We have a solid strategy and believe our future outlook is very good — but, as usual, there still are a lot of things to think and worry about
We already have spoken about the fact that most of our strategy will stay essentially the same and that while some areas may require a little surgery, we strongly believe we will be able to successfully navigate the new world. Some of that surgery will slow down our growth a little bit in certain areas, but we are quite optimistic that we can grow in others.
Most of our growth will be organic — we have been doing this successfully for a decade — and opportunities abound
We are optimistic that all of our businesses can grow, and, below, I describe some initiatives that are particularly exciting.
Chase Private Client started as a gleam in our eye back in 2010. Chase Private Client branches are dedicated to serving our affluent clients’ investment needs. From one test branch (which didn’t go very well, but, fortunately, we kept on trying), we now have more than 2,500 Chase Private Client offices. They now manage investments and deposits of $190 billion. While the branch buildout is essentially complete, we think the potential for growth remains large.
Small business. We are making our premier products and services work better together for a more holistic experience for our small business customers, whose time and attention should be spent on running their business, not going to the bank. We see a huge opportunity in this fragmented market — there is no dominant bank for the 28 million small businesses in the United States. At JPMorgan Chase, we serve 3.9 million American small businesses across Business Banking, Card Services and Chase Commerce Solutions, and we have successfully grown all of these businesses. We want to become the easiest bank to do business with, and we are working hard to speed applications, simplify forms and add digital conveniences. For example, we want a small business to fill out an application that can qualify it for Ink® (our small business credit card), Paymentech, deposits and loans all at once. We believe that if we bundle the services that small businesses really want and also provide meaningful advice, we can dramatically grow this business. Looking ahead, we know small businesses become large companies at a much more rapid pace than in years past. Serving these companies well now can solidify long–term client relationships that could span several lines of business in the future.
Excellent prospects for our Corporate & Investment Bank. Our Corporate & Investment Bank is an example of a business that has had exceptional relative multi–year performance. And even recently when it has been under a lot of regulatory pressure due to higher capital constraints and other regulatory demands, the business has been able to earn a 13% return on equity footnote 1. It is an endgame winner, and it benefits substantially from the rest of the company, which helps drive its best–in–class results.
However, in our current environment, we don’t expect a lot of growth or robust returns as we adjust to the new world. But we continue to believe that the long run is quite attractive. At Investor Day, we showed that the Corporate & Investment Bank in 2006 was #1, #2 or #3 in eight of the 16 product categories that we are in. Now we are #1, #2 or #3 in 15 of the 16 product categories that we are in. But the exciting part is a program that Daniel Pinto calls Path to #1, which shows when you divide those 16 businesses into sub–businesses and geographies, there are lots of areas where we are not close to #1, #2 or #3, and, in most of those places, we should be able to improve. So as the business goes through an inordinate amount of change, the underlying needs of our clients continue to grow, and we will grow with them and believe we can gain share, too.
We are going to do a better job of covering family and private offices in both the Private Bank and the Investment Bank. Family offices have become larger, more sophisticated and more global, and they actively buy minority or whole stakes in businesses. More than 2,300 families across the globe had assets of $1 billion or more in 2014. Together, they control over $7 trillion in assets, a number that has grown in excess of 10% since 2011. While J.P. Morgan already works with many of these families as clients, we believe we can do a far better job of providing the full range of products and services offered by our Private Bank and Investment Bank.
Private banking will grow for years. In Mary Erdoes’ Investor Day presentation, she showed that while we have the best private bank in the United States, our business still is rather small, and there is plenty of room to grow. This is even truer in Asia Pacific and Latin America. The chart below shows how strong our business is and illustrates that there is plenty of room to grow our market share internationally.
Retail banking presence still has room to grow. While we cannot acquire a retail bank in the United States, we can — and intend to — enter cities where we have never been. We will keep those cities we might choose to enter a surprise — but we hope to begin doing this in 2016. And remember, when we enter a city, we can bring the full force of JPMorgan Chase to bear, from retail, small business and private banking to middle market and local coverage of large corporations.
We particularly are excited about our payments business in total. The combination of Chase Paymentech, our merchant acquirer, ChaseNet, our proprietary Visa–supported network, and ChasePay, our proprietary wallet, allows us to offer merchants — large and small — better deals in terms of economics, simpler contracts, better data and more effective marketing to their clients. It also allows us to better serve consumer clients with a wide variety of offers and ease of use. We are going to be very aggressive in growing this business, and we will be disappointed if we don’t announce some exciting and potentially market–changing ventures.
Big, fast data. We continue to leverage the data generated across JPMorgan Chase, as well as data that we purchase to create intelligent solutions that support our internal activities and allow us to provide value and insights to our clients. For example, we are monitoring our credit card and treasury services transactions to catch fraudulent activities before they impact our clients, we are helping our clients mitigate costs by optimizing the collateral they post in support of derivatives contracts, and we are highlighting insights to our merchant acquiring and co–brand partners.
There always will be new emerging competitors that we need to keep an eye on
New competitors always will be emerging — and that is even truer today because of new technologies and large changes in regulations. The combination of these factors will have a lot of people looking to compete with banks because they have fewer capital and regulatory constraints and fewer legacy systems. We also have a healthy fear of the potential effects of an uneven playing field, which may be developing. Below are some areas that we are keeping an eye on.
Large banks outside the United States are coming. In terms of profitability, the top two Chinese banks are almost twice our size. Thirty years ago, Industrial and Commercial Bank of China operated in only a handful of countries, but it now has branches or subsidiaries in more than 50 countries. It has a huge home market and a strategic reason to follow the large, rapidly growing global Chinese multinationals overseas. It may take 10 years, but we’d be foolish to discount their ambition and resources. We’re also seeing world–class banks emerge and grow in places like India and Brazil, and Japanese and Canadian banks are coming on strong, too. Many of these banks are supported in their expansionary efforts by their government and will not need to live by some of the same rules that we in the United States must adhere to, including capital requirements. We welcome the competition, but we are worried that an uneven playing field may hamper us many years from now.
Silicon Valley is coming. There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking. The ones you read about most are in the lending business, whereby the firms can lend to individuals and small businesses very quickly and — these entities believe — effectively by using Big Data to enhance credit underwriting. They are very good at reducing the “pain points” in that they can make loans in minutes, which might take banks weeks. We are going to work hard to make our services as seamless and competitive as theirs. And we also are completely comfortable with partnering where it makes sense.
Competitors are coming in the payments area. You all have read about Bitcoin, merchants building their own networks, PayPal and PayPal look–alikes. Payments are a critical business for us — and we are quite good at it. But there is much for us to learn in terms of real–time systems, better encryption techniques, and reduction of costs and “pain points” for customers.
Some payments systems, particularly the ACH system controlled by NACHA, cannot function in real time and, worse, are continuously misused by free riders on the system. There is a true cost to allowing people to move money. For example, it costs retailers 50–70 basis points to use cash (due to preventing fraud and providing security, etc.). And retailers often will pay 1% to an intermediary to guarantee that a check is good. A guaranteed check essentially is the same as a debit card transaction for which they want to pay 0%. For some competitors, free riding is the only thing that makes their competition possible. Having said that, we need to acknowledge our own flaws. We need to build a real–time system that properly charges participants for usage, allows for good customer service, and minimizes fraud and bad behavior.
Rest assured, we analyze all of our competitors in excruciating detail — so we can learn what they are doing and develop our own strategies accordingly.
Cybersecurity, fraud and privacy need intensive investment on the part of your entire company, and we must do it in collaboration with the government and regulators
Matt Zames describes on page 40 some of the efforts we are making on cyber. What I want to emphasize to our shareholders is the absolute, critical and immediate need to combat cybersecurity threats and the related issues of fighting fraud and protecting privacy. In these areas, we will do whatever it takes to protect the company and its clients. Regarding privacy, I do not believe that most people fully understand what no longer is private and how their information is being bought, sold and used. As a bank, we are appropriately restricted in how we can use our data, but we have found many examples of our data being misused by a third party. We are going to be very aggressive in limiting and controlling how third parties can use JPMorgan Chase data.
It is critical that government and business and regulators collaborate effectively and in real time. Cybersecurity is an area where government and business have been working well together, but there is much more to be done. And if it is not done in a concerted way, we all will pay a terrible price.
The banking system is far safer than it has been in the past, but we need to be mindful of the consequences of the myriad new regulations and current monetary policy on the money markets and liquidity in the marketplace — particularly if we enter a highly stressed environment
There are many new rules, and, in conjunction with current monetary policy, they already are having a large effect on money markets and liquidity in the marketplace. One famous scientist once said, “A Rule of Three (ART): A statistical specification with more than three explanatory variables is meaningless.” Simply put, it is impossible to figure out the cumulative effect of all these changes even in a benign environment. But what is far more important is what the effect of these changes might be if we enter a stressed environment. As a risk policy matter, we need to make the assumption that there will be unpredictable and unintended consequences — sometimes these are to good effect, but what we need to worry about are those that have a potentially bad effect.
In the rest of this section, we will look at how the table is set — what is going on that is the same or different than in the past. Later in this section, we will speculate on what might happen differently if we enter a new crisis.
Most important, we will enter the next crisis with a banking system that is stronger than it has ever been
Each individual bank is safer than before, and the banking sector overall is stronger and sounder because, among other things:
- Capital levels are far higher today than before the crisis and, by some measures, higher than they have ever been. For example, a very basic measure of capital, going back around 100 years, was a simple ratio of equity to assets. In the last six years, it’s back to high numbers not seen since the late 1930s.
- Highly liquid assets held by banks probably are much higher than ever before.
- Many exotic and complex products are gone.
- Many standardized derivatives are moving to clearinghouses.
- Both consumer and commercial loans are underwritten to better standards than before the crisis.
- Transparency to investors is far higher.
- Boards and regulators are far more engaged.
But many things will be different — for example, there will be far more risk residing in the central clearinghouses, and non–bank competitors will have become bigger lenders in the marketplace
Clearinghouses will be the repository of far more risk than they were in the last crisis because more derivatives will be cleared in central clearinghouses. It is important to remember that clearinghouses consolidate — but don’t necessarily eliminate — risk. That risk, however, is mitigated by proper margining and collateral. We have long maintained that it is important to stress test central clearinghouses in a similar way that banks are stress tested to make sure the central clearinghouses’ capital and resources are sufficient for a highly stressed environment. Clearinghouses are a good thing but not if they are a point of failure in the next crisis.
Non–bank competitors are increasingly beginning to do basic lending in consumer, small business and middle market. In middle market syndicated lending, their share recently has increased from 3% a few years ago to 5% today, and many people estimate that it will continue to increase over the years to come. There is nothing wrong with having competitors, including non–bank competitors. However, they will act differently from banks in the next stressed environment. I will write about this later in this section when we go through a thought exercise of the next crisis.
There already is far less liquidity in the general marketplace: why this is important to issuers and investors
Liquidity in the marketplace is of value to both issuers of securities and investors in securities. For issuers, it reduces their cost of issuance, and for investors, it reduces their cost when they buy or sell. Liquidity can be even more important in a stressed time because investors need to sell quickly, and without liquidity, prices can gap, fear can grow and illiquidity can quickly spread — even in supposedly the most liquid markets.
Some investors take comfort in the fact that spreads (i.e., the price between bid and ask) have remained rather low and healthy. But market depth is far lower than it was, and we believe that is a precursor of liquidity. For example, the market depth of 10–year Treasuries (defined as the average size of the best three bids and offers) today is $125 million, down from $500 million at its peak in 2007. The likely explanation for the lower depth in almost all bond markets is that inventories of market–makers’ positions are dramatically lower than in the past. For instance, the total inventory of Treasuries readily available to market–makers today is $1.7 trillion, down from $2.7 trillion at its peak in 2007. Meanwhile, the Treasury market is $12.5 trillion; it was $4.4 trillion in 2007. The trend in dealer positions of corporate bonds is similar. Dealer positions in corporate securities are down by about 75% from their 2007 peak, while the amount of corporate bonds outstanding has grown by 50% since then.
Inventories are lower — not because of one new rule but because of the multiple new rules that affect market–making, including far higher capital and liquidity requirements and the pending implementation of the Volcker Rule. There are other potential rules, which also may be adding to this phenomenon. For example, post–trade transparency makes it harder to do sizable trades since the whole world will know one’s position, in short order.
Recent activity in the Treasury markets and the currency markets is a warning shot across the bow
Treasury markets were quite turbulent in the spring and summer of 2013, when the Fed hinted that it soon would slow its asset purchases. Then on one day, October 15, 2014, Treasury securities moved 40 basis points, statistically 7 to 8 standard deviations — an unprecedented move — an event that is supposed to happen only once in every 3 billion years or so (the Treasury market has only been around for 200 years or so — of course, this should make you question statistics to begin with). Some currencies recently have had similar large moves. Importantly, Treasuries and major country currencies are considered the most standardized and liquid financial instruments in the world.
The good news is that almost no one was significantly hurt by this, which does show good resilience in the system. But this happened in what we still would consider a fairly benign environment. If it were to happen in a stressed environment, it could have far worse consequences.
Some things never change — there will be another crisis, and its impact will be felt by the financial markets
The trigger to the next crisis will not be the same as the trigger to the last one — but there will be another crisis. Triggering events could be geopolitical (the 1973 Middle East crisis), a recession where the Fed rapidly increases interest rates (the 1980–1982 recession), a commodities price collapse (oil in the late 1980s), the commercial real estate crisis (in the early 1990s), the Asian crisis (in 1997), so–called “bubbles” (the 2000 Internet bubble and the 2008 mortgage/housing bubble), etc. While the past crises had different roots (you could spend a lot of time arguing the degree to which geopolitical, economic or purely financial factors caused each crisis), they generally had a strong effect across the financial markets.
While crises look different, the anatomy of how they play out does have common threads. When a crisis starts, investors try to protect themselves. First, they sell the assets they believe are at the root of the problem. Second, they generally look to put more of their money in safe havens, commonly selling riskier assets like credit and equities and buying safer assets by putting deposits in strong banks, buying Treasuries or purchasing very safe money market funds. Often at one point in a crisis, investors can sell only less risky assets if they need to raise cash because, virtually, there may be no market for the riskier ones. These investors include individuals, corporations, mutual funds, pension plans, hedge funds — pretty much everyone — each individually doing the right thing for themselves but, collectively, creating the market disruption that we’ve witnessed before. This is the “run–on–the–market” phenomenon that you saw in the last crisis.
And now, a thought exercise of what might be different in the next crisis
It sometimes is productive to conduct a thought exercise — in effect trying to re–enact a “run on the market” but, in this case, applying the new rules to see what effect they might have. Even though we must necessarily be prepared for a crisis at all times, we hope a real crisis is many years down the road. And in the United States, we would be entering the crisis with a banking system that is far stronger than in the past, which, on its own, could reduce the probability and severity of the next crisis. We are not going to guess at the potential cause of the crisis, but we will assume that, as usual, we will have the normal “run–on–the–market” type of behavior by investors. So let’s now turn to look at how a crisis might affect the markets in the new world.
The money markets (deposits, repos, short–term Treasuries) will behave differently in the next crisis
- Banks are required to hold liquid assets against 100% of potential cash outflows in a crisis. Liquid assets essentially are cash held at central banks, Treasuries and agency mortgage–backed securities. Outflows are an estimate of how much cash would leave the bank in the first 30 days of a crisis. This would include things like deposit outflows, depending on the type of deposit, and revolver takedowns, depending primarily on the type of borrower. In my opinion, banks and their board of directors will be very reluctant to allow a liquidity coverage ratio below 100% — even if the regulators say it is okay. And, in particular, no bank will want to be the first institution to report a liquidity coverage ratio below 100% for fear of looking weak.
- In a crisis, weak banks lose deposits, while strong banks usually gain them. In 2008, JPMorgan Chase’s deposits went up more than $100 billion. It is unlikely that we would want to accept new deposits the next time around because they would be considered non–operating deposits (short term in nature) and would require valuable capital under both the supplementary leverage ratio and G–SIB.
- In a crisis, everyone rushes into Treasuries to protect themselves. In the last crisis, many investors sold risky assets and added more than $2 trillion to their ownership of Treasuries (by buying Treasuries or government money market funds). This will be even more true in the next crisis. But it seems to us that there is a greatly reduced supply of Treasuries to go around — in effect, there may be a shortage of all forms of good collateral. Currently, $13 trillion of Treasuries are outstanding, but, according to our estimates, less than half of this amount is effectively free to be sold. Approximately $6 trillion is accounted for by foreign exchange reserve holdings for foreign countries that have a strong desire to hold Treasuries in order to manage their currencies. The Federal Reserve owns $2.5 trillion in Treasuries, which it has said it will not sell for now; and banks hold $0.5 trillion, which, for the most part, they are required to hold due to liquidity requirements. Many people point out that the banks now hold $2.7 trillion in “excess” reserves at the Federal Reserve (JPMorgan Chase alone has more than $450 billion at the Fed). But in the new world, these reserves are not “excess” sources of liquidity at all, as they are required to maintain a bank’s liquidity coverage ratio. In a crisis, if banks turn away deposits, most investors will have other options, which include:
- 1. Buying Treasuries directly.
- 2. Buying money market funds, which own Treasuries.
- 3. Buying repos, which are collateralized by Treasuries.
- 4. Investing directly at the Fed for a limited set of investors (government–sponsored enterprises, money funds).
- 5. Purchasing credit instruments like commercial paper.
Buyers of credit (loans, secured loans, underwriting and investments) will be more reluctant to extend credit
- In the crisis, many banks lent against various forms of good collateral (but not necessarily the highest quality collateral) to help clients create liquidity and navigate through the crisis. The collateral often came with significant haircuts and was of the type that banks thought they easily could risk–manage, and, for the most part, they did. In the last crisis, JPMorgan Chase did tens of billions of this type of lending. In the next crisis, banks will have a hard time increasing this type of credit because it will require capital and more liquidity.
- In a crisis, clients also draw down revolvers (for JPMorgan Chase alone, this peaked at approximately $20 billion at one point in 2009) — sometimes because they want to be conservative and have cash on hand and sometimes because they need the money. As clients draw down revolvers, risk–weighted assets go up, as will the capital needed to support the revolver. In addition, under the advanced Basel rules, we calculate that capital requirements can go up more than 15% because, in a crisis, assets are calculated to be even riskier. This certainly is very procyclical and would force banks to hoard capital.
- In addition, banks may have a decrease in capital because new regulatory capital rules require losses on investment securities to reduce regulatory capital. This would be particularly true if interest rates were rising in the next crisis, which cannot be ruled out. (Typically, Treasury yields drop dramatically in a crisis, and that possibly could happen in this case, too, especially as they would be in short supply. But, again, one cannot rely on this.)
- In the last crisis, some healthy banks used their investment portfolios to buy and hold securities or loans. In the next crisis, banks will not be able to do that because buying most types of securities or loans would increase their RWA and reduce their liquidity.
- In the last crisis, banks underwrote (for other banks) $110 billion of stock issuance through rights offerings. Banks might be reluctant to do this again because it utilizes precious capital and requires more liquidity.
- It is my belief that in a crisis environment, non–bank lenders will not continue rolling over loans or extending new credit except at exorbitant prices that take advantage of the crisis situation.
On the other hand, banks continued to lend at fair prices in the last crisis because of the long–term and total relationship involved. Banks knew they had to lend freely because effectively they are the “lender of last resort” to their clients as the Federal Reserve is to the banks. This is a critical point: JPMorgan Chase and most other banks understood their vital role in actively lending to clients. In 2008 and 2009, JPMorgan Chase rolled over more than $260 billion of loans and credit facilities to small businesses, middle market companies and large companies, in addition to $18 billion for states and municipalities, hospitals and nonprofits. We rolled over these capital and lending commitments to support our clients and always maintained fair (and not rapacious) pricing, reflecting our long–term relationship with them.
The markets in general could be more volatile — this could lead to a more rapid reduction of valuations
The items mentioned above (low inventory, reluctance to extend credit, etc.) make it more likely that a crisis will cause more volatile market movements with a rapid decline in valuations even in what are very liquid markets. It will be harder for banks either as lenders or market–makers to “stand against the tide.”
But the American financial markets and, more important, the American economy generally have been extraordinarily resilient
Banks may be less able to act positively in the next crisis, but they also are far stronger and unlikely, in our opinion, to create the next crisis. Many other actors in the financial system, from hedge funds to long–term investors, including corporations and large money managers, will, at some point, step in and buy assets. The government, of course, always is able to step in and play an important role.
In addition, regulators can improve the liquidity rules to allow banks to provide liquidity on a more “graduated” basis against more types of assets and give more flexibility on the “margin” than is required. That is, they can give themselves both gas and brakes; i.e., change liquidity rules to fit the environment. In addition, we should try to eliminate procyclical rules, which can exacerbate a crisis.
Fundamentally, as long as the economy is not collapsing, financial markets generally recover. Whatever the turn of events, JPMorgan Chase will have the capability to play its role in supporting clients and communities in the countries in which we operate.
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