JPMorgan Chase & Co.’s $2 billion trading loss has unleashed a whirlwind of commentary on how (and how not) to regulate the financial system. A few observations on some of the central questions that have been raised:
Does this mean the Dodd-Frank financial reform law hasn’t worked? Not at all. It doesn’t really tell us much of anything about the effectiveness of the law overall or of the Volcker rule in particular. The anti-Volcker set argues that, because the bank was hedging, and hedging is allowed under an exception to the Volcker rule’s proprietary trading ban, then the rule is unworkable and should be repealed.
Sorry, but this can’t be true. The rule hasn’t been put into force yet, and won’t be until 2014. Regulators, moreover, haven’t decided to what extent banks will be able to call their trading activities “hedging.”
This is doubly true for so-called portfolio hedging -- buying and selling instruments to protect a bank’s aggregated level of risk, instead of matching an individual exposure with a countervailing one. Only the latter are considered true hedges, and regulators haven’t decided whether and how much portfolio hedging they will allow.
Aren’t new derivatives rules ineffective? These, too, are part of the Dodd-Frank law and haven’t been put into force. But it’s not as if JPMorgan’s derivatives trades were inaccessible to Federal Reserve supervisors. Bank regulators had every right to look at the books of the London branch of the chief investment office, where the trades -- in a credit-derivative index known as the CDX, which tracks the default risk of a basket of companies -- were conducted.
Shouldn’t the traders and their bosses be thrown in jail? Of all the commentary these last few days, this seems the strangest. Nor does it seem relevant to remark, as some pundits have, on the fact that no top financial executives have been thrown into jail for their roles in the 2008 financial meltdown. What Chief Executive Officer Jamie Dimon or his former chief investment officer, Ina Drew, did may have been ill-advised, but it was hardly criminal. More important, the 2008 crisis occurred not because of a criminal conspiracy among top bankers but because of errors of policy and regulatory oversight and institutional greed.
Aren’t banks taking too many risks? Wait -- isn’t that what banks do? Every time a bank lends money, it’s taking on risk. And sometimes the same people complaining that banks are too risky are simultaneously lamenting that banks aren’t lending enough. They can’t have it both ways.
Here’s what JPMorgan’s trading losses do tell us: Extending credit is a risky business, and banks must have the ability to hedge those risks. But because bank deposits are guaranteed by taxpayers, regulators must make sure banks are hedging properly -- and not letting hedges become new risks.
Regulators haven’t finalized plans, also authorized by the Dodd-Frank law, for winding down very large banks on the verge of failure. But even after regulators have off-the-shelf instructions on how to liquidate the big banks in an orderly way, the market will probably continue to view too-big-to-fail banks, including JPMorgan, as operating with an implicit federal guarantee.
To account for both implicit and explicit federal guarantees, the Volcker rule must be explicit: It shouldn’t allow the kind of portfolio hedging that caused JPMorgan to lose $2 billion. It shouldn’t let banks disguise proprietary trading as hedging. And it shouldn’t let banks continue prop trading under the guise of market making, in which they trade on behalf of customers. For their part, regulators, who may have been (once again) blind to the risks taken on by a major bank, must be more vigilant.
Dimon was the rare Wall Street leader with credibility, having brought JPMorgan through the 2008 crisis with only minor scratches. In the end, though, the bank may have proven that it’s too big to manage, all of which means that regulators may need to consider something far tougher than last year’s Volcker rule proposal.
One solution would be to require financial institutions to separate commercial banking using depositors’ money from other activities, similar to the ring-fencing the U.K. government is demanding of its banks. Banks say they want the certainty of clear rules, yet they don’t want regulators second-guessing their trading desks or reinstating the Glass-Steagall law that broke off investment from commercial banking. Ring-fencing would accomplish it all.
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