JPMorgan Chase (JPM – Free JPMorgan Stock Report) disclosed in May that its chief investment office (CIO), which invests the company’s excess cash and manages its credit risk, failed to detect and put a stop to risky wagers by a trader (nicknamed the London whale, owing to the size of his trading positions) that ultimately could result in losses, now rumored to be as much as $9 billion, for the company.
To be sure, the expected trading loss is small relative to the company’s over $450 billion of trading assets at the end of March.
Nonetheless, the announcement immediately resulted in calls by legislators for tougher regulation of the bank industry’s trading activities. Many bankers had been critical of a regulation included in the 2010 Dodd-Frank Wall Street Reform law, called the Volcker Rule, which prohibits banks from engaging in proprietary trading, but permits banks to hedge their credit risk. It’s unclear whether the rule would have prevented JPMorgan’s blunder, but any attempt to water down the rule now seems unlikely to succeed. Regulators still need to finalize the rule’s details, however.
Meanwhile, in hearings before both houses of Congress, lawmakers recently questioned whether big banks, like JPMorgan, Bank of America (BAC – Free Bank of America Stock Report), and Citigroup (C), are too big and complicated to manage. Calls to break up big banks are not new, and the Dodd-Frank law contains provisions to cushion the impact of a possible failure of a big bank, like making banks write living wills detailing how they might be dismantled. As for breaking a healthy bank into smaller pieces, however, there doesn’t appear to be much support for such a drastic move at present.
Additionally, in the aftermath of the trading mishap, some have called for JPMorgan’s chairman, James Dimon, to resign his position on the board of the New York Federal Reserve. Three bankers sit on each of the 12 nine-member regional Federal Reserve Boards.
Some fear that the banks may become too cozy with their regulators. Note that the Office of the Comptroller of the Currency, which also regulates banks, has come under fire for failing to detect JPMorgan’s flawed trading early on.
But others defend the practice of including bankers on Fed boards, claiming that the bankers provide the boards with important information about how the economy is doing. They also point out that bankers on the Fed boards don’t participate in regulatory activities. While this issue is igniting a lot of debate, we don’t expect bankers to be excluded from Fed boards anytime soon.
On the other hand, JPMorgan’s trading blunder has put the issue of banks maintaining adequate equity capital back on the front burner. Even JPMorgan’s Dimon admits that the bank may occasionally make mistakes and sees the need to build capital to serve as a buffer when things go wrong. Many argue that it’s impossible for regulators to identify all of the risks in banking all of the time, so having banks build adequate capital cushions is the best alternative. Although some problems still need to be ironed out regarding new international capital guidelines due to be phased in over the next seven years, the case for more bank capital probably will attract greater support following JPMorgan’s big trading loss.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.