Last week we were treated with the news of another multi-billion dollar loss suffered at the hands of one of the largest and most respected banking institutions in the world, JP Morgan Chase. While the loss of $2 billion may turn out to be nothing more than a blip on JP Morgan’s financial statement, it is a stark reminder of how inexplicably linked we, as taxpayers, are to the fortunes of banks that are “too big to fail.”
Although JP Morgan is not about to fail anytime soon – they will easily be able to absorb the loss – the incident has fueled the fires raging over the need for more bank reform which, thus far has done little to stem the systemic risks that led to the financial crisis in 2008. In fact, if anything, the reform measures advanced through the Dodd-Frank financial reform law has done nothing more than make life more miserable for the banking public by increasing costs and reducing bank lending.
Just a “Stupid” Mistake?
At issue for banking regulators is the way in which JP Morgan used “risky” credit derivatives to minimize its investment risks. Essentially, it utilized a convoluted series of trades to offset the perceived risk of corporate default on its loan portfolio. First, it hedged its portfolio against the possibility of default, so that its portfolio could profit with an increase in defaults. Then, when it was determined that the default risk no longer existed, it hedged against its hedge so it could make money the other way.
In the end, the massive portfolio wrapped in hedges and hedges of hedges became unmanageable, and the traders lost control. While the loss was egregious, the trading strategy was characterized by the CEO of JP Morgan as “flawed, complex, poorly reviewed, poorly executed and poorly monitored.” And for that, several heads rolled. But, other than that, it is business as usual at JP Morgan.
Never One to Let a “Crisis” Go to Waste
Enter the knee-jerk regulators and legislators crying “the sky is falling” as they usually do when they want something more heavily regulated. Invoking the “Volker Rule”, a provision of Dodd-Frank that was supposed to outlaw proprietary trading by banks, legislators called the senior management of JP Morgan to Washington D.C. to explain themselves.
Even after it was determined that what JP Morgan did was not a violation of the Volker Rule (banks are allowed to protect their loan portfolios against credit risk using hedges), the legislators are using this as an opportunity to reinforce the need for Dodd-Frank, which a growing number in Congress would like to repeal.
The problem for those in favor of the law is that they don’t even know how it is supposed to work. In fact, since its enactment, fewer people – legislators and citizens alike – truly understand what the law is intended to do. It certainly isn’t doing anything to fix the systemic problems as promised by its authors.
What the regulators and the legislators have failed to acknowledge, or perhaps chosen to ignore, is that a rash of bank failures over the last several years had very little to do with the investment behavior of the banks; rather it has everything to do with bad housing loans which are still generating massive losses for the major banks. Yet, there is nothing in Dodd-Frank that regulates a bank’s ability to issue bad loans.
The guiding principle of the Dodd-Frank legislation was that it was supposed to end the “too big to fail” mentality of our government and shift the burden of failed institutions away from taxpayers and to investors. While Dodd-Frank falls short of a government takeover of the banking industry, it imposes such a massive web of bureaucratic entanglement that the banks will need permission from the government to sneeze. Most people do want banking reform, but Dodd-Frank reforms nothing, and only reinforces the “too big to fail” mentality.
Just as the political winds were starting to shift against Dodd-Frank with the real possibility of its repeal following the elections, the timing of the JP Morgan blooper could not have been worse. The banks will continue to get bigger, and the taxpayers will continue to be their ultimate safety net. Consumers will fare the worst in the meantime, as the banks will do whatever they can to boost shareholder value, which has to come at the expense of their customers. Thanks a lot JP.
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