Did Too Big To Fail Help Make JPMorgan's $2 Billion Loss Possible?

Reuters financial columnist Felix Salmon offers some useful speculation about how JPMorgan Chase's $2 billion loss might have happened, and argues that too-big-to-fail was part of the story.

[Ina] Drew's Chief Investment Office [at JPM]  quadrupled in size between 2006 and 2011, reaching $356 billion in total, and it's easy to see how that happened. On the one hand, it was incredibly profitable, with the London team alone, which oversaw some $200 billion, making $5 billion of profit in 2010, more than 25% of JP Morgan's net income for the year. At the same time JP Morgan accumulated enormous new deposits in the wake of the financial crisis, both by acquiring banks and by attracting big new clients wanting the safety of a too-big-to-fail bank. Historically, JP Morgan has served big corporations by lending them money, but nowadays, as the cash balances on corporate balance sheets get ever more enormous, the main thing these companies want from JP Morgan is a simple checking account — one where they can be sure that their money is safe.

With lots of deposits coming in, and little corporate demand for loans, it was easy for all that money to find its way to the Chief Investment Office, which could take any amount of liabilities (deposits are liabilities, for a bank) and turn them into assets generating billions of dollars in profits.

…Taking a much bigger-picture view, however, what was really going on here was that JP Morgan had hundreds of billions of dollars in excess deposits, thanks to its too-big-to-fail status. And rather than lending out that money and boosting the economy, Jamie Dimon decided to simply play with it in financial markets, just as a hedge fund would.

Obviously the trades didn't work out, and probably should have been managed better. But the implicit subsidy granted to some of the biggest financial institutions by too-big-to-fail status helped make JPMorgan's huge loss possible.

Salmon is quite critical of Dimon and suggests that in the end JPMorgan was behaving badly, making deals that it shouldn't have been making by chasing house profits rather than focusing strictly on hedging risk exposure, which is the primary job of the CIO. In theory, the "Volcker rule" would prevent big banks from pursuing proprietary trading —using client money make trades that create profit for the bank—while allowing banks to take reasonable steps to manage risk exposure through hedges. Indeed, as drafts of the Volcker rule progressed, they actually became more expansive in terms of how much leeway they gave financial institutions to hedge various risks.

And that's important, because as Noah Millman argues, it can be extremely difficult to draw a clear line between hedging risk and trading for profit. Millman's explanation is complex enough that it needs to be read in full, but the broader picture is that, as always, writing rules and regulations to prevent the supposedly bad stuff and only the bad stuff isn't nearly as easy as a lot of folks in Washington seem to think.

It's common enough to hear advocates of financial regulation say that all we really need to do is put the "right rules" in place, but when you spend time looking at the underlying details of the transactions up for review, it's not always obvious what the "right rules" are, which is why much of what Congress passed in Dodd-Frank was sort of TBA regulation that called for a lot of studies and instructed regulators to do something but left it to the regulators to figure out exactly what that something should be. If it were obvious which rules could be followed to avoid only the transactions that result in headline-grabbing multibillion-dollar losses, financial institutions with money on the line probably would have put those rules in place.