What does JP Morgan tell us about the US Economy?

14th May 2012

The actions of rogue trader Bruno Iksil would seem to call into question the recent ‘stress testing of the US banks by regulators. As recently as March, the prevailing view was that US banks had built ‘fortress'-like capital strength: "The Fed yesterday said 15 of 19 banks would be able to maintain capital levels above a regulatory minimum in an "extremely adverse" economic scenario, even while continuing to pay dividends and repurchasing stock. Those results were due to scrutiny by the Fed on capital payouts over the past three years, the central bank said."

This is difficult to reconcile with a bank losing $2bn in a matter of weeks, particularly given that the huge exposures of ‘the whale' were apparently known to everyone except JP Morgan's compliance department.

The losses have prompted panic on the blogs:  jp  says: "One could argue regulations aren't stringent enough to prevent unnecessary risk-taking. Realistically, banks will find ways around rules: the deals at JPM CIO were meant to be hedges, right? The problem is a cultural one, inherent in most banks. Traders are compensated on absolute return, not on their ability to hedge a portfolio. The incentives were just wrong."

It has also prompted some hand-wringing about accelerating the separation between retail and investment banking. Here the Wall Street Journal quotes Sheila Bair, former chairperson of the U.S.Federal Deposit Insurance Corporation: "The J.P. Morgan loss illustrates the need for large banks to have separate management for their major business lines, Bair said, noting that even a well-managed bank like J.P. Morgan couldn't stay on top of all its complex operations. Departments of mega-banks should be split into divisions with their own executives and boards, even if they share a brand under one bank-holding company, she said."

The BBC's Robert Peston argues that it will strengthen the case for the Volker Rule, which is designed to put an end to risky proprietary trading in banks: . He believes that it may also lead to downgrades in the global banking sector: "They are engaged in a fraught debate with Moody's to dissuade the ratings agency from downgrading many of them, in a way that would make it much more expensive for them to borrow and would squeeze their profits.

JPMorgan's accident won't strengthen their case that they are less risky institutions than Moody's fears."

Yet, does the JP Morgan experience suggest the need for a raft of new legislation? Scarf66 points out on the BBC site: "The only losers here are the shareholders and the traders who will be sacked."  John Gapper points out in today's FT that ‘a loss of $2bn is indeed a very small proportion of the total $360bn at risk – about half a percent.' : "The best that can be said of JPMorgan's trading loss is that, as Mr Dimon noted, it can absorb it…. JPMorgan's "fortress balance sheet" will only be dented: it will still make $4bn in post-tax profit this quarter."

JP Morgan shareholders may rue the loss of $2bn, but it was not systemically significant and, whatever the flaw in JP Morgan's risk management processes, the loss was picked up before it had a material impact on the bank.

Also, this would be banned under the Volker rule. Gapper says: "JPMorgan would clearly be barred under the Volcker rule from placing Mr Iksil within its investment bank and giving him anything like the same amount of capital to play with as a proprietary trader." This would seem to suggest that regulation is going in the right direction.

The WSJ points out that the ‘system' hasn't lost – others have profited from JP Morgan's loss. ‘Dave' wrote in response to the article: "JPM lost, but others gained. It was a zero sum transaction. I don't see why the feds need to get involved. The numbers were tiny compared to JPM's capitalization, so they represent no threat to the taxpayer. If they are going to do anything, they should just limit the size of these trades."

It is tempting to see all bank losses as systemically important. $2bn sounds like a lot of money to lose in a few weeks, particularly from a bank considered to be Teflon-coated, but it is only a worry for the shareholders, and regulation is already being put in place to deal with the problem.


More on Mindful Money:

JP Morgan’s 'egregious error' and the case of the known unknowns

Can Yahoo learn from its mistakes?

Invested interests: debunking the economic case for the one percent

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