In light of JP Morgan’s $2 Billion blunder this is a very crucial question we all should be asking ourselves. If a bank can’t even manage its own finances, what makes you think they can manage your finances?
This isn’t the Wild West. This is an institution that takes customer deposits that are explicitly insured by U.S. taxpayers and is suppose to operate conservatively lest it suffers a major “blow up.”
The most important question is what does this enormous trading loss say about JP Morgan’s and other banks’ abilities to manage their own risk? Especially considering the quadrillion dollars worth of derivatives that don’t even show up on their corporate balanced sheets?
This losing trade for all intents and purposes allowed JP Morgan to dramatically increase the size of its lending business without any oversight. It was responsible for eating through a substantial amount of the bank’s capital in a blink of an eye even with JP Morgan’s efforts to try hiding and delaying the losses.
The banks are not going to regulate themselves; this seems incredibly obvious. But investors do have choices. They do not have to be and should not be complacent.
I don’t know all that much about the banking business, but I assume that when a bank drives itself into insolvency, you couldn’t give it away because its liabilities exceed its assets, so who’d want it? At that point, the taxpayers are the only source of capital that can clean up the mess. If this is the case, why shouldn’t the banks be regulated? If they don’t want to be regulated, they should just get out of the banking business. They could go put their own money at risk, and keep the taxpayers out of their casino business. True or not true?
Since U.S. taxpayers are explicitly guaranteeing a large portion of our banks liabilities(i.e. FDIC insured deposits) and implicitly guaranteeing the rest, these are very good reasons for regulating banks like utility companies. The 2008 bank bailouts and all the other implicit guarantees (U.S. taxpayers currently have trillions of dollars at risk due to the 2008 bailouts) have effectively made the largest U.S. banks government-guaranteed enterprises, like Fannie Mae and Freddie Mac. If the government will never allow our largest banks to fail (remember they are “Too big to fail”) due to the problems the public would face, then they cannot be treated like other firms. Systematically receiving bailouts whenever they need one such as in 1982, 1989 and most recently in 2008, arguably makes banks utilities.
We’ve had policies in this country that existed for decades barring commercial banks from engaging in risky investment banking activities. These regulations existed for obvious reasons, but in 1999 these laws were wiped out by the repeal of the Glass-Steagall Act, a law created in 1933 that prohibited commercial banks from engaging in the investment business, and it restored public confidence in banking practices during the Great Depression. In the late 1990′s legislators and bankers argued that the act was not necessary, had become outdated and should be repealed. At the end of that decade Congress passed the Gramm-Leach-Bilely Act of 1999 which repealed the Glass-Steagall Act’s restrictions on bank and securities-firm affiliations removing the very barriers that Glass-Steagall had erected.
The crisis of 2008 happened because of an explosive combination of agency problems, moral hazard, and incompetence – the banks deluding themselves into believing they could manage their risks with flawed methods like Value at Risk(VaR) and predict rare unforeseen events. To prevent irresponsible risk-taking from continuing bankers have to have more “skin in the game.” Currently bankers are compensated with asymmetric bonus arrangements which allow them to have all the upside when things go well and no downside when things turn out poorly. So they have every incentive to take all the risk in the world with customer deposits (i.e. your savings and checking accounts) without any worry about negative consequences. Absolutely nobody should be allowed to have all the upside without sharing in the downside, especially when U.S. taxpayers and the investing public may be harmed.
The compensation methods at these financial institutions are flawed. If you have no economic downside then you should not be allowed to have unlimited upside at the potential expense of taxpayers. If you have unlimited upside then you need to face unlimited downside risk. For instance, when the “stuff” hits the propeller because you misguided your institution, you need to lose the mansions, turn in the expensive cars, and give back the extremely large bonuses. This would seem to be a very basic tenet of capitalism. Likewise, when you engage the services of a “financial advisor” you should make sure that he has downside or “skin in the game” if the investment he recommends you buy loses value. If he does not have this risk in your investment, I would not be investing with him. His economic interest are not aligned with yours.