JPMorgan Fiasco Highlights Need For Simpler Banking

Even as details trickle out about how JPMorgan Chase lost several billion dollars on derivatives trades, the essential unknowns continue to outweigh the knowns. This inevitable ignorance is worth keeping in mind as -- let us hope -- regulators focus on the latest fiasco as a teachable moment, and impose rules to protect taxpayers against another system-wide catastrophe.

What happened this time, and how did it happen? You can parse the stories about how the bank's risk-management people were really incentivized to load up on risk, or digest the accounts of how JPMorgan's financial wizards engineered mind-bendingly complex means of limiting their vulnerability to troubles in Europe. But the simplest answer is the most pertinent: It's extraordinarily complicated. So complicated that the trades involved exceed the intellectual bandwidth of would-be regulators, which is another way of saying that taxpayer-ensured deposits should not be allowed in such gambling.

"They can't explain this," said Sheila Bair, the former chairwoman of the FDIC, when I called her last week to get her take. She ran through JPMorgan's evolving explanations for what had gone down -- how the trades were a hedge against securities in its portfolio, then a hedge on loans on its books, or maybe a hedge for its entire banking operation -- and dismissed each as inadequate and troubling. "It makes no sense whatsoever."

Sheila Bair has spent her distinguished career peering into finance and regulating financial institutions. She has held senior posts at the Treasury Department and at the New York Stock Exchange. She held a seat on the Commodity Futures Trading Commission. At the FDIC, she was among the earliest officials to sound a warning about the growing risks of subprime mortgages on banks' balance sheets. If she can't get clear on what happened, how is anyone supposed to?

The opacity around JPMorgan's losses underscores the fundamental problem: Mega-banks are prone to do diabolically complicated things with their money. And their money has a tendency to become our money when they find themselves staring at losses big enough to pose a risk to the broader financial system.

Bair was careful to note that JPMorgan's losses, however serious, do not not appear to be anywhere close to big enough to threaten the solvency of that institution, let alone the soundness of the broader financial system. Still, the fact that these losses appear to stem from gambling inside the bank, using depositor funds that are ultimately ensured by taxpayers, highlights how the same incentives and regulatory gaps that nurtured the financial crisis of 2008 remain with us today.

"It really shows that most of the problems that we saw during the last financial crisis have not been fixed yet," Bair said.

This would be a problem even in a time of easy prosperity, because the murkiness of high finance and the complexity of modern-day investments have made risks hard to discern even for people tasked with looking for trouble. The list of wise men who said not to worry, even as signs emerged in the run-up to the last crisis, is long and distinguished, and includes Alan Greenspan, Hank Paulson and Ben Bernanke. And these are far from days of easy prosperity, not with the eurozone at risk of cracking up, China's mammoth economy slowing and Republicans here at home threatening another tantrum over lifting the debt ceiling.

"The potential sources of shock that now confront the system are greater than we saw in 2008," Bair said. "I don't want to alarm people, but I don't think we have a good sense of what would happen here if there were a large banking failure in Europe. We don't have a handle on what will happen if the eurozone breaks up and there are bank runs."

Bair has been a vocal proponent of squeezing much of the excitement out of modern banking: Banks ought to stick to taking deposits and making loans, while setting dollars aside to cover the possibility that some of those loans will not get paid back. If they want to gamble on things like credit default swaps, they ought not be allowed to do that with deposits ensured by the taxpayer. This seems so sensible that anyone not employed by the financial industry ought to agree. Indeed, this is the spirit of the Volcker Rule, which is supposed to be implemented in July.

But banks like JPMorgan, along with the rest of the financial services lobby, have labored hard and effectively to ensure that the details are so complex that the Volcker rule is essentially unenforceable, with huge exemptions for institutions that assert they are not gambling but rather hedging. Sift through the convoluted, ever-changing justifications offered up by JPMorgan for its multibillion-dollar derivatives bender, and the basic dodge comes down to semantics: We weren't speculating, we were hedging.

These sorts of shenanigans need to end. Simplicity must now trump complexity. In short, if a bank cannot explain in plainest English to an ordinary group of adults what it is doing and how, then that activity ought to be prohibited when the dollars involved are ensured by taxpayers.

The financial lobby has inoculated itself against this sort of common sense by throwing around terms like "innovation": Force us into boring, old-fashioned banking and you deprive the economy of the vigor that comes from creative Wall Street geniuses being allowed to do what they do.

But if that's true, why does Wall Street need a subsidy in the form of taxpayer-ensured deposits?

If JPMorgan wants to place bets on movements in an index that tracks the intensity of moonbeams reaching the sea floor in Tonga, divided by Kobe Bryant's free-throw percentage, so be it. Let markets run free. But it can do so with its own money, minus the corporate welfare that now has taxpayers on the hook for the damage when the losses get big enough to threaten the system.