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JPMorgan's $2b loss exposes flaws in Volcker Rule

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JPMorgan's $2 billion loss tells us something about our banking system. But despite crowing from Washington, it's not all clear what the loss tells us.

Democrats are wrong to think that the 2010 Dodd-Frank financial regulations will stop this sort of dangerous risk-taking when they go into effect in July.

They argue that Dodd-Frank's Volcker Rule, named after former Federal Reserve Chairman Paul Volcker, will prevent banks from making big financial bets with the banks' own money. In finance-speak, it bans proprietary trading by banks.

But the rule is -- by necessity -- full of exceptions, and there's no telling if JPMorgan's disastrous trades would have been allowed.

Under the Volcker Rule, banks will still be allowed to hedge their risk. JPMorgan, as a core business, lends billions of dollars to big corporations. If these corporations start defaulting on their debts, JPMorgan is in trouble. The bank, accordingly, hedged against this risk. Similar to how a Hollywood studio might buy insurance on the star of a movie -- to hedge against his dying or getting maimed before the film is done -- JPMorgan, in effect, bought insurance on corporate debt. That insurance took the form of "credit default swaps" against corporate debt.

So if major U.S. corporations like Walmart or Boeing defaulted on their loans, JPMorgan as a lender would lose money, but those losses would be partly offset because JPMorgan's swaps would pay off -- like an insurance policy pays off when something goes wrong.

You can see why regulators wouldn't want to infringe on hedging by banks. But you could also see how a clever bank could use hedging exceptions as a loophole through which to engage in the same profit-seeking proprietary trading the Volcker Rule intends to stop. It looks like that was going on here: JPMorgan had hedged against its hedges, the whole thing got messy, and then imploded.

Rather than justifying the Volcker Rule, JPMorgan's $2 billion loss may actually show why the rule will be ineffective.

In theory, the Volcker Rule is not particularly objectionable, even to conservatives. Banks benefit from government deposit insurance through the Federal Deposit Insurance Corporation, and they have access to cheap capital through the Federal Reserve. The biggest banks also profit from the widespread assumption that the government will bail them out -- an assumption that shows up in the banks' inflated credit ratings and thus lower borrowing costs.

The Volcker Rule, then, can be understood as a condition that the government places on access to such government privileges as the FDIC and the Fed's lending windows. If Uncle Sam is going to back you up, you can't be a gambler. That makes the rule legitimate. But it doesn't make it a good idea.

To see the flaws inherent in the rule, consider the objections from the Left today: Big banks are hijacking the rule-making process, sending their lobbyists to pressure the regulators and tweak the rules. Liberals are correct. This is happening, and it may be destructive. But it's also inevitable.

If you pass a law that primarily affects big banks, who do you think will spend the most time and money trying to influence the final shape of the law? Predictably, big banks and the K Street firms they employ have hired former congressional and federal staffers who had a hand in Dodd-Frank, along with other revolving-door figures friendly with those in power.

Eugene Ludwig, a former bank regulator who donated $35,800 to the Obama Victory Fund last year, has publicly argued for bigger exemptions to the Volcker Rule. His consulting firm, Promontory, has many big financial institutions as clients. Promontory hired a Senate Banking Committee aide who helped write Dodd-Frank in 2010.

JPMorgan's outside lobbyists include Jason Rosenberg, a recent Democratic alumnus of the Senate Banking Committee, and Republican Banking Committee staffers like Thomas Walter, who is also a Republican fundraiser. Susan Brophy, a lobbyist at the Democrat-heavy Glover Park Group, represents JPMorgan, and her husband Gerry McGowan is a $35,800 maxed-out donor to the Obama Victory Fund.

Finally, consider the nature of JPMorgan's $2 billion loss. It comes at no cost to taxpayers, it doesn't endanger the $2 trillion bank and it poses no risk to the broader banking system. Ironically, the loss might do more to curb excessive risk than any regulation could, because it reminds us how fallible these big banks are. If only the Left would learn to put less trust in regulators, too.

Timothy P.Carney, the Examiner's senior political columnist, can be contacted at tcarney@washingtonexaminer.com. His column appears Monday and Thursday, and his stories and blog posts appear on washingtonexaminer.com.

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