For public interest advocates fighting the David vs. Goliath battle to win meaningful reform of the financial system, there was a certain satisfaction in watching Jamie Dimon eat humble pie last week as he announced that JPMorgan has lost a little over $2 billion trading credit derivatives. After all, no one has been less apologetic for the role Wall Street played in triggering the 2008 financial meltdown that left millions of Americans jobless, cost millions more their homes, and brought the financial system to the brink of collapse. No one has been more dismissive of efforts to rein in the reckless bank practices that put the global economy at risk. And no one is accorded greater respect in the halls of power.
To his credit, Dimon has been nearly as caustic in his criticism of the bank's "egregious, self-inflicted" mistake as he has been in the past toward those, such as former Federal Reserve Bank Chairman Paul Volcker, who dared to disagree with him on policy issues. But even as Dimon acknowledged that the trading strategy behind the $2 billion loss "was flawed, complex, poorly reviewed, poorly executed and poorly monitored," he couldn't resist a dismissive reference to the "pundits" who would seek to capitalize on the news to make the case for tougher regulations to rein in the banks.
There is, of course, a very good reason why reform advocates would make that connection. The trading practices that led to the $2 billion-plus loss are at the heart of a number of the most contentious battles that banks are fighting, and all too often winning, to gut reform efforts. The question is whether JPMorgan's dramatic loss will be enough to change the terms of the debate.
- None of these battles has been more in the public eye than the fight over Volcker Rule implementation. So it should come as no surprise that Dimon was quick to state last week that the trading that led to the bank's $2 billion loss didn't involve the proprietary trading that the Volcker Rule is intended to ban. But what does and does not constitute proprietary trading is the number one question being debated as regulators struggle to implement this crucial reform. If a massive, complex gamble on the direction of the economy doesn't constitute proprietary trading under the Volcker Rule, the question for regulators drafting the rule is, "Why the heck not?"
- Less in the public eye, but every bit as important to banks seeking to roll back reforms is the Lincoln Rule, a provision in Dodd-Frank that requires that risky practices, such as trading in uncleared swaps, be moved out of the insured bank and into separately capitalized affiliates. Banks fought hard to keep this provision out of Dodd-Frank, and they are now pushing legislation to drastically scale back this reform. As approved on a voice vote last month by the House Financial Services Committee, the bill would enable banks trading in all but a few types of swaps to keep their government backstop. (It is no small irony that the bill is titled the "Swaps Bailout Prevention Act," since it would have precisely the opposite effect.) Will the members of Congress who have been all too willing to renege on reform learn from JPMorgan's mistake and stop pushing bills to gut these crucial safety and soundness reforms?
- In a further irony, it appears that the trading strategy that produced the $2 billion loss was part of the bank's risk management strategy. This distinction between trades designed to hedge risks and all other derivatives trading is an important one, since Dodd-Frank accords a lighter regulatory touch to risk hedging in a variety of different contexts, from the Lincoln rule, to determinations of who has to register as swaps dealers and major swaps participants, to end user clearing requirements. As part of their efforts to water down the rules, banks have sought a definition of risk hedging you could drive a truck through. The regulatory filing that disclosed the loss explained that the strategy JPMorgan had been using to hedge risks "has proven to be riskier, more volatile and less effective as an economic hedge than the firm previously believed." In other words, JPMorgan's risk hedging strategy sounds a lot like speculation. Will regulators take JPMorgan's misfortune as a timely reminder that a narrow definition of risk hedging is essential to keep banks from once again putting the financial system at risk?
In leading the fight to fend off tough regulations, Dimon has argued not only that the regulations are misguided, but also that they are simply too costly. But, as Congressman Barney Frank pointed out in a news release last Friday, JPMorgan lost roughly five times as much in this one set of transactions as it has estimated its total annual cost of compliance with Dodd-Frank regulations to be. In other words, while regulation comes with a significant price tag, those costs pale beside the losses that banks can incur when left to their own devices. If the banks succeed in gutting regulations and winning passage of the many bills now moving through Congress that would blow a hole in financial reform, the cost is going to make $2 billion look like chump change. Will regulators take the hint that the cost-benefit fight is one they can win and stop cowering every time industry threatens to take them to court over a rule they don't like?
Right now, the fate of regulatory reform hangs in the balance. And, make no mistake about it, the banks are winning. Before we can reverse this dangerous trend, Congress and the regulators must recognize that the arguments that Dimon and his fellow Wall Street titans have put forward to justify their assault on Dodd-Frank are just as "flawed" as JPMorgan's costly hedging strategy. Given everything that is at stake, if JPMorgan's $2 billion trading loss provides that lesson, it will have been well worth the cost.
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