Henry Cao

About the Author Henry Cao

Henry Cao is an enthusiastic young business professional with diverse experience in the private sector, public sector, entrepreneurship, and non-profit organization. He is currently pursuing an MBA from the Rotman School of Management at University of Toronto. In his spare time, Henry enjoys a good game of badminton as well as catching-up with friends over a cup of coffee.

JPMorgan: Under The Regulatory Microscope, ROE On Hold


Company Description

JPMorgan Chase & Co. (NYSE:JPM) is a New York based financial holding company that provides diversified financial services worldwide. The company operates via four segments:

•Consumer & Community Banking: deposit, investment products, and loan services to retail consumers

• Corporate & Investment Bank: investment banking, market-making, prime brokerage, and treasury and securities products and services

•Commercial Banking: financial solutions, including lending, treasury, investment banking

•Asset Management: investment and wealth management services

Investment Summary

JPMorgan took significant de-risking activity in 2014 to reduce its risk profile while growing its asset management business. The US economic growth and improvement in interest rate in 2015 are key catalysts driving the firm’s growth. However, new regulatory burden creates additional uncertainty and puts downward pressure on near-term ROE.

Additional Tier 1 Capital Required

In early December, the Fed announced new regulatory capital requirements for the eight largest banks, effectively requiring JPMorgan and its peers to meet 11.5% Tier 1 common equity ratio by 2019. Comparing to the current 10.1% Tier 1 common equity ratio (as of Q3 2014), the new requirement represents a $22 billion shortfall based on $1.62 trillion RWA. US Federal Reserve vice chairman Stanley Fischer called it “a pretty impressive shortfall.” JPMorgan CFO Marianne Lake said that JPMorgan plans to increase its Tier 1 ratio to 12% within three years without major effect on payout to investors. This will likely impact the firm’s short-term ROE.

Trading Below Big Four Peers

Relative analysis shows JP Morgan is trading below its Big Four peers. I expect this trend to continue as JP Morgan boosts capital to meet new regulatory requirement.

Stable ROE

Expected higher interest rate and US economic growth will offset the effect of new regulatory requirement, keeping short-term ROE stable at its historical rate of 9.8%.

Valuation

Relative Valuation

Relative valuation looks attractive due to higher peer multiples. However, it is a poor reflection of JPMorgan’s value since its regulatory capital ratios is much lower than its peers. This creates ROE pressure in the short term and will require the company to raise capital to meet new regulatory requirement.

Residual Income Valuation

Investment Risks

1. Regulation and legal: Increasing regulatory burden creates additional compliance cost and uncertainty. Proprietary trading revenue has also been curtailed. The regulation of systematically important financial institutions (SIFIs) has placed additional requirements on major financial institutions.

2. Litigation: JPMorgan has been under the legal microscope and a significant legal settlement fee was paid in 2013. The firm, along with its Big Four peers, is the primary target for regulators.

3. US economy: Declining US GDP growth rate can lead to increasing non-performing assets and lower revenues.

4. Europe debt crisis: The ongoing issue with the debt crisis in Europe can potentially spiral out of control and affect the North America market.

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