Which Matters More: A Bank's Size, or Its Appetite for Risk?

The big banks have certainly been hogging the spotlight lately, as JPMorgan Chase's trading blunder once again brings the issue of megabank risk-taking to the fore. The incident added grist to the mill of the too-big-to-fail argument as well, with ex-titans of the banking industry chiming in with the growing chorus demanding that huge institutions be carved up into oversight-friendly pieces. So is it the girth of the big banks that lies at the root of the sector's woes, or is it the risky behavior in which these banks engage? Or is it both?

Lending is out; investing is in
As reported by CFO.com, Standard & Poor's recently took a look at the financial profiles of the six biggest banks and found some interesting tidbits. Megabanks are bumping up the risk factor in their investment portfolios to increase profits, and this portion of big banks' income generation is trumping other areas, such as lending and other services. In fact, it's a bigger piece of the earnings pie now than it was before the crash.

Where are banks getting the money to invest in these ticklish securities-based investment vehicles? The lack of lending by these institutions, coupled with high retail deposit rates, has given banks a nice big pile of cash to play with. The difference between outstanding loans and deposits has grown since right before the meltdown, according to the ratings agency. Investable funds now total $889 billion, compared with a negative $199 billion at the end of 2007.

A movement toward more risky portfolio ingredients
Usually, these portfolios are made up of low-risk products such as Treasuries and mortgage securities backed by Fannie and Freddie. But three banks in particular -- Wells Fargo (NYS: WFC) , JPMorgan Chase, and Citigroup (NYS: C) -- have packed these holdings half-full with more risky securities such as non-agency mortgage-backed securities and foreign government debt. By contrast, Bank of America (NYS: BAC) has a mere 15% of the riskiest securities, and US Bancorp's (NYS: USB) portfolio contains only 20%.

In the piling on of risk-on-top-of-risk category, Wells Fargo and PNC Financial (NYS: PNC) take the cake with the highest percentage of Level 3 assets in their portfolios. These securities are hard to pin down as far as riskiness goes, since they're based on the banks' own modeling systems. Wells' portfolio holds 14.5% Level 3 assets, while PNC has 13.6%. The report also noted that all these banks appear to be using derivatives to hedge the assets in these portfolios, but the banks are being less than transparent as to how these hedges actually offset risk. Remember -- it was one such supposed "hedge" that blew up, costing JPMorgan some $6 billion in trading losses.

The movement toward more risk-taking seems to be a direct consequence of the low-interest environment, but Fitch Ratings points out another reason: the increase in put-back requests to large banks from government-sponsored enterprises such as Fannie and Freddie. Banks have been forced to increase reserves against such claims and are thus unable to count that cash as income. Trying to make up the difference by upping the ante on securities seems like a probable scenario to Fitch, which, unlike S&P, hasn't noticed a trend in that direction.

A senior economist at the New York Federal Reserve Bank points out that the largest banks make substantially more of their income from investment banking and trading, as opposed to traditional sources such as lending and banking services, than small and medium-sized banks do. While all banks made approximately the same amount of money from bundled securities during the years between 2001 and 2010, big banks made most of their money from investment and trading up until 2006. A drop-off occurred in 2007 to 2008, but activity shot right back up again in 2009. It seems that, given their druthers, big banks much prefer this type of banking to any other.

An insurmountable problem?
While it seems that the actual behavior of the banks is the real problem, the correlation between megabanks and the predilection to risky behavior can't be discounted. It seems that the crescendo of voices calling for the breakup of these behemoths is spot-on after all. Are regulators -- is Congress -- listening?

According to Neil Barofsky, onetime special investigator general for the Troubled Asset Relief Program, the government has no interest in slimming huge banks down to a manageable size. Currently plugging his new book about the financial crisis, Barofsky says Washington's main concern is seeing the big banks make money, not making them toe the line on safety. To illustrate, he points to the demise of the SAFE Banking Act, which would have put limits on the size of TBTF banks.

If a steady diet of investment portfolios filled with products so dodgy that the banks use an esoteric internal mechanism to rate them doesn't whet regulators' appetite for reform, what will? After all, this is a serious problem -- so serious that S&P states in its report that the current level of risk attached to the six biggest banks could lead to additional downgrades. The increasing tendency of megabanks to use depositors' money to execute these trades is especially troubling.

Barofsky postulates that only a groundswell of public indignation will eventually pressure regulators to fix the broken system. If so, perhaps the current climate of distaste for big banks and the call to downsize them is the beginning of a movement that will bring about change -- hopefully, before another crisis hits.

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The article Which Matters More: A Bank's Size, or Its Appetite for Risk? originally appeared on Fool.com.

Fool contributorAmanda Alixowns no shares in the companies mentioned above. The Motley Fool owns shares of Bank of America, PNC Financial Services Group, Citigroup, and JPMorgan Chase.Motley Fool newsletter serviceshave recommended buying shares of Wells Fargo. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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