JPMorgan’s Whale Losses Risk Sinking The Mega-Banks Diversified Model

JPMorgan’s (NYSE:JPM) $2 billion loss from a failed hedging bet could end up hurting the country’s financial system in more ways than what was earlier anticipated. The heavily publicized mistake by the largest U.S. bank in terms of assets played right into the hands of Volcker Rule supporters – severely undermining the effort major banks had put in for well over 2 years against the controversial law. And to make matters worse, conclusions that the loss was a result of the top management’s inability to oversee the bank’s massive operations has sparked off another debate about the possible need to scale down the “too-big-to-manage banks” – primarily the heavily diversified JPMorgan, Bank of America (NYSE:BAC) and Citigroup (NYSE:C). ((Banks Worry As Breakup Talk Revived After JPMorgan Loss, Bloomberg Businessweek, Jun 18 2012))

We have a price estimate of $48 for JPMorgan’s stock, which we are in the process of reviewing to factor in the effect of the series of events triggered by the trading loss.

See our full analysis of JPMorgan

Early in May, JPMorgan announced that a large-sized hedging position its London-based investment office entered into resulted in losses of $2 billion, with a possibility that the loss figure could cross $4 billion over coming quarters. The news took investors by surprise, coming from the bank that is widely recognized as the ideal among diversified banking institutions.

Almost immediately after JPMorgan announced the problem, its impact on the implementation of proprietary trade restrictions included as a part of the Volcker Rule was established. The Volcker Rule intends to ban all trades that banks enter into using their own money. This includes hedging bets like the one that went wrong for JPMorgan. The biggest banks put up a strong fight against this provision in the recent past, with JPMorgan essentially seen as leading from the front.

But when JPMorgan opened Pandora’s box with this mistake, support for the Volcker Rule was not the only thing that sprung out.

Talks that the sheer size of big banks makes them difficult to manage – something that had been whispered about since the global economic crisis of 2008 – have also garnered more vocal supporters now. This can potentially do much more damage to banks total value than the Volcker Rule as the solution to this is either for diversified banks to be split up dramatically – separating their retail and investment banking operations – or to go for some sort of ‘ring-fence’ similar to what the U.K. intends to implement (see U.K. Will Split Retail and Investment Banking by 2015).

So why will this hurt the big banks?

Simply put, it is because the division of a bank – complete or partial through ring-fencing – will effectively make it two separate banks with each having its own operational, and more importantly, funding costs. This will drag down return yields and margin figures for the newly separated parts given limitations due to a smaller balance sheet and capital it can put at risk. It also loses from lower economies of scale.

The impact on investment banking operations would be more pronounced. To understand the impact of a decrease in trading margins on JPMorgan’s total value, you can make changes to the chart above.

What the trading debacle ends up doing to the U.S. banking system remains to be seen. Let’s wait and watch if this Pandora’s box too has its share of hope still trapped in it.

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