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Dimon Makes the Case for the Volcker Rule

The JP Morgan Chase fiasco in which it lost $2 billion (so far) on a “hedge” of the bank’s global exposures to corporate risks bristles with implications for the push to implement the reforms of the Dodd-Frank Act -- and the effort to strangle reform in its crib.

First of all, we must ask: how on earth could JP Morgan Chase have lost money on a hedge? Hedges are logically used to reduce risk. The bank might have lost money on the underlying risk because it did not completely hedge it. But, since it lost money on the hedge itself, the reported loss means that the transactions it calls “hedges” in fact added risk to the bank, over and above the underlying risk it started with. This incremental risk means that the purported “hedge” constituted a new risk position, even though it may have offset some (or even all) of the underlying risk.

The proposed rules implementing the Volcker Rule provision of the Dodd-Frank Act prohibit proprietary trading by banks that benefit from FDIC insurance and access to the Fed window for liquidity. The rules make an exception for a “risk reducing hedge” so long as the hedge “does not give rise, at the inception of the hedge, to significant exposures that were not already present in the individual or aggregated positions, contracts, or other holdings of a covered banking entity and that are not hedged contemporaneously.” If the JP Morgan Chase transactions conformed to this principle, the hedging transactions could not generate a loss on their own.

The only conclusion that can be drawn is that the transactions that JP Morgan Chase calls hedges actually piled more risk on the bank, and quite a great deal more risk it seems.

Opponents of the Volcker Rule, like Jamie Dimon, ridicule the concept that hedges must be risk reducing, not risk adding. This episode not only shows that they are dead wrong, but also provides an insight into the vehemence of their objections. If you can lose $2 billion on a position, it is clear that you can make similar amounts under different circumstances. The growing spotlight on the bank’s “chief investment office” illuminates the massive profits previously recorded by this operation, even though its mission was to mitigate risk, not to turn a profit. In fact, turning a profit should be seen as an indication that it was taking risk on board rather than mitigating it. Without risk, there is no reward.

Which brings us to the second broad implication of these events. Dimon’s crew has pounded on the complexity of the Volcker Rule implementation proposal. Almost all of the complexity relates to proposed rules’ required processes that monitor bank business units that are supposed to be non-risk taking. Monitoring is needed because the largest banks have turned these business lines into virtual hedge funds in their frenzy to exploit their oligopolistic dominance of markets. With these advantages, they can extract massive profits until, inevitably, hubris and greed entice them across the line of prudency. The symmetry of risk and reward means that large profit means that disastrous loss is just around the corner.

That is exactly what happened here. The first indication of the massive position taken on by the London Morgan trader Bruno Iskil, known in the market by his nom de guerre, “Voldemort,” was the widespread complaint by hedge funds that Voldemort was distorting certain credit default swap prices by dominating the market. (Which I wrote about last month.) Now, the hedge funds have exacted their revenge, trading furiously against JP Morgan Chase’s “chief investment office.”

Closing down specific trading desks that employ the word “proprietary” in their names is simply not enough. The risk-taking corporate culture permeates every area of the big banks. How else could a bank employee assigned to the boring task of reducing risk or serving the needs of customers make a bonus like their prop trader colleagues? Rigorous and comprehensive monitoring is essential, given the imprudent business practices to which the big banks are addicted.

And Dimon has relentlessly lobbied to restrict the reach of financial reform from non-U.S. operations. He argues that these operations do not affect the U.S. company and are sufficiently regulated abroad. That seems far fetched now.

Finally, the banks (along with a number of academics who are naïve or worse) smugly suggest that prohibiting specific bank activities is an outdated approach, rooted in the financial system of the 20th Century rather than the modern, high-tech global markets. They argue for allowing all forms of risk-taking, but making certain that the banks keep capital reserves on hand to cover the inevitable meltdown. These people are, to put it mildly, the overly simplistic thinkers. In order to calculate the amount of capital that must be reserved, the regulators must be able to measure the risk exposures created by bank activities. Professor Simon Johnson points out that JP Morgan Chase passed its stress test with flying colors and that the regulators had no inkling of the time bomb ticking away in Voldemort’s positions. No less an expert on the fiasco than Jamie Dimon himself characterized the trading tactic used by Voldemort as a “terrible, egregious mistake.” It should be noted that no one claims that Voldemort engaged in a rogue act. The mistake was the bank’s, not his alone.

It is abundantly clear that the megabanks routinely engage in trading activity, throughout their operations, that expose them to risks that neither they nor the regulators can possibly measure. It must be pointed out that it is widely believed that JP Morgan Chase’s risk management systems are the best in the business. To rely on the internal risk management systems of these banks or on the ability of the far less sophisticated measurement capabilities of the regulators who establish capital reserve requirements means that the next financial crisis will look like 2008, except that the resources needed to avoid complete failure no longer exist. It also means that the next crisis will happen soon.

The Volcker Rule, or the alternative approach of the SAFE Bank Bill introduced by Senator Sherrod Brown last Wednesday, simply must go into effect. Why on earth would anyone consider following the wisdom of Jamie Dimon on this question?