It’s a teachable moment, but what’s the right lesson? Already, the $2 billion-plus trading debacle at JPMorgan Chase has inspired a powerful storyline. Nothing has changed since the financial crisis, it’s said. Big banks remain out of control, gambling recklessly. If Jamie Dimon’s bank, reputed to be one of the best-managed, can get into trouble, what can we expect of the others? Government regulations and regulators need to be tougher to counteract bankers’ greed and incompetence.
The storyline is marred only by this: Everything in it is exaggerated, misleading or wrong.
Let’s take stock. Here are four propositions that defy conventional wisdom.
(1) The U.S. banking system is far stronger now than before the 2007-09 financial crisis, and JPMorgan Chase’s trading loss never threatened the bank or the banking system. In a speech last week before JPMorgan’s announcement, Federal Reserve Chairman Ben Bernanke reported that since 2009, the 19 largest banks had increased their stockholders’ equity capital by $300 billion to nearly $760 billion. Capital offsets losses, and Bernanke noted that most banks survived the Fed’s latest “stress test” simulating a harsh recession. In it, unemployment peaked at 13 percent; stock prices dropped 50 percent; housing prices declined another 21 percent. Despite collective losses of $500 billion, 15 of the 19 banks still met regulatory capital rules.
Even if JPMorgan’s trading loss doubled to $4 billion, the amount would be dwarfed by last year’s profits of $19 billion and the bank’s shareholders’ common equity of $184 billion, notes Douglas Elliott of the Brookings Institution. (Disclosure: Elliott once worked at JPMorgan.)
(2) Banks’ greatest exposure to losses usually comes from old-fashioned lending, not “proprietary trading.” The 2007-09 financial crisis originated in the deterioration of traditional home mortgage lending as opposed to banks’ short-term trading of exotic financial instruments for profit. Proprietary trading has a bad image because it’s so easily likened to gambling. If the Volcker Rule — named after former Federal Reserve Chairman Paul Volcker — barring banks from proprietary trading had existed before the financial crisis, there still would have been a crisis.
Although proprietary trading can create large losses for individual institutions, it has yet to breed a major financial crisis. The Latin American debt crisis of the 1980s resulted from conventional loans to Latin countries, which were presumed (wrongly) to be good credit risks. Similarly, U.S. banks lost lots of money in the 1980s on bad farm and real estate loans that were predicated (again, wrongly) on the continued inflation of land values and crop prices.
(3) Government regulation can’t prevent banking or financial crises. Of course, regulation does some good. Deposit insurance has averted bank runs by individuals. Some safeguards can be imposed. But regulators’ practical power is limited, because they are no smarter than the bankers they regulate. Sharing similar assumptions, regulators and bankers may recognize a true crisis only when it’s become unavoidable.
Here’s an example. In the 1980s, regulators from major countries set bank capital requirements: the amount of capital required to be held against various loans and investments. The standard for most consumer and business loans was 8 percent, with lower amounts for safer assets. Home mortgages and most government bonds were considered among the safest. Mortgages required only 4 percent; most government securities were deemed so safe that they carried no capital requirement. These regulations, which remained in effect for most of the 2000s, steered banks toward the very credits that led to America’s financial crisis and Europe’s sovereign debt crisis, as political scientist Jeffrey Friedman has noted.
(4) The trading loss at JPMorgan is good for the system — though not for JPMorgan — because it reminds people that risk is unavoidable and may identify specific practices that, if they became widespread, could spawn a broader crisis. The time for genuine worry is when everyone agrees that the outlook is bright and risks are few. This suggests the wishful thinking that often precedes financial “bubbles.” Government regulation often follows a perverse cycle: too loose when the economy is strong; too rigid when it’s weak.
We don’t yet know all the details of JPMorgan’s loss. How did trades initially intended to hedge risk — to reduce it — end up having the opposite effect? Until we can answer that, the wider implications for government regulation, including the Volcker Rule, remain unsettled.
But we ought to avoid simple morality tales of avaricious bankers versus virtuous regulators. The real world is more complicated. The global financial system’s complexities and interconnections have grown. Some of these can be restrained; few can be repealed. Bankers and regulators are hostage to a rapidly changing, poorly understood system.
One lesson is obvious. Banks and other major financial institutions need ample capital. The dangers lie not in what we know — but in what we don't.
Read more on this debate: