Does JP Morgan loss show regulators' great failure?

JP Morgan sign Image copyright Getty Images
Image caption JP Morgan has enough equity to absorb the $2bn loss

Regulators could not be happier about JP Morgan's loss of at least $2bn that was generated by its Chief Investment Office.

On the one hand, it didn't sink JP Morgan: the bank has enough equity and is generating sufficient profit to absorb the loss.

On the other hand, the bank's chairman and chief executive, Jamie Dimon, is utterly mortified that he allowed the loss to grow and grow, under his nose, and in spite of warnings in the media that one of the bank's London-based trading desks, home of the famous Whale, was engaging in huge and potentially risky transactions.

So, as one senior international regulator said to me, the debacle should reinforce his and his colleagues attempts to force banks to hold vastly more capital as a protection against losses on banks' trading activities (the Basel Committee's "fundamental review of trading book capital requirements").

In the US, it may also derail attempts by banks to water down the post-crash prohibition on how they trade for their own benefit in the drafting of the detailed rules for the implementation of the so-called Volcker Rule.

"It is all pretty good for us", this regulator said.

Is he right? There is another way of seeing the Morgan mess, which - some would say - reflects poorly on bankers and regulators: it highlights that bankers have been forced by regulators to do almost nothing to eliminate the impenetrable complexity of how they operate.

Morgan's $2bn plus loss has been generated by the way that a series of opaque and complicated transactions were heaped on top of each other, each one intended to offset or hedge the impact of the previous transaction, but whose cumulative impact appears to have been just short of lethal.

These deals appear to have been initiated by JP Morgan's perhaps laudable attempt to protect itself from the impact of a recession in the eurozone: it used derivative contracts whose value would have risen if there was a rise in defaults on loans, which would have mitigated the losses for JP Morgan from defaults on the vast loans it makes to companies in the normal course of business.

Now whether banks really need to insure themselves against possible defaults in that way is moot. The better protections may be the old-fashioned ones: make sure you lend to businesses with a great variety of different characteristics, so that they are very unlikely to all go bust at the same time; and try to know your customers well enough to measure the risks you are taking.

However perhaps it is luddite to rail against all financial innovation. It may make sense for banks to be allowed some degree of financial protection, or insurance, against changing economic conditions.

But how much "protection" can any bank sensibly need?

At the beginning of this year JP Morgan seems to have taken out another series of insurance contracts to heap on top of the first lot.

These ones, called credit default swaps, appear to have had the characteristic of potentially yielding a profit for JP Morgan if the debt of highly rated companies performed significantly better than that of lowly rated companies. So they can be seen as a hedge against the first hedge.

And then there seems to have been a third hedge taken out, described in today's Wall Street Journal as "protection on investment-grade bonds" - which appears to have been protection against the risk that the second hedge went wrong.

Also, according to the WSJ, there was "a related trade...allowing the bank to capture the premium between the cost of default protection ending in 2014 and the cost of protection ending in 2017".

If you have the faintest idea what that means, you will be doing quite a lot better than quite a lot of the individuals who sit on the boards of big international banks and are supposed to keep them on the straight and narrow.

Here is the thing. With three or possibly four huge layers of derivative deals heaped on top of JP Morgan's loans of more than $700bn, it is not surprising that the bank was unable to keep track of the risks it was running.

What is surprising is that a banker of Mr Dimon's reputation and experience allowed this to happen.

One under-reported but highly significant aspect of the whole extraordinary incident is that Mr Dimon announced that he was abandoning a new financial system for monitoring the risks run by the Chief Investment Office and reverting to the old one - because the new model was chronically understating the potential losses the bank could have generated on any given day.

Mr Dimon disclosed that the Chief Investment Office's transactions had the potential to generate losses at any instant of $129m, which is not far off double what the bank had been admitting as the daily "value at risk".

So what is the big issue here?

At JP Morgan itself there will be some nervousness that the Department of Justice and the FBI have opened a preliminary investigation of whether the bank broke any rules.

But as we still count the cost of the 2007-8 banking crisis, there is something much more important at stake - which is whether governments and regulators have made a fundamental error in the way they reacted to that crisis.

The response of the Basel Committee, the Financial Stability Board, the European Commission and the G20 has been to devise ever more complicated and more detailed rules to limit the risks to banks and the wider economy of the byzantine complexity of the way banks manage themselves and the astonishing counter-intuitive complexity of products created by financial innovation.

But if the financial system that evolved over the past 20 years is now so huge, sprawling and opaque as to defy comprehension or reliable risk assessment, maybe a better way would have been to start prohibiting certain activities.

Would it have been so naive and futile to attempt to contain the risks of banking by forcing banks to become simpler, easier-to-understand institutions?