The size of the reported $13 billion settlement between the Justice Department and JPMorgan Chase commands awe and attention. It's also garnering a lot of criticism.
The New York Post portrays it as a kind of bank robbery. The Wall Street Journal describes it as the government "confiscating" half of JPMorgan's annual earnings to "appease…left-wing populist allies" of the Obama administration.
We still do not know all the details of the tentative settlement or the evidence the government has against the bank. But the initial outburst of horror at the $13 billion figure is very likely unwarranted and appears to be based on a fundamental misunderstanding of how damages should be assessed in cases of financial wrongdoing.
(Read more: Considering the fairness of the JPMorgan deal)
In the first place, any view about the unprecedented size of the fines needs to be balanced by the unprecedented size of JPMorgan.
The bank now has $2.4 trillion in assets. This means there are more opportunities for legal liabilities to arise and a need for larger fines to punish wrong-doing. A fine of a few million dollars—even several hundred million dollars—barely merits a footnote in a JPMorgan earnings report.
In thinking about the size of the potential JPMorgan settlement, it's helpful to begin with the very basics.
Fines levied by the government should aim to deter undesirable behavior without over-deterring beneficial behavior. We want to avoid outright fraud and negligence without making it impossible for banks to offer mortgage securities to investors.
Many people worry that very large settlements could permanently disrupt the mortgage market.
Extreme fines could make playing the role of issuer just too risky for banks. Or, alternatively, the cost of investigating mortgage quality and compliance with representations and warranties required by investors (and, after the fact, by regulators) may simply be more than the market can bear.
(Read more: How the JPMorgan deal could curtail credit.)
But this is only one side of equation.
On the other side, there are the potential investors who need to know that banks are properly incentivized to live up to the promises they make when issuing mortgage-backed securities. That there is no room for "efficient fraud" or "efficient negligence" whereby the bank makes more by fraudulent or negligent issuance than loses through fines years later.
Large fines should convince investors that the market in mortgage-backed securities is safe enough to re-enter.
In other words, if we focus on the demand side, strict enforcement of promised credit standards in mortgage-backed securities could lead to looser credit and more mortgage finance availability. Investors will know that the system can be trusted.
Ideally, the fines for the negligence claims would be high enough to incentivize future issuers to properly investigate the underlying mortgages but not so high as to make issuance prohibitive because of possible legal liabilities. Which is to say, we'd want the fines to exceed to cost of undertaking an investigation into the loans multiplied by the odds of getting away with not investigating—and we'd want that number not to be so high that they make issuance completely uneconomical.
We do not, however, live in the ideal world. In the real world, there may be no actual middle ground on which regulators, investors and issuers can meet.
Fines large enough to convince investors that issuers will be well-behaved may be too large for issuers to bear. There may not be a market for the securitization of any but the safest mortgages.
That would mean that we either have to accept that the market for riskier-mortgages will be tighter for the foreseeable future or allow for continued subsidization of this market through government guarantees.
Instead, however, everyone seems to want to pretend that we live in the ideal world where mortgages are safe, cheap and readily available so long as everyone follows the rules.
But assuming that the admittedly shocking size of the JPMorgan settlement is a sign that regulators are over-reaching is a mistake. In a world of multi-trillion dollar banks taking in scores of billions in revenue, effective deterrence comes with a high price tag.
—By CNBC's John Carney. Follow him on Twitter @Carney