As the nation’s largest bank undergoes an unprecedented onslaught of regulatory scrutiny and fends off charges or investigations of fraudulent marketing practices, bribery, market manipulation, and gross mismanagement of risk, perhaps it is time for JPMorgan Chase to consider strategic alternatives that could satisfy regulators, increase its market value, and lay a secure foundation for the future.
While the bank is currently contemplating offloading some non-core assets, such as its student loan business, that will do little to appease regulators or add value. What the bank’s CEO Jamie Dimon needs to realize is that the real problem does not lie in the actual size of the assets it manages, but in the varying risk profiles across its divisions.
To address this, JPM should consider reorganizing its business into three broad divisions and spinning off each of the divisions into a separate company, shares of which would be held both by existing shareholders as well as new ones through IPOs. The three divisions, which would comprise parts of the existing five divisions of the bank, should be:
• Traditional Banking (consisting of deposits and consumer, corporate, and mortgage lending)
• Investment Banking and Asset Management (consisting of advisory services, capital raising, market-making and accompanying trading, and asset management for individuals and institutions)
• Proprietary Trading (consisting of all trading activities with the division’s own capital as opposed to the trading activities involved in market making)
These three business lines have very distinct risk profiles, very distinct returns, and very different demands on a bank’s balance sheet. Traditional banking requires high capital reserves against loans but is relatively immune to market volatility and provides predictable, if modest, returns (LOW RISK/LOW REWARD); investment banking and asset management require little proprietary capital (except temporarily for market making) and provide high returns but can fluctuate somewhat in response to market conditions (MODEST RISK/HIGH REWARD); and proprietary trading requires vast amounts of capital and is highly risky but can provide oversize returns if the bets are good (HIGH RISK/HIGH REWARD).
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Each of these divisions then, if traded separately in the market, can be valued based on their appetite for risk and desire for returns, yielding more accurate valuations. More importantly, separating out traditional banking, investment banking, and proprietary trading into standalone companies with their own balance sheets will go a long way in assuaging government regulators and, in my assessment, promoting better risk management. This in turn is likely to lead to a higher valuation for the sum of the parts compared to the whole because of a lack of profit-bleed between the businesses and greater accountability within each publicly traded division.
JPMorgan (JPM) has long been undervalued relative to its peers, trading currently in the range of 8.3 times forward P/E versus 10.2 or more for other large banks like Bank of America (BAC) and Well Fargo (WFC), despite its record profits. That is no doubt due to the many legal troubles that the bank is facing, not to mention the bad press that the bank has sustained, and even perhaps due to the antagonistic relationship that Dimon has had with US regulators, particularly over Dodd-Frank.
A sharp observer will recognize that such a spin-off into three divisions would be a voluntary re-creation of the Glass-Steagall Act of 1934, which mandated the separation of investment and commercial banking with the aim of controlling risk within banks, but that is precisely what is needed in the post-2008 environment. JPM may be the nation’s largest bank and it may have weathered the financial crisis better than others, but that does not make it immune to the reality it is facing now, and action is imperative.
An even bigger consideration for investors should be that even if all the charges against the bank do not actually stick, the distraction of fighting so many legal battles, the cost ($17.3 billion from 2010 through 2012 alone and several billions more to come), the public relations nightmare that will accompany this, and the fact that JPM’s many alleged infractions have made it a prime candidate to be broken up by the government, will do plenty of damage in itself.
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In other words, if the bank does not reorganize its varied lines of business to silo risk of its own volition, then that job will either be done by the government or the bank will continue to be punished by the markets for not doing so. Conversely, a spin off will protect the interests of existing shareholders while helping to unlock further value in the bank’s assets through new investors. Anything less will be a disservice to all investors.
It is possible, of course, that Dimon will refuse to take such steps out of a much-publicized aversion to regulation and his desire to maintain control of his banking empire, but then that would be an even bigger breach of his responsibility towards his bank.
It is better for JPMorgan Chase to embrace change on its own terms by breaking itself up into three parts, and reaping the benefits, than to resist the change and risk an ongoing regulatory nightmare that will eat into the bank’s profits, and hurt shareholders.
Sanjay Sanghoee is a political and business commentator. He has worked at leading investment banks Lazard Freres and Dresdner Kleinwort Wasserstein, as well as at a multi-billion dollar hedge fund.
