J.P. Morgan, the largest bank in the United States, stunned Wall Street when it announced Thursday, May 10, 2012 that it had suffered a $2 billion trading loss due to a failed hedging strategy. The fallout from the announcement has intensified the debate regarding the finalization of the Volcker Rule, which is set to take effect in July of 2012. However, some who wish to impose stricter regulations on the financial industry argue for a return of the Glass-Steagall Act, the regulation enacted by Franklin Delano Roosevelt in 1933 to protect Americans’ savings by separating commercial banking from investment banking.
Drop in the bucket
According to Charles Kochakian, J.P. Morgan’s $2 billion loss is merely a drop in the bucket compared to its $608 billion in customer deposits. Even so, news of the loss renewed painful memories of the 2008 financial meltdown. In his May 18, 2012 article for the New Haven Register titled, “JP Morgan has Goldman Sachs look after loss?” Kochakian explained the J.P. Morgan error.
“Specifically, the loss stemmed from a complex deal involving ‘credit default swaps,’ the insurance-like contracts that essentially allow companies to bet on whether a given loan will default,” Kochakian said.
In 2010, Congress passed the Dodd-Frank Act Wall Street Reform and Consumer Protection Act, which provides for the following:
- consumer protections regarding loans and credit
- stronger oversight on companies to prevent a repeat of the situations that brought about the 2008 crisis
- elimination of loopholes and risky practices linked to hedge funds, derivatives, and asset-backed securities
- new tough transparency rules for credit rating agencies
One of the provisions of Dodd-Frank is the Volcker Rule — named after Paul Volcker, the former Federal Reserve chairman who proposed it. The aim of the Volcker Rule is to prevent banks from engaging in speculative private equity trading for their own benefit. The Volcker Rule is set to go into effect on July 21, 2012 with a two-year phase-in, but it is being fought at every turn by leaders in the financial industry.
J.P. Morgan CEO Jamie Dimon has said that the Volcker Rule would not have prevented this loss because it still allows hedging, or the making of one risky investment in order to offset the risk of another investment — just the kind of betting that led to J.P. Morgan’s loss.
Could things get worse?
Things could get worse according to James Bianco. In his May 20, 2012 post for Ritholtz.com titled, “More On J.P. Morgan’s Losses,” Bianco pointed out how the sheer size of J.P. Morgan’s trades could cause the losses to grow.
Referring to stories covering the JPM loss, Bianco said, “So what exactly is being misunderstood in this story? Namely, the positions that J.P. Morgan lost money on are still open and could grow many times over. They are still open because they are so large J.P. Morgan cannot find counter-parties to close them. Instead, the story above writes about these losses as if they are a one-time loss and the positions are already closed.”
Volcker Rule vs. Glass-Steagall
The Volcker Rule is the section of the Dodd-Frank financial reform bill that would place limits on a bank’s ability to use federally insured deposits of its customers to make risky trades. In the aftermath of the 2008 financial meltdown, such legislation would seem to make a lot of sense. However, it is being fought at every turn by the banking and financial industry to the point where there is doubt that it will be completed by its July deadline. Leaders in the industry argue that regulations such as the Volcker Rule stifle growth, free enterprise and job creation.
Enacted in 1933, The Glass-Steagall Act forced financial institutions to choose between engaging in commercial banking or investment banking. The Act was repealed in 1999 by President Clinton, thus removing the wall between commercial services (deposit accounts) and making financial bets that could result in large losses and taxpayer-funded bailouts. The Volcker Rule is meant to be a return to banking regulation, but some say that it won’t be enough. What’s more, it won’t go into full effect until 2014.
In his May 17, 2012 post for NextNewDeal.net titled, “J.P. Morgan Will Keep Gambling with ‘Other People’s Money’ Without a New Glass-Steagall,” Senior Fellow and Hyde Park Resident Historian for the Roosevelt Institute, David Woolner reviewed the origins of Glass-Steagall and explained why its restoration is called for.
“Contrary to what free market fundamentalists have been telling us again and again this campaign season, the basic banking and financial structure that was put in place in the early years of the Roosevelt administration was not put in place to strangle the free market,” Woolner said.“It was put in place to protect the free market — and it did so with great aplomb for over half a century.”
There are many similarities between the underlying causes of the crash of 1929 and the 2008 financial meltdown. Glass-Steagall helped the nation recover then, perhaps its reinstatement can help us now.