A Teachable Moment

Wednesday’s Senate Banking hearing, in which JPMorgan Chase CEO Jamie Dimon sought to explain his company’s recent trading losses, should have served as a teachable moment. First, for Jamie Dimon and other banking execs, who have fought financial reform efforts every step of the way. Their banks would be better served if they spent their time, effort, and energy improving their risk management practices. Second, for policymakers and regulators. They must resist pressures from the banking lobby to water down crucial rules meant to safeguard financial stability.

Flickr by kricav

One lesson learned from the JPMorgan’s trading loss is that we need a strong implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and specifically a strong implementation of the Volcker Rule. The Volcker Rule is a provision in Dodd-Frank that would prohibit bank holding companies, which have access to the federal safety net, from gambling and exposing American taxpayers to loss.

The effectiveness of the Volcker Rule depends largely on what regulators view as legitimate “hedging activity.” Hedging is supposed to decrease risk, in effect offsetting trading positions with one another.  However, under the currently proposed regulations to implement the Volcker Rule provision, banks are allowed to hedge within an entire trading portfolio. This means they can disregard specific risks if the portfolio viewed as a whole seems safe. In reality, portfolio hedging allows banks to trade exotic assets that can’t be directly offset.  When those exotic trades deteriorate, the bank—and possibly the American taxpayer—loses big.

A strong final version of the Volcker Rule must prohibit portfolio hedging and require bona-fide hedging to take place at a much more granular level so that specific trades are offset with one another. Anything that can’t be directly offset shouldn’t be traded. Such a rule would stop trades like the ones gone awry at JPMorgan.

Esteemed Levy Economics Institute Scholar Jan Kregel believes that there is a bigger lesson to be learned from the recent trading fiasco: banks must leave the business of gambling and return to the business of banking. Part of JPMorgan’s strategy was to use “excess deposits” to finance purely speculative activities rather than make loans to individuals and businesses, loans that could lead to productive investments, increased job creation, and a stronger economy.

On this, Kregel draws from the teachings of famed economist Hyman Minsky, who argued that “effective regulation should ensure that banks provide financing for the capital development of the economy, as well as the personal wealth of their traders and shareholders.”

Kregel highlights a crucial point. Banking has traditionally been based on a long-term customer relationship where the interests of the bank and customer are aligned. This relationship serves the broader economy. But the current casino culture in which banks would rather turn a quick profit for themselves at their customers’ expense sullies this arrangement. Banks must return to the business of banking, manage their risk effectively, and prove they have learned the lesson that this moment had to offer.