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July 24, 2023 | Premium Service | Last week we heard from our friend Alex Pollock, who had an interesting letter in the Financial Times about the growing insolvency of the Fed and other global central banks as interest rates rise. He writes:
"In the past nine months, the Federal Reserve has suffered previously unimaginable operating losses of $74bn from its deeply underwater interest rate risk position, a loss which far exceeds its total capital of $42bn. In misleading and arguably fraudulent accounting, the Fed refuses to reduce its reported capital by these losses; with proper bookkeeping, it would now be reporting capital of negative $32bn, growing more negative every month. It insists that no one should care about its negative capital, but carefully cooks the books to avoid reporting it."
Speaking of financial boondoggles, the Fed just launched its “FedNow” payments system at considerable cost to the taxpayer. Why does the central bank want to compete with the large banks that it regulates? George Selgin, Senior Fellow and Director Emeritus, Center for Monetary and Financial Alternatives, Cato Institute, noted in testimony before Congress in 2019 regarding FedNow:
“The Federal Reserve banks enjoy many legal advantages over private suppliers of payment services. They command a monopoly of bank reserves that serve as means of final payment; they are empowered to regulate commercial banks and some other private-sector payment service providers; and they are exempt from antitrust laws. Finally, although the 1980 Monetary Control Act requires that the Fed charge prices for its services that recover those services' capital and operating expenses, it only needs to do so over a ‘long run’ of unspecified length, and then only according to accounting methods of its own choosing that are not subject to external review. These and other Fed privileges mean that, when it enters into direct competition with private-sector payment service providers, it does so on a playing field that it can easily slant in its favor. It is owing to this that the Fed itself has established strict criteria it must meet before offering any new payment service, including the requirement that the service in question ‘be one that other providers alone cannot be expected to provide with reasonable effectiveness, scope, and equity.’"
Here's our question: When is Fed Chairman Jerome Powell going to announce the privatization of most of the equity value of FedNow to recover the cost? When the Fed incurs any expense, it spends public funds. Other than as a systemic backstop, there is no reason for FedNow to compete with the Clearing House member banks.
If the Fed were to sell down its Fed Now position to 24.9%, it could mitigate the obvious conflict of interest and create an arm’s length relationship in terms of governance and day-to-day management. The Fed can still exercise control over standards and operational risk.
In his note, Alex and some readers queried us about the appropriate level of double leverage for a bank holding company (BHC). Our answer: That depends. Double leverage occurs when a parent company raises debt capital and downstream that capital to a subsidiary bank, dealer or company as common equity or debt. But the parent company must receive enough income in dividends to support the cost of the debt, thus a more profitable bank can support a higher double leverage ratio (DLR) by the parent BHC.
“The Federal Reserve's typical guidance encourages maintaining a DLR below 120,” a reader notes. “The average BHC in Peer Group 1 falls well within this guidance. This Richmond Fed blog gives Fed guidance on double leverage… To my knowledge, aside from a few narrow exceptions, such as permitting small BHCs to operate with high leverage temporarily after acquisitions, the Fed only allows (and through TLAC debt issuance requirements actually requires) G-SIBs to operate with high holding company leverage. Currently, all G-SIBs maintain double leverage ratios near 200%, which equates to a 1:1 debt-to-equity ratio (and that’s even with counting their preferred stock as equity though it is really another form of debt).”
The table below shows the double leverage ratio of selected large banks from the FFIEC. We use total leverage, which in most but not all cases closely approximates the classical measure of Equity investments in Subs/ Equity Capital.
Source: FFIEC
Notice that JPMorgan (JPM) has a 180% DLR, virtually all of which represents equity investments by JPM in the subsidiary bank and broker dealer. Other BHCs use debt to provide capital to their subsidiaries, in part because the interest payments are tax deductible. These numbers do not move around a lot over time. Of interest, Goldman Sachs (GS) and Morgan Stanley (MS) each run over 300% DLR, in part because of the large broker-dealer subsidiaries.
Large banks have been growing the use of parent company leverage since the 1970s, when the LDC debt crisis and the energy bust in Texas contributed to a number of bank failures and related mergers. The growth of DLR in recent years reflects the diversification of many large banks into capital markets and asset management businesses. But the Fed has also made a conscious decision to allow large banks to use higher leverage in many different parts of the business, much like having an ocean racer running downwind with lots of spinnakers aloft. This makes the banks larger and, in theory, more liquid.
So long as wind conditions are favorable, having more leverage on a bank can contribute to profitability. But as we learned with Silicon Valley Bank, excessive leverage also magnifies mistakes, meaning that institutions which run their business with more leverage at the bank level feel the impact of credit losses in the form of diminished or suspended dividends. Over the years, there have been instances where an insolvent small BHC was restructured without the FDIC seizing the bank.
Fitch noted in December: "Rising interest rates have increased unrealized losses in banks’ available for sale (AFS) bond portfolios, causing declines in accumulated other comprehensive income (AOCI) and tangible common equity (TCE) ratios and increasing double leverage for bank holding companies."
So if a BHC has a 200% DLR, meaning 50% cash equity and 50% debt, combined the two sources of finance gives us the bank’s cost of capital. If the bank should become under capitalized, then common and preferred shareholders, and even bond holders, can face interruption of dividends and interest payments. Most public investors in banks own highly-levered shares in BHCs, not in the subsidiary bank. Below is a list of the significant subsidiaries of JPM.
JPMorganChase
From a risk management perspective, first we consider the leverage of the parent company and how those funds are deployed by the bank. What is the payback period, in years, for the debt financing incurred by the BHC? In the case of JPM, the payback on the parent company debt is more than six years, even with the relatively low interest rates of recent times. The comparable metric for small BHCs is one year. As interest rates rise, the effective cost of leverage on large banks grows.
Next we look at how the bank leverages its equity capital via loans and investments, which are funded with deposits at the bank and debt, including debt to the parent company. Most banks run at 15:1 leverage, meaning $1 in bank equity capital and $14 in deposits and other borrowed funds. Like a leveraged buyout, large banks employ leverage to boost equity returns. If the parent BHC has only 50% equity, how much leverage is in the bank operating at 15:1 leverage?
Finally we look at the bank’s use of derivatives to add further leverage to the overall business. The table below shows the gross derivatives positions of the largest banks as a percentage of assets. The point of the comparison with total assets is to understand the size of the derivatives book relative to the bank’s balance sheet. Notice that American Express (AXP), one of the best performing banks in the US, has a tiny derivatives book.
Source: FFIEC
Start with the 1:1 leverage at the parent BHC, add the 15:1 leverage on the subsidiary bank’s capital, then finally assess the exposures and operational risk from the bank’s derivatives activities. When you sum up all of the debt and derivative exposures on the capital of a BHC, the leverage on the balance sheet of JPM is basically infinite.
So when we ask why large banks are so big, the answer is that the Federal Reserve Board allows large BHCs to use more leverage than small banks. If the Fed constrained the use of double leverage by large banks to the same levels as smaller institutions, then JPM and other large banks would be far smaller. But in a country where the federal government is running trillion dollar annual deficits, then you need big banks to hold the debt. That's the Fed's dirty secret.
The Fed's decision to allow large banks to use more leverage has never been approved or even discussed by Congress. If you are a Member of Congress and want to make large banks smaller, then force BHCs to fund investments in bank subsidiaries with 100% equity. Somebody should ask Chairman Powell about this at the FOMC press conference this week. But does anybody in the media understand finance sufficiently to ask such a question?
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