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Regulatory tweak provides $1 trillion benefit to big banks

Wheninternational regulators altered how they calculate a bank's size, the changesdid not sound major. But just one tweak slashed the size of eight U.S. banks bymore than $1 trillion, boosting their potential for profits but also increasingtheir vulnerability in a crisis.

Thebanks did not necessarily reduce their holdings. Regulators changed a formula,and billions of dollars of exposures disappeared from banks' balance sheets.

Big banksbenefited the most. Among the 34 U.S. banks that submit the data, the eightbanks that pose the greatest risk to financial stability saw their combinedexposures drop by $1.094 trillion while the other 26 banks experienced anaggregate decline of $487.46 billion.

"Thisis the state that we're in as big banks chip away at reform," said SimonJohnson, an economics professor at Massachusetts Institute of Technology and amember of The Systemic Risk Council."One very effective way to push back is to have apparent risk reduced inthe data, and that's what's going on here."

Thechange, one of several in the final rule, governs how banks treat off-balancesheet exposures, arguably a significant contributor to the crisis. But whenregulators changed the rules in 2014, there was little uproar.

"Ithink it's a big deal," said Mark Calabria, director of financialregulation studies for libertarian think tank the Cato Institute. "Part ofthe issue was that there was so much going on regulatory-wise in 2014. Ifsomeone had brought it to my attention, I would've said, 'We really need tolook at this.' … The banks, I'm sure they knew about it."

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Johnsonand Calabria are thought leaders on systemic risk from opposite ends of thepolitical spectrum. Both have testified to Congress on numerous occasions,generally with Johnson pushing for tighter regulation and Calabria advocatingfor less. On this issue, both experts agree: the change underrepresents banks'exposures.

'Back-door' relief

Theway a bank calculates size is crucially important in deciding how much capitalit must maintain. If the bank appears smaller, it needs less capital, whichimproves returns but leaves a smaller margin of error in a recession.Insufficient bank capital was one of many factors that contributed to thecredit crisis of 2008.

Afterthe Great Recession, regulators knew it was time to rip up the rule book. Whenthe leading regulatory body, the Basel Committee for Banking Supervision,issued its new framework in 2010, the document took an absolutist approach onoff-balance sheet items: Banks had to include 100% of all off-balance sheetitems in their size calculation.

"TheCommittee recognises that [off-balance sheet] items are a source of potentiallysignificant leverage," regulators wrote in the original framework.

Bankingindustry groups hated the idea. In a jointletter, the American Bankers Association, Securities Industry and FinancialMarkets Association and the Financial Services Roundtable argued the approachrisked "constraining credit in the broader economy."Instead, banking groupspushed for a "more granular," "standardized" approach.Banks would apply "credit conversion factors" to less-risky items.

Theindustry groups sent the letter to Basel in October 2013; internationalregulators revised the rule in January 2014, adopting the standardizedapproach. For example, the change would allow banks to cut a loan's size by 80%if it were collateralized by a shipment of goods. Other items that could beweighted less under the change include securitizations that qualify asliquidity facilities under Basel II — the framework that was in effect beforethe crisis.

U.S.-basedbanking regulators, the FDIC, OCC and Federal Reserve, followed suit and passeda final rule in September 2014. The impact of the change has only becomevisible in recent months. Banks are required to submit systemic risk dataannually, and year-end 2015 reports — which banks filed between April and June— were the first to include the change.

"Thefact that it played out this way shows that regulators are not hostile to back-doorregulatory relief," Calabria said.

Askedabout the changes, OCC spokesman Bill Grassano said "this is really a Fedstory." The Federal Reserve declined to comment. In an interview, FDICVice Chair Thomas Hoenig heavily criticized the rule, known as thesupplementary leverage ratio, saying the data "can be massaged."Banks calculate the size measure themselves.

InApril, Basel proposed even more changes to the rule.

"[The]effect, I would suggest, will be to make the leverage ratio seem higher even thoughthe balance sheet doesn't fundamentally change. I'd be willing to bet that itwon't go the other way," said Hoenig, who advocates for adoption of aninternational accounting standard that would be calculated by third-partyaccountants, preventing data manipulation.

Who benefited?

Inaddition to determining how much capital a bank needs, size data is importantfor determining capital surcharges. Banks that pose the greatest risk to the financialsystem are subject to higher capital requirements than smaller banks. Exactlyhow high is determined by systemic risk scores, composed of five equallyweighted factors, one of which is size.

On apercentage basis, the banks to benefit the most from the change were , and Goldman Sachs Group Inc.The change cut their off-balance sheet exposures by more than half. On atotal-dollar basis, JPMorgan Chase& Co. received the largest benefit, reporting off-balance sheetitems of $314.1 billion under the new calculation, compared to the $578.1 billionit would have had to report under the original framework.

Beforethe changes, JPMorgan was in danger of a 5% capital surcharge. That would haveput the bank at a distinct disadvantage since no other bank in the world had asurcharge higher than 3.5%.

JPMorgandeclined to comment, directing S&P Global Market Intelligence to CFOMarianne Lake's comments at a February investor day.

Atthe event, Lake saidthe bank was comfortably in the 3.5% bucket. A presentation showed the bank cutits systemic risk score by as much as 240 basis points. The bank attributed 110basis points of the reduction to rule changes and clarifications, with theremaining 130 basis points coming from genuine shedding of assets and non-operatingdeposits. Getting a lower surcharge appears difficult, and management seemssatisfied.

"Thelower-hanging fruit has been harvested," Lake said.