A Shock From JPMorgan Is New Fodder for Reformers
It didn’t take long for bank reformers to say we told you so. 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 JPMorganannounced 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 missteps by JPMorgan could highlight that murky line between proprietary trading and hedging. The bank unit responsible for losses takes positions to hedge activities in other parts of the bank.
“This is a crucial moment in the debate,” said Frank Partnoy, a professor of law and finance at the University of San Diego, who has been a longtime supporter of tighter rules for the nation’s banks. “It couldn’t have come at a worse time for JPMorgan Chase. After everything we went through in the financial crisis, the fact that something of this magnitude could happen shows that the reform didn’t do the job.”
On Wall Street, few have been more outspoken about the pitfalls of the Volcker Rule than JPMorgan’s chief executive, Jamie Dimon. Mr. Dimon not only attacked the rule, he personally criticized Paul Volcker, the former Federal Reserve chairman and the regulation’s namesake.
“Paul Volcker by his own admission has said he doesn’t understand capital markets,” Mr. Dimon told Fox Business earlier this year. “He has proven that to me.”
The industry reasons that the Volcker Rule would be a costly burden for the banks. But more important, industry officials say, it would hurt the markets and the broader economy.
“Regardless of how the final rule turns out, it will be a shock to the U.S. financial system, as banking entities will need to take extraordinary measures to attempt to implement it,” said Barry Zubrow, JPMorgan’s executive vice president of corporate and regulatory affairs, in a letter to federal regulators earlier this year. In the letter, Mr. Zubrow defended exactly this kind of trade.
Even Mr. Dimon had to admit Thursday’s disclosure was a setback for JPMorgan and other banks that want more flexibility when the final version of the Volcker Rule is issued. “It plays into the hands of a bunch of pundits but you have to deal with that and that’s life,” Mr. Dimon said Thursday on a conference call with analysts.
As fuel for industry reformers, JPMorgan provides a compelling case study.
Unlike the collapse of MF Global last fall, JPMorgan is a Wall Street giant, and under Mr. Dimon’s oversight, it seemed to have mastered risk management. After all, the bank weathered the financial crisis better than most.
Nor was JPMorgan damaged by rogue traders of the sort that cost UBS $2.3 billion in September, or hit Société Générale with a $7 billion loss in 2008. This was a strategy that the bank itself had devised, with the full knowledge and support of JPMorgan management. In other words, it is the kind of risk that executives like Mr. Dimon say they should be able to manage — but might not be to defend in the wake of the loss disclosed Thursday.
Mr. Dimon and other bank executives argue that hedging, when used properly, allows financial institutions to offset the normal risks they face from economic or market shifts, and doesn’t represent the kind of proprietary, directional bet that the Volcker Rule is intended to bar.
In Washington, proponents of stricter regulation say any permitted hedge trade should be tied to a specific position — say a loan to a particular company, or securities being held in inventory for customers on a trading desk. They argue that such trades represent appropriate activities to protect the bank’s balance sheet.
Broader hedges, like the one that proved so costly to JPMorgan, should be forbidden, they argue.
JPMorgan suffered losses in a portfolio of credit investments. Mr. Partnoy said broad economic hedging carries risks of its own — and sometimes they can be bigger than proprietary bets like the one that brought down MF Global.
“They’re playing with fire,” said Mr. Partnoy. “With proprietary trading, you know about the risks. With a hedge, you start to feel safe about it and it lulls people into a false sense of security. It can be a wolf in sheep’s clothing.”
Even as Mr. Dimon put the blame squarely on his bank, his arguments on Thursday seemed intended to leave the impression that it was poor execution, not the risks inherent in accumulating big trading positions, that caused the huge loss. In fact, he went out of his way not to blame market shifts or trading reverses.
“Just because we’re stupid doesn’t mean everybody else was,” he said. “There were huge moves in the marketplace but we made these positions more complex and they were badly monitored.”
“This may not have violated the Volcker Rule, but it violates the Dimon Principle.”