JPMorgan Chase’s new regulatory capital requirement is bad news for the company

America’s largest bank JPMorgan Chase (JPM -0.67%), continues to be the shortest of the regulatory stick when it comes to capital requirements. Following the Federal Reserve’s stress tests last week, JPMorgan recently said its new required Common Equity Tier 1 (CET1) ratio threshold had risen from 10.5% to 11.3%.

This means the bank will need to hold billions of additional dollars in regulatory capital to cover unexpected loan losses. While the move may be prudent given the times ahead, it does not bode well for JPMorgan shares as regulatory capital cannot generate any type of return for the bank. Additionally, this new requirement could make maintaining the dividend harder for JPMorgan down the line.

Image source: Getty.

How did it happen?

The Federal Reserve released the results of its annual stress tests last week. During this exercise, the Fed ran the 33 largest banks with more than $100 billion in assets through a series of what-if scenarios. Essentially, the Fed projects how a bank’s balance sheet might behave if GDP were to contract by, say, 13% over a given period, and unemployment were to rise to maybe 10%. The aim is to ensure that banks have enough capital to continue lending if their profits decline and loan losses increase significantly.

These tests are not only important for the global economy, but they also determine the amount of capital a bank should hold. The tests showed that JPMorgan could maintain healthy capital and continue to pay its normal dividend under the worst-case scenarios the Fed imposed on banks. But the results also forced JPMorgan to maintain a higher CET1 capital ratio.

An indicator closely monitored by regulators, the CET1 ratio measures the level of capital base that a bank must maintain as a percentage of its risk-weighted assets. The idea is that even after a bank books many unexpected loan losses, it should still be able to extend credit to individuals and businesses in the event of a downturn. CET1 capital includes retained earnings, excess common equity and accumulated other comprehensive income.

Here is how the CET1 ratio is established:

A diagram of the CET1 ratio

Image source: Federal Reserve.

  • Each bank has a minimum requirement (the bottom layer) of 4.5%.
  • The middle layer, the stress capital buffer, is new this year. It includes four quarters of ordinary dividends and a buffer to cushion potential loan losses that could arise from Fed stress test scenarios. That’s why stress tests are so important, because based on what the Fed projects into their models, they have the power to cause the banks to increase that middle layer, thereby increasing the whole requirement for CET1 ratio. JPMorgan saw that piece of the equation go from 2.5% to 3.3%, resulting in an overall increase.
  • The top layer, the Global Systemically Important Bank (GSIB) Surcharge, is for the nation’s largest banks, such as Bank of America (BAC -1.13%), Citigroup (VS -0.68%)and Wells Fargo (WFC -0.45%), as well as a few others. These banks are required to hold more capital than the others because if one of them fails, it could bring down the whole financial system. The GSIB surcharge varies from bank to bank, but JPMorgan said in its latest annual report that its GSIB surcharge will be 3.5% in 2020.

This gives JPMorgan a total CET1 ratio of 11.3% when the new capital requirements take effect on October 1.

Why it’s bad for JPMorgan

One reason this is bad is that Citigroup’s required CET1 ratio remained the same at 10%, while Bank of America’s remained at 9.5%.

JPMorgan will need to add billions of dollars to its regulatory capital buffer, however. For example, at the end of the first quarter, the bank had $1.6 trillion in risk-weighted assets (this amount will likely change after the second quarter results are released). With a required CET1 ratio of 10.5%, JPMorgan would need to hold $168 billion in CET1 capital to operate without crossing regulatory thresholds. But at 11.3%, JPMorgan must hold about $181 billion. That’s a difference of $13 billion, more than many community banks and some regional banks. Now, instead of deploying that $13 billion into assets like loans or securities that generate returns, the money will sit still. Of course, banks may not be too worried about making loans right now, but this requirement will last until September 30, 2021.

It could also make it more difficult for JPMorgan to keep its dividend down the road, because if a bank’s regulatory capital falls below the required threshold, it is limited to capital distributions equal to 60% of eligible retained earnings. . JPMorgan at the end of the first quarter had a CET1 ratio of 11.5%, slightly above the 11.3% requirement. I think there is a good chance that the ratio will increase, because in the first quarter, banks saw an unprecedented number of drawings on existing credit lines. But depending on the duration of the coronavirus pandemic, the bank could once again flirt with the 11.3% level. The bank might be able to continue paying its normal dividend at 60% eligible retained earnings, but at this point a cut in the dividend becomes a very serious consideration, and future share buybacks would be extremely limited, if they had to happen.

Look forward

While JPMorgan’s new CET1 ratio requirement appears to be 11.3%, the bank said in its announcement that the Fed would provide the bank with its final stress capital buffer, and therefore its final CET1 ratio, the August 31. The big banks will also have to resubmit their capital plans and undergo further stress tests later this year. I think JPMorgan’s actual CET1 ratio should go up after the second quarter, but given that the coronavirus doesn’t seem to go away until there’s a vaccine, the 11.3% ratio makes a dividend a lot more likely.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

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