JP Morgan: A Case For More Regulations or Capitalism at Work?

The $3 billion losses reported by JP Morgan have reignited debate over the government’s role in the financial industry. President Obama, along with most that lean left, urged that the JP Morgan fiasco demonstrates a need for more regulatory oversight, whereas likely Republican candidate Mitt Romney took, as expected, the other approach.  Romney cautioned law makers to not rush to the regulatory drawing board, expressing that JP Morgan’s losses were simply capitalism at work.  So, does the financial industry need more or less regulator oversight?

The Obama administration has taken the “more” approach with its signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act (herein Dodd-Frank) on July 21, 2010.  The aim of the legislation is to “promote the financial stability of the United States by improving accountability and transparency in the financial system.”  The bill requires regulators to create 243 new rules, conduct 67 studies, and issue 22 periodic reports.  With this massive regulatory overhaul of the financial system, how did the JP Morgan incident still happen?  Some argue that the Volcker Rule, which takes effect on July 21 of this year, would have prevented the risky trading, thus evidence that the regulatory action is beneficial.  Although this counterfactual argument sounds enticing, it inaccurately encompasses the JP Morgan situation.  Actually, if the Volcker Rule had already been implemented it would not have prevented the losses.

The Volcker Rule is intended to restrict banks from making certain kinds of speculative investments that do not benefit their customers, but benefit the banks rather.  This rule, similar to the Glass-Steagall Act of 1933, is regarded as a ban on proprietary trading by commercial banks.  The rule seeks to ban proprietary trading because it is speculative in nature and only benefits the bank.  JP Morgan, however, was hedging which the Volcker Rule does not speak too and which is a commonly used strategy.  More importantly, proponents of the Volcker Rule are missing a crucial point regarding this attempt at regulation: proprietary trading and hedging are vastly similar, which makes the rule nearly unworkable. 

Although proponents of regulatory oversight use the JP Morgan situation as an example for additional regulations, opponents view it quite differently.  Banking is a very risky business, one with promise of great returns, but also realities of large losses.  Although the isolated number of $3 billion in losses sounds catastrophic, the reality of the loss is minimal on the bank’s balancing sheet. Furthermore, the losses cost taxpayers nothing, rather the loss only impacted investors who invested in the risky business of trading where losses are natural.  As Romney stated, “the leadership of that company will be held accountable for this trading loss, but we don’t want to punish companies. There was no taxpayer money at risk. All of the losses went to investors, which is how it works in a public market.”  JP Morgan made a play and lost. That is the nature of the business.  It’s unrealistic to think that more regulations will create an environment where businesses will not see losses.  An issue with trading should arise when banks are making speculative trades with taxpayer’s money.  That was not the case, however, so proponents of Dodd-Frank and the Volcker Rule should use the JP Morgan incident with caution.