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Jamie Dimon’s letter to shareholders

JPMorgan has released its Annual Report. JPM’s Chairman Jamie Dimon introduces the 320 page tome with a 50 page letter.  Dimon’s letter is worth a read – both for what it says and for what it doesn’t.

Dimon says that JPM is stronger, safer and more profitable than ever before. How? By being better capitalised; by doing less business with clients it should never have done business with; by reducing activities for which the risk-adjusted return was unattractive; and by cutting costs that in retrospect were unnecessary.  And JPM is accomplishing all of this despite the burdensome regulation with which it must contend – regulation which if pushed further may have dire consequences for American banking and therefore America.  Naturally, these points are cloaked in “corporate speak” – but that’s about the gist of it.

There is more of course, much of it thoughtful. Dimon is at his best when commenting on high-frequency trading: HFT traders he notes, “add liquidity in liquid markets, but mostly disappear in illiquid markets.” And despite the predictable warning to policy makers, there is a conciliatory tone when it comes to many of the regulations already in place – regulations that Dimon acknowledges, should help restore confidence in the strength and stability of the system in which JPM operates.

It is also interesting to see what was not said. That JPM’s derivative contracts outstanding declined by $15 trillion is noted; that $50 trillion remain is not. With one exception, JPM’s scandal-linked litigation gets a miss. (The list of such entanglements runs to seven pages in the Annual Report.) The exception is the bank’s guilty plea to FX market manipulation. This commands a paragraph in which the episode is described as the work of an errant individual rather than a failure of management. The import of corporate values receives multiple mentions; accountability for failure to live up to them almost none. Caring for clients gets a fair share of print – though the words “fiduciary duty” are absent from Dimon’s note.

Finally there is some muddled thinking. Much is said about capital strength, profitability, and shareholder returns. JPM has posted record results in five of the last six years. Earnings per share are 50% higher than their pre-crisis peak and the stock price has outperformed its peers – sharply. Interestingly, for Dimon the one measure that disappoints is that of Return on Equity (RoE).  At 13% RoE is flat to prior year, remains below levels reached pre-crisis and falls short of his 15% target. The Chairman attributes the RoE decline to “higher capital requirements, higher control costs, and low interest rates.” Yet is it not precisely because capital ratios are higher that JPM is stronger? And is it not because of better controls and lower rates that investors have pushed the stock to record highs?  Oh and by the way, the Bank for International Settlements says that greater equity funding pays for itself in the reduced cost of debt.

This is key. The successful long term investor does not seek short term RoE. He seeks attractive risk-adjusted returns. Short term RoE is a flawed target because it says nothing about the risk it takes to produce it.  JPM’s 13% RoE is extraordinarily attractive against a zero rate backdrop – provided management understand its risks and manage them effectively. No doubt investors would accept an even lower RoE so long as the risks that produce it are lower as well. In this regard one might suggest that the Chairman revisit those $50 trillion of derivatives and the degree of loss absorbing equity supporting them. Granted there are collateral contracts and offset agreements in place. But 50 trillion is a big number. Management misjudgement amounting to a mere one percent of JPM’s derivatives could cause losses of $500 billion – a sum more than twice the firm’s equity. Losses on this scale would make JPM’s $6billion “London Whale” look like a minnow.

In short, the Chairman’s letter hits all the points but fails to connect the dots. Higher capital funding and the safer banking system it produces are clearly compatible with shareholder value. Excessive risk taking and leverage are not. Short term RoE is the wrong target. Competitive risk adjusted returns is the bogey to hit. Indeed, properly adjusting returns for risk whilst ensuring sufficient capital for when risk taking fails would be good for JPMorgan, American banking and even America.

Robert Jenkins is a Senior Fellow at Better Markets and a Governor of the CFA Institute

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