- The Washington Times - Sunday, May 20, 2012

J.P. Morgan’s announcement of a spectacular trading loss of $2 billion last week gives fuel to regulators who are inclined to slim down or at least stop the growth of such “too-big-to-fail” megabanks in the future, banking analysts say.

As the nation’s largest bank with a breathtaking $2.3 trillion in assets, J.P. Morgan rivals the U.S. government in size and is bigger and more influential in the global economy and financial markets than most nations.

The $2 billion loss that shocked Washington and Wall Street was just small change for the New York goliath, which the Federal Reserve deemed to be the only megabank that was strong enough to have survived the 2008 financial crisis without a bailout. J.P. Morgan even took advantage of the crippling of its rivals to acquire Bear Stearns at a bargain-basement price in a move that helped make it the giant it is today.

The complex and highly leveraged transactions on which J.P. Morgan lost money involved the kind of arcane derivative securities that the bank invented, sells and distributes around the world in the so-called “shadow” financial markets that blew up during the 2008 crisis.

The wrong turn taken by J.P. Morgan’s traders in London last quarter escaped detection not only by the bank’s regulators at the Fed, but also by its own vaunted chief executive officer, Jamie Dimon, whose brilliance and command of the mind-numbing details of finance had brought him widespread respect and deference as the main defender of the megabanks in recent years.

Because J.P. Morgan was viewed as the best, brightest and most infallible of the big banks, “we think the bigger impact of the news will be on the debate over ‘too big to fail,’ ” rather than whether the megabank was violating any particular rules or regulations, said Brian Gardner, analyst at Keefe, Bruyette & Woods.

Regulators have begun investigations into the incident and are empowered under the 2010 financial-reform law to prohibit risky trading as well as limit the banks’ leverage and acquisitions in the future, if they deem that to be justified, he said.

The J.P. Morgan incident may provide them with the “political will to act” to cut down the size of such banks, he said.

“The argument will be, some transactions are too complex for even the best bank management teams; therefore, we the regulators need to limit the size and complexity of the biggest banks,” he said.

The bank’s announcement prompted lawmakers who favor breaking up the big banks to reintroduce legislation this week mandating limits on their size and concentration.

While that legislation is not likely to pass in the heavily divided Congress, where most Republicans want to roll back the financial-reform law, today’s significantly empowered regulators may not need any new tools to accomplish the same kind of downsizing, Mr. Gardner said.

Liberal groups are calling for action by both Congress and the regulators.

“When banks are so big they assume government will bail them out, their excesses can be catastrophes,” said Robert Borosage, co-director of Campaign for America’s Future. “It’s time for the government to place sensible limits on the big banks.”

Some conservatives have also advocated downsizing the big banks. Thomas Hoenig, the influential former president of the Fed’s St. Louis reserve bank, is an “outspoken critic of ‘too big to fail,’ ” and he recently was appointed to the board of the Federal Deposit Insurance Corp., which is responsible for seizing and dismantling failing banks.

Mr. Borosage noted that the six largest Wall Street banks today control assets equal to 64 percent of annual U.S. economic output and remain so large that their collapse has as much potential to bring down the U.S. economy and financial markets as in 2008.

Regulators are on alert as a result of the incident. Investigations have been launched by the Fed, the Securities and Exchange Commission and the Justice Department to determine what happened and whether any wrongdoing was involved.

President Obama also used his weekly address to say the J.P. Morgan loss wouldn’t have occurred if all the rules governing risky trading, enacted in 2010, were in place today.

But Mr. Dimon insists that the bank’s activities were within legal bounds, though he admitted to shareholders that the bank made “egregious” errors and misguided investments.

“This is an important event,” former chief White House economic adviser Lawrence H. Summers told Reuters television. “It reminds us that even very well managed institutions with very sophisticated systems can make very large mistakes.”

Mr. Summers, who was instrumental first in deregulating banks during the 1990s and then in passing the regulatory-reform bill in 2010, said regulators will not be able to prevent such spectacular mistakes in the future, so they must try somehow to make the system resilient enough to withstand them.

“Significant errors will be made at almost all institutions at one time or another,” he said. “In light of what has happened, one would tend to have a bias towards larger safety buffers, larger capital requirements, and larger levels of liquidity” at the biggest banks.

While regulators are planning more such restrictions on the big banks, others openly advocate downsizing them as the best way of ensuring they can’t drag down the economy if they fail again. Besides Mr. Hoenig, officials at the Fed’s Dallas reserve bank also are arguing in favor of breaking up the big banks or at least reducing their size, Mr. Gardner said.

Some bank analysts say regulators and the press are overreacting to the incident.

“What’s the fuss?” asked Richard Christopher Whalen, who noted that J.P. Morgan’s trading loss was dwarfed by the bank’s $25 billion in annual profits and even larger revenues and assets.

“What J.P. Morgan was doing is precisely how the bank makes more than half of its annual profit,” he said. “The creation, trading and arbitrage of risk exposures is a big business for JPM and one that the bank has done well.”

The fact is, the federal government needs banks as big as J.P. Morgan to buy and resell the U.S. Treasury’s enormous debts — the result of budget deficits of more than $1 trillion in recent years — and help the Fed manage its gigantic balance sheet with assets totaling more than $5 trillion, Mr. Whalen said.

“The vast expansion of the U.S. money supply over the past three decades makes such financial alchemy necessary,” he said. “The Fed keeps these zombies alive in order to preserve the Treasury’s ability to issue debt. In that sense, nothing has changed in Washington since Abraham Lincoln created national banks to finance the Civil War.”

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