A good education is worth a little tuition, and everyone got away relatively cheaply when it emerged that America's biggest bank, JPMorgan Chase, had unexpectedly lost $2 billion in some complex bets known as derivatives.
The lesson, well worth the fee, is that Uncle Sam must sharply curtail such gambling by big banks. These institutions are so important that they can't be allowed to fail -- meaning taxpayers ultimately are on the hook for their risky dealings. That's why strong regulations are needed to limit the risk.
Given the financial crisis of 2008 and its legacy of unemployment and foreclosures, you'd think this would be obvious by now. But banks -- led by JP Morgan -- have been fighting stricter limits on trading as well as requirements that they hold a larger cushion against losses.
Morgan's losses, which reportedly could reach $3 billion when the dust settles, may make tougher regulation likelier by giving others the chance to say, "I told you so." It's a message that needs to be heard.
A loss of this size poses no threat to the banking giant, which remains profitable. Yet it's an embarrassment to the bank's vocal chief executive, Jamie Dimon. It has cost shareholders billions since Thursday, when it was disclosed, by knocking down the bank's stock price. Most of all, the loss is an unsettling reminder of what can go wrong when basic banking functions and complex, high-risk speculation coexist in a single huge financial institution.
It's not entirely clear what happened, but it appears that Morgan's London office made a large, complex bet that corporate debt was getting less risky, presumably thanks to a strengthening economy, and this bet started going bad last month. Also unclear is the extent to which this bet was supposed to hedge, or reduce, the risk of other Morgan bets, yet instead ended up magnifying risk. The full extent of losses isn't known either.
Get the sense you've taken this class before? You sure have. The last lesson, in the form of the 2008 financial crisis, led Uncle Sam to adopt the Dodd-Frank financial reforms. These include the proposed Volcker rule, named for former Fed chairman Paul Volcker, which would bar banks from risky speculation on their own accounts while allowing some hedging plus some holding of securities, to facilitate buying and selling by others. Bankers, especially Dimon, have argued for a looser rule. But the Morgan episode shows that it should be tightened; the trading that caused Morgan's big loss may be permitted, technically speaking, under the Volcker rule as proposed. And next time the losses might not be so easily contained.
It would be better not to let banks engage in any such risky speculation. Congress imposed a virtual ban in 1933 and this worked well until changing attitudes and intensive lobbying led to repeal in 1999. An outright ban, or something close, would avoid the need to distinguish hedging trades from those aimed only at profit. But at the very least, the Volcker rule should limit trading by banks to narrowly defined market-making and mundane hedging that indisputably reduces risk.
A strong rule of this kind may dampen bank profits. But a Volcker rule that leaves taxpayers exposed to trading like Morgan's flunks the smell test.