Cross-posted from the New York Times Room for Debate…
Preventing blow-ups like the JPMorgan “hedge” that bears no resemblance to any known hedge isn’t difficult. What makes preventing it difficult is that banks that exist only by virtue of state-granted charters — and more recently, huge transfers from the public — have persuaded public officials and regulators that they have a God-granted right not just to high levels of profit but also high levels of employee and executive compensation.
Banks enjoy state support because they provide essential services, like a payments system and a repository for deposits. One proposal to limit them to these vital services is “narrow banking,” or requiring that deposits be invested in only safe and liquid instruments. This idea was put forward by Irving Fisher and Henry Simons in the 1930s, and has been championed by the right (Milton Friedman), the left (James Tobin) and banking experts (Lowell Bryan of McKinsey).
A less radical idea would be to eliminate credit default swaps over time (they are too embedded in current practice to ban them; banks need to be weaned off them). There are no socially valuable uses for the product. Contrary to defenders’ claims, they aren’t a good way to short bonds (not only does it deal with only one attribute of bond risk, it does so badly: payouts in actual credit events on credit default swaps vary considerably, and are generally less than payouts to holders of real bonds). These swaps were the driver of the crisis. They were the mechanism that allowed real economy exposures to risky subprime bonds to be multiplied well beyond the number of actual borrowers and thus cause vastly more damage.
Another route would be to implement the Volcker Rule as Paul Volcker envisaged, meaning without the portfolio hedging exemption that JPMorgan relied on. Or officials could enforce Sarbanes Oxley, which has the chief executive officer certify the adequacy of internal controls, which for a major financial firm includes risk controls. Had any chief executives been targeted for Sarbanes Oxley violations for the massive risk management failures during the financial crisis, it’s pretty likely thatJamie Dimon, head of JPMorgan, would have thought twice before giving the chief investment officer both the mandate and the rope to enter into risky trades.
Maybe it’s time to recognize that these firms are too big and in too many complex businesses to be managed. Jamie Dimon was touted as a star who could supervise a sprawling firm running huge risks, and he fell short because no one can do the job adequately. A less disaster-prone financial system requires more simplicity and redundancy. Re-instituting Glass-Steagall or other variants on the narrow banking theme isn’t a full solution, but it would make for a good start.
Update by Yves: I’m not happy with the headline the Times put on this piece. The article did not say implementing Glass Steagall would have stopped Dimon’s losses but was an example of the sort of step that could help make the financial system less crash prone.