If you’ve perused the blogosphere at any length recently, you’ve probably noticed that Jamie Dimon is not the most popular guy these days. Just weeks after the JP Morgan Chase president and chief executive officer derided a number of Dodd-Frank provisions, including the Volcker Rule, the firm announced that it lost $2 billion on a derivatives bet gone bad. The outcry against Dimon and his company has been unrelenting. But what will the ultimate impact be? It may depend on whether policymakers decide JP Morgan’s bet was stupid, dangerous or both.
There are a number of issues at stake for industry participants, the most obvious being the eventual scope of the Volcker Rule, Dodd-Frank’s ban on banks’ proprietary trading.
The Securities and Exchange Commission is looking into what happened, but it appears the derivatives bet that got JP Morgan into trouble was actually at least two bets. Several months ago, when it looked like the economy was sputtering, the firm reportedly used the markets to buy short-term insurance against a double dip recession. That was a hedge against risk, so no trouble with Volcker there.
It was the second derivatives bet that turned heads. It seemed the bet was structured to allow the bank to profit if the economy improved. That smacked of proprietary trading –– a Volcker no-no. However, Dimon repeatedly argued that this second trade was actually a portfolio hedge and would be permissible under the Volcker Rule.
Of course, regulations implementing the Volcker Rule aren’t complete, and even if this particular trading strategy wasn’t expressly banned under the proposal, regulators still have time to tighten things up if they deem necessary.
If anything, industry participants had been hoping for a kinder, gentler Volcker Rule. Before the JP Morgan debacle, the Securities Industry and Financial Markets Association, the American Bankers Association, the Financial Services Roundtable and the Clearing House argued that the proposal set forth by regulators established an onerous compliance regime that would mandate scrutiny of every transaction. They claimed this would hamper banks’ market making functions and would make it difficult for banks to hedge their own risks.
“We strongly believe that an overly narrow risk-mitigating, hedging-permitted activity, based on hard-coded criteria that may not apply to all valid hedging, is not only contrary to congressional intent, but also will significantly harm the safety of banking entities, their clients and the financial system as a whole,” the groups wrote in a Feb. 13 comment letter.
The groups said the proposal’s transaction-specific “hard-coded” criteria should be recast as guidance. Banks would be required to adopt risk limits and policies based on the guidance, and regulators would review risk-mitigating hedging through metrics and examinations, thereby easing banks’ compliance burden.
The industry declared total war on the Volcker proposal, and prior to JP Morgan’s loss, it seemed they were gaining ground.
“Even senior regulators now recognize that the current proposed rules are unworkable and will be impossible to implement,” Dimon wrote in his March 30 letter to shareholders.
“Much of the uncertainty around regulation will be resolved over the next 12-24 months,” he continued. “In my opinion, only two regulations materially can hurt our competitive ability –– the Volcker Rule and the derivatives rules. We believe they both will be properly resolved in a way that will allow us to compete fairly.”
Now the ground may have shifted. Even if regulators choose not to amend the Volcker proposal’s portfolio hedging provisions, the JP Morgan loss may increase their desire to keep an eye on individual transactions, not just metrics.
Beyond the Volcker Rule, Dimon may have lost his fight against increased capital standards for the world’s largest financial institutions. An entity identified as a global systemically important bank [G-SIB] will face a capital surcharge in addition to the other capital policies adopted by the Basel Committee on Banking Supervision under Basel III. The Federal Reserve signaled support for these additional requirements.
“Once again, very complex regulations are being overlaid on already complex regulations,” Dimon wrote in his letter. “Under the new Basel III rules, all banks will be required to have 7 percent Basel III common equity. The new G-SIB requirements mandate for a company our size approximately 2.5 percent more capital, totaling 9.5 percent Tier 1 common equity. This is capital that we simply don’t need.”
If JP Morgan can lose $2 billion at a crack, it’s logical to think policymakers will want big banks to carry more capital, not less.
So, will the Volcker Rule get tougher and tighter than it otherwise might have? It may depend on whether this trading strategy or similar strategies that could be utilized by big banks in the future pose a real danger to the public.
One goal of Dodd-Frank is to protect citizens –– and their tax dollars –– from the dangers posed by big banks’ bad bets, regardless of whether those bets are stupid, illegal or otherwise. In JP Morgan’s case it seems “stupid” is a slam dunk. Dimon himself referred to the trading strategy as “stupid” during an interview on NBC’s Meet the Press. (Although, given that the FBI was so quick to open an investigation, conspiracy theorists may wonder if the trades were “stupid” the way the Watergate break-in was a “third-rate burglary” –– but I digress.)
With stupidity affirmed, the more difficult trick for policymakers may be establishing that what JP Morgan did was dangerous to anyone but the company.
In a recent USA Today op-ed, Peter Wallison, a financial policy expert at the American Enterprise Institute and former White House counsel, noted that the $2 billion loss was less than 1/1000th the size of the bank and “only 0.5 percent the size of the portfolio the bank was trying to protect.”
“As usual, the size of the media outcry is far out of proportion to the problem,” he said.