'Nobody Knows What Risks Banks Should or Should Not Take’

'Nobody Knows What Risks Banks Should or Should Not Take’
June 11, 2012

JPMorgan Chase & Co., considered one of the better-run banks on Wall Street, stunned the markets in May with the revelation that it lost more than $2 billion in the span of a few weeks on derivative trades that were meant to be a hedge.

The bank used its own capital, and although it's not enough to bring the giant down, University of Michigan Professor Nejat Seyhun notes the incident occurred just as rules for regulating banks and financial firms are being finalized. It didn't take Congress long to jump on the case, and regulatory agencies are investigating.

In this Q&A, Seyhun, the university’s Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, says the troubling thing is that J.P. Morgan decided to take this kind of risk in the first place. Also, regulators were in the dark until the bank disclosed the fact itself, which means the rules could stand some review to protect taxpayers.

But Seyhun hopes Congress doesn't overreact. The United States still needs big banks for its corporations to be globally competitive, he argues.

What was supposed to be some kind of hedge obviously went awry with derivative trades. From what's been disclosed, what went wrong here?

Seyhun: The most important issue from my view is that a trade or series of trades was made in a particular instrument that has the possibility of generating these kinds of gains or losses—plus $3 billion or minus $2 billion. That means they were taking a lot of risk, regardless of whether they made or lost money.

What this case clearly illustrates is that J.P. Morgan engaged in trades that could have endangered the existence of the bank itself. They happened to lose money in this case, which is why they're getting a lot of attention.

But even if they made $2 billion or $3 billion in a single trade or a series of trades, the same kind of attention would have been warranted. The problem isn't so much that they lost money, but that they engaged in trades that could have required taxpayers to back them up. That's taking too much risk on the trading side.

Three years after the financial crisis that almost broke down the entire banking system—which was rescued thanks to the generosity of the U.S. taxpayers—we're again worrying about the health of these banks. We passed legislation like the Dodd-Frank Wall Street Reform and Consumer Protection Act, although many of the provisions have not yet been made effective as a result of lobbying from the banks. What happened, exactly, with this transaction is less important. The whole point of Dodd-Frank was to separate these kinds of activities so the banks' trades don't endanger the deposit-taking function and the taxpayers won't be called upon to save the banks from themselves.

One of the proponents of lighter regulation has been James Dimon, the CEO of JPMorgan Chase, and this happened under his watch. How surprising was that?

Seyhun: It speaks to another problematic aspect. Dimon sits on the board of the Federal Reserve Bank of New York, which is charged with regulating JPMorgan Chase. You know the saying about the fox watching the hen house. I'm not suggesting the issue is particular to Dimon. It's just that the setup is unsatisfactory. Those who are to be regulated should not be in charge of writing the rules. That's a strange situation.

It didn't take long for some members of Congress to act on this. Will we see the stricter interpretations of Dodd-Frank prevail, and perhaps more coming down the line?

Seyhun: Possibly, because my understanding is that this transaction would not have violated the Volcker Rule had it been in effect. The Volcker Rule is supposed to reduce incentives of the banks [for] taking risks with deposits, but not with their own capital. But if they lose their own capital, what's left? The deposits are next, and in such a situation, they would be at risk.

If the banks have a big loss that wipes out their capital and other junior claims and only the deposits are left, the U.S. taxpayer will be called upon once again to save them. I think there's going to be a lot of attention on the Volcker Rule and the regulatory structure where the banks are, in effect, regulating themselves.

The main problem is that nobody knows how to implement the Volcker Rule. There is no clear language. Nobody knows whether the Volcker Rule will be sufficient. Nobody knows what kinds of trades are okay and what kinds are too risky. Nobody knows what risks banks should or should not take.

This includes the top officers of the banks, legislators, and regulators. This incident also may provide fodder for regulators and legislators who would like to be seen as doing something about this problem.

How could this affect perceptions of economic strength and the strength of the markets? Europe was dragging things down, but everything else was holding its own, more or less. Is this another big negative that could change perceptions?

Seyhun: It's possible that the markets will worry there will be too much of a backlash and too much regulation. Overall, corporate earnings came in very healthy—about 6 percent growth year over year, which was higher than expectations at the beginning of the season. The U.S. economy is growing, although not as much as we'd hoped. The Federal Reserve's interest rate policies have recapitalized the banks by lending to them at zero-percent interest rates and having them invest in Treasuries.

I don't think things are bad, but this is a negative. We will need to rethink regulations, and the market may be worrying about where the regulations will wind up.

Is it a real risk that Congress may push too far with regulations?

Seyhun: It's possible. Just when the details for implementing the Volcker Rule are being finalized, this happens. The timing couldn't be worse. But I don't think we're going to overreact.

It's true the banks required taxpayer bailout money, but so did other corporations that aren't banks. General Motors and AIG come to mind. The idea of 'too big to fail' is not limited to banks. If any corporation gets too big, even a hedge fund like Long-Term Capital Management, it can require a Federal Reserve-engineered rescue.

Being big has benefits and costs, and we need to strike that balance. Some people, like Elizabeth Warren, who is running for the Senate in Massachusetts, would like to see 1960s-era banks, the single-branch types. I think that would be going too far because then U.S. banks would not be competitive worldwide. Large corporations need large banks. They don't need to deal with 1,000 different banks. They need one bank for all their operations.

Any other lessons that can be drawn from this?

Seyhun: Yes. What's interesting is that we only became aware of the problem when Jamie Dimon told us. So the regulators are still in the dark, and we need the banks to tell us what they are doing. After the big financial crisis, the No. 1 priority was transparency, so we would know what the banks are doing before they do it. We still don't have any idea.

We're still waiting for J.P. Morgan to give us details. How come the Federal Reserve was not aware of the risks J.P. Morgan was taking with this series of transactions? I'd like to know what happened to transparency. They're a deposit bank under the purview of the Federal Reserve.

We need to make more headway on the issue of transparency as well as delineating what banks can and cannot do.

Having said all that, we have to be careful not to overreact. We need a cooling period so we can be rational and understand what happened while making sure we don't punish. The point of regulation should not be to punish banks but to protect U.S. taxpayers.

Terry Kosdrosky (terrykos@umich.edu) writes for the Stephen M. Ross School of Business at the University of Michigan, Used with permission from bus.umich.edu.