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Tuesday, May 22, 2012
Back to Earth for Mr. Dimon
JPMorgan Chase recently posted $2 billion in trading losses. Mr. Jaimie Dimon, JPMorgan Chase chief executive and a man considered one of the savviest bankers in the world, has dismissed the losses as "a tempest in a teapot." Given the scale of his bank's business, he is correct — at least when crunching the numbers.
But the problem is not the size of the loss, but the very fact that one of the world's top banks could fail so miserably while it was doing something central to its strategy and while it was, ostensibly, being overseen.
This episode is proof once again of the need for limits on the ability of banks to take big risks, incur bigger losses and jeopardize not only their existence but that of the financial system and the countries that depend on them.
The mechanics of the trade that cost JPMorgan its money and its reputation are incredibly complex. Basically, a London-based trader tried to hedge bets on the future of European companies. The purchases got so large that they ultimately distorted the markets selling the various "products."
When the bets turned out to be wrong, the trader held out against liquidating holdings, hoping that tides would turn — and increased positions to cover the losses. The trends did not change and the size of the holdings became a problem in themselves. By the time the positions were closed, the bank had lost $2 billion.
As Mr. Dimon notes, $2 billion is a drop in the bucket to the largest bank holding company in the United States, with assets said to exceed $2.5 trillion. The ensuing scandal has cost JPMorgan Chase $15 billion in market value, however, as shares have fallen in the aftermath of the incident. That's more than the entire banking unit at the company made in 2011 and 75 percent of the net income for last year.
Moreover, the reputation of the bank, the only major financial institution to remain profitable after the events of 2008, along with that of its leader, has taken a big hit.
The entire episode raises basic questions about the way that financial institutions operate. Mr. Dimon was said to be unaware of the positions until reporters brought them to his attention. His bank is said to have the best risk-management people in the business, but the handling of the case — and the dismissal of key executives in the chain of command after it became public — implies that supervision was lax.
Of course, capitalism is about winners and losers. Profits and losses are part of the system itself. But financial institutions are considered special types of companies and are treated differently because of the central role they play in modern society. Society deems that role so important that governments guarantee their liabilities (the deposits of ordinary citizens) and are prepared to protect them against losses.
This protection creates perverse incentives. It can encourage bankers to take large risks to generate profits — which is returned to them in the form of salaries and bonuses — because they know the government will bail them out if they fail.
The prospect of financial insolvency is always dangerous, but it is magnified countless times when financial institutions are so large that their failure risks the solvency of the entire financial system. That is what happened most recently in 2008, but even that breakdown was not unprecedented.
In reaction to the global financial crisis of four years ago, many governments, international financial regulators and experts have called for limits on the amount of money that banks can trade for their own profit. (Losing customers' money is another matter.)
The most famous attempt to put controls in place is "the Volcker Rule," named after its advocate, former U.S. Federal Reserve Chairman Paul Volcker. The rule was created under U.S. financial reform legislation that was passed in 2010, but the exact content has been debated by regulators and the entities they will regulate.
Ironically, Mr. Dimon has been the most outspoken opponent of these new rules, arguing that strict regulation will only force banks to leave the U.S. or that it will dry up the capital that banks provide to business. In recent weeks, he has conceded that the trades in question were stupid, but noted that just because JPMorgan Chase makes mistakes does not mean other banks will, too.
The problem with that logic is that Mr. Dimon and his bank were considered the very best. If even they are not immune to mistakes, then no financial institution is.
While risk is inherent in a system that "bets" on the future — every investment or loan is such a bet — the risk must be managed. Financial managers are correct when they point out that more stringent regulation will shrink the pool of capital available for aspiring business people.
Then again, every bet should not be made. One of the most important lessons of the last four years is that much of the wealth that resulted from new financial instruments should never have been "created"; many of those bets were just plain wrong.
Bankers must accept that the go-go days are gone. They cannot afford to take risks — no matter how artfully "hedged" or delicately constructed — that threaten failure on a systemic scale. That is especially true when they expect the rest of society to pay the price of their failure. Mr. Dimon and JPMorgan Chase may be lucky because they "only" lost $2 billion.
We must figure out ways to ensure that "luck" has nothing to do with it.