Banks have a number of different ways that they can meet the new capital thresholds.   They can grow into it via profits since net income (less dividends) adds to the retained earnings account.   In the early stages of the recovery,  when CEOs didn’t seem too concerned about FinReg,  I think many believed that the economy would recover sufficiently quickly to allow them to grow equity organically.   But with the economy remaining stagnant,  and with the clock ticking, banks are having to find other avenues.

Since banks have to meet a target equity ratio –  and not a specific equity dollar amount –  the next natural step is to change the denominator (remember: capital ratios are capital divided by risk-weighted assets).   If you can’t increase the numerator fast enough,  another option is to decrease the denominator.   Some banks have been doing this in recent months by exiting business lines and selling off stakes in minority investments.

Another step –  an unfortunate one –  that more banks are taking,  is to increase net income by decreasing expenses.   In banking, a major expense is personnel,  so it is hardly surprising to see a number of banks announcing layoffs.   Bloomberg ran a story this morning on the wave of layoffs hitting the sector this year.   Traders and investment bankers seem to be especially hard hit.

Expect to see more of this over the next year or two.   We have all become inured to stories of bank layoffs,  but I think that these waves might be different.    The moves the banks have made over the past few months,  with asset sales, and now with layoffs,  may signal the beginning of a changed banking model.   With capital ratios rising,  allocating capital –  and earning a decent return on it –  is front of mind for bankers.    Riskier businesses,  such as trading,  will now require more capital than in the past.   In a slow-growth economy,  some banks are now realizing that it may not be worth it to be in those businesses.

I was struck by a few comments made in these mini-essays.   Steve Bartlett,  the president and CEO of the Financial Services Roundtable (whose members are the heads of the country’s major financial institutions),  backed up Dimon’s assertion the the new rules were “anti-American” because some things,  like mortgage servicing rights and obligations of government-sponsored enterprises,  that U.S. banks tend to count toward their capital will no longer be allowed in a few years.

That complaint is not entirely without merit,  and, as the rules are being finalized,  some tweaking might be in order.   Having said that,  these elements are minor issues.   To espouse, as Bartlett does,  that “If international regulators insist on proceeding,  American regulators should be cautious in how they implement these rules for U.S. banks” seems a bit over the top.   The banks need more capital  -  and the largest banks should probably have an incremental buffer to counteract their asymmetrical impact on the world’s financial system.   U.S. regulators have been involved with these negotiations from the beginning – let’s not threaten to walk over minor points.

I have another quibble on the other side of the debate.   Lynn Stout,  a law professor at UCLA who favors increased capital requirements for banks also takes things a bit far.    She first talks about how capital requirements limit banks’ ability to use leverage – which,  strictly speaking they don’t,  but that’s ok:  point taken.  My issue with her argument is when she claims that “Bank shareholders want capital requirements that are as low as possible so the bank can borrow as much as possible.  That way, they enjoy all the profits when times are good, but have only limited losses if the bank goes under.”

All I can say to that is:  there are a lot of bank shareholders who actually want a boring,  predictable company to provide boring,  predictable dividends.   Limited losses?  Those dividends have largely been wiped out at some of the largest banks, and the stock prices are still very much in “loss” territory for many people.   There are many bank shareholders who are middle-class investors who are hurting right now because of these “limited losses.”   I’m sure that many are highly in favor of regulations that will get their bank back to boring and predictable.

For some down the middle commentary on Basel from this series,  Simon Johnson and Douglas Elliott both provide what I think is a balanced look at the current situation.   Johnson lays out why the social costs of limited bank capital matter,  and Elliott,  while supportive of the new accords,  correctly points out that “the devel is in the details” and that we must be vigilant about ensuring that all countries implement the regulations.   Not that they cry foul and go home.

Is the economy being hampered by a lack of credit or is it being hampered by a mis-allocation of credit?   Or,  more accurately,  by a supply/demand mismatch of credit.   Mind you, by calling it  mis-allocation,  I am blithely ignoring creditworthiness and just focusing on credit need.   I was a banker,  not an economist,  so I might be missing something,  but it is hard for me to believe that there is a complete lack of credit out there.   This is not 2008.

On the contrary,  as has been the case for the past two years,  the credit market continues to be a bifuracted market.   Broadly,  large companies have continued to have access to credit and small companies have not.

With the exception of temporary market disruptions,  the large, investment grade companies are awash in offers of credit.   Bankers are still knocking down the door to give them money,  but many don’t need it.   Earlier this week,  the Fed released the flow of funds report that showed cash levels at nonfinancial firms topping $2 trillion  -  over 7% of assets.   According to the Wall Street Journal,  that is the highest percentage since 1963.

If you’re a large company,  you don’t necessarily even need to be investment grade to get a good bank deal.   The Wall St. Journal recently summarized the increased demand among banks for loans to leveraged companies.   Leveraged lending is up year over year as bankers reach for increased yield by going down the credit curve to lend to companies where they can charge a higher rate and earn a higher return.   The market here has stalled recently, but when the window re-opens, companies in the BB sector that have a large wallet for bank services should still attract a lot of attention from the banks.

For those who doubt that large banks are lending,  this week’s H.8 report from the Fed (Assets and Liabilities of Commercial Banks in the U.S) is worth a look.   Large banks (defined as the top 25 by assets) have increased C&I lending 9.8% since August 2010.   In the same time period,  small banks (all others) have only increased C&I lending by 1.5%.

So banks are lending  -  to some companies,  and large banks are lending at an increasing rate  -  but a number of small and medium-sized companies are still struggling to find credit.   Part of the problem is certainly that smaller businesses often rely on personal assets,  such as homes,  as collateral for their loans and since that collateral is now not worth as much,  there is no more room to borrow against it.

Another part of the problem has to be on the demand side for small companies.   For many of these businesses,  even a slight drop off in revenue can impair margins and make loans harder to come by.   Larger companies are seeing sufficient demand to make money,  but perhaps not enough to entice them to expand and invest some of that $2 trillion on their balance sheets  -  money that would trickle down as demand for the products and services of smaller companies.   Either that, or the lack of liquidity in the market in late 2008 scared large corporates and changed their view of the amount of cash they wanted to hold on their balance sheets in times of potential bank crises.

So large companies are holding $2 trillion in cash and banks are holding roughly $1.6 trillion in excess reserves at the Fed,  where they have been getting paid to hold those reserves  -  not much,  granted,  but something.   That is an awful lot of liquidity.

If the Fed does undertake Operation Twist and flatten the yield curve,  that could make it more difficult for banks to make money,  as net interest margin generally compresses when the yield curve is flattening.   It might be time that the Fed also reconsiders paying banks for excess reserves.  Maybe that will entice banks to start taking a harder look at how to earn something on that $1.6 trillion  -  say by lending to smaller businesses.   Even a fraction of $1.6 trillion would be a big help.

Tarullo rightly points out that the latest crisis was a systemic crisis  -  and, therefore,  requires systemic oversight  -  what many refer to as “macroprudential” risk (as opposed to the “microprudential” risk of individual banks,  regardless of size).   The key word in all of this is “risk.”   Banking is,  literally,  risky business.   It is all about risk management,  and most banks really do a very good job of managing and underwriting risk.   Sometimes they face losses because they make mistakes,  and sometimes they face losses because of economic downturns or unforeseen events (like UBS’ rogue trader).   Regardless of why losses occur,  what protects banks from insolvency is their capital layer.

And that capital layer got mighty thin for some banks in 2008 and 2009.   In light of the degree of losses from the recent crisis,  and in light of the impact of bank inter-connectivity,  it seems prudent to require banks to hold an increased layer of capital for additional protection  -  which is what Basel III,  Dodd-Frank,  and the recently released Vickers Report all call for.

Predictably,  many in the banking sector are trying to water down the requirements because holding more equity is expensive and impacts banks’ return on equity.   The question of course is,  what is the right level of equity capital?

The answer,  as it so often is in banking,  is,  ”it depends.”   How risky is a bank’s business,  how critical to the financial system,  what products does it offer?   Prior to 1999,  regulation was made a bit easier by the Glass-Steagall provisions that largely split riskier investment banking from more stable commercial and retail banking.   With the rise of the universal banking model,  risk increased in ways that were unclear until very recently.

Now that we know that risk is systemic and that it does not disappear with the use of structured products,  how do we manage the risk so that the system does not fail?   The choices seem to be:  1) re-introduce Glass-Steagall in some form and limit what banks can do  2) let them do what they want but limit their size,  or 3) require banks to hold significant capital buffers  -  and require the largest to hold a little bit more.

In industries like utilities,  where activities are highly regulated and where losses can be recovered through rate-making,  a thin equity layer can work because the risk is largely managed by the regulatory process.   The regulatory environment provides the high level of certainty that mitigates the high levels of leverage that many utilities carry.

Banking used to be like that.   If we are going to allow the universal banking model,  a riskier model,  to move forward,  those banks need to hold more capital.   The regulatory reins were loosened to allow banks to offer more products.   Now they need to be tightened a bit to counteract the increased risk.

The Vickers Report has an interesting concept whereby banks “ringfence” their retail and small business accounts with extra capital and protect them from the bank’s riskier activities.   That’s not a bad solution.   Protect the basic banking system but let banks take risk if they want  -  and then let them fail if that is their fate.

Keep an eye on the U.K. and on anything that Daniel Tarullo says.  His speeches are worth following.

While he still claims to be supportive of increased capital,  Dimon claims that the additional charge for SIFI’s (systemically important financial institutions) is needlessly punitive.   Since this is an additional charge that will hit all SIFIs worldwide,  I’m not sure about this complaint.   If anything, American banks are much more strongly capitalized than many of their global competitors and should benefit as they have already bitten the bullet and raised the needed capital.

Dimon should be grateful that he’s not in the U.K.   There, the Independent Banking Commission, led by Sir John Vickers,  just issued its regulatory plan -  dubbed “the Vickers report,”  which will require even higher levels of capital than Basel and which will require banks to “ringfence” retail and small business accounts to separate them from investment banking activities.   Glass-Steagall Lite, anyone?

So,  everyone has to play by the Basel rules – including many of the Asian countries that Dimon cited as the likely long-term winners in the industry.   UK and Swiss regulators are actually demanding even more stringent measures for their own banks,  and the rest of the European banks are in a much weaker capital position than JPMorgan.

Let’s move on.   The article also says that Dimon was unhappy with the way that certain elements of the capital structure would be counted to be in compliance with the new liquidity rules.   Specifically,  covered bonds,  which are an important element of European banks’ capital structure,  would help them reach required liquidity levels while securities backed by Ginnie Mae would be treated less favorably,  potentially impacting U.S. banks.

Apparently,  the reason for the discrepancy is that covered bonds,  due to their structure,  were viewed as very safe instruments.   John Carney,  from NetNet has a great post explaining why this isn’t necessarily the case and why Dimon has a beef.   On the surface,  I would agree that it sounds like Dimon has a complaint regarding this aspect of the regulations,  but the good news is that the liquidity provisions of Basel won’t even be finalized for a few more years -  so there is time to try to fix things.

Aside from the inflammatory “anti-American” quote,  I actually thought that the more interesting quotes from Dimon were in another article that was posted to FT.com on the same day.   Specifically,  I was interested in Dimon’s quotes on regulations impacting the derivatives market.

First,  he asks,  ”Were derivatives unregulated with no capital?   No they were fully regulated.”    But they were not fully capitalized.   The capital charge for derivatives now is minimal in comparison to what will have to be set aside in the future – and that is meaningful to a bank like JPMorgan that is a huge player in the derivatives market.

Later in the same article,  he seems to scoff at the notion that derivatives trading is not transparent and points out,  “You can go on any Bloomberg screen and price 90 percent [of trades] within pennies and there are very narrow spreads.”    That’s sort of true,  but it is a bit misleading.   You can’t punch in a ticker on Bloomberg and get a swap quote the way that you can for a stock or a bond.

For interest rate swaps -  which comprise the vast majority of the derivatives market - what Bloomberg shows is the swap rate,  which is just one input into the pricing of a swap.   The others, credit spread and profit,  are determined by the banks,  and all of it is quoted as one all-in rate.

Dimon says that companies,  ”negotiate the hell out of the price” on derivatives trades.   Some do.   Sophisticated companies that have access to Bloomberg data,  are experienced in executing swaps,  and have a number of banks to provide bids,  will indeed get a good price.   Smaller companies,  however,  pay much more for their swaps – primarily because they have no idea how the trades are priced.

Dimon’s quotes about derivatives pricing make it sound like a terrible,  low-margin business -  and on some trades,  it is low margin.   But if you have any doubt about how profitable and attractive swaps are to the big banks,  just pull up the quarterly OCC report on derivatives – the names atop the leaderboard are the most sophisticated Wall St. banks.   They wouldn’t be doing it if they weren’t making a whole lot of money.

I suspect that Dimon’s complaints are much more geared toward trying to protect the profitability of a key line of business than they are about any regulations being “anti-American.”

The reason banks have capital buffers is to absorb losses and prevent insolvency.   We are only coming up on the third anniversary of Lehman’s failure,  and already people are forgetting just how valuable capital is to a bank.    A quick refresher:  if a bank has $100 it can now lend out,  theoretically,  about $92 of it and must hold the rest as capital in case of a loss.   In the future,  that theoretical lending limit might be $90 or lower,  with the balance held as capital.

The basic argument against stronger regulation and increased capital levels at banks is that it will either decrease the supply of credit or ratchet up the pricing on loans to onerous levels  -  thus stifling the economy and preventing businesses from hiring new workers.

In the WSJ article linked to above (“Banks Shouldn’t Hold Too Much Capital”),  Mark Gongloff cites a report by Deutsche Bank analyst Matt O’Connor where O’Connor says that increased capital levels will increase the required return on equity demanded by investors,  thus compelling banks to either increase their lending rates or to chase riskier assets so that they can earn the higher required return.

I haven’t read O’Connor’s note,  so I might be missing some nuance,  but this argument seems to simplify the situation – and it seems to hold all other variables constant.  The demand side,  for instance.

In the recently released Shared National Credit report,  there is a note that “refinancing risk remains elevated as nearly $2 trillion,  or 78 percent, of the SNC portfolio will mature by the end of 2014.”   That is a big number,  and corporations do need to be aware of it  -  and it is quite likely that pricing will go up on their new deals,  mostly because they couldn’t go much lower than the deals that priced in ’06 and ’07.   Anyone fortunate enough to have signed a deal back then is not in any hurry to go back into the market right now  -  which is one reason why that refinancing number is so high.

The truth is,  any company that absolutely did not have to re-fi their ’06 or ’07 deals is going to enjoy that low pricing as long as possible.   That is the demand side.   There are a lot of companies who are sitting on piles of cash and undrawn revolvers that they don’t need to fund their businesses right now.   Many, many companies took advantage of low loan rates and stored “dry powder” on their balance sheets in the form of inflated loans.   The companies loved the deals because they were cheap and the banks loved the deal because they made their money on fees and then either sold down their positions or bought some CDS against it.

Whenever these companies go back into the market,  they will likely get preferred pricing and,  if necessary,  they will reduce the size of their bank deals.   For smaller companies that depend on the bank market,  pricing is definitely more of a concern,  as it always is.   But the pricing increase on loans cited by Gongloff (25-35 bps. for each 1% increasse in capital),  assumes that the entire impact of increased capital will flow through loans.   I doubt that will be the case.   Loans are competitive products, and lenders will shave pricing down as much as they can  -  and hope to make it up on ancillary business  -  just as they always have.

What will be interesting will be to see if the increased capital standards make some banks re-think their business model and actually move away from risky products and back towards plain-vanilla corporate banking.   That would actually lower the required ROE because their cost of equity should come down if they move toward a more stable,  consistent source of profits.

In years to come,  I do think that tighter regulations will impact the banking sector,  and, therefore, the supply of credit -  at least on the margin.   With tougher capital requirements on products like credit default swaps and other derivatives, banks will likely be more selective about who they do business with.   As in the housing sector,  those that qualified for generous loan terms in the past won’t necessarily qualify for them now or in the future,  but I don’t think that a return to sane underwriting is something to fear.

The good news is that the report shows an improvement in credit quality since the last report in 2010.  The volume of criticized loans (those rated Special Mention, Substandard, Doubtful or Loss) fell 28 percent from the prior year, from 17.8% of the total portfolio to 12.7%.  Criticized assets peaked at 22.3% of the portfolio in 2009, so a drop to 12.7% is certainly welcome news.

The bad news, however, is that 12.7% is still a very high level – especially at this stage of what is supposed to be a recovery.  To give you some sense of this, during the last recession, total criticized assets peaked at 12.6% in 2002 and 2003 before dropping to 6.9% in 2004.

This run of four years of elevated levels of criticized assets is more reminiscent of what happened in the early ’90′s when criticized assets remained high from 1990 to 1993 – although that peak level was only 16%.

All of this matters, of course, to the companies that rely on bank loans as an important part of their capital structure.  When banks have a high level of problem loans on their books, they are less enthusiastic about lending – at least at the low prices that companies have grown to love.

Large companies with either strong investment grade ratings or lots of fee business will always get a lot of attention from the banks, and they are not the concern.  It’s the smaller, less credit-worthy companies that tend to bear the brunt of credit contractions.

Right now, the credit quality of outstanding loans appears to be improving, and that’s a great sign for everyone who needs to do a bank financing in the next few years – and according to the SNC report, $2 trillion of the total $2.5 trillion portfolio will mature by 2014. Right when banks are getting ready to implement Basel III.