Fundamentally this is all about the inevitability of human nature.
Lenders must not be allowed to speculate while those who speculate need
to be constrained in terms of size by lenders and regulators.
That was put into regulation after the 1929 collapse and abandoned
only in 1998 under Clinton. Unsurprisingly inside a mere decade, we
truly revisited 1929 in full and have had to print money like crazy
to avoid a full press deflation.
The US economy remains unrepaired while the several too big to fail
continue to destroy capital and are certainly in no creditable
position to internally grow unless they accept larger and riskier
bets. They all need to be broken up into units that can be allowed
to fail.
Remember the USSR was too big to fail.
JP Morgan Debacle
Reveals Fatal Flaw In Federal Reserve Thinking
Author: Simon Johnson
May 11th, 2012
http://www.economonitor.com/blog/2012/05/jp-morgan-debacle-reveals-fatal-flaw-in-federal-reserve-thinking/
Experienced Wall
Street executives and traders concede, in private, that Bank of
America is not well run and that Citigroup has long been a recipe for
disaster. But they always insist that attempts to re-regulate
Wall Street are misguided because risk-management has become more
sophisticated – everyone, in this view, has become more like Jamie
Dimon, head of JP Morgan Chase, with his legendary attention to
detail and concern about quantifying the downside.
In the light of JP
Morgan’s stunning losses on derivatives, announced yesterday but
with the full scope of total potential losses still not yet clear
(and not yet determined), Jamie Dimon and his company do not look
like any kind of appealing role model. But the real losers in
this turn of events are the Board of Governors of the Federal Reserve
System and the New York Fed, whose approach to bank capital is now
demonstrated to be deeply flawed.
JP Morgan claimed to
have great risk management systems – and these are widely regarded
as the best on Wall Street. But what does the “best on Wall
Street” mean when bank executives and key employees have an
incentive to make and misrepresent big bets – they are compensated
based on return on equity, unadjusted for risk? Bank executives
get the upside and the downside falls on everyone else – this is
what it means to be “too big to fail” in modern America.
The Federal Reserve
knows this, of course – it is stuffed full of smart people.
Its leadership, including Chairman Ben Bernanke, Dan Tarullo (lead
governor for overseeing bank capital rules), and Bill Dudley
(president of the New York Fed) are all well aware that bankers want
to reduce equity levels and run a more highly leveraged business
(i.e., more debt relative to equity). To prevent this from
occurring in an egregious manner, the Fed now runs regular “stress
tests” to assess how much banks could lose – and therefore how
much of a buffer they need in the form of shareholder equity.
In the spring, JP
Morgan passed the latest Fed stress tests with flying
colors. The Fed agreed to let JP Morgan increase its dividend
and buy back shares (both of which reduce the value of shareholder
equity on the books of the bank). Jamie Dimon received an
official seal of approval. (Amazingly, Mr. Dimon indicated in
his conference call on Thursday that the buybacks will continue;
surely the Fed will step in to prevent this until the relevant losses
have been capped.)
There was no hint in
the stress tests that JP Morgan could be facing these kinds of
potential losses. We still do not know the exact source of this
disaster, but it appears to involve credit derivatives – and some
reports point directly to credit default swaps (i.e., a form of
insurance policy sold against losses in various kinds of debt.)
Presumably there are problems with illiquid securities for which
prices have fallen due to recent pressures in some markets and the
general “risk-off” attitude – meaning that many investors
prefer to reduce leverage and avoid high-yield/high-risk assets.
But global stress
levels are not particularly high at present – certainly not
compared to what they will be if the euro situation continues to
spiral out of control. We are not at the end of a big global
credit boom – we are still trying to recover from the last
calamity. For JP Morgan to have incurred such losses at such a
relatively mild part of the credit cycle is simply stunning.
The lessons from JP
Morgan’s losses are simple. Such banks have become too large
and complex for management to control what is going on. The
breakdown in internal governance is profound. The breakdown in
external corporate governance is also complete — in any other
industry, when faced with large losses incurred in such a haphazard
way and under his direct personal supervision, the CEO would resign.
No doubt Jamie Dimon will remain in place.
And the regulators
also have no idea about what is going on. Attempts to oversee
these banks in a sophisticated and nuanced way are not working.
The SAFE Banking Act,
re-introduced by Senator Sherrod Brown on Wednesday, exactly hits the
nail on the head. The discussion he instigated at the Senate
Banking Committee hearing on Wednesday can only be described as
prescient. Thought leaders such as Sheila Bair, Richard Fisher,
and Tom Hoenig have been right all along about “too big to fail”
banks (see my piece from the NYT.com on Thursday on SAFE
and the growing consensus behind it).
The Financial Services
Roundtable, in contrast, is spouting nonsense – they can
only feel deeply embarrassed today. Continued opposition to the
Volcker Rule invites ridicule. It is immaterial whether or not
this particular set of trades by JP Morgan is classified as
“proprietary”; all megabanks should be presumed incapable of
managing their risks appropriately.
Dennis Kelleher and
Better Markets are right about the broad need for implementing
Dodd-Frank and they are particularly right about the problems that
surround non-transparent derivatives (follow them @bettermarkets for
some of the smartest lines and best links as the JP Morgan debacle
continues to develop). The Better Marketspress release on
Thursday night put the entire situation in a nutshell:
“Jamie Dimon and JP
Morgan Chase just proved what anyone not getting a paycheck from a
Wall Street bank already knows: gigantic too-big-to-fail banks are
too-big-to-manage.”
Anat Admati and her
colleagues at Stanford (and her growing band of supporters in the US
and around the world) are right about bank capital. The people
in charge of Federal Reserve policy in this regard are dead wrong –
perhaps because they spend far too much time talking to Jamie Dimon
and his fellow executives, while consistently refusing to engage with
their better informed critics.
Ms. Admati skewered
Jamie Dimon at length and in detail 18 months ago on exactly these
issues. You must read her original Huffington Post piece.
She has been relentless ever since – see this material.
She was right then and she is right now: we need much higher capital
requirements and much simpler rules – focus on limiting leverage.
Big banks should be forced to become smaller – small enough and
simple enough to fail.
It is time for the
Federal Reserve to move its policy on these issues.
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