Hedge Funds Dancing In The Streets: Why?

The 2020 market crash and subsequent economic challenges related to the pandemic tested Dimon’s skills again, and he brought Chase through the crisis period effectively. By October 2021, Chase stock saw record highs and share prices are rising again after the 2022 bear market.

Now regulators are finally ready to implement the last component of comprehensive banking reforms developed after the Great Recession. During JPMorgan Chase & Co.’s most recent earnings call, Dimon strongly opposed those regulations. He shared them with participants in no uncertain terms.

What Exactly Did Jamie Dimon Say About Bank Regulations?

JPMorgan Chase & Co. announced its second-quarter results on July 14, 2023, and the market responded favorably. However, the financials weren’t necessarily the most interesting part of the call. During the Q&A period, an analyst from Wells Fargo Securities asked about Chase’s perspective on recent remarks from Federal Reserve Vice Chair for Supervision Michael Barr.

Specifically, Barr said that increasing capital ratio requirements is the best way to ensure that banks are resilient against unexpected risks. He explained it this way:

Banks rely on both debt and capital to fund loans and other assets, but capital is what allows the bank to take a loss and keep on operating. The beauty of capital is that it doesn’t care about the source of the loss.

Whatever the vulnerability or the shock, capital can help absorb the resulting loss and, if sufficient, allow the bank to keep serving its critical role in the economy.

Barr referenced “Basel III Endgame,” an international agreement that was finalized in 2017. The Basel Committee was tasked with designing new regulatory standards to reduce the risk of bank failures such as those during the Great Recession.

This final rule would require large financial institutions to increase capital ratios by two percentage points. In other words, for every $100 of risk-weighted assets, financial institutions covered under the new requirement would need to hold an additional $2 dollars of capital.

Barr pointed out that the logic behind his support of higher capital ratio requirements is quite simple. He believes it’s unreasonable – and unsafe – to rely on banks and regulators to predict and mitigate all possible risks before the economy is harmed. The Great Recession proved that, and the economic impact of COVID-19 hammered the point home.

Barr said: “Our dynamic financial system is complex and constantly evolving. Regulators and bank managers are limited in our ability to comprehensively identify risks and to measure them. We cannot fully appreciate how a specific vulnerability can interact with other vulnerabilities to amplify and propagate risk in the face of a shock, or multiple shocks.”

Though Barr specified that he was speaking on behalf of himself and not as a member of the Board of Governors of the Federal Reserve System or the Federal Open Market Committee, his opinion carries a lot of weight.

In response, Jamie Dimon made it clear that his own views are quite different. Dimon said, “This is great news for hedge funds, private equity, private credit, Apollo, Blackstone – and they’re dancing in the streets.”

Why Are Hedge Funds “Dancing In The Streets”?

The Chief Financial Officer of JPMorgan Chase & Co., Jeremy Barnum, explained his concerns with the higher capital ratio requirements, starting with the impact on shareholders. Generally, when a financial institution has excess capital, it is returned to shareholders. That means if capital ratio requirements go up, returns on equity will go down.

Barnum said that it might be possible to offset some of the lost return on equity by adjusting product pricing, but it is not yet clear how consumers will respond to higher prices. For example, mortgages may be more expensive under this pricing model.

If it is not possible to recover lost returns on equity through pricing, banks may need to give up certain high-risk products that carry more weight in the capital ratio. If that happens, the demand for such products won’t disappear.

The most likely outcome is that less-regulated and unregulated financial services providers like private equity firms and hedge funds will take over this area of the market. Both Barnum and Dimon indicated that allowing the “shadow banking system” to manage these critical financial products carries far more risk than leaving capital ratio requirements as they are.

Dimon’s comment that hedge funds are “dancing in the streets” references the fact that these firms believe higher capital ratios will enable them to compete with traditional financial institutions for mainstream banking products. It was immediately clear that investors saw the opportunity capital ratio changes present for hedge funds – Apollo Global Management stock achieved an all-time high within a week of Vice Chairman Barr’s speech.

For the moment, it’s hard to tell whether Dimon or Barr is right on this subject. Dimon’s point that moving high-demand banking products outside of the traditional banking system carries substantial risk is well taken.

On the other hand, Barr isn’t wrong when he says that shoring up reserves against unpredicted risks is critical for a resilient economy. The answer might be somewhere in the middle. Perhaps reducing risk for traditional banks doesn’t mean that risk is gone. Instead, it may just shift to other types of financial services firms.

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