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JPMorgan Chase & Co. (JPM), Citigroup Inc (C): Good News for America, Bad News for Banks

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Wall Street bankers make millions of dollars a year, many (many) multiples of what the average Joe makes. And when they screw up — big time, I might add — taxpayers like Average Joe combine their relatively paltry earnings to bail them out.

This is ironic, of course, because when Average Joe screws up, he’s summarily fired by the very same people that he bailed out — thank you, private equity industry for showing us that it’s OK to profit off the misery of others. But I digress.

Do you like this narrative?

If not, then you’ll be happy to hear that nation’s primary banking regulators have decided to make it slightly less likely to happen again.

JPMorgan Chase & Co (NYSE:JPM)

Earlier this week, the Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency proposed to increase in the so-called leverage ratio of the nation’s largest banks. This ratio compares the amount of capital that banks like JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc (NYSE:C) must hold against their assets.

The newly minted international standard, known as Basel III, pegs the ratio at 3%. Meanwhile, our regulators, in all their recently renewed glory, believe that banks should be required to hold capital equivalent to 5% of their assets — and 6% if the bank is characterized as a systematically important financial institution, as are the two above, as well as Bank of America Corp (NYSE:BAC) and Wells Fargo & Co (NYSE:WFC) and others.

Despite all of the squealing that’s erupted on Wall Street claiming that the higher floor will “make the U.S. banks a little less competitive, a little less profitable,” there’s no question that this is a positive development for the country.

Sure, when times are good, it’s great to run a bank like you would a highly leveraged hedge fund — though to be fair to hedge funds, most are too savvy and risk averse to use the quantity of leverage that banks employ. This juices return on equity and, more importantly, executive compensation.

But when money gets tight, as it did in 2007 and 2008, the downside is equally dramatic, as high leverage leaves little capital to absorb losses from the comparatively massive asset portfolios. My colleague Morgan Housel discussed how this factored into the fall of Lehman Brothers.

The key to Lehman’s failure was, of course, leverage. At the end of 2007, leverage stood at more than 30-to-1, with $22 billion of equity supporting $691 billion in assets. The mechanics of such leverage is nauseating: A little more than a 3% decline in asset values, and it’s game over. Anyone with a handle on fifth-grade arithmetic gets this, and the pre-Lehman leveraged failures of Long-Term Capital Management and Bear Stearns reiterated its cruelty. Name one bank that’s flourished long-term on gross leverage, and you’ll find thousands that met a quick death. It just doesn’t work.

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