 2.5% of total assets, depending on the riskiness of those assets and interconnectedness of the bank's dealings. Global regulators have specified that, among U.S. banks, only JPMorgan would pay 2.5%.

But the final figure for domestic implementation is likely to be higher. The second method the Fed proposes would use many of the same inputs as the Basel rule, but would require banks to hold additional capital based on their reliance on short-term wholesale funding. Because banks' wholesale funding profiles are not public information, Fed officials said the surcharge assessed against individual banks would not be publicly available.

Yet the central bank said in the proposal that the second method would "result in significantly higher surcharges than the [Basel] framework." Fed staff said banks, on average, would have to keep 1.8% more capital on hand as a result of the rule.

Fed Chair Janet Yellen said the proposal would "provide incentives to these banking organizations to hold substantially increased levels of high-quality capital" which in turn would "encourage such firms to reduce their systemic footprint and lessen the threat that their failure could pose to overall financial stability."

During the meeting, Yellen indicated that the Fed might go even further in targeting short-term wholesale funding, asking whether the plan goes far enough to dissuade banks from relying on such funding. Yellen called on staff to work to ensure that the plan, in combination with other long-term liquidity rules, will provide a meaningful set of standards that can prevent broad systemic failures.

"In terms of forcing firms to internalize the externalities … associated with their decision to rely on short-term wholesale financing, I don't think this proposal completely addresses these risks," Yellen said. "I hope staff will continue to consider a minimum set of margin requirements that would address this issue and would do so broadly throughout the financial sector."

Fed Gov. Daniel Tarullo likewise said the plan is meant to target and reduce reliance on short-term wholesale funding because it is one of the most consistent determinants of global systemic risk. The Basel proposal, Tarullo said, did not appropriately weight those risks.

"Inclusion of a short-term wholesale funding factor reflects the fact that reliance on short-term wholesale funding can leave a firm vulnerable to creditor runs that force the firm to rapidly liquidate its own positions or call in short-term loans to clients," Tarullo said. "Thus, reliance on short-term wholesale funding is among the more important determinants of the potential impact of the distress or failure of a systemically important financial firm on the broader financial system."

Under the proposal, all systemically important financial institutions — that is, banks with more than $50 billion in assets — would have to undergo an annual systemic indicator test to determine whether it is a G-SIB and subject to the surcharge. The test is based on five broad categories: size, interconnectedness, cross-jurisdictional activity, substitutability and complexity. Within those categories there are 12 additional systemic indicators that identify and weight a bank's risk profile. Banks who score more than 130 basis points in the annual test are considered G-SIBs under the proposal.

The proposal is open for comment until Feb. 28.

The rule comes as the Financial Stability Board last month released its 2014 list of globally significant banks. The Fed had been hinting for months that its surcharge would go even farther than the FSB, and that it would heavily weight a firm's reliance on short-term wholesale funding.

Banking industry stakeholders lashed out at the proposal. Ernie Patrikis, partner at White & Case and former head of the New York Federal Reserve, said the plan would hurt banks' ability to compete by keeping the capital restrictions and compliance burdens high while making shadow banks or foreign banks more competitive. While the eight banks subject to the proposal may be compliant now, Patrikis said, the rules ensure that in the future, financial activity will steadily move away from the banking sector.

"What does the Fed expect the banking system to look like in five years?" Patrikis said. "What we have had over the years is others in the nonbanking sector picking apart the business of banking. This will allow that to continue."

Jaret Seiberg, an analyst at Guggenheim Securities, said one of the most troubling aspects of the proposed rule is a note in the staff memo accompanying the rule suggesting that in the future, the capital surcharge will be applied as part of the Comprehensive Capital Analysis and Review "stress test," meaning that the Fed could require the capital surcharge to be even higher.

"We believe such an inclusion could only be a negative for the big banks and would likely result in an even more prolonged period of modest capital distributions," Seiberg said.