JPMorgan Chase is one of the largest banks on the planet. I’ve written several times over the past week or so about the risks of financial engineering. I thought it was worth diving into some financial statements to try to answer one question: how does JPMorgan Chase make money?
Let’s look at the 10-K report JPMorgan Chase filed on February 23, 2016. I’ll start with their Consolidated Results of Operations.
You’ll see two charts below. The first chart shows JPMorgan Chase’s total net revenue for 2013, 2014, and 2015 (in billions), which has declined from $97.4 to $95.1 to $93.5 billion in that timeframe. The second chart is a pie showing how the 2015 total net revenue falls across nine different buckets.
The three biggest buckets make up nearly 75% of JPMorgan Chase’s 2015 revenue. Here’s the breakdown:
- Net interest income: $43.5 billion (47% of revenue)
- Asset management, administration, and commissions: $15.5 billion ($17% of revenue)
- Principal transactions: $10.4 billion (11% of revenue)
These three buckets will help us understand how JPMorgan Chase generates the lion’s share of its revenue. Let’s dive in.
Net interest income
A big bank like JPMorgan Chase finds itself on both sides of loans. As a creditor, big banks issue loans to people or businesses. For people, think of mortgages. The bank loans someone money to buy a house, and that person pays the bank interest on his or her mortgage (along with repaying the principal). For businesses, think of revolving credit lines. The bank can make a pool of money available to a business. If and when the business draws money from that pool, it’ll pay interest to the bank.
For what kind of loan is JPMorgan Chase the debtor? Customer bank deposits. When we deposit money in an interest-bearing bank account, we’re effectively loaning the bank money. The bank, in turn, pays us interest.
The difference between (a) the interest the bank collects from its debtors and (b) the interest the bank pays to its customers is what we call (c) the bank’s net interest income. As we saw, in 2015, net interest income accounted for nearly half (47%) of JPMorgan Chase’s revenue.
Asset management, administration, and commissions
Here’s how JPMorgan Chase describes this revenue category in its 2015 10-K report:
This revenue category includes fees from investment management and related services, custody, brokerage services, insurance premiums and commissions, and other products.
In their report, they say the $15.5 billion in 2015 revenue from asset management, administration, and commissions breaks down like this:
- Asset management fees: $9.8 billion
- Administration fees: $2.0 billion
- Commissions and fees: $3.7 billion
According to its website, “J.P. Morgan Asset Management is a leading asset manager for individuals, advisors and institutions.” Basically, JPMorgan Chase helps clients turn money into more money. The bank itself makes money from the fees it charges clients. These fees cover the bank’s advice, along with any transactions the bank makes on the client’s behalf.
Here’s how JPMorgan Chase describes this revenue category in its 2015 10-K report:
Principal transactions revenue consists of realized and unrealized gains and losses on derivatives and other instruments (including those accounted for under the fair value option) primarily used in client-driven market-making activities and on private equity investments.
The $10.4 billion in 2015 principal transactions revenue breaks down like this:
- Interest rate: $1.9 billion
- Credit: $1.7 billion
- Foreign exchange: $2.6 billion
- Equity: $3.0 billion
- Commodity: $0.8 billion
- Private equity gains: $0.4 billion
To wrap our minds around market-making, think about buying and selling stock. You might have an E*TRADE account. Say you want to buy a share of Coca Cola. You fire up your E*TRADE portal, navigate to Coca Cola, tell it to buy one share, and you’re done.
What happened? E*TRADE, as your broker, executed your trade with the New York Stock Exchange. Your buy order was matched up against someone else’s sell order, and a single share of Coca Cola changed hands.
That system works great for stock in publicly-traded companies, where there are tons of shares, with tons of interested buyers and sellers. Things get a lot more dicey when you talk about financial instruments that are much more exotic than simple shares of stock. These more exotic instruments might be much more expensive, and might attract far fewer buyers and sellers.
The more exotic instruments might be necessary for a large company or institution to hedge against a particular risk. Since these transactions are less standardized, you need a bank to make a new market.
In this case, JPMorgan Chase makes that market. Say a large company wants to sell some financial instrument. The bank can buy the instrument, with confidence it can sell to another buyer in the near future. The bank takes the risk of holding that instrument for some period of time. The bank serves a useful purpose, though, by making these instruments liquid (i.e. by allowing companies or institutions to sell them when they need to, without waiting around for a buyer).
The risk in principal transactions is clear. And as instruments become more complex, or more thinly traded, the risk grows. Regulators pay particularly close attention to this part of the bank’s operations.
A note about leverage
One theme, when describing how a bank operates, is leverage. Look through JPMorgan Chase’s three largest sources of revenues: net interest income, asset management, and principal transactions. In all three cases, the bank charges fees that are small percentages of the large dollar amounts trading hands.
With net interest income, the bank handles large amounts of deposits and loan balances, but it only keeps the (relatively) small interest payments involved. With asset management, the bank charges fees that are small fractions of the total amount of assets under management. With principal transactions, the bank keeps the (relatively) small difference between the large prices at which exotic financial instruments are bought and sold.
You see this leverage when you look at JPMorgan Chase’s balance sheet. As of the end of 2015, JPMorgan Chase had $2.4 trillion in assets, against $2.1 trillion in liabilities. Their stockholders’ equity (assets minus liabilities) was $247.6 billion. That means their debt to equity ratio (total liabilities divided by stockholders’ equity) was 8.5.
Let’s compare that with some other well-known companies:
- Google: 0.2
- ExxonMobil: 0.9
- Johnson & Johnson: 0.9
- Coca-Cola: 2.5
- General Motors: 3.8
Yikes, right? JPMorgan Chase is an order of magnitude more highly levered than ExxonMobil and Johnson & Johnson. It’s over 3 times more levered than Coca-Cola, and has over twice the leverage of General Motors.
If you want to know why banks are risky, in a nutshell, you’d look at leverage. Banks sit in the middle of the flow of huge volumes of money. They make money by skimming a small fraction off each of these flows.
You run into problems if the market loses liquidity. If more entities are demanding payment from the bank than are feeding cash to the bank, the bank can’t last too long.
You run into more problems if the bank hasn’t balanced its transactions properly. The bank needs to sit in the middle of even exchanges of money. If money flows more in one direction than another, the bank might be on the hook for the difference. Again, that situation won’t last too long.
Banks are precarious. That’s part of the reason they’re so highly regulated. They’re integral to our economy. But slight deviations from “normal” can cause profound harm.
That’s one of the many reasons we need to be careful with financial engineering. If you’re one step too clever, you can tip the balance and destabilize a massive financial institution. It’s far, far wiser to steer this pursuit of innovation toward real, technology-driven change. The downside risk is much smaller, and the upside is world-changing.
P.S. This is my 100th post here at STEM to Business. I’ve been publishing posts almost every weekday for a little over five months now. I’m having a blast. And I want to thank you for reading. This is so much more fun than writing in a private journal. Let’s do at least another hundred posts, shall we?