Capital Adequacy Calculations

In this video we're going to calculate JP Morgan's regulatory capital and look at some of the key
metrics in ratios relating to Tier One, Tier Two, Total Capital, and so on. And this is a topic that
we've already covered in the overview videos, so I'm not going to go through the methodology
and the concept behind this all over again. But just to give a quick refresher here, basically the
point of regulatory capital is that for a bank their entire business model as we know depends on
making loans on the assets on the balance sheet, and then to make these loans and to take on
some of the other assets, like trading assets, to borrow securities, to buy securities for example.

They can only do this in proportion to how much in shareholders' equity they have--and
especially in proportion to how much common shareholders' equity they have. If they issue too
many loans

[01:00]

or they have too many risky assets on their balance sheet in relation to the amount of
shareholders' equity they have then the bank is going to be taking on too much in terms of risk,
and if they suddenly lose a large amount on their loans and their loan loss reserves go up by a
huge amount reducing their net loans then they're not going to have enough shareholders'
equity here to cover their losses. What's going to happen as a result if they don't have enough
shareholders' equity is that the customers who make deposits with them may actually lose their
money and anyone else who has loaned the company money on the liabilities side of the
balance sheet may actually end up losing this.

So that's why regulatory capital is so important. For a bank it's really about how much they are
risking in relation to the common equity in the shareholders' equity they currently have.

Now the reason why I've made this separate capital page right here; first off, we want to look at
this separately and create a different tab for it just so anyone who looks at our model later on
could have a view of what's going on.

The other reason that I've created this page is because

[02:00]

as we know from going through the operating model before, where we left off we had tied
together the statements finally, but we still had some holes--specifically we had not yet
calculated dividends per common share here. Also, on the cash flow statement we had not yet
calculated the shares repurchased, and for the dividends paid we had only taken into account

http://breakingintowallstreet.com
preferred dividends here. So we still have some holes and still have some areas here that we
need to fill in.

Of course to figure out the shares repurchased and the dividends paid we need to look at the
company's Tier One Common capital and Tier One Capital ratios, and we're going to look at the
other related metrics as well. The reason why we have to do this is because if they issue too
much in dividends or if they buy back too much in terms of stock it's going to reduce how much
Tier One Capital they have, and that in turn may make the bank too risky. So that's why it's so
important to look at these ratios and how they tie in directly to our operating model.

So in terms of the actual calculation here, I have created a separate PDF

[03:00]

link right below this video, and this is actually something we've been over before in the
overview videos when we went through regulatory capital. But the idea is you start with
stockholders' equity, you subtract preferred stock to just get to the common stockholders'
equity. You might make some adjustments based on the accumulated other comprehensive
income line item, so you might make FX adjustments and other items, other accounting related
items, here, and then you take out most of your intangible assets.

So you're subtracting goodwill here. If you look at the footnote it's net of any deferred tax
liabilities. The reason is that deferred tax liability and deferred tax assets have cash flow value,
whereas goodwill of course does not. So we're looking at a slightly different number in terms of
goodwill here. And then we're making some other adjustments related to their derivative and
structured note liabilities. We're taking out investments in certain subsidiaries, so it's sort of
like equity interest for a normal company.

[04:00]

And then we're taking out only certain intangible assets; specifically, if you remember, going
back to our operating model usually how it works on the balance sheet of a bank is that
mortgage servicing rights are accounted and can be included in this calculation, whereas other
intangible assets here, anything besides these mortgage servicing rates cannot be included
because these typically do not have a tangible cash flow value.

So these get us to our Tier One Common Capital, and then to get to the total Tier One Capital
we add back preferred stock. We add in certain hybrid securities and non-controlling interest. If
we look at the footnotes, they are giving us more detail, the trust preferred capital debt
securities. This is something I mentioned before in the overview videos. These are basically a

http://breakingintowallstreet.com
combination of preferred stock and debt, so we're adding back those here. That gives us our
total Tier One Capital. So this is what's available in total to absorb losses on the asset side of the
balance sheet.

[5:00]

And then Tier Two Capital, long-term debt; notice here that this is not even close to our total
long-term debt balance in the operating model. So it looks as though we're only adding in a
small portion of this long-term debt. We have $266 billion here, but we're only adding back
around $28 billion in our calculations. And then qualifying allowance for credit losses; so we're
not quite adding in all of our provision for credit losses here, so we're going to have to look at
this and see what percentage we can actually add back.

And then adjustment for investments in certain subsidiaries; again, not clear exactly what this is
referring to, because we don't have a footnote. But nevertheless we are making a small
adjustment here.

And then that gets us to our total Tier Two Capital, our Total Capital, and then we have our risk-
weighted assets and total adjusted average assets at the bottom. Remember risk-weighted
assets, we went over this before, but you assign a weighting to each of these different assets on
the balance sheet. You add those up and then that gets you to your risk-weighted

[06:00]

assets. It tells you roughly how much in terms of risky assets a bank has, how much of their
assets, their total assets could actually see a potential loss here.

And then total adjusted average assets here; basically this is otherwise known as tangible
assets, so they include total average assets adjusted for unrealized gains or losses, less
deductions for disallowed goodwill and other intangibles, investments in certain subsidiaries,
and the total adjusted carrying value of non-financial equity investments.

So basically what we're doing here is just looking at total assets and we're taking out some of
these items that have also been excluded from the Tier One calculation right here.

Now let's go back here now and actually start filling in some of these items so we can get to an
idea of what our Tier One Common ratio to our capital ratio, Total Capital and Tier One leverage
ratios here at the bottom look like.

http://breakingintowallstreet.com
For stockholders' equity I am going to go to the operating model, and we actually have this laid
out right here in our balance sheet as you'd expect.

[7:00]

For preferred stock I'm going to do the same thing, and link in directly from our operating
model. And then I'm going to subtract them, subtract the preferred stock to get to the common
stockholders' equity.

For the accumulated and other comprehensive income adjustments, I'm going to set this to
zero and assume that all the way across. We really don't have any other information to go on
here, and we don't know what these adjustments consist of. Actually I linked to the wrong thing
here; I should really be doing the 2010 numbers. Now that we have this in place I'm just going
to copy this formula across.

Now for these next items here; Goodwill, fair value of the derivatives, and then investments
and subsidiaries, and non-qualifying intangibles. So for goodwill it's not entirely correct,
because technically we need to look at deferred tax liabilities. The problem is it's not even a
separate item on the balance sheet, so again, we just don't know what they're including here.

[08:00]

We could do this a couple of different ways. We could just link to the old balance here, because
we're assuming goodwill stays the same anyway. What I'm going to do is actually link to the
operating model and pull in goodwill directly from there. So 2010, and again, we could just link
to the old number here. It's not going to make a tremendous difference, so I'm linking to the
balance sheet instead.

And then for the fair value of the derivatives and investment in subsidiaries, what I'm going to
say is that these are equal to the old numbers, because we just don't know how they are
arriving at these calculations. These are not broken out as separate balance-sheet items, so it
would be total guesswork if we tried to make this up ourselves. We're just going to link to the
old items and assume that these stay constant going all the way across.

Now for non-qualifying intangibles; remember that mortgage servicing rights should be
included in this calculation, so we're really subtracting the other intangible assets right here.
Now if you look at the numbers you'll see that it's not exactly equal. We have about $3.6 billion
in 2009

[09:00]

http://breakingintowallstreet.com
versus around $4.6 billion on the balance sheet. So what I'm going to do here is assume that
only a certain percentage of those can actually be excluded, should actually be subtracted, from
this calculation. It looks like this number is going up and converging to about 80% here. So I'm
going to say 80% and copy this across.

And then for the actual number here, I'm going to go to the balance sheet and take our
intangible assets for 2010 and multiply it by the percent that are actually non-qualifying here.
Copy this across. We see overall this is going down by quite a bit, primarily because we have
amortization for those intangibles, so the balance here keeps getting lower.

For Tier One Common capital, we want to take our common equity, the accumulated other
comprehensive income adjustments, and then subtract goodwill, derivatives, and investments
in subsidiaries, and non-qualifying intangibles. This is a metric

[10:00]

that we didn't pay too much attention to in the overview videos, but especially with the U.S.
Government's TARP Program and preferred stock, it became more important around the time
of the crisis because you want to look at how much in common capital outside of preferred
stock is actually available to absorb losses here.

For preferred stock we can simply link to our preferred stock line item at the top here. Then for
qualifying hybrid securities and non-controlling interests it's not clear exactly what's being
included in there. If you look at the liability side of the balance sheet it looks close to the
beneficial interest line item, but it may be referring to something different, and it maybe
referring to only parts of the securities that are listed on the liability side. So as with the other
items the safest thing to do here is to assume that this one is constant going all the way across.

And then for total Tier One Capital, of course, we take the Tier One Common and add in
preferred, and non-controlling interests and hybrid securities.

[11:00]

So we're going to take this one and copy it across. So overall our Tier One Capital is going up by
quite a bit here. Of course what really matters is what percentage of the risk-weighted assets
this represents.

We also want to look at the growth ratio here, the growth percentage just for our own
purposes to make sure it's not going up by too much or too little. And it looks like it's rising by

http://breakingintowallstreet.com
around 13%, 14%, 15%, 16% per year, which seems reasonable based on the historical data. It
actually fell in 2009, but in the previous years it was going up by around 5% to 10%, up to 50%
in 2008. This oneof course, you can really look at 2008 because we had a lot of unusual items.
We had TARP being issued. We had the acquisition of Bear Stearns and WAMU here, so that is
definitely affecting things. That's why the numbers in 2008 are probably off from the historical
ones here.

[12:00]

Now I'm moving down to the Tier Two Capital calculations. So remember here, the idea is we
mostly take subordinating debt and qualifying credit loss provisions. So subordinate debt is not
a separate item on our balance sheet, but we do know that it probably falls in the category of
long-term debt, right here. Long-term debt, of course, if a percentage of our loans, our loan
portfolio; so this one is definitely going up over time. Again, we don't know how much of that is
subordinated versus senior notes versus other types of debt, so the safest thing to do here is to
assume that this is again constant going all the way across.

To be honest, this one is probably not accurate; this one is probably going up by a little bit, but
if you look at the changes historically here it's really not too much. It's changing from about $22
billion to $28 billion here over the course of 5 years. So we're probably under counting this by a
little bit. It probably should be going up to around $35 billion or $40 billion here. But again, not
a big deal because we just don't know how much of the debt

[13:00]

is really subordinated versus senior notes versus other types of debt there.

Then for qualifying credit loss provisions; remember that not everything is going to qualify and
be allowed to count for Tier Two Capital, so what we're going to do is actually look at the
percentage that does qualify. What I've done here is I've taken the qualifying credit loss
provisions and just made a simple percentage estimate of the total credit loss provisions. It
looks like we start out at around 100% or over 100% and then it falls to around 50%,
presumably due to the financial crisis and the rapid increase in credit loss provisions in 2008
and 2009. What I'm going to do is assume they return to normalcy here, so I'm going to say
60%, 70%, 80%, 90% and 100% so that in year 5 we have all of our credit loss provisions
qualifying once again.

For this one I'm going to go to the balance sheet and take our allowance for loan losses

[14:00]

http://breakingintowallstreet.com
and multiply it by the qualifying credit loss provisions. This number I actually want to put a
negative sign in front of because we want this to be a positive; copy this across. So you can see
here in year five the $14.5 billion exactly matches our loan loss reserve in 2014 here. And
actually I mentioned before that these are credit loss provisions--actually this is really referring
to the loan loss reserve. So if you look here, qualifying allowance for credit losses, I should
really call this qualifying allowance for loan loss to be more accurate here.

Because otherwise you might get this confused with the provision for credit losses on the
income statement; this is actually referring to the loan loss reserve on the balance sheet.
Because with all the capital calculations we're looking at balance sheet items, not income
statement items. Then for adjustments, again we don't know whats in here,

[15:00]

but we're just going to set it equal to the old number and carry this across. It's very small to
begin with.

For Total Tier Two Capital; again, we're just going to add these up and remember, Tier Two
Capital has to be less than Tier One Capital, so we're fine here. You might be wondering now,
well, shouldn't we build in a check to our model to make sure that Tier Two Capital is always
less than Tier One Capital?

The answer is it really doesn't matter here. It would be almost pointless to do this because Tier
Two Capital is so small to begin with. It's not like it's even close here. Tier One Capital is always
going up because of net income increasing the shareholders' equity here. The other items are
mostly constant or going down. Tier Two Capital is pretty much stagnant here. Qualifying
allowance for loan losses does affect it, but overall, Tier Two Capital is really never going to be
greater than Tier One Capital here, so there's not much of a point in building in check to our
model to make sure it stays less than Tier One Capital.

For the percent growth we're just going to use a simple percentage here.

[16:00]

We see it's falling in later years. And then for Total Capital here we're just going to take Tier
Two plus Tier One; so Tier Two Capital plus Tier One Capital. This should actually be cell J20
there. And I will copy this across.

http://breakingintowallstreet.com
Percent growthwe just like to look at this as with all forms of capital; 14%, so it's staying about
the same range here, around the 10% to 15% range. That is good news because that means that
we can check this against our equity research and some of the other projections and see what
they have for risk-weighted assets and for total assets for example.

For the risk-weighted assets, we are going to have to hold off on this one for now until I explain
how to get to it. For total adjusted average assets the same thing. We're going to have to hold
off on this one until I explain how to actually get this.

[17:00]

Total assets by contrast we can just link in directly from our balance sheet. So total assets, right
here, for 2010, and I'll link in right there.

Now for the tangible assets here; what I originally had for this calculation is the total assets
minus goodwill, minus non-qualifying intangibles, which is not wrong, but actually if we look at
the note here in more detail we see adjusted average assets for purposes of calculating the
leverage ratio include total average assets, adjusted for unrealized gains, less deductions for
goodwill and other intangibles. Basically they're deducting everything that we deducted from
the Tier One Common capital calculation right here.

So what I'm going to do actually is go in and change tangible assets right here. I'm going to take
total assets and then I'm going to deduct everything that we deducted to get to our Tier One
Common capital ratio.

[18:00]

It's not going to make a huge difference, but we do want to be as complete as possible and try
to match JP Morgan's filings as closely as possible.

So I'm going to go in and change this item right now. It changes by a little bit, and the same for
tangible equity. I am going to take our common stockholders' equity and simply deduct
everything that we deducted for the Tier One Common calculations here. So it does change by a
little bit--not too large of a difference, but it does make somewhat of an impact.

And then for future years, I'm just going to copy this formula across, unbold this and then the
same for tangible equity.

The reason why we're looking at this of course is that we want to make sure when we look at
metrics like return on equity, for example, and some of the other capital related metrics,

http://breakingintowallstreet.com
[19:00]

that we're only looking at tangible hard assets that are actually earning interest for the bank or
have some kind of cash flow value.

Non-qualifying intangibles, of course, don't have any cash flow value. The unrealized gains and
losses that we see here for the fair value item, and then also investments in subsidiaries; many
of these may not have actual cash flow value and are not actually earning interest. So that's
why we're taking them out of this calculation.

So we have our tangible assets and we have our tangible equity here. The next thing I want to
do is figure out what our total adjusted average assets are, and to do this remember, we have
the calculation right here where they're telling us in their filings that their averaging up basically
our tangible assets number right here. So for total adjusted average assets, I'm going to take
the average of our tangible assets, so basically we're looking at their total assets and excluding
everything that we took out of our Tier One Common calculation.

[20:00]

I'll copy this across.

And then for the risk-weighted assets; if you remember way back to our overview videos, in
those videos we assigned a risk weight to all the assets on a bank's balance sheet, and then we
added those up. The problem is that large commercial banks like JP Morgan just do not do this
in their filings. They're not going to tell you how much their risk weighting their assets by. So it
would be great for example if we could just go over to their balance sheet and say that cash is a
zero percent risk weighting; deposits has a 10% risk weighting, and so on and so forth until we
risk-weight every single asset. But unfortunately they just do not give us enough detail to do
that.

Instead what we're going to go is assume that risk-weighted assets are a percent of the average
interest earning assets here. And the reason for that is, remember back on our regulatory
capital worksheet right here cash had a risk weight of zero because it's earning minimal
interest, or sometimes no interest.

[21:00]

Whereas with the other assets, the more interest that they're earning for the bank the higher
the risk weight they have.

http://breakingintowallstreet.com
So corporate loans to triple A companies are going to have a lower interest rate than corporate
loans to BB minus companies here. So of course, according to Basel II, anyway, they are also
going to have a lower risk weight.

What this means if you think about it is that only assets they're actually earning interest on are
going to be risky. We know for example that goodwill is going to have a risk weight of zero, that
cash is going to have a risk weight of zero. What this really means is that their risk-weighted
assets are going to be proportional to the interest-earning assets here. And so that's the
assumption that we're going to use for our calculation.

Now the one flaw with this is that going back to our regulatory worksheet, we're not including
off-balance sheet assets here, but that's okay, because off-balance sheet assets are generally
going to still be linked to the on-balance sheet assets. So for example we would normally not
have a situation where a bank suddenly gets a lot of off-balance sheet assets,

[22:00]

but then has nothing on-balance sheet or the on-balance sheet assets are declining. So it's
generally okay that we do this, and this is actually the standard way that you see risk-weighted
assets being projected as a percentage of the average interest-earning assets in your model
here, specifically on the balance sheet.

Now what I'm going to do here is say that this is a 75% in the first two years, matching the 2009
level, and then it goes back toward 100% here, 90% to 100% range, to match the earlier
historical years; so 80%, 85%, and then 90% here. So to actually make this calculation now I'm
going to go to the balance sheet, actually the interest earning assets section, and take the
average interest earning assets from 2010 and multiply it by the 75% here. We see of course
that it's going to be lower than our total adjusted average assets, and I'll copy this across now.

[23:00]

We also want to look at the growth rate here just to check ourselves, and copy that across. So
it's growing by around 3% or 1%, 2% in the first two years, and then around 10%. It's a little
alarming that it jumps up like this, but again, if you look at the projections it sort of makes
sense, because we had a downturn in 2008 and 2009 and a recovery, then a growth flattening
off after that. But in later years we just have a much higher asset base, so it sort of makes sense
if you go in and look at the interest-earning assets calculations here. These are actually jumping
up in 2012 to 2014 as well, so it's not terribly wrong here that our risk-weighted assets are also
jumping up.

http://breakingintowallstreet.com
Now with all this in place, what we can do is calculate these ratios at the bottom, Tier One
Common, Tier One Capital, and Total Capital. So Tier One Common,

[24:00]

we're going to take the Tier One Common Capital here and divide by the risk-weighted assets.
Tier One Capital, we're going to include preferred and non-controlling interests and hybrid
securities, and then divide it by risk-weighted assets. And then Total Capital, we're going to take
our Total Capital numbers here and divide by the risk-weighted assets.

Then for Tier One leverage, we see the calculation here; Tier One Capital divided by the
adjusted average assets. The point of this one is to really look at a very simple metric, basically
how much in Tier One Capital a bank has relative to how many assets total are on its balance
sheet.

Now the reason that it's not quite that simple is because, remember, for Tier One Capital here
we're making some adjustments, we're subtracting some items. And so in our total adjusted
average assets item we're also going to be subtracting these same items. We want to have an
apples-to-apples comparison,

[25:00]

which is why we subtract these items in both and why we're actually going to be using, if you
think about what adjusted average assets is; we're really averaging tangible assets here, and
tangible assets, of course, are also subtracting these items.

So for the Tier One average ratio bottom line is that we're going to take Tier One Capital and
divide by the total adjusted average assets here. And now we'll copy this across.

So there we have our capital ratios for JP Morgan. Overall these are greatly increasing. We have
our Total Capital ratio going up to around 20% here, Tier One Common going up to around 15%.
No bank would ever actually get ratios that are this high. Typically for Tier One Common and
Tier One Capital you like to see an 8%, 9%, 10% range, so we are clearly way too high right now.
And of course we're going to end up fixing this because the next thing we need to do

[26:00]

is figure out how much in dividends and share repurchases JP Morgan is going to make. Those
in turn are going to reduce many of these ratios here.

http://breakingintowallstreet.com
We see that even a Tier One leverage ratio is very high here, over 10% in later years. So part of
the reason why we have to look at dividends and shares repurchased is to make sure that these
ratios stay in a reasonable range for a large commercial bank like JP Morgan. They are more
conservative than other institutions, but they are still a commercial bank with shareholders and
shareholders expect to get paid dividends, expect to get share repurchases, capital returned in
the form of share repurchases as well, so we need to take those into account.

And to do that we're going to be looking at our minimum Tier One Capital here in the next
lesson, and we're going to be going through and actually using all of our calculations here to
determine the minimum amount of Tier One Capital JP Morgan needs and then figure out
based on that how much in dividends can they actually issue, and how much in share can they
actually repurchase each year.

http://breakingintowallstreet.com