Whale Hunting Isn't Fed's Job

Regulators can't protect banks from making mistakes.

A government auditor has criticized the Federal Reserve for failing to prevent the 2012 "London Whale" fiasco at JPMorgan Chase & Co -- a series of bad trades that ended up costing the bank more than $6 billion. The audit may be right on the facts, but the premise is questionable. Regulators can't be expected to stop banks from making bad decisions that cost them money.

The Office of the Inspector General says that examiners from the New York Fed noticed something risky going on at JPMorgan's chief investment office as early as 2008. They were either too busy or too disorganized to take a closer look, and they didn't share their concerns with the bank's primary supervisor, the Office of the Comptroller of the Currency.

No doubt the Fed and the OCC could have done a better job of cooperating and setting priorities. But suppose they'd done that flawlessly. Would this have avoided the losses? As the inspector general admits, it's impossible to say.

More to the point, regulators aren't well placed to manage such risks. No matter how many people they throw at the task, they can't prevent banks from making mistakes. It's one thing to make rules that protect shareholders and the public by containing moral hazard and creating the right incentives; it's quite another to try to set up as shadow managers.

Regulators ought to concentrate on minimizing the risk that the broader economy will suffer when banks do dumb things -- because, now and then, you can bet they will, regardless of how well they're supervised. If traders and executives break the law, of course, they should be punished.

For all the bad behavior it entailed, the London Whale loss wasn't big enough to present a systemic risk on its own. Along with other recent failures of management, though, it suggests that the size and complexity of the largest banks remain a problem. Regulators are right to look closely at the systemic risks posed by the biggest banks, a theme that New York Fed President William Dudley returned to this week. They're also right to demand that banks write credible living wills, describing how they would be dismantled in bankruptcy; to require more loss-absorbing capital; and to build a financial early warning system to identify dangerous concentrations of risk.

This is, as yet, work in progress. For instance, officials are collecting early warning data, but struggling to make sense of it. Last year, a regulator said the information was such a mess that the agency wouldn't have seen JPMorgan's London Whale positions, much less been able to assess the systemic risk they presented.

Regulators have their own unfinished work -- and plenty of it -- to be getting on with. Don't ask them to be bank managers as well.

--Editors: Mark Whitehouse, Clive Crook

To contact the editor on this story:
David Shipley at davidshipley@bloomberg.net