Appearances, and therefore politics, dictate that J.P. Morgan Chase’s trading loss will push reforms in financial regulation in a more aggressive direction. Two billion dollars is a lot of money and the public already dislikes banks investing in derivatives.
Politics aside, it is much less clear what the policy implications should be, even for a strong supporter of the Dodd-Frank Act such as myself. There is a great deal that we do not yet know about J.P. Morgan’s actions and why they were taken. Further, we must place the size of the loss in context. It represents approximately one month of Morgan’s pretax earnings, one hundredth of its net worth, and one thousandth of the value of its assets. (The figure may rise significantly, but will remain small relative to J.P. Morgan’s size.)
The role of regulation is not to prevent banks from making losses, unless a loss would threaten the bank. There is no reason to care more about a big bank losing one tenth of one percent of the value of its assets than about a small bank doing the same. Either loss is of insignificant size. Besides, if loss prevention were the goal, banks would have to stop lending, since big loan losses are significantly more frequent than large trading losses. The biggest losses for banks in the financial crisis were from lending, not from more arcane products.
The real question is whether the way the loss occurred should be blocked by regulation. J.P. Morgan says the trades were originally intended to offset the bank’s large exposure to a potential acceleration of the euro crisis. I believe broad hedges of this nature should be allowed, even if they are only fairly approximate, because it is important to provide even partial protection against major systemic risks.
However the trades started, they evidently became more speculative, so there is legitimate debate about whether the Volcker Rule against proprietary trading would or should have applied. But, we will need more information to judge this knowledgeably.
The most disturbing thing, though, is the possibility the loss may be the tip of the iceberg, revealing massive risk management problems at the major banks. If so, there will be important implications for regulation. However, we should not leap to the conclusion that one debacle means the entire risk management system is rotten. Regulators and bank managements are doubtless scurrying to examine this question already. We should await the additional information.