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Repeal Volcker, It Wouldn’t Have Saved the Whale

The $2 billion loss at JPMorgan Chase (JPM) has reopened debate on the Volcker rule. The proponents of the rule have seized on the story as proof that the Volcker rule is necessary and should be quickly put into effect by regulation. In reality, however, if the facts are as thus far reported, what happened at JPMorgan is proof that the Volcker rule is unworkable and should be repealed.

According to JPMorgan Chase CEO Jamie Dimon, his bank suffered the losses while pursuing a hedging strategy. If so, the losses would not have been prevented by the Volcker rule, which specifically permits hedging. Senators Levin and Merkley have argued that while hedging is permitted, hedging a whole portfolio — as JPMorgan apparently attempted to do — is not allowed. This is incorrect. The Volcker rule specifically permits hedging "aggregated positions" which would include efforts to hedge a portfolio. Since hedging is the main way that banks and others limit their risks, limiting its use would be extremely bad policy.

The problem is that, operationally, hedging is virtually indistinguishable from proprietary trading (also occasionally labeled "speculation") which is specifically prohibited by the Volcker rule. Whether a trade or a series of trades is a hedging transaction — an effort to reduce risk that the bank has already taken on — or a proprietary trade, a new risk that the bank is putting on its books, can only be determined by a full understanding of the bank's risk position. That is the fundamental flaw in the Volcker rule, and why the regulators who are now struggling with drafting the implementing regulation for the rule are having such difficulty. Instead of this continuing effort to square the circle, the regulators should tell Congress it can't be done; the Volcker rule should be repealed.

This does not mean that Congress's desire to curb proprietary trading should necessarily be abandoned. If the answer to the hedging/proprietary trading question cannot be determined except by knowing all the circumstances surrounding a trade, including the intentions of the trader when the trade was put on, it is not suitable for a written regulation. Instead, the same objective can be sought through a subsequent supervisory action — a review of the bank's actions by a bank supervisor to determine the facts after the event — which may then result in a penalty if the bank has failed to comply with the distinction between speculation and hedging.

The danger of the Volcker rule, embodied in a regulation, is that its attempt to draw fine distinctions between proprietary trading and hedging may prevent banks from engaging in the hedging or market-making that the Dodd-Frank Act and the Volcker rule specifically permits. The draft rule was almost 300 pages, and contained more than 300 questions that the drafters asked in order to avoid unintended consequences. This suggests the difficulty of imposing such a rule on an operating firm. It is not possible to run a real time trading operation with a lawyer or Fed examiner sitting at your elbow.

A $2 billion loss is a big number, to be sure, but a lot of the expressions of horror by commentators are wildly out of proportion to the problem. $2 billion is 1/1000th of the size of JPMorgan, and only .5 percent of the portfolio the bank was attempting to protect. It is logical that very large banks will suffer large absolute losses in attempting to protect large asset portfolios. The departure of the official in charge of the hedging program now suggests that the hedge was not fully thought through and the employee responsible, and perhaps others, must be held accountable.

What is unfortunate about the debate over the Volcker rule thus far is the sense from many of the participants that banks — because they take insured deposits — shouldn't be taking risks. Occasionally this is said to be the very underpinning of the Volcker rule. This position reminds me of the motto of Bob's Bank in the famous town of Lake Wobegone: "Neither a borrower nor a lender be." It fails to understand that banking — in transforming short term liabilities into long term assets — is an inherently risky business. Lending is risky and a portfolio of loans or fixed income securities is constantly at risk from changing economic and financial circumstances. If Congress wants banks to make loans, it must also permit banks to mitigate the risks that lending entails.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He was a general counsel of the U.S. Treasury Department and served as White House counsel to President Ronald Reagan.


(8) Comments



Comments (8)
What is the difference between Investment Banking and gambling? The signage on the building is brighter and more flamboyant. As an industry, we can legitimately argue the merits of regulation, but what we seem to have trouble reconciling is this notion that a FDIC insured Bank has the right to make bets without oversight. All of this could be avoided if there were transparency and discernible rules to govern the practice. We are not there yet. Instead of looking to the government to police the industry, how about old fashioned self policing. In my view capitalism works, when there are will defined rules of the road.
Posted by smrice | Wednesday, May 23 2012 at 1:55PM ET
Reinstate Glass-Steagall. Investment bankers should be free to take as much risk as their shareholders or investors allow. But merchant banks holding FDIC insured deposits, should not.
Posted by ricpfi | Thursday, May 17 2012 at 10:27AM ET
Clearly some education is needed and the incessant cheer-leading for prop trading does make a buy side investor wonder how some talking heads get paid. Tacit lobbyist for the banks, or just someone who fails to understand traded risk, markets, and products? Bascially, "delete" is the key I will start reaching for....

While trading books are funded by repo markets, in a systemic crisis - which this was NOT - JPM's risky trading bets are indeed backstopped by the US taxpayer. The question should be decoupled from FDIC insurance and should be about systemic risk and contagion. Your comments on Kudlow were almost funny in their error.

You are NOT hedging when you are SELLING insurance. You are collecting premium. Can you - Peter - explain how short-selling optionality is "hedging"? If the whale was attempting to "square a book" for hedging purposes, where is the offsetting gain? This was CLEARLY a prop trade and was conducted in London in order to create legal distance from the Volcker Rule. While the Volcker Rule may be unworkable, Glass-Steagall is not unworkable.

The loss of $2 billion is inconsequential from a JPM safety and soundness perspective. At $200 billion in capital, it hurts but is a blip. This is only about 40% of quarterly earnings. What I would hate to find out is that these really are premium collection trades and poor hedge offsets. The hedge being poor seems clear, else there would've been an offset gain.

These appear to be short positions without a cap on losses unless they can disclose how they "reinsured" the loss past a threshold of $x. Like selling a put and buying one back deep out of the money.

Given what has happened in France, Spain and Greece the last few days, and Draghi's comments today, I sure hope JPM risk management and the examiners are asking the right questions. Would think that some transparency could help minimize some concern too (i.e., that the risk is capped/stopped out). All evidence suggests that JPM was selling protection. We will find out. If so, these deals are STILL ON THE BOOKS and if Greece has more trouble on June 15th, and Spain bond yields keep marching the wrong way and go above the magic 7%, Katie bar the door......the losses could be far more than $2 billion and become a REAL issue for JPM.

I would really like to know the counterparties to the whale trades and the ISDA collateral annex requirements, and how this relates to the bank and the BHC's available unencumbered liquidity pool.

The most fundamental question should be: should we revert back to a pre-GLBA world? As long as the BHC/FHCs are going to be bailed out in a systemic stress, the answer should be a clear "yes". Revisit the Brown-Kaufman Amendment, make it far more punitive.
Posted by Stentor | Thursday, May 17 2012 at 12:52AM ET
It is absolutely stupifying that the investment bankers would continue to argue the legitimacy of gambling on such a staggering scale--as a de facto public utility. If the Folker Rule was not farr-reaching enough, the Glass-Steagel needs to be re-enacted--period. The investment bankers 1st persuaded everyone that did not need Glass-Steagel--------Folker enough--then when they still get burned gambling--they asset it was sort-of hedging and Folker would not have prevented it so no need for Folker. This is disenguous to say the least--lousey PR. All I can Say really is : God help them all --including the lobbyists if the system goes down due to their misrepresentations. There will be nowhere in the world where they will be able to hide from crimes against humanity on such a scale.
Posted by OLDER&WISER | Wednesday, May 16 2012 at 4:39PM ET
How about telling politicians to pass a budget, something they haven't done for 3 years, instead of clucking and fluttering about a loss that merely reduced profitability of one part of JPM. There is not risk to "the system" here; the regulators have no grounds for intervening. JPM's shareholders suffered. People lost their jobs for screwing up (and/or making their boss look bad). Capitalism worked. What the politicians and regulators are advocating is un-necessary and un-American and the entire business community should tell them just that. Kill the Volcker rule, and while we're at it, kill the rest of DF as well.
Posted by micha | Wednesday, May 16 2012 at 4:01PM ET
Banks are risky and the Volkerrulewill never accurately define thedistinction between hedging and speculation and hedging. More capital is the only answer.
Posted by kvillani | Wednesday, May 16 2012 at 3:57PM ET
Do away with the Volcker Rule, but seperate the FDIC insured business from the trading and investment bank. Then they can use their equity on risks they choose, not risks the DIF or taxpayers back.

Tom Frost has a great op ed in WSJ today which states the case very well.
Posted by jimsturgeon | Wednesday, May 16 2012 at 3:53PM ET
Finally, some common sense! Thank you.

May I add that if the "hedge" was ill-conceived in relation to the bank's portfolio, then the activitiy also constituted an unsafe and unsound banking practice. Bank regulators already have all the tools they need to deal with unsafe and unsound practices.
Posted by GMahler | Wednesday, May 16 2012 at 1:27PM ET
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