When reporters began writing in April about the outsized positions of a single trader in the London office of JPMorgan Chase—positions so large that some feared they were distorting markets—CEO Jamie Dimon dismissed the whole thing as a “tempest in a teapot.” A month later, a contrite Dimon had to explain to analysts on a conference call that JPMorgan had lost more than US$2 billion in just a few weeks because of a “flawed, complex, poorly reviewed, poorly executed and poorly monitored” trading strategy.
That sounds like exactly the sort of risky activity that regulatory reforms enacted or proposed after the financial crisis were supposed to prevent. Proponents of reform are seizing the moment to push for stricter regulation.
There is an element of poetic justice at play, too. Dimon is one of the most outspoken critics of reform. He’s been particularly scornful of the Volcker rule in the U.S., which would prohibit banks with government-insured deposits from proprietary trading—essentially, trading solely to reap profits for themselves. (The final draft of the legislation should be completed by the summer.) Dimon argues that compliance would be a massive burden, and possibly destructive. “[For] every trader, we are going to have to have a lawyer, a compliance officer, a doctor to see what their testosterone levels are, and a shrink,” he told Fox Business in February.
The trading loss is a small one for JPMorgan, America’s biggest bank, but an important question is whether the Volcker rule would have prevented the blunder from happening in the first place. The answer could indicate the effectiveness of a flagship piece of new financial regulation. Dimon characterized the ill-fated trading strategy as a legitimate hedge—not speculation—that did not cause the company’s flawed risk models to sound alarm bells. “This trading may not violate the Volcker rule,” he told analysts.
His comment strikes at one of the perceived shortcomings of the rule. Distinguishing proprietary trading from legitimate trading to limit risk or to ensure a market for certain securities is difficult. Even proponents of reform acknowledge the challenge. “The Volcker rule is extremely well-intentioned,” says Anat Admati, a professor of finance and economics at the Stanford Graduate School of Business. “But it’s a mess to implement.”
The full details of JP Morgan’s trading strategy aren’t known, but Wallace Turbeville, a former Goldman Sachs investment banker and currently a fellow with public policy think-tank Demos, doesn’t buy the bank’s explanation that it was simply hedging. “How can you possibly lose that kind of money on a hedge?” he asks. “The answer is, they weren’t off setting risk. They actually took a risk position on their proprietary book.” The proposed Volcker rule would, in fact, ban hedging that creates new “significant exposures” to risk or reward. In Turbeville’s view, it’s likely JPMorgan’s trade would have violated this provision, though the definition of “significant” is open to interpretation.
Simon Johnson, a professor of global economics at MIT’s Sloan School of Management, argues it’s “immaterial” how JPMorgan’s trades are classified. “All megabanks should be presumed incapable of managing their risks appropriately,” he wrote on his blog. To truly insulate the financial system from the inevitable mistakes institutions will make, steps need to be taken to limit the size of banks, he argues. A bill to do just that was recently reintroduced in the U.S. Congress. The SAFE Banking Act would, among other things, put a 10% cap on the liabilities any one bank can take on relative to the U.S. financial sector. The bill was already rejected in 2010, however, and this new mishap doesn’t assure its passage.