Yesterday, J. P. Morgan announced that its chief investment office has experienced a paper loss of $2 billion on its synthetic credit holdings (meaning securities whose values are derived from various credit products like corporate debt). Especially because J. P. Morgan CEO Jamie Dimon has been a particularly vociferous critic of banking regulation, this has predictably given rise to more calls for further regulation of banks, especially in terms of the investments they can make on their own account. But the particular kind of regulation that liberals are fighting for at the margin wouldn’t really have prevented J. P. Morgan’s huge loss. Dealbook explains their case:
JPMorgan Chase’s $2 billion trading loss, which was disclosed on Thursday, could give supporters of tighter industry regulation a huge new piece of ammunition as they fight a last-ditch battle with the banks over new federal rules that may redefine how banks do business.
“The enormous loss JPMorgan announced today is just the latest evidence that what banks call ‘hedges’ are often risky bets that so-called ‘too big to fail’ banks have no business making,” said Senator Carl Levin, a Michigan Democrat who co-wrote the language at the heart of the battle between the financial and government worlds, in a statement. “Today’s announcement is a stark reminder of the need for regulators to establish tough, effective standards.”
The centerpiece of the new regulations, the so-called Volcker Rule, forbids banks from making bets with their own money, and a final version is expected to be issued by federal officials in the coming months. With the financial crisis fading from view, banks have successfully pushed for some exceptions that critics say will allow them to simply make proprietary trades under a different name, in this case for the purposes of hedging and market-making.
The problem for reformers, though, is that they shouldn’t really claim this as an example (though of course they still will) of why we need less proprietary trading, and less risky types of it, via a stricter Volcker Rule. That’s because the CIO’s positions here were a couple steps removed from what the Volcker Rule will actually consider proprietary trading. The debate about the Volcker Rule is what activities constitute banks’ trading on their own account, for profit, and what constitutes market-making, that is, the positions the bank has to take on its own account in order to execute trades for its clients. The latter can realize large profits as well, and lead to the banks’ taking on serious amounts of risk; thus, some regulation proponents would like to see these activities severely restricted as well, while free marketeers claim this would clam up capital markets.
But the problem at J. P. Morgan wasn’t the size or riskiness of the bank’s underlying bets (the CIO was hedging against the bank’s whole portfolio risk). It was extremely poorly executed hedging of those underlying bets, and that kind of activity shouldn’t be restricted by even a very zealous Volcker Rule. That said, one could call for stricter regulations about how closely banks’ own risk officers must oversee traders — indeed, it’s fairly obvious that J. P. Morgan should have reined in the CIO’s bets long before it got to this point. One particular trader, the size of whose (eventually catastrophic) positions earned him the sobriquet “the London Whale,” clearly should have had a Captain Ahab looking over his shoulder a long time ago, hounding him to rein in his risk. Whether federal regulators should be standing over his shoulder, too, is a separate question. For the most part, though, in order to justify that, you’d have to prove that the banks’ positions represent a significant risk to the U.S. or global financial system and therefore must be overseen or reined in, which, again, wasn’t really the case here.