* Fed's Tarullo: Volcker will shed light on hedging trades
* JPMorgan trading losses tied to failed hedging strategy
* OCC's Curry says JPMorgan red flags apparent in hindsight
* Lawmakers back tough capital rules
By Dave Clarke and Alexandra Alper
WASHINGTON, June 6 (Reuters) - U.S. bank regulators likely would have had an earlier look at JPMorgan Chase & Co's unraveling hedging strategy if the Volcker rule had been in place, Federal Reserve Governor Daniel Tarullo said on Wednesday.
Tarullo argued that under a proposal released in October to implement the crackdown on proprietary trading, banks would have to say in writing how a trade would hedge risk and should therefore be exempted from the Volcker rule.
"If a firm said, 'We are doing this as a hedge', they would be required to explain to themselves internally as well as to the primary supervisor, what the hedging strategy was... and how they would make sure it didn't give rise to new exposures," he told the Senate Banking Committee.
"I suspect we're going to find in this case that there was an absence of documentation both within the firm and in reporting to supervisors," said Tarullo.
JPMorgan announced last month that a failed hedging strategy had morphed into something more speculative that has produced at least $2 billion in losses. JPMorgan Chief Executive Jamie Dimon, who will appear before the same Senate panel next week, has called the trades "sloppy" and "stupid".
The announcement has shaken Wall Street and Washington, raising questions about whether banks are still taking too many risks following the 2007-2009 financial crisis and how much capital they should have to hold as a safeguard against losses.
During the hearing on Wednesday, lawmakers pressed regulators on whether they fell down on the job and what sort of implications JPMorgan's losses have for financial reform.
"Shouldn't the sheer size of these trades have been a huge red flag for the OCC?" asked Democratic Senator Robert Menendez to Thomas Curry, the head of the Office of the Comptroller of the Currency.
The OCC is the primary regulator for JPMorgan's banking activities and has 65 on-site examiners for the institution.
Curry became head of the OCC in April, and JPMorgan's trading losses pose an immediate test for how he will lead an agency that oversees the largest U.S. banks and has come under criticism, particularly from Democrats, for not being tough enough on the industry.
In his testimony, Curry said his office is still investigating what his office could have done better, as well as exactly what the bank was doing with the trades. Curry was nominated for the job by President Barack Obama but he faced the stiffest questioning from the president's fellow Democrats on Wednesday.
Senator Sherrod Brown of Ohio observed that some JPMorgan executives have left in the wake of the trading loss, including Ina Drew, chief of the hedging unit in question.
"If JPMorgan can hold its senior executives accountable, which they appear, at least in part, to be doing, we should expect nothing less than you, Mr. Curry, and the people who work for you," Brown said.
VOLCKER RULE IN THE WORKS
The losses have, in particular, put a renewed focus on regulators efforts to put the Volcker rule in place, which prohibits banks from making trades with their own money for profit.
The goal of the rule is to prevent banks that enjoy government backstops like deposit insurance from making risky trades that could ultimately endanger taxpayer and depositor funds.
A proposed Volcker rule was released in October and a final rule is expected in the next few months.
The 2010 Dodd-Frank financial oversight law allows for some exemptions to the Volcker rule, including making trades to hedge against risks.
Supporters of the restrictions are pressuring regulators to tighten the hedging exemption, arguing the JPMorgan losses are evidence that the October draft would provide too much leeway.
Curry said it's too early to know if JPMorgan's trades would have fallen under the exemption. He told the senators that the trading losses speak more to risk management problems at the bank that go beyond individual rules.
"It's still a risk management issue regardless of the Volcker rule," he said.
CAPITAL IS KING
The hearing underlined that the largest U.S. banks are losing their argument that new capital rules, which govern how banks fund themselves, are too strict and will impair their ability to lend.
Tarullo emphasized that JPMorgan's ability to successfully weather the trading losses was evidence that the central bank's focus on tougher capital standards is justified.
Several Republicans backed this stance. "The larger you are, the more capital you need," said Richard Shelby, the top Republican on the committee, who told reporters after the hearing that Basel III standards calling for a 7 percent capital buffer may not be high enough.
Republicans have been critical of Dodd-Frank, saying it is overly complicated and will damage the banking industry without greatly enhancing financial stability.
Particularly since JPMorgan announced its losses, Republicans have pointed to tough capital standards as a simple way to ensure that if a bank takes risks that result in losses they will have enough equity on hand to absorb the blow.
The Fed on Thursday will release a proposal for how the United States will implement the new Basel III international capital agreement.