I couldn’t have timed yesterday’s post about JPMorgan Chase any better. Right as I published that post, The Wall Street Journal reported on a proxy statement the bank filed. The proxy was in response to a shareholder proposal for the bank to explore breaking itself up.
As Emily Glazer of The Wall Street Journal said,
J.P. Morgan Chase & Co. says it is huge, but only in the best way, and just sprawling enough to serve its clients without being unmanageable.
Any bank sees several advantages as it gets bigger:
- It enjoys economies of scale, which reduces its per unit costs
- It has more diverse revenue streams, which mitigates against all kinds of risk (losing customers, regulators pounding on one source of revenue, etc.)
- It gets access to large, lucrative deals that can only be shopped to a small number of huge banks
That’s all good, but as a bank gets bigger, it also runs into some problems:
- It takes on less attractive opportunities, in a diminishing returns sense, which dilutes its overall performance
- It affects a larger fraction of the total economy, so failure has greater scope and magnitude
- It becomes more difficult to manage, and accountability can be hard to trace
Here’s the core of the shareholder proposal that The Wall Street Journal reported on:
The Board of Directors should appoint a committee (the ‘Stockholder Value Committee’) composed exclusively of independent directors to address whether the divestiture of all non-core banking business segments would enhance shareholder value.
The shareholder (Bartlett Naylor) claims that “an analysis by Goldman Sachs argues that implementation of [the 2010 Dodd-Frank Act] means JP Morgan would be worth more in parts.” The proposal is for the bank to explore this possibility.
As you might imagine, JPMorgan Chase isn’t interested. It argues that it constantly assesses its strategy, and selling off assets is always under consideration. To this point, the bank believes all the pieces together offer shareholders more value together than they do apart.
Unfortunately, we’re in a situation where JPMorgan Chase executives said exactly what you’d expect them to say, whether the shareholder value argument is right or wrong. No executive wants to lead a less valuable company. The compensation of most executives is tied to the value of the company they lead. JPMorgan Chase itself would certainly be less valuable if it sold off some of its assets. The sitting executives don’t like that.
Large companies have split up before, though. A recent example is HP, which split into HP Inc (PCs and printers) and Hewlett Packard Enterprise (business computing solutions). Clearly, this kind of result can happen. However, it’s often preceded by abysmal performance from the company in question.
If anything, JPMorgan Chase’s financial performance is ascending. Jamie Dimon, the CEO, had his total compensation package bumped up to $27 million in 2015, from $20 million in 2014, because of the bank’s improved performance. While shareholders may be nervous about the size of the bank, and a repeat of the financial crisis, the bank’s executives see nothing but sunny skies ahead.
I’m reading The Black Swan by Nassim Taleb right now. It’s a fantastic book. One of my early takeaways is that financial catastrophe is unavoidable. It might be a stagnation event like in the 1970s. Or the Savings & Loan crisis in the 1980s and 1990s. Or the global financial crisis of the 2000s. We don’t know what form it’ll take, but financial disruption will strike again.
That’s the motivation for breaking up the big banks. It’s not that anyone can point to any one aspect of the bank and say, “Look! That’s how it’ll fail.” The idea is that failure is coming, it’s unpredictable, and the best we can do is mitigate the downside risk.
The easiest way to mitigate against bank failure is to have a larger number of smaller banks. That way, if one or more banks fail, they impact a smaller fraction of the total economy. You’re less likely to have systemic risk.
But management and shareholders will push back. There’s undeniable value in having large banks. The challenge comes down to finding the tipping point. At what point is the incremental value from a larger bank not worth the increased risk?
The banks have always argued that they understand their risks. They’ve always argued that they’re positioned to navigate uncertain markets. And yet we had a global financial crisis in large part because banks didn’t understand the trades they were making. It’s not because they don’t have smart people. It’s because they fool themselves into believing they know more than they do.
That’s one of my main takeaways, so far, from The Black Swan. We focus way too much on what we know. What we don’t know is what’s going to determine our future. It’s the unpredictable events that have an outsized impact that matter.
I wrote yesterday about how highly levered JPMorgan Chase is. Their debt to equity ratio is an order of magnitude larger than ExxonMobil and Johnson & Johnson. It’s over three times that of Coca-Cola, and it’s over twice that of General Motors.
JPMorgan Chase is a highly levered, massive institution. Huge leverage plus huge size equals huge risk. That’s why I’m a fan of breaking up the big banks, like Minneapolis Fed President Neel Kushkari suggests. The risks are too great. The unknowns are too consequential. Yes, we’ll probably leave some shareholder value on the table. But we can’t risk another financial crisis for a bit of incremental value.