JP Morgan, TBTF and ZIRP: James Saft
By James Saft
(Reuters) – JP Morgan Chase’s loss is the perhaps inevitable result of the interaction of two policies: too big to fail and zero interest rates.
JP Morgan lost $2 billion when trades put on by its chief investment office blew up, prompting a sell-off in its stock, an investigation by regulators and new calls to limit speculative activities by banks.
Too big to fail, the de facto insurance provided by the U.S. to financial institutions so big their failure would be disastrous, provides JP Morgan and its peers with a material advantage in funding and as counterparties. Depositors see it as an advantage, as do bondholders and other lenders. That leaves TBTF banks flush with cash.
At the same time, ultra-low interest rates make the traditional business of banks less attractive, naturally leading to a push to make money elsewhere. With interest rates virtually nothing at the short end but not terribly higher three, five or even 10 years out, net interest margins, once the lifeblood of large money center banks, are disappointingly thin. Given that investors are rightly dubious about the quality of bank earnings, and thus unwilling to attach large equity market multiples to them, this puts even more pressure on managers to look elsewhere for profits.
Investors believe, rightly, that the largest banks won’t be allowed to fail; what they also appear to believe is that they very well may not be able to prosper and that to the extent they do shareholders won’t fairly participate.
What would you do if you had a built-in funding advantage but little demand for your services as a traditional lender, i.e., one which borrows short and lends long? If you are anything like JP Morgan Chase appears to be you will put some of that lovely liquidity to work in financial markets, hoping to turn a built-in advantage into revenue.
JP Morgan stoutly maintains that the purpose of the trades was to hedge exposure elsewhere, as opposed to being proprietary trading intended to generate profits. That’s contradicted by a report from Bloomberg citing current and former employees of the chief executive office, including its former head of credit trading. here
The Volcker Rule, now being shaped, is intended to stop such speculative trades, though in practice debating what is a hedge and what isn’t is a sort of angels-dancing-on-the-heads-of-pins argument which makes effective regulation almost impossible.
The keys are motive, opportunity and ability. Profits – and the investment office is reported to have made considerable ones in the past – provide a more believable motive than simple hedging. Opportunity is afforded by the combination of a privileged funding cost combined with poor alternative places to put money to work elsewhere in the banking business. While there may be some active borrowers, and TBTF banks enjoy an unfair advantage in serving their needs, the trans-Atlantic balance-sheet recession means households and businesses are showing a preference for paying back loans rather than taking them out.
Bruce Lee, chief credit officer of Fifth Third Bancorp, which isn’t TBTF, was frank about this recently, saying that the value of deposit funding was now at its lowest in his career.
Finally there is ability, and like common sense all bankers believe they have the ability to trade successfully despite the wealth of historical evidence to the contrary.
While events show clearly that JP Morgan wasn’t able to adequately manage its own business, an attack on it engaging in speculation doesn’t actually hinge on that.
There is clearly a public policy outrage here because should JP Morgan find itself in difficulties due to speculation the taxpayer will end up paying the freight. That’s probably not even the worst of it. All of the profits that TBTF banks make through speculation have been subsidized and enabled by the taxpayer. It is obvious that managers and employees have an incentive to take risks because, after all, TBTF may not be forever but they will capture 35 or 40 percent of the inflated takings so long as it lasts. Even if JP Morgan never blew up speculative trades, we should still oppose them so long as they are made possible and profitable by government policy.
Raising interest rates in order to remove an incentive to speculation probably wouldn’t work; low rates are the result of too much debt as well as a palliative for that disease.
The Volcker Rule won’t be effective; it is impossible to distinguish hedges from speculation and either can blow up banks.
The better alternative is to end the policy of too big to fail, preferably while at the same time forcing all banks out of the business of market speculation through a revival of the kind of Glass-Steagall-like policy which encouraged a small and useful financial sector for decades, forcing those that want government insurance to act like utilities, taking deposits, processing payments and making simple loans.
Let the investment banks take their risks, take their chances and suffer their losses – as separate entities.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(Editing by James Dalgleish)
(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)