Wednesday’s Senate Banking hearing, in which JPMorgan Chase CEO Jamie Dimon sought to explain his company’s recent trading losses, should have served as a teachable moment. First, for Jamie Dimon and other banking execs, who have fought financial reform efforts every step of the way. Their banks would be better served if they spent their time, effort, and energy improving their risk management practices. Second, for policymakers and regulators. They must resist pressures from the banking lobby to water down crucial rules meant to safeguard financial stability.
One lesson learned from the JPMorgan’s trading loss is that we need a strong implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and specifically a strong implementation of the Volcker Rule. The Volcker Rule is a provision in Dodd-Frank that would prohibit bank holding companies, which have access to the federal safety net, from gambling and exposing American taxpayers to loss.
The effectiveness of the Volcker Rule depends largely on what regulators view as legitimate “hedging activity.” Hedging is supposed to decrease risk, in effect offsetting trading positions with one another. However, under the currently proposed regulations to implement the Volcker Rule provision, banks are allowed to hedge within an entire trading portfolio. This means they can disregard specific risks if the portfolio viewed as a whole seems safe. In reality, portfolio hedging allows banks to trade exotic assets that can’t be directly offset. When those exotic trades deteriorate, the bank—and possibly the American taxpayer—loses big.