- - Friday, May 11, 2012

J.P. Morgan’s $2 billion loss from betting on corporate bonds will embolden advocates of the Volcker Rule - a provision of the 2010 Dodd-Frank law that will prohibit banks from trading on their own account. Unfortunately for federal regulators, trading in securities is essential to modern banking, and busting up the big Wall Street financial houses may be the only way to better ensure financial stability.

The Glass-Steagall Act of 1933 separated commercial banking - taking deposits and making loans to finance businesses, homes and the like - from investment banking - selling stocks, bonds and other securities and making markets for investors to buy and sell those assets quickly. That separation was repealed during the final years of the Clinton administration, and Wall Street institutions including J.P. Morgan perform both roles.

Modern commercial banking simply won’t tolerate an absolute separation because banks cannot finance all the demand for loans from deposits. In recent decades, too many savers have found they can earn higher returns than at the bank by investing in money-market funds and bond funds and buying bonds directly.

Consequently, banks make loans, issue credit cards and the like, and bundle borrowers’ promises to pay into securities and sell those to bond investors. Fannie Mae and other government-backed housing banks don’t take deposits and get virtually all their financing selling mortgage-backed securities.

Also, regional banks can buy securities backed by the loans of banks in other regions to mitigate the risks inherent in serving a local economy. Kansas banks are just too dependent on the price of corn and do well to hold some debt whose repayment depends on the vitality of other regions and industries.

Of the many activities performed by large investment banks - essentially, the big financial houses on Wall Street, such as J.P. Morgan - making markets for securities so investors can buy and sell when they like is most essential for making the U.S. and broader global economies work.

Without assurance that bonds can be sold when liquidity is needed, many investors simply would not buy mortgage-backed securities or would demand much higher interest rates, making the cost ordinary folks pay on home mortgages prohibitively high. The same reasoning applies to the availability and cost of business, auto loans and credit card debt that create jobs.

Investment banks must buy and sell securities with their own capital - “on their own account” - to ensure liquidity and hedge - to insure their positions against losses. The Volcker Rule would permit these activities but ban simple gambling - the latter is what cost J.P. Morgan at least $2 billion in recent weeks.

The basic problem is that regulators have been working for the past two years to define the difference between hedging and gambling, and they can’t. Either the rules would be too severe and shut down banking, or they would permit reckless risk-taking that could take down a huge bank and potentially put the taxpayer on the hook to pay off depositors through the Federal Deposit Insurance Corp. (FDIC).

Commercial banks are essential to the smooth function of a market economy - capitalism runs on credit much as air conditioning runs on electricity - and without stable commercial banks, the economy can’t grow.

The simplest solution is to once again separate commercial and investment banking, as was required by the Glass Steagall Act, with some modest exceptions.

Let banks take deposits and make loans, and sell those to investors through investment banks, which would do the bundling of loans into securities. Even let commercial banks own securities backed by loans in other regions to balance default risk, but leave the business of making markets and trading to separate investment banks.

Commercial banks would continue to be regulated and government-insured by the FDIC, and investment banks would be free to trade and take risks with their stockholders’ capital. If the latter failed from foolish trades, their investors would lose their capital, but the taxpayer would not be on the hook.

Peter Morici is an economist and professor at the Smith School of Business at the University of Maryland.

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