May 16, 2012
Robert Samuelson says that people are taking away the wrong lessons from JPMorgan’s $2 billion loss on a proprietary trade gone bad. He has some legitimate points but carries his case too far.
First, he notes that this bet did not threaten either the banking system or JPMorgan. He points out that JPMorgan is a huge and highly profitable bank. Its books look to be in reasonably good shape. A $2 billion loss will be felt, but this is less than the normal profit in a quarter. It does not come close to threatening the bank’s survival and certainly poses no risk to the financial system.
This is all true, but it misses the point that even in the post Dodd-Frank era, a large financial institution is still effectively able to take big risks with the taxpayers’ money. If this bet, or a bigger one, had gone bad when the bank’s balance sheets were more questionable (suppose Bank of America or Citigroup had done the same deal — especially in 2009), it could well have pushed them off the cliff. At the least, this would mean a government payout to cover insured depositors. Since JPMorgan is certainly in the “too big to fail category,” it almost certainly would have meant payments to non-insured creditors as well.
Samuelson then tells us that the banks’ biggest losses usually come from old-fashioned lending, not proprietary trading. This is right. The huge losses in 2007-2009 were on mortgage loans, but this does not preclude the fact that individual banks can, and often do, put their survival in jeopardy by making big proprietary bets. Again, the point is to not have the banks take big bets with the taxpayers’ money.
Samuelson’s third point is the most problematic. He tells readers that:
“Government regulation can’t prevent banking or financial crises. …. But regulators’ practical power is limited, because they are no smarter than the bankers they regulate. Sharing similar assumptions, regulators and bankers may recognize a true crisis only when it’s become unavoidable.”
This one really gets to the crux of the problem. The housing bubble was easy to see and those of us who are fans of arithmetic absolutely did see it. House prices had risen hugely out of line with their long-term trend with no remotely plausible explanation in the fundamentals of the housing market.
There were people in the financial sector and the regulatory agencies who did recognize that things had gone awry. These people were told keep their mouths shut and in some cases were fired. With few exceptions, nothing bad happened to the people who got things wrong in a really big way. Alan Greenspan and Robert Rubin are both really rich and still feted as wise men who have great pearls of wisdom to share with the rest of us.
As long as this structure of incentive is not changed, then Samuelson will be right, regulators will not be able to prevent financial crisis. However the key point is to change the structure of incentives. There should be no blanket “who could have known?” amnesties.
The people on top should have known. The information was all there. Anyone in a top policy position in the bubble years (2002-2007) who was not screaming warnings at the top of their lungs should be sent packing. They obviously are not qualified for their jobs.
Shareholders in financial institutions should treat their top management the same way, although the corruption of corporate governance makes this sort of accountability almost impossible. At the least, the financial institutions most caught up in pushing and securitizing bad packages should be scrutinized for criminal conduct. Issuing and securitizing a mortgage that is known to be fraudulent is fraud.
Of course none of this has happened. Given the current incentive structure, Samuelson is absolutely right. There is no reason to believe that regulation will prevent a financial crisis. After all, why should a civil servant go out of their way to pick a fight with Lloyd Blankfein or Jamie Dimon? It will always be easier to look the other way when they see dangerous practices and then take advantage of the “who could have known?” amnesty. Unless we change the structure of incentives, we have done nothing to reduce the risk of another crisis.
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