In the wake of J.P. Morgan’s epic speculatory fail a whole lot of commentators are talking about regulation. And yes — this was speculation — if Dimon gets to call these activities “hedging portfolio risk“, then I have the right to go to Vegas, play the Martingale roulette system, and happily call it “hedging portfolio risk” too, because hey — the Martingale system always wins in theory.
The Volcker rule, part of the Dodd-Frank financial reform law, was inspired by former Federal Reserve Chairman Paul Volcker. It’s supposed to stop federally insured banks from making speculative bets for their own profit — leaving taxpayers to bail them out when things go wrong.
As we have said, banks have both explicit and implicit federal guarantees, so the market doesn’t impose the same discipline on them as, say, hedge funds. For this reason, the Volcker rule should be as airtight as possible.
Proponents of regulation point to the period of relative financial stability between the enactment of Glass-Steagall and its repeal. But let’s not confuse Glass-Steagall with what’s on the table today. It’s a totally different ball game.
To be honest, I think the Volcker rule is extremely unlikely to be effective, mostly because megabanks can bullshit their way around the definitional divide between proprietary trading and hedging. If anything, I think the last few days have proven the ineffectiveness, as opposed to the necessity of the Volcker rule. Definitions are fuzzy enough for this to continue. And whatever is put in place will be loopholed through by teams of Ivy League lawyers. What is the difference between hedging and speculation, for example? In my mind it’s very clear — hedging is betting to counterbalance specific and explicit risks, for example buying puts on a held equity. In the mind of Jamie Dimon, hedging is a fuzzy form of speculative betting to guard against more general externalities. I know that I am technically right, and Dimon is technically wrong, but I am also fairly certain that Dimon and his ilk can bend regulators into accepting his definition.
What we really need is a system that enforced the Volcker principle:
As Matt Yglesias notes:
Once bank lawyers finish finding loopholes in the detailed provisions, whatever they prove to be, the rule will probably have little meaningful impact.
The problem with principles-based regulation in this context is that you might fear that banks will use their political influence to get regulators to engage in a lot of forebearance. The problem with rules-based regulation in this context is that it’s really hard to turn a principle into a rule.
And I fear that nothing short of a return to Glass-Steagall — the explicit and categorical separation of investment and retail banking — will even come close to enforcing the Volcker principle.
Going even further, I am not even sure that Glass-Steagall will assure an end to this kind of hyper-risky activities that lead to crashes and bailouts.
The benefits of the Glass-Steagall era (particularly the high-growth 1950s and 1960s) were not solely derived from banking regulation. America was a very different place. There was a gold exchange standard that limited credit creation beyond the economy’s productive capacity (which as a Bank of England study recently found is correlated with financial and banking stability). But beyond that, America was creditor to the world, and an industrial powerhouse. And I’m sure Paul Krugman would hastily point out that tax revenues on the richest were as high as 90% (although it must be noted that this made no difference whatever for tax revenues). And we should not forget that it was that world that give birth to this one.
Anyone who worked in finance in the decade before Glass-Steagall was repealed knows that prior to Gramm-Leach-Bliley the megabanks just took their hyper-leveraged activities offshore (primarily to London where no such regulations existed). The big problem (at least in my mind) with Glass-Steagall is that it didn’t prevent the financial-industrial complex from gaining the power to loophole and lobby Glass-Steagall out of existence, and incorporate a new regime of hyper-leverage, convoluted shadow banking intermediation, and a multi-quadrillion-dollar derivatives web (and more importantly a taxpayer-funded safety net for when it all goes wrong: heads I win, tails you lose).
I fear that the only answer to the dastardly combination of hyper-risk and huge bailouts is to let the junkies eat dirt the next time the system comes crashing down. You can’t keep bailing out hyper-fragile systems and expect them to just fix themselves. The answer to stupidity is not the moral hazard of bailouts, it is the educational lesson of failure. You screw up, you take more care next time. If you’re bailed out, you just don’t care. Corzine affirms it; Iksil affrims it; Adoboli affirms it. And there will be more names. Which chump is next? If you’re trading for a TBTF bank right now — especially if your trading pattern involves making large bets for small profits (picking up nickels in front of steamrollers) — it could be you.
I fear that the only effective regulation was that advocated way back before Gramm-Leach-Blilely by Warren G and Nate Dogg:
We regulate any stealing off this property. And we’re damn good too. But you can’t be any geek off [Wall] street, gotta be handy with the steel, if you know what I mean, earn your keep.
In other words, the next time the fragilista algos and arbitrageurs come clawing to the taxpayer looking for a bailout, the taxpayer must kick them off the teat.