For Washington, JPMorgan’s big failure can be an opportunity
In light of JPMorgan Chaseâ€™s bad derivatives trades, the mediaâ€™s spotlight has appropriately turned to the pending Volcker Rule. Thatâ€™s the moniker for the still-under-development regulation that might restrict big banks from pursuing hedging strategies across their entire portfolio, including their own bets. Proponents say banks shouldnâ€™t be able to do this, since banks hold consumer deposits that are effectively guaranteed by taxpayers and since taxpayers could be forced to bail out a foundering bank if itâ€™s deemed too big to fail. On the other hand, the underlying law for the Volcker Rule, the Dodd-Frank financial reform law, specifically exempts or allows hedging related to individual or “aggregated” positions, contracts or other holdings, which may very well have covered JPMorganâ€™s recent trade.
Inside the beltway, a fresh dispute is now emerging between regulators and policymakers on whether the current draft of the Volcker Rule can even apply to scenarios like JPMorganâ€™s, given how explicit Dodd-Frank is on this topic. On the one hand, there is the Office of the Comptroller of the Currency, which is starting to argue that these JPMorgan trades would likely have been exempted from the not-yet-final Volcker Rule. But then there are policymakers (namely, Senator Carl Levin) who are trying to make the case that Congress never intended for the law’s language to be interpreted so broadly.
While all the details around JPMorganâ€™s failed trading strategy emerge, there is an even more interesting backdrop to consider â€“Â whether JPMorgan Chase and other banks are still too big to fail. It was only a week ago that the Senate Banking Committee held a hearing where Paul Volcker, Thomas Hoenig and Randall Kroszner testified on “Limiting Federal Support for Financial Institutions.” While they each expressed different viewpoints, it was newly installed FDIC Director Hoenig who made the most news. He used the stage to discuss a paper he wrote in May 2011 on “Restructuring the Banking System to Improve Safety and Soundness.”
In broad strokes, Hoenig doesnâ€™t think that the â€śtoo big to failâ€ť (TBTF) problem has been adequately addressed. His conclusion is that the TBTF banks are effectively too big to manage and too complex to understand, and should be made smaller by defining what is and isnâ€™t an â€śallowable activity.â€ť For Hoenig, â€śbanks should not engage in activities beyond their core services of loans and deposits if those activities disproportionately increase the complexity of banks such that it impedes the ability of the market, bank management, and regulators to assess, monitor, and/or control bank risk taking.â€ť
Hoenigâ€™s plan is bold, to say the least, and even Senator Bob Corker joked at one point that maybe it should be called the Hoenig Rule.
Volcker actually spoke first at the hearing and alluded to Hoenigâ€™s plan when the committee asked if anything should be done about the great increase in concentration at the largest banks (before and through the crisis years):
I don’t know how to break up these banks very easily. But some of the things we’re talking about â€“ reduced trading, for instance â€“ will reduce the overall size of the bank reasonably. Some of the restraints on derivatives will reduce their off-balance sheet liabilities significantly.
So they are at least modest steps. There is a provision in the law they cannot grow beyond certain limits by merger or acquisition. So there are some limits here. But if you say â€“ asked me whether I prefer a banking system that had less concentration, I would. But I â€“ I think we can live more or less with what we have.
While Volcker thinks we can more or less live with this ongoing TBTF problem, the broader public and even some regulators arenâ€™t so sure. For example, the acting head of the FDIC, Martin Gruenberg, recently gave an important speech that was intended to persuade the market that existing tools will work when the next crisis hits. As a Dow Jones reporter put it, â€śregulators are looking to chip away at the tacit understanding that the government will step in to save top financial institutions seen as vital to the economy or banking system.â€ť
This is where the JPMorgan story provides a potentially revealing case study on just how much progress has actually been made over the past few years. Josh Rosner, managing director at Graham Fisher & Co and co-author of the great book Reckless Endangerment, posed a very interesting question during a recent television interview:
Can we really talk about there being a free market when at the end of the day youâ€™ve got institutions that are in fact Too Big to Fail? â€¦ One of the questions I would ask is, did JPMorganâ€™s counterparties demand more collateral from them in the face of these exposures the way they [JPM] did against Lehman right before its failure?
If the answer is noâ€¦ then clearly everyone assumes that JPM is always money good because it is Too Big to Fail â€¦ so weâ€™re not talking about regular risk taking behavior of firms that can win or lose or succeed or fail. Weâ€™re talking about a specific subset of firms. I keep coming back to when are we going to actually address that issue.
Right now, there doesnâ€™t appear to be any (public) evidence that counterparties demanded more collateral as JPMorgan revealed the position details or the extent of its losses. Then again, perhaps itâ€™s just that a $2 billion-plus loss isnâ€™t viewed by the market as that big a deal when the balance sheet of the firm in question is about 1,000 times larger (and is still generating profits)?
Look for the Senate to stitch all these themes together in the next couple of weeks when it holds its first hearing since JPMorganâ€™s disclosure. Remember, the aforementioned Senate hearing with Volcker and Hoenig occurred just before the JPMorgan story broke. Senators will surely want to examine whether this derivatives loss is a (potential) public policy problem because it occurred at a bank, or because it occurred at a $2 trillion-plus bank. Context is very important. Risk taking is not â€śbadâ€ť unless it occurs inside an institution that cannot fail, and cannot fail because the government, on behalf of taxpayers, wonâ€™t let it.
For now, however, itâ€™s hard to see how any new Dodd-Frank-related legislation moves through the divided Congress, especially in an election year. This means that itâ€™s the regulators and the signals they send out to the market that will matter most for gauging when, how and in what form the Volcker Rule gets finalized. That said, one hopes this JPMorgan situation will spark a fresh debate about the shortcomings of Dodd-Frank and specifically on the most important systemic problem post-crisis â€“ ending too big to fail, once and for all.