Financial Regulation

Why JPMorgan Chase's $2 Billion Blown Deal Doesn't Prove the Case for More Financial Regulation

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News that megabank JPMorgan Chase lost $2 billion on a trading scheme designed to help hedge risk has predictably resulted in smug told-you-sos from those who favor increased regulation of the financial sector. In his column this morning, for example, Paul Krugman writes that while many business mistakes do not require a government response, "banks are special, because the risks they take are borne, in large part, by taxpayers and the economy as a whole. And what JPMorgan has just demonstrated is that even supposedly smart bankers must be sharply limited in the kinds of risk they're allowed to take on."

But here's the thing: JP Morgan Chase's bad deal might show up as a quarterly loss on the company's balance sheet (although CEO Jamie Dimon is still predicting a small profit), but it is almost certainly not going to result in a direct loss to taxpayers. This is a $2.3 trillion company with a $190 billion capital base. The banking unit made more than $12 billion last year. Gene Kirsch of Seeking Alpha points out that the $800 million quarterly loss "represents approximately 4% of its total net profit for all of 2011, less than 2.7% of its operating income." Even Jared Bernstein, a former White House economic adviser who also thinks the loss proves the case for regulation, agrees that the bank "appears to be handily able to cover the losses." So even with a relatively large loss like this, we're not talking about a serious direct risk to taxpayers. Instead, we're looking at a substantial loss to the individual bank.

That's important, because the Wall Street calamities that shook the economy a few years back weren't a result of isolated mistakes at the individual bank level. They were the result of networked failures, in which multiple market players make the same set of mistakes at the same time, taking up all the give in the system simultaneously.

Would tougher regulation of the financial sector have prevented JPMorgan's loss? That's not at all clear. The Washington Post's Allen Sloan, who favors many stricter financial sector rules, says that because there's no likely loss to taxpayers, the blown deal proves mostly that the bank should be embarrassed. Bernstein argues that Dodd-Frank would have prevented the loss if "properly implemented and enforced."

But "proper" implementation is always harder than it sounds. And I'm not sure we have any more reason to trust that regulators have the wisdom and judgment to prevent such losses any more or better than the bankers themselves. As Bernstein writes, "the fundamental truth here is the one known since Adam (Smith, that is) and amplified by the great financial economist Hy Minsky: humans underprice risk." But that's true of regulators as well. And even the smartest and most capable regulators have several disadvantages compared to their industry counterparts. One is that they lack the kind of intimate knowledge that deal makers have of their own transactions. The second is that they don't have the same sort of financial incentives not to fail. As an institution, JPMorgan Chase lost several billion dollars and took a huge hit to their credibility with this trade. Three executives tied to the blown deal are likely to lose their jobs. CEO Jamie Dimon is facing tremendous embarrassment and pressure from the media, public officials, and, no doubt, his shareholders. Overall, these folks had a lot more riding on the success of these deals than any regulator ever would have. And yet they still made mistakes.

Which is ultimately the nature of the marketplace. Markets don't evolve by preventing mistakes entirely. They learn by making mistakes, by experimenting with new business models, some of which prove unsuccessful, and then further refining the process, and usually making more mistakes along the way. But it's incredibly difficult for anyone — regulator or market player — to know what will fail in advance, and regulations that prevent some failures also typically end up blocking a lot of potential successes. What JPMorgan's blown deal mostly proves is that complex systems sometimes fail, and that it's very hard to know exactly when and how those systems will fail until they do. 

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  1. Clearly regulators aren’t going to be able to prevent banks from making risky decisions. If we are insuring deposits at these banks, then those risks will be in part be taxpayer risks and the bank will have an incentive to increase that risk.

    Like with most problems in this country, we can solve this by making government smaller. We need to do is reduce the scope deposit insurance. If you want an insured account, then the money should be put in 100% treasury bonds and the rates you earn will reflect that. If you want to earn more than that, then you take your own risks.

  2. Krugnuts disagrees:

    http://www.nytimes.com/2012/05…..yt&emc=rss

    Shorter Krugnuts: “Genuflect, bitches!”

    1. Ye gods, how did he become so godawful? This isn’t some total disaster for Chase.

      You can’t regulate away mistakes. The company has as much incentive as it possibly could need not to lose billions of dollars. I’m sure they’ll take radical steps on their little lonesome to make sure this sort of thing doesn’t happen again.

      1. Team Blue thinks it’s possible to have a risk-free, injury-free America. That mindset guides their every step.

        Of course, The Right People have to be in charge…

        1. If the government would stop being a huge parasite and impediment to economic growth, we might be financially healthy enough to take some risks and fail occasionally.

          1. Unfortunately, such logic is not exercised by the Top. Men. in government.

      2. The company has as much incentive as it possibly could need not to lose billions of dollars.

        So did AIG. How’d that work out?

        Faith in the markets should not equate to faith in individual actors (individuals or corporate) to always make the best call. Rather, such faith should be that the net outcome of all decisions will be to sort it all out.

        But what about the concepts of “To Big to Fail” and “Systemic Risk”? Faith in the Markets eliminates neither of these. Rather, strict Market adherence means that “Systemic Risk” may lead to a full restructuring of the marketplace, with a deep trough while failed companies, and the companies they take down with them, are unwound.

        Is this a bad thing? Depends on your philosophy.

        1. I meant in reference to the loss they just took. By the time AIG realized that their gambles were going to be disastrous, it was far too late.

          You have to wonder whether ginormous banks would be so prevalent in a more free marketesque financial services industry. They usually aren’t the best option for consumers, anyway, and without the government favors that rain on them (not just bailouts, but in the regulatory sense, which involves the construction of substantial barriers to entry), they probably couldn’t maintain that size and remain competitive.

          Back before the meltdown, when I was in banking, there was some very strong and well-supported criticism of the idea that there were significant economies of scale in financial services. In other words, being gigantic didn’t necessarily serve any great financial purpose, in and of itself.

          1. You have to wonder whether ginormous banks would be so prevalent in a more free marketesque financial services industry.

            I dunno. Reducing banking regulation has led to banks getting significantly larger, rather than smaller. The only thing holding down their size currently is regulation around deposit limits. I would be hard pressed to see why getting rid of regulation would magically reverse all of the other trends.

        2. AIG made really bad bets. What’s your point? Are you contending that regulators, had they been reviewing every AIG trade, would have recognized the risk?

          1. No. Risk cannot be eliminated. But it can be reduced. Arguing that we should remove banking regulations and let the Market manage risk independently is also an argument that regulations cannot have a net positive impact on risk.

            I do not believe that argument has merit.

            1. The problem is that the regulators tend to prevent and block competition. Which results in many of the problems we have.

              Some regulation might be a good thing, providing more stability in the market, but the damage done by too much is tremendous. And I’m not convinced that that regulation has to come from the government, which has so many axes to grind that have nothing to do with consumer protection that you wonder whether we’re worried about an invasion of Ents.

              1. The ultimate problem is that the political body cannot accept the concept of imperfection. It is not possible to craft the perfect regulatory state, and it is not possible to craft regulations without being influenced by Public Choice theory.

                What simply tends to happen too much in press snippets, pithy remarks, and OWS signage, is simplification.

                And I believe what also happens around these parts is a net frustration with the realities of Public Choice theory that lead one to want to say “Fuck it” and abandon a state driven regulatory state altogether.

                I’m a bit more pragmatic. There are clearly limits to what can be accomplished politically. But overall, there does appear to be a net positive in terms of risk mitigation, and even the high costs are justified.

                But that’s still just a gut feeling. It’s very hard to quantify.

  3. Focusing too closely on Two Billion can make one lose sight of the overall issue. What prevented this from being a 20 billion dollar loss? Or more? AIG was taken down by a very minute part of the company that exposed it to risks well beyond what the entire company could support. And then BOOM.

    Systemic Risk is a real concern. Is the solution a rapid leverage unwind with the resulting takedown of multiple firms and massive devaluation of assets? Maybe. But it takes a lot of cajones to accept that path.

    And thus you’ll never see Washington buy into that.

    1. How would smaller institutions reduce systemic risk?

      1. Because they’d have fewer counter-parties for their outstanding obligations.

        1. Or the counterparty risk for one bank wouldn’t be so large that it exposed everyone to some degree of loss.

      2. How would smaller institutions reduce systemic risk?

        Because each institution is, effectively, surrounded by firewalls. If a $1BB bank blows it, nobody cares. When a $100BB bank blows it, the whole edifice totters.

        Smaller institutions don’t pose a risk to the entire system. At some point, though, larger institutions do. We call that point “too big to fail”.

        1. I recall something in my finance classes about eggs, baskets, oneness. Can’t remember exactly how that went.

        2. I don’t think that’s true. A relatively small institution can still rack up huge liabilies through derivatives and threaten the system. See Long Term Capital Management ($129B in assets when it went down, which is tiny compared to JPMorgan, Citi, BofA, etc.- there are thousands of banks and other financial companies that have $100B+ in assets). I just don’t see how size and systemic risk are particularly related (and therefore question the notion of too big to fail). Bigness can actually be a plus- JPMorgan will easily take this loss and make good on the derivatives contract because it’s got over a $1T in assets. If a $1B company had taken the same risk, it would default on the derivatives contract and possibly send a chain reaction through the system.

          1. Right, but when LTCM fell the Fed could gather a posse of private firms to manage the fallout (and profit handsomely). If JP Morgan Chase were to hit the same problem, the only player big enough to handle it is the US Government.

            1. The ability of wall street to bail out LTCM was a function of LCTM’s derivatives exposure, not its size measured in assets. If LTCM’s exposure had been bigger (which it easily could have been, notwithstanding its asset size), then it’s possible that US Government subsidies would have been needed too. Also, the Fed could never have organized the bail-out of LTCM if the largest institutions were only worth a few billion dollars- the Fed had to go to the big guys like Goldman, JPMorgan, Morgan Stanley, etc.

              Similarly in the JPMorgan case, its exposure wasn’t really too big- and it can essentially do a self-bail-out because it’s so huge.

              My point is, there are thousands of firms that can take crazy positions in derivatives that are large enough to threaten the system. Bigness, if anything, is a buffer, not a transmittter for risk.

            2. The ability of wall street to bail out LTCM was a function of LCTM’s derivatives exposure, not its size measured in assets. If LTCM’s exposure had been bigger (which it easily could have been, notwithstanding its asset size), then it’s possible that US Government subsidies would have been needed too. Also, the Fed could never have organized the bail-out of LTCM if the largest institutions were only worth a few billion dollars- the Fed had to go to the big guys like Goldman, JPMorgan, Morgan Stanley, etc.

              Similarly in the JPMorgan case, its exposure wasn’t really too big- and it can essentially do a self-bail-out because it’s so huge.

              My point is, there are thousands of firms that can take crazy positions in derivatives that are large enough to threaten the system. Bigness, if anything, is a buffer, not a transmittter for risk.

  4. What prevented this from being a 20 billion dollar loss?

    Its my understanding that they still have exposure on the “whale trade”, and that we may (probably?) have not seen the full extent of their losses.

  5. The same sort of Top Men who blew $500 million of our money on Soylndra are supposed to put a stop to banks losing money on complex investments designed to hedge risk? Somehow I’m a bit unpersuaded.

    1. Get back to me when our toppest of top men can manage to get through Turbotax without fucking it up.

  6. As much as I support capitalism, I agree that banks should be at least partially nationalized because they are a special case in that their risk-taking affects the whole economy.

    But only banks should be nationalized.

    And healthcare. Because healthcare affects everybody as well. Banks and healthcare and food should be nationalized. But that’s all.

    And automobiles. Banks, healthcare, food, and automobiles should be nationalized, but that’s it. Except clothes and houses. Education, electricity, water, phone service, garbage pick-up, mail delivery – those have to be nationalized for obvious reasons. So should gas. And coal and iron ore and lumber and other raw materials.

    But everything else should be left up to the free market. Just the stuff that affects the economy should be nationalized.

    1. I am glad you kept going. You had me going at the banks. Unfortunately this is how a lot of people think.

      1. You could post that verbatim on Daily Kos and it would be received with great delight.

    2. No one expects the nationalization inquisition!

  7. When the government loses $500M of taxpayer money on an obviously bad loan, liberals point out that it “represented only 1.3 percent of the loans that the DOE has backed” and it shouldn’t let us get distracted from making more of these loans. http://www.tnr.com/article/pol…..epublicans

    When JP Morgan loses $2B of stockholder money, it proves that the government needs to ban banks from engaging in these transactions.

    I’m confused.

  8. Putting the government in charge of anything is the first step in screwing it up even further. How is this not obvious to everyone.

  9. Isn’t the part that’s being ignored by Reason the source of the loss? This wasn’t an internal prop trading desk, but rather the CIO’s office. That’s why this was news. If it was just a random group of traders that lost cash, it’s BAU, but that the CIO’s office was taking these sorts of crazy positions and risks are what make it very unusual and alarming.

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