Dimon’s testimony yesterday before the Senate Banking Committee -- the week of the anniversary of the passage of the Glass-Steagall Act in 1933 -- is ironic, to say the least. He objected to the Volcker Rule’s prohibitions against proprietary trading by federally insured banks (acting like hedge funds, in the words of Senator Merkley), characterizing the re-instatement of a separation of commercial banks and trading markets as an imprudent act taken by Congress in anger. He would, of course, prefer the public to rely on bank capital reserves (“fortress capital,” in his words) and the vaunted risk management systems of the sophisticated 21st century banks.
The hearing was to inquire about the massive trading losses experienced by JP Morgan Chase in its Chief Investment Office group that was tasked with hedging risks and managing excess deposits. In an attempt to disarm criticism, Dimon readily admitted that the bank made mistakes in its evaluation of the risk taken on by the CIO and how, by allowing it to stray from its mundane mission, it was turned into a massive and risky trading operation.
In a phrase popular in my native state of Tennessee, “that old dog won’t hunt.” Admitting mistakes is a fine thing, but it is irrelevant to the question whether activities are definitionally too risky for a too-big-to-fail bank that is subsidized by the safety net of federal deposit insurance and Fed window access. If some activities are permitted, “mistakes” of a certain type are more likely to occur and their consequences are likely to be far more severe. The safety net even encourages the excessive risk-taking by limiting adverse consequences because bailouts are inevitable.
Dimon certainly did not intend it, but his testimony provided compelling justification for the re-imposition of some form of the Glass-Steagall firewall between commercial banking and the trading of securities and derivatives.
The mistakes that Dimon owned up to were not typographical errors in software codes or a dropped decimal place. He claimed that the proprietary risk taking by the CIO was not appropriate, responding to Senator Merkley that the group was not supposed to be operating like a hedge fund. Surely, he and others at JP Morgan Chase noticed the outsized profits that preceded the calamitous losses. These profits (and the loss that purportedly finally got his attention) were totally inconsistent with an operation designed to insure against risk and manage cash. Most significantly, the compensation levels inside the CIO were the best expression of an institutional awareness of the proprietary risk business that it engaged in.
Dimon pointed to another “mistake,” a change to the Value at Risk model that masked the amount of risk embedded in the CIO. Anyone who is passingly familiar with VaR understands that results that are so different is not a function of an algorithmic nuance of the VaR calculation employed by the bank. The only things that could cause such a variance are differing judgments about the assumptions used in applying the model. Two come to mind: the assumed correlation between the long and short credit default swap components of the so-called “hedging” strategy (that in fact was a curve flattening bet); and the illiquidity of the position, especially given that the “London Whale’s” share of the entire market for the indexed credit default swaps was massive. If both of these assumptions were changed, the real risk of the strategy might have been obscured. The testimony cries out for further inquiry into the details of the change to the VaR calculation and, most importantly, the motives behind the change.
This episode underscores the importance of limiting activities by commercial banks to assure that bailouts will not recur. If the risk of engaging in this type of trading is so difficult to measure, the American taxpayers should not be exposed to it.
Moreover, risk and reward are broadly symmetrical. The vast profits that can be realized over a short term from high-risk trading will always bias banks to use assumptions that understate potential losses. After all, with their immense market power, the megabanks are likely to rake in profits for as long as they resist greed and hubris (words Mr. Dimon used to describe the downside of megabanks). But humans are frail, and losses that far exceed profits are inevitable. This is an important lesson taught us once again by the debacle of the London Whale.
Dimon and like-minded executives and policy makers prefer to allow the banks to do as they please, but rely on risk controls and capital reserves. Ultimately, in markets that are highly complex, illiquid and volatile, measurement of risks must be provided by the banks. The regulators are ill-equipped to do independent modeling except in the broadest sense. This can never be sufficient if the risks are nearly impossible to measure and the metrics are inevitably biased. The primary flaw in reliance on capital reserves is the inaccurate measurement of the risks that are reserved against. If JP Morgan Chase finds itself engaged in risk taking that it neither understands nor is even is fully aware of, the problem must be universal.
So on the anniversary of the Glass-Steagall Act, its wisdom has been underscored by the unlikeliest of persons - the individual most identified with resistance to its modern form, the Volcker Rule.